GRAT Planning Strategies – Annuity Trusts Can Cut Estate and Gift Taxes

Since a GRAT is a grantor trust, all tax items realized by the GRAT during the annuity term, such as income and capital gain, will be taxable on the grantor’s personal income tax return.

A grantor retained annuity trust, commonly called a GRAT, allows a grantor to pass assets to a beneficiary while minimizing his or her federal gift and estate tax burden. While GRATs offer some undeniable advantages, like any estate planning technique they are not right for everyone.

A grantor places assets in a trust that pays the grantor an annuity for a set period of time. After the trust’s term is up, any remaining assets pass to the beneficiaries — often the grantor’s children.

A well-executed GRAT allows you to pass along appreciation in the assets free of transfer tax while also receiving an income stream to meet your own needs. The GRAT’s tax benefits mainly come from the way the Internal Revenue Service (IRS) values the transfer to the trust.

The IRS calculates a grantor’s taxable gift to his or her beneficiaries based on two things: the amount of the annuity payments and the rate of expected return on the trust assets, which is pegged to a monthly figure called the Internal Revenue Code Section 7520 rate. The 7520 rate is based on the mid-term applicable federal rate at the time the grantor sets up the trust. GRATs are more attractive during times of low interest rates, because of the lower hurdle rate for trust assets to clear.

While some characteristics of a GRAT are set by regulation, a grantor does face some choices in structuring the trust. A GRAT’s term is, in most if not all cases, established for a set number of years when the GRAT is created. Annuity payments can be made once per year or more frequently, and they can remain flat, increase or decrease over time. Because of the annuity stipulation, GRATs have a minimum term of two years.

A short-term GRAT mitigates some of the vehicle’s risks, such as the grantor dying before the term is over or the trust assets underperforming. For this reason, many people choose to set up “rolling” or “laddered” short-term GRATs. The idea is to create a series of consecutive short-term GRATs, funding each with the previous trust’s annuity payments. Rolling GRATs can capture rapid asset appreciation and offer the flexibility to stop at any time.

In addition to the trust’s term, a grantor will need to decide whether or not to “zero out” the GRAT. If you choose to make the present value of the annuity payments, discounted using the 7520 rate, equal to the amount you transfer to the GRAT, the IRS will not consider the transfer a gift for federal tax purposes. After all, in theory, you are not transferring any value.

In a world where the 7520 rate accurately predicted appreciation, you would get back the entirety of the trust’s assets in annuity payments, leaving nothing for the beneficiaries. In reality, though, trust assets may well earn more than the 7520 rate; such earnings go to your beneficiaries free of gift tax.

You are not required to set up a zeroed-out GRAT. If you choose, you can set a lower annuity amount and have some of your transfer treated as a taxable gift. This is often an inefficient tax strategy, since a GRAT’s main benefit is allowing you to transfer value without having to pay gift tax. In addition, if the assets funding the GRAT decline in value, rather than appreciating, you could end up paying gift tax on nothing. If the assets don’t surpass the 7520 rate, the transaction has created a taxable gift without any assets passing to your beneficiary, which is a lose-lose scenario (except for Uncle Sam).

Note that a GRAT is not an always the most tax-efficient choice for every beneficiary. For example, while a zeroed-out GRAT allows you to bypass the federal gift and estate tax, it does not negate the generation-skipping transfer (GST) tax. Generally, outright gifts to grandchildren or other “skip persons” will be more efficient than a remainder interest in a GRAT.

Since a GRAT is a grantor trust, all tax items realized by the GRAT during the annuity term, such as income and capital gain, will be taxable on the grantor’s personal income tax return. Annuity distributions are not considered taxable and, at the expiration of the trust term, all remaining assets are distributed to the remainder beneficiary, who becomes responsible for paying tax on any future income from the assets.

Funding A GRAT

Another factor that may affect your GRAT’s structure is the nature of the assets you intend to use to fund the trust. For obvious reasons, you will want to focus on assets that are likely to appreciate beyond the 7520 rate, but this still leaves a wide range of options. Note that you cannot make additional contributions to a GRAT once you have created it, so you will need to make funding decisions upfront.

