Trusts & Estates
September 26, 2022
Grantor Retained Annuity Trusts: A Tax-Efficient Strategy for Transferring Wealth
A Grantor Retained Annuity Trust (GRAT) is a compelling tax-efficient strategy individuals and families can use to transfer wealth to their beneficiaries. Learn what a GRAT is, how it works, its key advantages and potential risks, and who can benefit.
Defining a GRAT
A GRAT is an irrevocable trust sanctioned by Section 2702 of the Internal Revenue Code. A GRAT is typically funded with growth assets and has a defined term of years. During the term, the Grantor receives an annuity, and at termination the assets remaining in the GRAT pass to the Grantor’s named beneficiaries with no additional estate, gift or income tax.
Who can benefit from a GRAT?
A GRAT can be a powerful tax-efficient wealth-transfer strategy for individuals or families who anticipate having an estate valued at more than the federal taxable estate exemption amount — $12.06 million for individuals and $24.12 million for married couples in 2022. GRATs are often funded with a single security or a basket of correlated securities, as well as assets with strong short- to midterm growth potential, including undervalued securities, real property or a business.
How GRATs work
There are several ways to structure a GRAT, but all typically include the following elements:
1. A person establishing the GRAT (the Grantor) partners with legal counsel to establish the trust, which has a fixed term of typically two years.
2. The trust is funded with a one-time transfer of assets.
3. GRATs are typically funded with assets that have potential for capital appreciation over the term of the trust. The tax effectiveness of the transaction derives from the outperformance of the investments over an IRS-defined “hurdle rate.” After the GRAT is funded, the Grantor receives an annual (or more frequent) annuity payment from the GRAT throughout its term.
- The amount of the annuity payment is calculated with reference to IRS regulations and, in the aggregate, is often nearly equal to the amount initially contributed to the GRAT plus a rate of return referred to as the hurdle rate. The hurdle rate is the Section 7520 rate (equivalent to 120% of the current applicable federal midterm rate, which is based on the average yield on 3-9-year Treasury notes, rounded to the nearest two-tenths of 1%.)
- Most GRATs are structured so that the actuarial value of the annuities plus the IRS required assumed rate of return is nearly equal to the funding amount. This is called a “zeroed-out” GRAT because the actuarial value of the taxable gift is almost zero.
4. For income tax purposes, the Grantor pays the income tax on all income earned inside the GRAT.
5. When the GRAT’s term expires, the trust remainder — that is, the appreciation earned in the trust less the amount paid as the annuity — passes to the beneficiaries outright or in trust for them.
How GRATS work: An example
Chris is a 40-year-old woman with an estate valued at $15 million. She establishes a GRAT in February 2022 with a 2-year term and names her son Bill as beneficiary. Chris funds the GRAT with $5 million of potential high-growth securities — an investment that she expects will appreciate significantly over the term of the GRAT.
According to the trust agreement and referencing the IRS hurdle rate, Chris will receive an annuity payment of $2,329,048 at the end of the first year, and another annuity payment of $2,794,857 at the end of the second year of the trust. Let’s assume that the rate of return on the trust assets will be 7.0% annually, and the IRS assumed hurdle rate of return is 1.6%. The market value of the trust assets is $5 million at the trust’s inception. The present value of the annuity is $4,999,999.92 based on IRS regulations.
Two-year GRAT, 1.6% hurdle rate, 7% rate of return
Subtracting this present value from the market value of the trust assets, the taxable gift is less than one dollar. At a 7% rate of return, the assets remaining in the trust at the end of the two-year period will be $437,561; this will pass tax-free to Bill.
Note that, by the end of the trust term, Chris will have recouped the value of the assets she used to establish the trust. If Chris retained the assets during this same two-year period and did not create the GRAT, that same $437,561 which goes to Bill from the GRAT would be retained in her taxable estate and trigger a 40% estate tax at her death.
- GRATs are sanctioned by the Internal Revenue Code and supported by strong case law.
- Grantors regain the initial assets in the form of an annuity. No income tax is imposed on transfers into or out of the GRAT, making it possible to fund the trust with low basis securities.
