A GRAT is an irrevocable trust designed to transfer future asset appreciation to beneficiaries while potentially minimizing gift and estate taxes. The grantor transfers assets into the trust but retains the right to receive annuity payments for a specified number of years.
At the end of the term, any assets remaining in the trust pass to the beneficiaries. A GRAT can therefore effectively freeze the value of certain assets for transfer-tax purposes while allowing future appreciation to move outside the grantor’s estate. It is one of several techniques that may be considered as part of broader Estate Planning for families with substantial assets.
When assets are transferred to a GRAT, the grantor receives annuity payments based partly on the IRS Section 7520 rate (the hurdle rate) in effect when the trust is created. The initial value transferred, plus the assumed IRS return, can effectively be returned to the grantor through those payments.
The opportunity arises when the assets grow faster than the 7520 rate. That excess growth remains in the trust and can ultimately pass to beneficiaries. Properly structured GRAT estate planning can therefore transfer appreciation while using little or none of the grantor’s lifetime federal gift and estate-tax exclusion.
A zeroed out GRAT is structured so that the present value of the grantor’s retained annuity payments is approximately equal to the value initially transferred into the trust. As a result, the taxable gift to the beneficiaries can be reduced to little or nothing.
The strategy is widely used because it allows the grantor to make a relatively low-risk attempt at transferring future appreciation. If the assets outperform the applicable IRS hurdle rate, the excess can pass to beneficiaries. If they do not, the assets generally return to the grantor through the annuity payments, leaving primarily the costs of establishing and administering the trust.
Two risks are especially important. First, the assets must outperform the IRS hurdle rate. If investment performance does not exceed that rate, there may be little or no property remaining to transfer to beneficiaries after the annuity payments are made.
Second, the grantor must survive the GRAT term. If the grantor dies before the term ends, most or all of the trust property and its appreciation may be included in the grantor’s taxable estate. These risks make asset selection and term length important considerations when evaluating whether a GRAT is appropriate.
Instead of creating one long-term GRAT, a grantor may establish a series of shorter-term trusts. With a rolling GRAT strategy, annuity payments received from one GRAT may be used to fund another, creating repeated opportunities for assets to outperform the applicable hurdle rate.
Shorter terms can reduce mortality risk because the grantor needs to survive each GRAT for a shorter period. They can also reduce the effect of poor investment performance during any single period and provide flexibility as interest rates change. GRATs may also permit assets to be substituted during the term when circumstances or expected growth prospects change.
What assets work best inside a GRAT?
GRATs generally work best with assets expected to appreciate significantly. Examples include investment assets, pre-IPO shares and interests in family or privately held businesses. The stronger the appreciation above the IRS hurdle rate, the greater the potential wealth transfer.
What is the IRS 7520 rate and why does it matter for a GRAT?
The Section 7520 rate is an IRS-prescribed interest rate that changes monthly. It establishes the hurdle a GRAT’s assets generally must outperform for appreciation to remain in the trust and ultimately pass to beneficiaries.
Can a GRAT be used to transfer interests in a privately held business?
Yes. Interests in family or privately held businesses may be appropriate GRAT assets when significant appreciation is expected. Because those interests may lack readily available market prices, appropriate Estate, Gift and Trust Tax Valuations may be required when funding the trust.
How does the length of a GRAT term affect the likelihood of successfully transferring wealth?
Longer terms provide more time for assets to appreciate but increase the period during which the grantor must survive. Shorter terms reduce mortality exposure and allow hurdle rates to reset more frequently, but assets have less time to outperform them.
Because a GRAT is generally treated under grantor trust rules, its income, gains, and losses are generally reported on the grantor’s personal income-tax return. The grantor’s payment of those taxes is not treated as an additional gift to the trust beneficiaries, allowing more trust assets to remain invested and potentially grow for the beneficiaries.
For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Jonathan Swartz, partner in Bennett Thrasher’s Trusts & Estates Planning, or call us at 770.396.2200.
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