Grantor Retained Annuity Trust (GRAT)

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.

Why Use It?

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.

How Does It Work?

The gift tax value of the remainder is the present value of that future payment, 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 is based on an assumption that the GRAT will earn a certain rate of interest, so the present value of the remainder can be zero if the GRAT pays an annuity that greatly exceeds the interest it is assumed that the trust will earn, because in that case the trust has to distribute principal along with income in order to make the annuity payments. Using the assumed interest rate, it is possible to calculate an annuity amount that will result in the distribution of all of the principal over the term of the trust, so that there is nothing left to distribute at the end of the term. However, if the GRAT actually earns more than the assumed rate of interest, then there will be money left over at the end of the term of the trust, which is how the remainder beneficiaries can receive money without the grantor making a taxable gift.

Benefits

The benefit of a GRAT is the possibility (but not certainty) that the beneficiaries selected by the grantor of the GRAT will receive money or property at the end of the term of the trust, free of federal estate and gift tax, as explained above. This benefit is only a possibility, and not a certainty, because the remainder beneficiaries will receive money or property at the end of the trust only if the trust investments produce income and capital gains in excess of the interest rate that is used to value the remainder when the GRAT is created.

As explained below, this benefit comes with very few costs.

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 not able to earn more than the assumed interest rate, so that all of the trust assets are returned to the grantor in order to make the annuity payments and the remainder beneficiaries receive nothing. There is, from that point of view, no "downside" to the creation of a GRAT.

There is a possible estate tax cost because of the possibility of the grantor might die during the term of the trust, in which case the assets held in the GRAT should be included in the grantor’s gross estate for federal estate tax purposes. This is not necessarily a cost, because those same assets would have been part of the grantor’s estate if the GRAT had not been created, but it could result in more federal estate tax than would otherwise be payable 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 grantor’s interests in the trust for the federal estate tax marital deduction.

There are no federal income tax costs for a GRAT because:

• The transfer of property by the grantor to the GRAT is not a sale or other taxable disposition, so no gain or loss is realized when the trust is created.
• The GRAT should be considered a "grantor trust" for federal income tax purposes, so all of the income, gains or losses, deductions, and credits of the GRAT should be reported on the grantor’s own individual income tax return, and not a separate return for the trust (where the income or gains might be subject to higher tax rates).
• If the GRAT needs to distribute assets of the trust “in kind” to make annuity payments (such as by transferring stocks or bonds back to the grantor), there should not be any taxable gain or loss because the GRAT should be a “grantor trust” for federal income tax purposes. (However, there could be gains or losses for state income tax purposes if the state income tax is different from the federal income tax and does not recognize the GRAT as a "grantor trust.")
• The distribution of whatever is left in the GRAT at the end of the term of the trust to the remainder beneficiaries should not result in any gain or loss, or any taxable income to the remainder beneficiaries.

Because there should be no tax costs for creating a trust, the only costs for the GRAT should be transactional:

• The legal fees or other costs in preparing the GRAT trust document.
• The costs of preparing any gift tax returns that will be needed to report the creation of the trust and the present value of the remainder interests in the GRAT, which would include the costs of valuing the assets being transferred to the GRAT and the costs of calculating the value of the remainder interests based on the values of the assets transferred to the GRAT and the federal interest rate that is applicable with the GRAT is created. If real property, closely held business interests, or other properties with no readily ascertainable market values are transferred to the GRAT, appraisals might be needed for those properties.
• If the GRAT needs to distribute assets of the trust "in kind" to make annuity payments (such as by transferring stocks or bonds back to the grantor), then those assets will need to be valued when they are transferred to the grantor, and there may be costs of valuing those assets. If the assets being transferred back to the grantor include interests in real property, closely held business interests, or other properties without readily ascertainable market values, then appraisals might be needed for each distribution.
• The costs (if any) of administering the trust. The investment costs of the GRAT should be the same as what the grantor would have paid for investment advisors if the GRAT had not been created, so the creation of the GRAT should not cause additional administrative costs beyond what might be required for accounting for the receipts and disbursements of the GRAT.

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.

Who Should Use It?

A GRAT is usually 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 steps should be taken to qualify the grantor’s retained interests in the GRAT for the federal estate tax marital deduction in order to avoid payment of tax at the death of the grantor.

Decisions

Before a GRAT is created, there are some decisions to be made:

• What should be the term of the GRAT? The usual decision is to make the GRAT for a short term, usually two years. This is because the investments of a GRAT could increase suddenly in value, due to market or other conditions, but in a GRAT with a term of many years, that increase in a short term could be offset by decreases in value in a longer term.
• Should payments increase over time? The annuity payments must be “fixed” in amount, which means that it must be possible to calculate the amounts to be paid when the trust is created. The payments can therefore increase over the term of the trust if the increases can be calculated in advance, but increases of more than 20% from one year to the next will be disregarded for valuation purposes. Having payments increase by 20% each year is usually considered desirable, because it increases the time that money will be held in trust before it is paid out, which increases the discount.