Grantor Retained Annuity Trust (GRAT)
Grantor retained annuity trusts (GRATs) are estate planning tools that can shift the appreciation (post-gift) of assets to beneficiaries tax-free
Strategy Overview
A Grantor Retained Annuity Trust (GRAT) is an estate planning strategy designed to allow the appreciation of assets (post GRAT formation) to pass to the beneficiary free of gift or estate taxes. When setup correctly, GRATs can create a "heads I win, tails we tie" scenario, making them an attractive, and relatively common, estate planning tool.
Tax Details
A GRAT is a trust whose typical purpose is to allow wealthy individuals to shift a greater portion of their assets to beneficiaries free of gift (including the lifetime federal gift) and estate tax. They work primary as follows:
An individual sets up an irrevocable GRAT trust and transfers assets into it
The GRAT specifies that the individual who funded the GRAT will receive back an annuity payment (at least annually) over a specified number of years.
Via the annuity payments, the initial funded amount plus some interest is returned back to the grantor
The remaining balance (if any) is passed on to the beneficiary, free of gift or estate tax
The most popular kind of GRAT is a "zeroed-out GRAT". It is setup so that the total of all annuity payments will sum to the original value of assets contributed to the GRAT plus an annual rate of interest (via IRS Section 7520). It's popular because this typically results in no federal gift tax or use of the lifetime state tax/gift exemption.
Key Aspects to Know Regarding GRATs
Heads I win; tails we tie. A GRAT strategy works when the appreciation of the assets in the GRAT exceed the IRS specified interest rate (i.e. assets remain after the required annuity payments are made, which are passed tax-free). If the asset fails to generate returns above the IRS specified rate, the GRAT is considered a "failed" GRAT -> but this just means that the funding individual does not receive back the full annuity amounts and the beneficiary does not get/receive any funds.
Annuity payments can be made in kind (very common for tech workers/private companies). Annuity payments can be made in cash, or also in-kind (i.e. via shares). The in-kind method is most commonly utilized when a GRAT is funded with private company stock.
GRATs should be funded with assets anticipated to appreciate significantly over time. Any asset can be used to fund a GRAT, but assets with high appreciation rates are usually the most preferred. For tech workers, pre-IPO equity can be an ideal asset to utilize due to the valuation differences between the 409a and VC-preferred prices.
Single-asset GRATs are typically preferred. The intent of a GRAT is for the asset's appreciation to exceed the IRS rate. Placing multiple assets in a GRAT diversifies the asset base, reducing the odds that the GRAT asset will outperform. Creating multiple single-asset GRATs instead will maximize the amount of assets able to be passed tax-free via the GRAT.
Shorter-term GRATs are common (and many times preferred). A GRAT typically has a life of 2-10 years. Shorter GRATs are more common, as they allow for an individual pursuing a GRAT strategy to get more chances of a GRAT strategy being successful and passing along a higher portion of their assets tax-free.
For more information, you may consider reading: Fidelity: Grantor Retained Annuity Trusts
Important: Congress has discussed changes to GRAT regulations, so laws may impact future benefits. Consult a tax advisor.
Key Benefits
Can shift all appreciation in contributed assets above the IRS hurdle rate out of the grantor's taxable estate. This minimizes future estate tax exposure.
When structured properly, gift tax should not be owed on the initial transfer into the GRAT. The annuity stream that is returned to the contributor in a "zeroed out" GRAT results in no value being transferred (for IRS/tax purposes).
Key Considerations/Flags
The assets contributed must appreciate more than the IRS hurdle rate for a GRAT to be beneficial. Otherwise, all assets would be returned to the grantor.
Setting up GRATs has costs and complexity. Consultation with an experienced estate planning attorney is essential, and the cost of setting up GRATs should be considered in tandem with the prospective benefits.
Congress has discussed changes to GRAT regulations that could reduce benefits. Laws may change and impact utility.
Strategy: When to Consider This and When to Avoid It
🟢 When to Consider This Strategy:
If you have significant assets (i.e. you anticipate estate taxes will apply upon your death) and desire to transfer assets to heirs in a tax-efficient manner.
If you have assets that you believe are discounted or temporarily undervalued. GRATs work best when assets rapidly appreciate after being contributed.
If you are OK relinquishing control over contributed assets. Once in the GRAT, the grantor cannot access transferred assets.
🔴 When to Not Use This Strategy:
If you do not anticipate that estate taxes would apply upon your death. In this circumstance, you likely have other estate planning tools that will serve your needs better.
If you want to retain control over assets. GRATs require irrevocably transferring assets.
If assets are not expected to appreciate meaningfully. The GRAT may fail if growth does not exceed the hurdle rate.
Example
Last updated
