Transferring Wealth with a Grantor Retained Annuity Trust

A grantor retained annuity trust (GRAT) is a tax-efficient strategy to transfer wealth to children or other beneficiaries, especially if you anticipate having an estate valued at more than the federal estate exemption.

How a GRAT Works

A GRAT is an irrevocable trust with a defined term, typically two years (but can be longer), during which time the grantor receives an annuity plus the IRS published Section 7520 rate. When the trust’s term ends, any remaining assets pass to your beneficiaries with no additional estate, gift, or income tax.

Funding and Payments
A GRAT is funded with a one-time transfer of assets, often is a single security, basket of correlated securities, or assets with strong short- to mid-term growth potential, including undervalued securities, and shares of a family business. After the GRAT is funded, you receive an annuity payment throughout the trust’s term. Tax rules allow the “backloading” of annuity payments so that they are lower at the beginning and increase up to 20% per year throughout the trust’s term. You can also establish a “rolling GRAT”: As each annuity payment is received, it is “rolled” into a new GRAT, and the annuities from the new GRAT are rolled into additional new GRATs.

No income tax is imposed on transfers into or out of the GRAT. Gift tax is triggered on the difference between the value of the funded assets less the value of the retained annuity. The GRAT can be structured so that the initial taxable gift—and thus the potential gift tax—is a nominal amount, such as $100 or less.

GRATs are permitted, but not efficient, for generation-skipping asset transfers. The estate-tax inclusion period rules prevent allocating the generation-skipping transfer (GST) tax exemption until after the expiration of the term, and thus allocation of the GST tax exemption is on a dollar-for-dollar basis.

Remaining Assets Pass to Your Beneficiaries
When the trust’s term expires, the remaining assets, plus appreciation less the amount paid as the annuity, pass tax-free to your beneficiaries or into a trust for them. Be mindful that assets transfer with a carry-over tax basis, not a stepped-up or stepped-down) basis as with most inherited assets. Beneficiaries are liable for any taxable gain should those assets be sold later.

The larger the annuity or the longer the term reduces the gift taxable amount; however, the remainder is excluded from your gross estate only if you outlive the GRAT term. In the interim, you remain liable for income tax on sales and other income within the GRAT. This can provide two additional estate tax benefits: leaving more assets inside the trust for the beneficiaries and reducing the assets that otherwise would be subject to estate tax upon your passing. These benefits can be extended by having the remainder go into grantor trusts for the beneficiaries, which can continue the income tax burden falling on you.

Capturing Swings in Value
You may consider swapping assets with the GRAT during its term if:

• There is exceedingly rapid appreciation early in the GRAT term. You can replace the appreciating asset with cash or other assets and thus “freeze” the value inside the GRAT.
• Assets rapidly decline in value. You can swap them out and fund them into a new GRAT (so any recovery of value is appreciation to the new GRAT).

Potential Risks
GRATs can have several risks, including:

• Mortality: If you die during the trust’s term, the value of some or all assets will be included in your estate.
• Underperformance: If the assets in the GRAT decline in value below the IRS’s assumed rate of return, it will negate any tax benefits. There will be no appreciation upon the transfer to beneficiaries, and all property in the trust will revert to you as the grantor.
• Rate headwind: When interest rates increase, there is an accompanying bump in the IRS 7520 rate. Thus, a rolling GRAT program could face higher hurdles in the future.
• Legislative: GRATs have often been identified as a “loophole for the wealthy,” making them a potential target for future tax reform legislation.

Options to Address a Fluctuating 7520 Rate
There are GRATs that can help protect against the IRS 7520 rate rising dramatically or potential changes in tax laws that might restrict new GRATs, including:

Shelf GRATs
These are funded with low-growth assets, often cash, then essentially “placed on a shelf” to be activated later. If you identify a highly volatile asset you expect will increase significantly in value (e.g., pre-initial public offering stock or a family business), you can swap that volatile asset into the existing “shelf” GRAT in exchange for cash or other initial assets. This allows the future appreciation of the high-growth asset to potentially pass to beneficiaries without incurring gift tax. You must survive the term of the GRAT for the strategy to be successful; otherwise, most of the assets are included in your estate for estate tax purposes.

Sector GRATs
These are funded with assets from a specific industry sector, particularly one that may be expected to experience significant short-term growth (e.g., specific tech stocks or a new energy venture). Each distinct sector segment, or “sleeve,” funds its own GRAT, creating independent opportunities to possibly beat the Section 7520 hurdle and help isolate volatility. The higher the appreciation, the greater the potential tax-free transfer to trust beneficiaries.

Benefit from Experienced Advisors
GRATs can be powerful estate planning tools to accomplish your wealth transfer goals and help minimize tax liabilities. Work with a reputable wealth planner and attorney to help determine if a GRAT is well-suited to your situation and goals.

This material provides information of possible interest to Glenmede’s clients and friends, and does not provide investment, tax, legal or other advice. Any opinions, recommendations, expectations and/or projections expressed herein may change after the date of publication. Information obtained from third-party sources is assumed to be reliable but may not be independently verified, and the accuracy thereof is not guaranteed. Any potential outcome discussed, including but not limited to performance, legislation or tax consequence, ultimately may not occur due to various risks and uncertainties. Clients are encouraged to discuss any matter discussed herein with their tax advisor, attorney or Glenmede Relationship Manager.