What Is a Grantor Retained Annuity Trust (GRAT)?
A grantor retained annuity trust (GRAT) is a financial instrument used in estate planning to minimize taxes on large financial gifts to family members. Under these plans, an irrevocable trust is created for a certain period of time. Assets are placed under the trust and then an annuity is paid out to the grantor every year. When the trust expires and the last annuity payment is made, the beneficiary receives the assets and pays little or no gift taxes.
- Grantor retained annuity trusts (GRATs) are estate planning instruments in which a grantor locks assets in a trust from which they earn annual income.
- Upon expiry, the beneficiary receives the assets with minimal or no gift tax liability.
- GRATs are used by wealthy individuals to minimize tax liabilities.
Understanding Grantor Retained Annuity Trusts (GRATs)
A grantor retained annuity trust is a type of irrevocable gifting trust that allows a grantor or trustmaker to potentially pass a significant amount of wealth to the next generation with little or no gift tax cost. GRATs are established for a specific number of years.
When creating a GRAT, a grantor contributes assets in trust but retains a right to receive (over the term of the GRAT) the original value of the assets contributed to the trust while earning a rate of return specified by the IRS (known as the 7520 rate). When the GRAT's term expires, the leftover assets (essentially any appreciation of the original assets minus the IRS-assumed return rate) are given to the grantor's beneficiaries.
Under a GRAT, the annuity payments come from interest earned on the assets underlying the trust or as a percentage of the total value of the assets. If the individual who establishes the trust dies before the trust expires the assets become part of the taxable estate of the individual, and the beneficiary receives nothing, making the GRAT useless.
A successful GRAT also assumes that the assets appreciate, so if there is a Depreciation, the GRAT doesn't work well. There is also a risk with the IRS's 7520 rate, in that it has been so low over the last decade as to reduce the ultimate advantage of using a GRAT in the first place.
GRATs are most useful to wealthy individuals who face significant estate tax liability at death. In such a case, a GRAT may be used to freeze the value of their estate by shifting a portion or all of the appreciation onto their heirs. For example, if a person had an asset worth $10 million but expected it to grow to $12 million over the next two years, they could transfer the difference to their children tax-free.
If the grantor dies during the term of the GRAT, the value of the remainder interest is also included in the grantor's estate. However, the grantor can pass the right to receive any remaining annuity payments to their surviving spouse to qualify for the estate tax marital deduction, which could eliminate any estate tax liability relating to the GRAT assets.
GRATs are especially popular with individuals who own shares in startup companies, as stock price appreciation for IPO shares will usually far outpace the IRS assumed rate of return. That means more money can be passed to children while not eating into the grantor's lifetime exemption from estate and gift taxes.
GRATs saw a big surge in popularity in 2000 as a result of a favorable ruling in the U.S. Tax Court involving the Walton family of Walmart Inc. fame. Audrey J. Walton v. Commissioner of Internal Revenue saw the court rule in favor of Walton's use of two GRATs, in which annuity payments were set up to return all of the original assets to the grantor and leave only the appreciated value to beneficiaries.
Through this set-up, the value of the gift originally put in trust is reduced to zero, and any remaining value in the trust is transferred to the beneficiary tax-free. The use of GRATs in this way is known as a "zeroed-out GRAT" or "Walton GRAT."
Example of a GRAT
Facebook founder Mark Zuckerberg put his company's pre-IPO stock into a GRAT before it went public. While the exact numbers are not known, Forbes magazine ran estimated numbers and came up with an impressive number of $37,315,513 as the value of Zuckerberg's stock.