A Grantor Retained Annuity Trust (GRAT) is an Irrevocable Trust into which an individual transfers property and retains the right to receive annual payments from the Trust for a term of years. It is funded with a single contribution of assets, which pay a percentage of the initial contribution, either fixed or as an annuity. At the end of the term, the assets are distributed to the beneficiaries of the GRAT.

Why Use a Grantor Retained Annuity Trust (GRAT)?

A GRAT is a tax planning technique to reduce the size of an estate and the amount of the resulting estate tax. The objective of a GRAT is to shift future appreciation on the assets contributed to the GRAT to others at a minimal gift tax cost.  Typically you fund a GRAT with assets you anticipate will appreciate sharply over the term of the GRAT.

For the strategy to be successful, the assets transferred to the GRAT must appreciate at a rate greater than the IRS assumed rate of return. The difference between the actual rate of return on the investment and the IRS assumed rate of return will pass, gift tax free, to the beneficiaries at the end of the GRAT term. The current state of low interest rates makes a GRAT particularly attractive. Typically you only fund a GRAT with assets you anticipate will appreciate sharply over the term of the GRAT.

How Does a GRAT Work?

With this estate planning vehicle, you would transfer assets to a Trust from which you retain the right to receive an annuity for a set period of time (for example, five years), after which time the remainder passes to your children or other beneficiaries, either outright or in Trust. Under the terms of the GRAT, you retain the right to receive an amount equal to the value you transferred to the GRAT plus interest, and the remainder beneficiaries receive everything in excess of that value. If the value of what you are receiving is calculated to be worth the full value of the property you put into the Trust, the value going to the beneficiaries is presumed to be zero—even though they may end up getting a great deal of money.

Let’s show an example of how a GRAT works to your advantage. Let’s assume that you have $100,000 to invest in a five-year GRAT and that the government has set the interest rate of 4 percent the month the GRAT was created. If you pay yourself around $22,500 each year for five years, the value of the interest to your beneficiaries would be zero. How so?

If you invested the $100,000 at 4 percent you would end up with just enough money to pay yourself around $22,500 for five years before exhausting the Trust.

If however, you make more than the IRS determined 4 percent, any growth the Trust earns will pass to your beneficiaries tax free. If in our example the assets earned 7 percent, the balance at the end of the five-year term would be around $11,000, gift tax-free to the beneficiaries.  But imagine the result if the assets earned 15, 20, or 30 percent year?  That’s when the GRAT begins to make sense.

What if the assets under-perform the assumed interest rate? You would simply get all the assets back as though you had never created the Trust.

When it works, the results are excellent, and when it does not work, the loss is minimal.

GRAT Caveats

There are a tax points to consider regarding the GRAT:

• If you die before the end of the annuity period, the Trust assets will be includible in your estate, and the advantages of the GRAT strategy will be lost. This favors use of a relatively short annuity period.
• A GRAT should be taxed as a “Grantor Trust” for income tax purposes.
• Funding a GRAT with hard-to-value property, such as real estate, partnership interests or shares of a closely held business, poses valuation challenges. For example, if you fund the GRAT with illiquid assets and plan to have the annual annuity payments made from the GRAT by distributing back to you assets in kind, rather than selling assets to make the payment, you will need to value the assets on the date they are contributed to the GRAT and on each annuity payment date thereafter.
• It is better to have multiple GRATs, each holding a different investment, than a single GRAT with a diversified portfolio. This will prevent investments that do not appreciate substantially from diminishing the overall return of the GRAT. There is no limit on the number of GRATs a person can create.

Using a GRAT may be a good way for you to reduce your gift tax. However, it is only one estate planning tool available that helps to reduce gift and estate taxes. Consult with an attorney who focuses on estate planning to determine what tools will work best for you and your family.