A Grantor Retained Annuity Trust is a planning tool that you may use to transfer assets to your beneficiaries with little, or possibly no, wealth transfer tax costs. The primary benefit of a GRAT is to freeze the value of the property transferred to the trust, so that the future appreciation is transferred in a tax-efficient manner. The best assets to use with this technique are those that you expect to appreciate significantly in value, such as securities, business interests, or real estate.
A donor, called the grantor, creates a GRAT by transferring appreciating or income-producing assets to an irrevocable trust. The grantor retains the right to receive annuity payments from the trust during a stated term of years called the “fixed term.” The grantor’s annuity payments are based on an interest rate established by the IRS, known as the “Section 7520 rate.” At the end of the fixed term, the assets remaining in the trust pass to the beneficiaries of the trust, typically the grantor’s spouse and children.
The grantor’s initial gift to the GRAT is a taxable gift. The amount of the gift is the fair market value of the property transferred minus the value of the grantor’s retained annuity interest. Many times, a zeroed-out GRAT is implemented in order to eliminate any gift tax at the time the trust is created. At the end of the fixed term, if the assets the grantor transferred into the GRAT have appreciated at a rate greater than the Section 7520 rate, the excess growth passes to the remainder beneficiaries and no federal gift or estate tax is due on the transfer. However, if the grantor dies during the fixed term, the value of the GRAT assets are included in the grantor’s estate and may be subject to federal estate tax. To reduce this risk, the trust can be structured with a short fixed term, such as two or three years.
The key to creating a successful GRAT is selecting assets that will outperform the Section 7520 rate. Timing can be extremely beneficial as well. Implementing a GRAT after a downturn in the market may allow you to capture the recovery within the GRAT and, if the return exceeds the Section 7520 rate, pass that return to your beneficiaries free of wealth transfer taxes.