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For those with large estates, a common question that comes up when planning for the future is how to minimize or avoid estate and gift taxes when transferring assets to heirs. One possibility: using irrevocable trusts to move assets out of one’s estate.
Specifically, a type of irrevocable trust called a grantor retained annuity trust (also known as a GRAT) is an advanced estate planning technique sometimes used to accomplish this goal.
What is a grantor retained annuity trust, or GRAT?
A GRAT is an irrevocable trust that allows the trust’s creator — known as the grantor — to direct certain assets into a temporary trust and freeze its value, removing additional appreciation from the grantor’s estate and giving it to heirs with minimal estate or gift tax liability.
During the term of the GRAT, the trust pays an annuity out to the grantor, so the assets moved into the GRAT are considered returned to the grantor. This feature allows the GRAT to avoid triggering any gift tax. Any leftover assets (including the growth of those assets) can then be handed over to beneficiaries, reducing the size of the grantor’s estate and the impact of estate taxes in the future.
The design of the GRAT means the grantor doesn’t need to give away all of their assets to achieve the goal of minimizing tax liability.
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How a GRAT works
Here’s an overview of the GRAT strategy:
The grantor forms a GRAT by transferring assets, particularly those with high expected appreciation potential, to an irrevocable trust for a set period of time.
Applying IRS factors for valuing annuities, life estates and remainders, the GRAT’s value is split into two: the annuity stream and remainder interest. Often, the value of the annuity stream is set to equal the value of the assets transferred into the GRAT to construct a “zeroed-out" GRAT.
The grantor receives annuity payments from the GRAT. The trust is expected to produce a minimum return of at least the IRS Section 7520 interest rate. If it doesn't, the trust uses principal to cover the annuity payment and the GRAT fails, returning trust assets back to the grantor.
Assuming returns of the GRAT do surpass the Section 7520 rate during the fixed time period, all remaining assets and accumulated asset growth are distributed directly to beneficiaries gift-tax-free after the final annuity payment is made.
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Benefits of a GRAT
Estate tax can significantly impact the size of an estate — the tax burden can be up to 40% on the taxable amounts surpassing the federal estate tax exemption. (In 2022, that’s $12.06 million for an individual and $24.12 million for a married couple).
However, that exemption limit has historically been closer to $5 million, and if Congress doesn’t act, it could revert to that level when the Tax Cuts and Jobs Act expires post-2025. By removing the growth from your estate, you can reduce the overall size of your estate and hopefully avoid or lessen estate taxes in the future.
GRATs work best when interest rates are low, which lowers the IRS Section 7520 hurdle rate. Low rates make it easier for the growth of trust assets to outpace the Section 7520 rate and provide the best outcome — the grantor is able to get more appreciation out of their estate and give a larger amount to heirs. This is also why it makes sense to put assets with greater potential for appreciation into the trust — stocks (especially high-yield or growth stocks), shares of startup companies, interest in a business and real estate are all good contenders for a GRAT. By putting these assets into the GRAT, the grantor reduces the appreciation of their personal estate down the road and increases the amount gifted.
With a GRAT, the grantor also has flexibility, because trust assets can be exchanged with other assets of equal value. If trust assets aren't generating high enough returns, the grantor can replace them with other assets. If assets are performing very well and surpass the amount the grantor planned to give to heirs, slower-growing assets can be subbed in to tamp down appreciation.
GRAT caveats to keep in mind
Should the grantor die before the end of the GRAT term, all trust assets are returned to the grantor’s estate and will be counted for estate tax purposes. Often, grantors elect shorter terms for the GRAT (two to three years) or employ a rolling GRAT strategy to help reduce the mortality risk. By rolling short-term GRATs, the annuity payments from one GRAT fund a new GRAT, so if the grantor were to die, only the assets in the active GRAT would revert to their estate.
It’s also important for grantors to stay abreast of the legislation surrounding GRATs. Since using GRATs helps eliminate or reduce estate and gift tax liabilities, there have been proposals to increase restrictions, such as requiring a 10-year minimum fixed term or eliminating the zeroed-out GRAT strategy.
And as with any irrevocable trust, expert guidance will ensure that establishing a GRAT doesn’t create unintended consequences. You’ll need to pay legal fees to retain the advice of an informed estate planning attorney who can work alongside your tax and financial advisors to determine the ideal terms for your situation.