A grantor retained annuity trust, or "GRAT," is an irrevocable trust from which the grantor (i.e., the creator or settlor of the trust) has retained the right to receive an annuity of a fixed (or determinable) amount during the term of the trust. At the end of the term of the trust, the remaining assets of the trust go to the beneficiaries (such as children or grandchildren of the grantor) that are specified in the trust document.
A GRAT can be set up so that the present value of the remainder for federal gift tax purposes is very small, or even zero, which means that at the end of the term of the trust, the remaining trust assets (if any) that pass to the beneficiaries are free of federal gift tax and federal estate tax. There will be trust assets remaining at the end of the trust if the trust is able to earn more investment income and gains than are needed to make the annuity payments.
Usually, the GRAT is set up with a relatively short term, so that the grantor can survive the term of the GRAT, because if the grantor dies during the term of the GRAT, some or all of the assets of the GRAT will be included in the grantor's gross estate for federal estate tax purposes, and so subject to federal estate tax, under the same rules that require a trust to be included in the grantor's gross estate if the grantor has retained the right to receive (or control) the income from the trust.
A long-term GRAT would be set up for a term of 50, 100, or even 1,000 years (assuming that can be done under state law), which means that the grantor is certain to die during the term of the GRAT. That may be acceptable if current interest rates are low and likely to increase in the future, because if interest rates increase significantly then only part of the GRAT may be included in the grantor's gross estate. The GRAT will therefore get assets out of the grantor's taxable estate not because the grantor survives the term of the trust but because of an increase is interest rates.
The gift tax value of a GRAT remainder is the present value of that future distribution, and the present value of the remainder can be zero even though valuable trust assets may actually go to the remainder beneficiaries at the end of the term of the trust. This is because of the way the Internal Revenue Code and its regulations say that the remainder should be valued for gift tax purposes.
The present value of the remainder for gift tax purposes is the amount contributed to the trust less the present value of the annuity payments to be made to the grantor. The present value of the annuity is based on an assumed interest rate which is redetermined each month, and is usually known as the §7520 rate, that is based on the average yields of federal securities with maturities of three to nine years.
the calculation of the present value of the remainder is equivalent to assuming that the trust will earn the current §7520 rate for the entire term of the trust. If the present value of the remainder is zero, it is because the §7520 rate income will not be enough to pay the annuity amounts, so principal will be distributed and all of the principal will be distributed over the term of the trust. However, if the GRAT actually earns more than the §7520 rate, then less principal will need to be distributed, and there will be money left over at the end of the term of the trust. That is how remainder beneficiaries can receive money without the grantor making a taxable gift.
As explained above, a GRAT is usually set up with a relatively short term, so that the grantor can survive the term of the GRAT and the beneficiaries can receive any remainder free of both federal gift tax and estate tax.
In a long-term GRAT, for a term greater than the grantor's lifetime, the grantor is certain to die during the term of the GRAT and so at least part of the GRAT will be included in the grantor's taxable estate under the same principle that taxes a trust if the grantor creates a trust and retains the right to the income (or use) of the trust property. IRS regulations say that the part of the GRAT that is included in the taxable estate is the portion over which the grantor has retained the right to the income, which for an annuity trust is calculated by dividing the annuity payable by the trust by the §7520 rate that is in effect at the grantor's death. If the §7520 rate is relatively low when the trust is created, and the term of the trust is long, then the annuity that needs to be paid to create a remainder with a value of $0 will also be relatively small, not much more than the §7520 rate income that would be earned by the trust. If the §7520 rate goes up after the GRAT is created and before the grantor's death, it is possible that the value needed to produce an income equal to the annuity amount will be less than the value of the trust at the grantor's death, and so a portion of the assets in the trust will escape federal estate tax.
How much of the trust will be able to escape federal estate tax will depend upon:
The benefit of a long-term GRAT is the possibility (but not certainty) that not all of the trust will be included in the grantor's taxable estate at death. This benefit is only a possibility, and not a certainty, because (as explained above) the portion of the trust that is included in the grantor's taxable estate depends on (a) how much the trust has been able to earn to make the annuity payments and how much the trust may have decreased in value by making the annuity payments; and (b) the §7520 rate in effect at death, and whether it is significantly higher than the rate that was used to establish the annuity amount when the trust was created.
As explained below, this benefit comes with very few costs.
As explained above, a GRAT should have no (or insignificant) gift tax cost if the trust document is prepared to conform to the applicable tax rules, if the annuity amount is calculated properly, and if the trust is funded properly, so that the present value of the remainder is zero (or nearly zero). (There may be an extremely small gift tax cost, perhaps $1, because many practitioners believe that the GRAT remainder should not actually be zero, but should have some value for gift tax purposes, so that a value is reported on a gift tax return.)
Because the creation of a GRAT has little or no gift tax cost, there is no loss if the GRAT is ultimately included in the grantor's gross estate, and so subject to federal estate tax, because the estate tax will not be any more than what would have been payable if the GRAT had not been created. There is, from that point of view, no "downside" to the creation of a GRAT.
There is a possible estate tax cost if (a) the grantor is married and would otherwise have used the federal estate marital deduction to avoid or defer the estate tax, (b) the GRAT does not pass to the surviving spouse or the interests of the grantor's spouse do not qualify for the federal estate tax marital deduction, and (c) the value of the GRAT assets, plus the total of the taxable gifts made by the grantor during lifetime and or at death exceed the federal estate tax exclusion amount (which is $12,920,000 in 2023). If the possibility of federal estate tax payable at the grantor's death is a concern, then steps should be taken to qualify the portion of the grantor's interests in the trust that are included in the grantor's gross estate for the federal estate tax marital deduction.
There are no federal income tax costs for a GRAT because:
Because there should be no tax costs for creating a trust, the only costs for the GRAT should be transactional:
The only other cost of a GRAT is what might be described as an "opportunity cost," because the assets of the grantor that are used for a GRAT cannot be used for other estate planning steps, such as taxable gifts directly to children or grandchildren or trusts for their benefit. The benefit of a GRAT must therefore be weighed against the benefit of other steps that might have greater estate planning benefits.
A long-term GRAT will usually be best suited to an unmarried person who has an estate that is more than his or her applicable exclusion amount (which can include both the base exclusion amount, which is $12,920,000 in 2023, as well as the unused exclusion amount of a deceased spouse) and who has securities or other easily transferrable assets which could produce an investment yield of income or capital gain that could exceed the assumed interest rate that is used to value the remainder of the GRAT.
If the grantor is married, a GRAT might still be desirable, but it may also be desireable to take steps to try to qualify the portion of the grantor's retained interests in the GRAT that will be included in the gross estate for the federal estate tax marital deduction in order to avoid payment of tax at the death of the grantor.
Before a long-term GRAT is created, there are some decisions to be made: