GRANTOR RETAINED ANNUITY (GRAT) TRUST
A grantor retained annuity trust (GRAT) is an estate freeze technique that may help clients transfer significant wealth to future generations with minimal transfer tax impact.1 A GRAT is an irrevocable trust to which the grantor transfers property and retains an annuity interest from the transferred property for a fixed term. For transfer tax valuation purposes, the amount of the taxable gift is the fair market value of the property transferred minus the value of the grantor’s retained annuity interest.
How does a GRAT work?
- Grantor transfers assets to the GRAT and retains an income stream from the transferred property for a fixed term. The trust term and the amount of the income stream are determined by the grantor.
- GRAT makes annual annuity payments to the grantor for the length of the trust term.
- At the end of the GRAT term, the remaining trust assets are distributed to the remainder beneficiary without the imposition of additional gift tax and are excluded from the grantor’s taxable estate.
- The GRAT enables the grantor to make a current gift of assets with little or no gift tax cost while allowing the grantor the right to receive a fixed income interest during the term of the GRAT.
- Potentially leveraged gift to the remainder beneficiaries from the grantor. To the extent the return on the assets transferred to the GRAT exceed the Section 7520 rate, the excess value has been transferred to the GRAT beneficiaries without additional gift tax cost and removed from the grantor’s taxable estate.
- Unlike an installment sale to a grantor trust, a GRAT does not require the grantor to gift money to the trust prior to the transaction.
- A GRAT can provide the funds necessary to terminate premium leveraging arrangements with minimal gifting implications, while at the same time maintaining the client’s desired level of insurance protection.
- By paying the income tax liability generated by GRAT assets, the grantor has effectively made a gift-tax free transfer to the beneficiaries equal to the amount of the annual income tax liability of the GRAT.
- A GRAT is a statutorily created wealth transfer vehicle with a long history of use.
How is a GRAT used in Estate Planning?
Potential Gift Tax Leverage – One of the primary goals of utilizing a GRAT is to provide for a future transfer of wealth at a reduced gift tax cost. In order to transfer the asset at a reduced gift tax cost, the asset must appreciate at a rate greater than the 7520 rate in effect at the time of the transfer. If this occurs, the remaining assets in the trust will be greater than value of the gift calculated at the inception of the GRAT.
Walton Zeroed Out GRAT – It is possible for the client’s transfer to the GRAT to be valued at zero for gift tax purposes by utilizing what is commonly referred to as a Walton GRAT. A Walton GRAT is structured so the present value of the annuity payments equals the total value of assets transferred to the trust. By doing so, the gift to the GRAT may be valued at zero for gift tax purposes. Such an approach may be particularly appealing to a client that does not have gifting capacity available to fund the GRAT.
Obtaining Additional Gifting Leverage – Combining a GRAT with other estate planning techniques, such as a family limited partnership (FLP), can significantly increase the leverage and reduce the value of the taxable gift. Specifically, the grantor can transfer assets to the GRAT, which are subject to valuation discounts due to lack of marketability and/or lack of control (e.g., FLP interests, Limited Liability Company interests, or non-voting stock).
In that case, payments from the trust are based on the discounted value of these transferred assets rather than the underlying value of the assets, resulting in a lower payout during the trust term. Using these valuation discounts can also increase the value of the assets which ultimately pass to the remainder beneficiary, without any additional gift tax. It is not uncommon for valuation discounts of 20-50% to be applied to such assets, which can effectively increase the value of the remainder interest by 40-100% when compared to exit strategies utilizing transfers of assets not subject to valuation adjustments.
Use as an Exit Strategy for Premium Leveraging Arrangements – Many clients use premium leveraging arrangements (e.g., Premium Financing or Private Financing) to facilitate funding their life insurance premiums with little or no cash flow and/or gift tax impact. However, certain risks exist with these arrangements, including interest rate uncertainty and the decreasing net death benefits due to the collateral assignee’s increasing interest in the policy.
In general, the longer the arrangement is intended to be in effect, the greater the risk to the client. Thus, especially in the case of a long-term premium leveraging arrangement, a well planned exit strategy should be in place from the beginning. As a result of the risks inherent in premium leveraging arrangements, it is crucial to include a well-planned exit strategy from the inception for arrangements that will last longer than 10-15 years. The use of a GRAT as an exit strategy provides clients an effective way to terminate premium leveraging arrangements with minimal gifting implications by providing the funds necessary to retire the debt in whole or in part, while at the same time maintaining the client’s desired level of insurance protection.
- A high net worth ($5 Million in the case of an individual)
- Inadequate gifting capacity for planning objectives
- A need for sophisticated estate planning strategy
- Assets that will potentially appreciate and/or produce earnings at a rate in excess of the IRC 7520 rate (7520 rate) in effect when the Grantor Retained Annuity Trust (GRAT) is established.
- Involvement in or are considering a premium leveraging arrangements, such as Premium Financing, Private Financing and/or Private Split Dollar and would like an exit strategy to reduce the risks inherent in the premium leveraging arrangement.
- Assets which are subject to valuation discounts due to lack of marketability and/or lack of control (e.g., FLP interests, Limited Liability Company interests, or nonvoting stock).