Estate planning Q&A: Grantor Retained Annuity Trusts explained

How to transfer wealth using minimal gift and estate tax exemption

May 21, 2024
Family office services Washington National Tax Private client services

Do you have assets you expect to grow significantly? Leaving such assets in your estate to appreciate during your lifetime may increase your estate tax bill. However, if you have already utilized your current available lifetime gift tax exemption, making an outright transfer and triggering gift tax might not be the most desired option. A Grantor Retained Annuity Trust (GRAT) can be a valuable tool to address this. It allows you to transfer wealth to future generations while freezing the current value of the assets for tax purposes and using minimal lifetime gift tax exemption.

What is a GRAT?

A GRAT is an irrevocable trust that exists only for a specified period of time. You initially transfer assets to the GRAT and then receive annuity payments back for the term of the GRAT. For example, you transfer an asset worth $1 million to the GRAT. Over the term, the GRAT pays you $999,999 of annuity payments. This results in a $1 ‘taxable gift.’ If the assets appreciate more than the annuity payment back to you, the excess appreciation escapes your estate transfer tax free. If the $1 million of GRAT assets grows to $1.5 million during the term, that $500,000 of growth will pass to your beneficiaries free of estate and gift tax. At the end of the specified term, the GRAT terminates, and the remaining assets are transferred to the GRAT beneficiaries (typically a younger generation), either outright or in trust.

What are the requirements for establishing a GRAT?

  • The annuity payments must be:
    • Either a fixed dollar amount or a set percentage of the initial value of the transferred assets.
    • Paid to the grantor at least annually.
    • Payable for a fixed term (e.g., 2, 5, 10 years).
    • Made only to the grantor or grantor’s estate.
  • The annuity payments cannot:
    • Be prepaid by the GRAT.
    • Be paid via loans.
    • Increase more than 20% from the prior year’s payment.
  • After the initial GRAT funding, no additional contributions can be made.

What are the benefits of setting up a GRAT?

  • If the assets grow at a rate greater than the annuity rate specified by the IRS (the "hurdle rate" or "7520 rate"), that excess growth accrues to the beneficiaries transfer tax-free.
  • During the term of the GRAT, you are treated as the owner of the assets for income tax purposes. Thus, you are responsible for paying income tax on the GRAT income.  Paying income taxes on behalf of the GRAT is not considered an additional gift to the GRAT. The GRAT is able to grow without being reduced by the payment of income taxes, leaving more to pass to your beneficiaries.
  • Generally, GRATs can even hold shares in S corporations.

What are the potential downsides to setting up a GRAT?

  • If you die during the GRAT term, the assets go back to your estate, negating the transfer tax benefits.
  • If your assets don’t grow as much as expected (or even lose value), little or no assets may remain for the beneficiaries at the end of the GRAT term.
  • GRATs are generally not effective for transfers to grandchildren because the generation-skipping transfer (GST) tax rules may require you to use an excessive amount of GST exemption. Thus, GRAT assets are usually left to only children.  
  • When your beneficiaries inherit the assets, they inherit the original tax basis you had. This might not be ideal for assets with low basis, meaning the beneficiaries could owe more capital gains tax when they eventually sell.

Is a GRAT right for you?

GRATs can be a strategic way to transfer wealth to beneficiaries. However, the length of the GRAT term, the specific assets to be contributed to the GRAT, the beneficiaries of the GRAT and the IRS hurdle rate at the time the of the initial gift should all be carefully considered. The benefits and risks of a GRAT can vary greatly based on these factors and should always be adjusted for a grantor’s individual circumstances. By understanding the requirements, advantages, and potential downsides, you can make an informed decision about whether a GRAT is right for your estate planning needs. As always, consult with your RSM US tax advisor to tailor a strategy that best suits your situation and goals.

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