A grantor retained annuity trust (GRAT) is an advanced estate planning tool used to reduce an individual’s taxable estate by passing assets to trust beneficiaries free of estate and gift tax. However, like any advanced estate planning tool, GRATs can be complicated and must be structured properly to be beneficial. Dive into the following questions and answers to develop a better understanding of how GRATs work and how they may be useful for estate planning clients.
Above is a screenshot of WealthCounsel’s Wealth Docx® drafting system, which includes the GRAT in the Advanced Planning Techniques suite.
Q. What is a GRAT?
A. A GRAT is an irrevocable trust into which a grantor contributes assets and retains an annuity stream for a specified term. At the end of the term, any assets left in the trust are transferred to the trust beneficiaries free of estate and gift tax.
Q. What components must be included in the GRAT?
A. A GRAT must specify the annuity payment amount, the applicable Internal Revenue Code (IRC) section 7520 rate, and the term of the trust. The nature of assets transferred to the trust—ideally those with the potential for significant appreciation in value—will determine its success.
Q. When is the annuity payment established and how often is it paid to the grantor?
A. The annuity payment is established when the GRAT is created and is a percentage of the fair market value of the assets transferred to the GRAT. The final value of the annuity payment is calculated by applying the section 7520 rate, which is published monthly on the Internal Revenue Service’s website. The rate that applies to the GRAT is the rate published in the month in which the assets are transferred. The annuity payment is paid to the grantor at least annually.
Wealth Docx provides two options for stating the annuity amount.
Users can enter the annuity amount expressed as a percentage and select how frequently the payments will be made.
Q. How does the grantor achieve a tax benefit?
A. Under IRC section 2702, a GRAT—if structured correctly—allows a grantor to transfer a portion of the future appreciation of the assets that were transferred to the trust to future trust beneficiaries. If the assets transferred to the trust appreciate over the term of the GRAT at a rate higher than the section 7520 rate, any excess appreciation accumulates and is transferred to the trust beneficiaries free from estate and gift tax.
Learn more about GRATs, how to use them, and why they have nearly zero gift tax risk by attending our November 17 webinar.
Q. What is the GRAT term, and what happens if the grantor does not survive the term?
A. The GRAT term is the term specified in the trust; it is determined at the outset of the trust. The term should be shorter than the life expectancy of the grantor because if the grantor dies before the term ends, the trust property that remains in the trust at the grantor’s death will be included in the grantor’s taxable estate. The trust term must be a minimum of two years. Most GRAT terms are two or three years to hedge the risk that the grantor may not outlive the GRAT term and to address the unpredictability of the market.
The number of years for the initial GRAT term is entered early in the interview process. Users can click on the blue information icons for additional information.
Q. What are the best types of assets to contribute to a GRAT?
A. There is no limit on the amount of assets that can be transferred to a GRAT. Income-producing assets like closely held stock, business interests, bonds, and royalties are recommended because they are likely to appreciate at a rate higher than the section 7520 rate during the GRAT term.
Wealth Docx provides the related Schedule A where users can enter the asset descriptions.
Q. How do you know if the GRAT is successful?
A. A GRAT is successful if the grantor survives the term and the appreciated assets outgrow the section 7520 rate. If this happens, the GRAT is deemed successful because the appreciated assets remain in the trust and are distributed to the trust beneficiaries free of estate and gift tax. A client is taking somewhat of a gamble when creating a GRAT because when the assets are transferred to the trust, it is not known how they will perform during the trust term. Typically, though, when interest rates are low, a GRAT is more likely to be successful and is an excellent estate planning tool in a low interest rate environment. A GRAT is also more likely to be successful if the grantor funds it with income-producing or highly appreciating assets.
Q. What happens if the GRAT is not successful?
A. Another great advantage of GRATs is that they are low-risk. There is no penalty if the GRAT fails except for the loss of the trust administration cost. If the assets transferred to the GRAT do not appreciate at a rate higher than the section 7520 rate, there is nothing lost. If the grantor does not survive the term, the GRAT will fail, but again no assets are lost—they will simply be included in the grantor’s taxable estate.
Q. Who pays the income tax on the assets in the GRAT?
A. A GRAT is a grantor trust, so the grantor is required to pay the applicable federal income tax on the GRAT’s income during the term.
Q. Do clients need to have a high net worth to take advantage of a GRAT?
A. No, not necessarily. Anyone can take advantage of the benefits that a GRAT offers. However, a GRAT makes more sense for high net worth clients who need an estate planning tool that will help to reduce their ultimate estate tax liability. With the current federal estate tax exemption being so high ($11.7 million per individual in 2021), there has been less need to use GRATs in estate plans for individuals whose net worth is well below the federal estate tax exemption amount. This may change if a Biden administration passes legislation lowering the exemption amount. In addition, even if no changes are made, the current federal estate tax exemption is set to sunset in 2025, returning to $5 million per individual, adjusted for inflation.
Q. Why are GRATs frequently a topic of discussion in Congress?
A. GRATs give wealthy individuals the opportunity to reduce their estate tax liability, particularly when interest rates are low because the appreciated assets transferred to GRATs have a better chance of outgrowing the section 7520 interest rate. Generally speaking, Democrats believe wealthy individuals should be required to pay gift and estate tax on the transfer of wealth to their loved ones and are likely to minimize the effectiveness of GRATs by shortening the GRAT term or raising the section 7520 interest rate. Republicans favor the transfer of wealth with little or no gift or estate tax liability and are likely to continue to enact laws that enable the use of GRATs.
Learn why now is the perfect time to utilize GRATs by joining us for our next Thought Leader Series. On November 17, Steven J. Oshins, JD, AEP (Distinguished), will explain how GRATs work, when to use them, and why they have nearly zero gift tax risk. Register for the virtual event today.