Understanding Grantor Retained Annuity Trusts 

Key Takeaways 

• Grantor retained annuity trusts (GRATs) are estate planning tools that allow a grantor to transfer appreciating assets to the next generation with little to no gift or estate tax consequences. 

• The grantor receives the right to an annuity stream during the term of the GRAT with assets remaining at the end of the term passing to non-charitable beneficiaries such as the grantor’s children. 

• GRATs can be positioned for significant upside while limiting potential downside. 

What is a Grantor Retained Annuity Trust (GRAT) and how does it work? 

In simple terms, a GRAT is a specialized, fixed-term irrevocable trust used to transfer assets to beneficiaries (like your children) with minimal gift or estate taxes.  

A grantor contributes property to a GRAT and retains the right to be paid an annuity for a specified term of years. The required annuity payment is based on the Internal Revenue Code (“IRC”) Section 7520 interest rate. Due to the retained annuity, the GRAT can be structured so there is no gift, or a very small gift, for gift tax purposes. This is referred to as a Zeroed-out GRAT.  

The amount of the taxable gift is calculated by the subtraction method. The value of the annuity interest retained by the grantor, which is not a taxable gift, is subtracted from the value of the property transferred to the GRAT. At the end of the annuity term, the remainder interest, if any, is distributed to the trust beneficiaries. 

Benefits of using a GRAT 

The primary benefit of a GRAT is to freeze the value of assets transferred to a GRAT so that the future appreciation on such property will pass transfer tax-free to the grantor’s beneficiaries.  

GRATs can also largely avoid transfer taxes. The IRC Section 7520 rate, which is published monthly by the IRS, is used to determine the present value of an annuity, life estate, or remainder interest. A GRAT is successful when the earnings and appreciation on the property placed in the GRAT outperform the IRC Section 7520 rate.  

The October 2024 Section 7520 rate applicable to GRATs is 4.4%, the lowest in over a year. If the investment performance of property contributed to a GRAT exceeds the Section 7520 rate over the annuity term, then the GRAT will be successful and the remainder in the GRAT at the expiration of the annuity term will be distributed transfer tax-free to the GRAT’s remainder beneficiaries. 

Upsides to GRATs include:  

• The appreciation and future income on property distributed to remainder beneficiaries is removed from the grantor’s taxable estate reducing future federal estate tax. 

• A zeroed-out GRAT can be structured so there is little or no taxable gift and/or use of exclusion upon creation. 

• GRATs are statutorily sanctioned, and annuity amounts will generally automatically adjust if asset valuation is successfully challenged on audit. 

There are also certain caveats to GRATs: 

• Inherent with a GRAT is the potential for some or possibly all of the transferred assets to be included in the grantor’s estate in the event of his or her death before the end of the GRAT term.  

• Unlike other estate planning techniques, GRATs cannot skip generations. 

Setting Up and Funding a GRAT 

Creating a GRAT involves careful planning and professional guidance. Here’s a simplified overview of the process: 

1. Consult with a financial and legal professional experienced in estate planning and trusts to determine if a GRAT is appropriate in your circumstances. 
2. Choose the assets you want to transfer to the GRAT, such as stocks, hedge fund investments, closely-held business interests, or real estate. 
3. Determine the length of the GRAT term, which typically ranges from 2 to 10 years. The term length depends on your expectations for the trust assets’ growth. 
4. Calculate the annuity payments using the IRS Section 7520 rate, which changes monthly based on economic factors.
5. Set up the GRAT by working with an attorney to establish an irrevocable trust and transfer the selected assets into it. 
6. The grantor will receive an annuity payment at least annually for the duration of the GRAT term, with the initial transfer plus some interest returned to the grantor. 
7. At the conclusion of the GRAT term, assuming the trust is structured properly, any assets remaining in the trust would pass to heirs free of gift and estate taxes. 

Remember that the grantor is responsible for paying income tax on any trust income generated during the term of the trust, and the annuity payments made back to the grantor will be included in the estate. However, the growth on the assets would pass to heirs free of estate tax. 

Tax Implications of a GRAT 

GRATs offer potential tax advantages, but also have specific tax implications. Here’s a breakdown of what to consider: 

• During the term of the GRAT, the grantor is taxed on all income and capital gains earned by the trust, without regard to the amount of the annuity paid to the grantor. 

• At the end of the GRAT term, if the grantor is still alive, the beneficiaries named in the trust instrument will receive the assets remaining in the GRAT after the final annuity payment. 

• If the assets in the GRAT appreciate at a rate higher than the IRS’s assumed interest rate, the excess growth passes to the beneficiaries tax-free. 

• If the grantor passes away during the GRAT term, the value of the remainder interest is also included in the grantor’s estate. 

• The grantor can pass the right to receive any remaining annuity payments to their surviving spouse to qualify for the estate tax marital deduction, potentially eliminating any estate tax liability relating to the GRAT assets. 

Case Study: Using a GRAT for Estate Planning 

In this case study, we analyze a scenario of using a GRAT to demonstrate its potential applications in estate planning: 

A $5,000,000 zeroed-out GRAT based on the October 2024 Section 7520 rate of 4.4% will pay an annuity of $1,135,796 to the grantor for five years. If the trust earns 4.4% or less each year, the grantor will receive the entire trust property in annuity payments, and there will be nothing left after five years for the remainder beneficiaries. Although the GRAT just described will not be successful, the grantor will be in the same position as if the GRAT was never created, aside from fees and hassle. If, however, the trust outperforms the IRS rate by 20%, the grantor will receive the annual annuity payments, and there will also be $5,683,028 ($6,248,671 if annuity payments are fully backloaded as permitted under the GRAT statutes) distributed to the remainder beneficiaries free of transfer tax after the trust term ends.  Additionally, those appreciating assets are no longer included in the grantor’s taxable estate. 

Conclusion: Is a GRAT Right for You? 

GRATs are a powerful tool, but not suitable for everyone. Consider the following: 

• Best for: High net worth individuals looking to pass appreciating assets on to the next generation. 

• Benefits: Potential for transfer without hefty estate or gift taxes. 

• Risks: Irrevocable, can be complex to set up, success is contingent on asset performance and proper structuring. Limited downside. 

It is essential to consult with experienced legal professionals before setting up a GRAT to determine if it aligns with your goals and to understand potential implications. 

Disclaimer: This article is made available by Sterlington for informational purposes only. It is not intended to provide specific legal advice and should not be used as a substitute for competent legal advice from a licensed professional attorney in your state. Using this website does not establish any attorney-client relationship between Sterlington and yourself.