- The annuity can be paid with a distribution of property; cash is not required.
- The remainder, approximately equal in value to any appreciation during the term of the GRAT, passes to beneficiaries as a tax-free gift.
- The remainder is excluded from the Grantor’s gross estate on the condition the Grantor outlives the GRAT term.
- GRATs can be funded with low-growth but high-income-producing assets. Often, these GRAT terms are optimized to balance cash flow.
- “Cascading,” or “rolling,” GRATs can be funded using the annuity stream of an existing GRAT. As each annuity payment is received, it is “rolled” into a new GRAT. By keeping the term of each GRAT short, the Grantor reduces the likelihood the appreciation on the assets will be pulled back into the taxable estate should the Grantor pass away before the GRAT expires.
- The Grantor remains liable for income tax on sales and other income within the GRAT. This can be an additional estate planning benefit, since having the Grantor pay the tax for the trust leaves more assets inside the trust for the beneficiaries — it is essentially an additional tax-free gift to the beneficiaries and is paid with assets that otherwise would be subject to estate tax.
- The Grantor can swap assets with the GRAT during its term to lock in appreciation before the end of the term. Specifically, if 1) there is exceedingly rapid appreciation early in the GRAT term, and 2) the Grantor worries about downside volatility over the balance of the term, then replacing or swapping the appreciating asset with cash or other assets can “freeze” the inside value of the GRAT.
- The Grantor also can swap out assets that have rapidly declined in value and fund them into a new GRAT, creating an opportunity for success as the assets regain normal values.
Mortality risk: Estate tax
If the Grantor dies during the term of the trust, the value of some or all of the assets will be included in the Grantor’s estate, based on a sophisticated tax rule that may fully nullify the anticipated tax benefits. Careful consideration of the Grantor’s age, health and other risk factors is important when establishing the term of the trust.
If the assets in the GRAT decline in value below the IRS’s assumed rate of return, it will negate any tax benefits of the GRAT. There will be no appreciation to transfer to beneficiaries, and all property in the trust will revert to the Grantor. However, the swap power (as noted above) may be a beneficial solution.
Rising 7520 headwind
As interest rates increase, there is a concomitant increase in the 7520 rate. Thus, a “rolling GRAT” program could face higher hurdles in the future. There is a potential workaround.
In the past, GRATs have been identified as a “loophole for the wealthy,” making them a potential target for future tax reform legislation. If you are considering a GRAT, monitor ongoing discussions in Congress closely and consult with a tax attorney. That said, there is a technique to counter such a law change.
- Assets pass to the remainder beneficiaries with a carry-over tax basis — not a stepped-up basis as with other inherited assets. Beneficiaries are liable for any taxable gain should those assets be later sold.
- GRATs are not appropriate for generation-skipping asset transfers. The estate-tax inclusion period rules prevent allocating the generation-skipping tax exemption until after the expiration of the term, and thus is on a dollar-for-dollar basis.
- Once assets are placed within a GRAT, only the annuity is available to the Grantor.
- If the assets used to fund a GRAT are unique and hard to value, a qualified appraisal may be needed when the Grantor trust is established and for each subsequent annuity payment. However, there are strategies for GRATs with such assets.
A well-structured GRAT can help some individuals and families transfer significant assets to their beneficiaries with no estate tax and negligible gift tax. To learn more about this powerful, tax-efficient wealth transfer strategy and how it might fit into your wealth and estate planning goals, please contact your Glenmede Relationship Manager or visit us at Glenmede.com.
This presentation is intended to provide a review of issues or topics of possible interest to Glenmede Trust Company clients and friends and is not intended as investment, tax or legal advice. It contains Glenmede’s opinions, which may change after the date of publication. Information obtained from third-party sources is assumed reliable but is not verified. No outcome, including performance or tax consequences, is guaranteed, due to various risks and uncertainties. Clients are encouraged to discuss anything they see here of interest with their tax advisor, attorney or Glenmede Relationship Manager.