What is a Grantor Retained Annuity Trust (GRAT) &
How Does it Work?
What is a GRAT?
A Grantor Retained Annuity Trust is an irrevocable trust used to make lifetime gifts of assets to beneficiaries of the trust while incurring little or no federal gift tax.
A significant advantage of the GRAT over many other wealth transfer strategies is that the GRAT is supported by a considerable body of regulations and favorable tax court rulings.
Requirements to Create a GRAT
A GRAT is a Grantor Trust--which means the Grantor pays all of the tax on income earned by the Trust. The Grantor does not pay tax on the annuity payments that the Grantor receives each year;
Annuity payments may be made in cash or in kind. If not enough cash is held in the Trust when the annuity payment is due, the annuity payment can be made with stocks or bonds or any other assets held by the Trust, thereby avoiding capital gain taxes;
The term of the GRAT must be at least 2 years, but there is no limit on the maximum term;
If the Grantor dies before the Trust terminates, the Trust assets revert back to the Grantor's estate and, for gift & estate tax purposes, are treated as if the transfer to the Trust was never made;
The transfer of assets to a GRAT constitutes a future interest gift, which means the Grantor cannot use his/her gift tax annual exclusion amount to offset the amount of the transfer;
The amount of the Grantor's retained annuity interest is calculated using a modified government interest rate called the Section 7520 rate. The Section 7520 rate is re-set every month--it can remain the same or move up or down--but generally increases as interest rates increase. The lower the Section 7520 rate, the smaller the amount of the annuity payment returned to the Grantor, leaving more value in the Trust for the beneficiaries;
The amount of any gift tax due is calculated by subtracting the present value of the Grantor's retained interest from the value of the assets transferred to the trust.
A GRAT is an estate "freeze" strategy--meaning that a portion of the the value of the account is frozen by distributing the growth in excess of the Section 7520 rate to the beneficiaries.
What Are Cascading or Rolling GRATs?
Research shows that shorter-duration GRATs provide more benefit to the beneficiaries (the heirs of the Grantor) than longer-duration GRATS. Keep in mind that in each year that a GRAT exists, the Grantor's "retained annuity" must be returned from the Trust to the Grantor. Also, keep in mind that the goal of creating a GRAT is to distribute all of the growth in excess of the Section 7520 rate to the beneficiaries after the term of the GRAT has expired.
If a Grantor creates a 3-year GRAT, then the Grantor's year one retained annuity interest will be returned to the Grantor at the end of year one. Year two's retained annuity interest will be returned at the end of year two, and year three's annuity interest will be returned at the end of the term of the GRAT. Rather than waiting until the end of year 3 to start a new GRAT, it's possible to create a 2nd GRAT at the end of year one funded with the Grantor's retained interest from year one of GRAT One. That starts the clock running on the term of GRAT Two (also 3 years). The Grantor's retained interest from year two of GRAT One along with the Grantor's retained interest from year one of GRAT Two are then used to fund GRAT Three, and so on.
Click on the Cascading GRAT Simulator to see illustrations of the hypothetical benefits of creating one or more GRATs based on variable Section 7520 rates and variable annual rates of return of the trust assets.
For more information about how a GRAT works, download my April 2018 Article here:
The person creating the GRAT is called the "Grantor." The "Retained Interest" refers to the fact that the Grantor must receive from the Trust an annual fixed sum, called an "Annuity" payment. The annuity payment is typically made in-kind and is not taxable to the Grantor. However, the Grantor is responsible for the tax on all trust income. If the growth of the assets during the term of the Trust exceeds the Section 7520 Rate (see paragraph 6 below), that amount can be distributed to the Beneficiaries of the Trust without incurring any gift tax liability (or a very small amount).