One popular technique is to fund a GRAT with assets that are discounted for transfer tax purposes, such as noncontrolling interests in family-controlled entities or fractional interests in real property. Such assets are especially good candidates for transfer to a GRAT if the trust’s term extends beyond the time when they are expected to be marketable, paired with another liquid source of funds to satisfy annuity payment requirements in the meantime. For instance, if you expect to sell the family business in the next few years, you can structure a GRAT so that it will include sufficient liquid assets to make the annuity payments until the business is sold, generating additional liquidity.

While illiquid assets are a common choice for funding GRATs, they can create complications. Since a GRAT requires distributions on a regular basis, you may be required to obtain a qualified appraisal each time a distribution of the illiquid asset occurs. Say, for instance, you fund a GRAT with privately held company shares and plan to have the GRAT distribute back shares equal to the required annuity payment each year. You will need to value the shares on the date you contribute them to the GRAT and again on each annuity payment date for the GRAT’s term. This will involve extra administrative costs.

If you want to protect the growth of more than one asset from transfer taxes, consider using separate GRATs for each. This technique will prevent underperforming assets from diluting the effectiveness of strong performers. While multiple GRATs add complexity, such separation can pay major dividends. If, for example, a GRAT contained both stock in company A and company B, losses in company A would offset any gains in company B, potentially leaving beneficiaries with nothing. In two different GRATs, however, gains from company B would still pass to the beneficiaries, even if company A underperformed.

Risks and Potential Drawbacks

GRATs are irrevocable, and a grantor’s mortality can render a GRAT less useful than intended. If a grantor dies before the end of a GRAT’s term, trust assets will be included in the grantor’s gross estate. Using short-term or rolling GRATs can reduce this risk.

As with any trust, you will need to hire professionals to set up and maintain a GRAT properly. For this reason, individuals who are unlikely to reach the gift and estate tax threshold may find it more efficient to just gift assets outright. And while you may be able to take advantage of economies of scale, setting up multiple GRATs at once can still add cost and complexity.

Statements from both the White House and Capitol Hill suggest that the gift and estate tax, at least on the federal level, may vanish sometime in the next few years. While you should always build an estate plan based on current law, rather than the prospect of imminent change, it may make more sense to favor short-term or laddered GRATs over long-term GRATs in this political atmosphere.

A GRAT-based gifting strategy rests on the assumption that transferred assets will appreciate at a certain level. A GRAT that sustains major losses early in its term is unlikely to end profitably. You might consider purchasing an underperforming GRAT’s remaining assets and transferring them to a new GRAT. While GRATs are irrevocable, there is an exception for “bona fide sales made for an adequate and full consideration in money or money’s worth.” Such a purchase will have no tax consequences, because the IRS considers the GRAT the grantor’s property during its term; you are basically buying from and selling to yourself. With a fresh start, the GRAT will have a better chance of producing a profit to pass to your beneficiary.

On the other hand, a GRAT that performs better than expected upfront risks losing some of those gains to future poor performance. Purchasing assets from the GRAT and transferring to a new GRAT in this case will lock in those initial gains, regardless of later performance.

Another risk for grantors is the prospect of a dispute with the IRS over the value of assets in the trust. If you fund a GRAT with, for instance, a discounted interest in a family limited partnership, the IRS could later challenge your initial asset valuation. However, if you structure your trust so that the annuity is a percentage of the trust’s assets rather than a specific dollar amount, any increase in value will simply lead to a larger annuity payment. In this way, you can avoid the potential of unexpectedly owing gift tax, though such a scenario would reduce the amount passed to beneficiaries.

A GRAT is an excellent tool when considering ways to minimize your transfer tax obligations while passing assets to your beneficiaries. While not without risks, in many situations a GRAT may turn out to be the perfect fit.

Paul Jacobs, Certified Financial Planner (CFP), Enrolled Agent (EA), is chief investment officer of Palisades Hudson Financial Group, based in its Atlanta office. The firm is a fee-only wealth manager serving affluent clients. He can be reached at paul@ palisadeshudson.com.

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