- A GRAT is an irrevocable trust allowing the grantor to freeze asset value and transfer future appreciation to beneficiaries with minimal or no gift or estate taxes.
- For wealthy families, GRATs offer a means to preserve estate value while bypassing potential tax implications.
- GRATs provide predictable annuity payments for the grantor, estate tax reduction, gift tax benefits and efficient wealth transfer.
- GRATs provide estate tax reduction, predictable annuity payments for the grantor, efficient wealth transfer and gift tax benefits.
- Grantors should consider shorter GRAT terms, income tax implications during the GRAT term, and potential capital gains tax on appreciated property sold by beneficiaries after the trust ends.
What Is a Grantor Retained Annuity Trust (GRAT)?
A grantor retained annuity trust (GRAT) is an irrevocable trust that enables its creator, the grantor, to direct assets to a temporary trust. This effectively freezes the assets’ values before passing them on to a beneficiary.
Using a GRAT as part of your estate planning strategy provides a means to transfer appreciating assets to the next generation with minimal or no gift or estate tax consequences.
For affluent families, GRATs offer an opportunity to maintain the value of their estate while transferring future appreciation in the estate’s value to their beneficiaries.
Although the tax code specifically allows GRATs, the IRS describes them on its webpage for Abusive Trust Tax Evasion Schemes — Special Types of Trusts, which explains how promoters use GRATs and other legitimate trusts to “hide the true ownership of assets and income or to disguise the substance of transactions.”
Taxpayers should know abusive trust arrangements will not produce the tax benefits advertised by their promoters and that the IRS is actively examining these types of trust arrangements.
Including a GRAT in your estate planning strategy can provide a means to transfer appreciating assets to the next generation with minimal or no gift or estate tax consequences.
How GRATs Work
A grantor transfers assets they expect to appreciate in value to a fixed-term and irrevocable trust to create a GRAT. The GRAT then pays out an annuity stream based on the contributed assets’ value to the grantor during the trust’s term. When the term ends, remaining assets plus appreciation are distributed to noncharitable beneficiaries, usually the grantor’s children.
Calculating the value of annuities, life estates and remainders for a GRAT relies on specific IRS factors. The value is divided in two, the grantor’s annuity stream amount and the excess appreciation. Typically, the annuity stream is valued to match the assets transferred into the GRAT.
When the grantor transfers assets to a trust, the IRS expects them to generate a return that is at least equal to the applicable Sec. 7520 interest rate for that month. The rate changes monthly.
The lower the rate, the lower the appreciation needed to pass wealth on to your beneficiaries. Any increase in value beyond the Sec. 7520 rate is not subject to gift tax and is passed on to the beneficiaries.
If the assets in the GRAT do not perform better than the Sec. 7520 rates, they are returned to the grantor. The grantor doesn’t have to pay much (or any) gift tax, and the administrative expenses of setting up and maintaining the GRAT are minimal. There are no other adverse tax consequences of a substandard-performing GRAT.
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How GRATs Are Used
A GRAT allows you to freeze a portion of your estate’s value in time, meaning any future appreciation on your estate’s assets passes to your heirs with little to no estate or gift taxes. There are many ways to utilize a GRAT strategically for wealth management and estate planning purposes, a few of which are highlighted below.
Gift Taxes With a GRAT
An “annual exclusion” gift is exempt from federal gift taxes, with a maximum amount allowed annually. For instance, in 2023, you can give up to $17,000 worth of cash or property value per person without incurring gift tax.
A GRAT can minimize gift taxes since the value is returned to the grantor over time. Ideally, the trust’s assets will appreciate beyond the payments, tax-free, to be distributed to the annuity’s beneficiaries.
GRATs and Estate Taxes
With proper structuring, GRATs can allow wealthy families to transfer wealth between generations without incurring estate taxes.
The estate tax in 2023 applies to property valued at over $12.92 million for single individuals and $25.84 million for married couples.
In a GRAT, the grantor transfers high-income-producing assets with significant growth potential into a trust. The grantor receives a fixed amount of income annually for a specified period through an annuity.
When the GRAT term ends, if the grantor is still alive, the beneficiaries receive the trust’s remaining assets after receiving the final annuity payment. If the grantor passes away before the term ends, the heirs inherit assets in the trust.
Advantages of GRATs
A GRAT offers significant advantages, including the potential reduction of estate taxes, ease of transferring family wealth and gift tax efficiency.
- Estate Tax Reduction
- GRATs can help minimize estate taxes by transferring assets to beneficiaries at a discounted value, potentially reducing the taxable estate.
- Annuity Payments
- The grantor receives regular annuity payments from the trust, providing a predictable income stream during the trust’s term.
- Managing Taxes on Highly Appreciated Assets
- GRATs are especially effective for transferring assets expected to appreciate significantly over time, maximizing the potential for tax-free wealth transfer.
- Transferring Family Wealth
- GRATs allow for the efficient transfer of wealth to family members, facilitating financial support across generations while minimizing tax consequences.
- Gift Tax Efficiency
- The retained annuity interest reduces the value of the gift to beneficiaries, lowering potential gift tax liability.
Example of GRAT Advantages
Important GRAT Considerations
If a grantor dies before the end of the GRAT’s term, all the assets in the trust are returned to the grantor’s estate and are counted for estate tax purposes. For this reason, grantors may choose GRAT terms of three years or fewer.
When considering the use of GRATs, it’s also important to consider the income tax implications related to removing assets from the donor’s estate.
The donor will be taxed on all the income and capital gains generated by the trust during the term of the GRAT, irrespective of the amount of the annuity paid to the donor, according to Cummings & Lockwood LLC, a law firm with a focus on trusts and estates.
Additionally, suppose the beneficiaries decide to sell appreciated property gifted to the GRAT after the trust term ends. In this case, they might face higher capital gains tax than what they would have paid if they received property through a will.
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Frequently Asked Questions About GRATs
While the GRAT is in effect, the grantor is responsible for paying taxes on any income and capital gains that the trust generates, regardless of the size of the annuity payments received by the grantor.
There are two chief disadvantages to a GRAT. First, if the grantor does not survive the GRAT term, the GRAT loses its benefits. All the assets go back to the estate and estate taxes may apply. A second disadvantage is that if the assets do not appreciate as anticipated, the benefits of the GRAT may decrease.
The primary benefit of a GRAT is to freeze the value of an estate’s value, minimizing appreciation to avoid having to pay gift or estate taxes. This allows for greater tax efficiency in transferring family wealth to younger generations.