A properly structured grantor retained annuity trust (GRAT) can be a powerful tool for those with estates large enough that gift and estate taxes are a concern. It allows you to transfer wealth to your loved ones at little or no tax cost while continuing to enjoy an income stream for a period of years. However, there are some drawbacks to a GRAT.
GRAT benefits
A GRAT is an irrevocable trust that allows you, as the grantor, to transfer appreciating assets to beneficiaries while retaining the right to receive fixed annuity payments for a specified term. At the end of the term, any remaining assets pass to the beneficiaries you’ve named, such as your children.
The projected value of what will remain in the trust for the beneficiaries after the annuity is paid is generally a taxable gift for federal purposes. This is calculated by assuming the GRAT assets will grow at the Section 7520 rate, regardless of the specific assets’ projected or actual growth rate.
For taxpayers with estates that currently exceed the federal gift and estate tax exemption (or that might grow to exceed it in the future), one of the most attractive features of a GRAT is its ability to reduce gift and estate taxes. GRATs are commonly funded with assets that are expected to increase significantly in value, such as closely held business interests, stocks or investment portfolios. Any appreciation of the trust assets above the Sec. 7520 rate, also known as the “hurdle” rate, can pass to beneficiaries free of additional gift or estate tax.
Many GRATs are structured as “zeroed-out” GRATs, meaning the present value of the annuity is nearly equal to the value of the assets contributed to the trust. As a result, the taxable gift is minimal or even close to zero.
GRAT drawbacks
One of the most significant risks of using a GRAT is that the grantor must survive the trust term. If you die before the GRAT expires, some or all of the trust assets may be included in your taxable estate, potentially eliminating the anticipated tax benefits. For this reason, shorter-term GRATs are often preferred, particularly for older individuals or those with health concerns.
Also, the investment performance of a GRAT’s assets matters. A GRAT succeeds only if the trust assets appreciate at a rate greater than the hurdle rate. If the assets underperform or decline in value, the GRAT may produce little or no wealth-transfer benefit. While you, as the grantor, generally will still receive the annuity payments, the effort and costs associated with establishing the trust may be wasted.
Bear in mind, too, that because a GRAT is irrevocable, you can’t simply change the terms or reclaim the transferred assets once the trust has been established. This lack of flexibility requires careful planning and consideration of future financial needs.
Right for you?
A GRAT can be a powerful estate planning tool for individuals with large estates and a desire to transfer wealth tax efficiently to future generations. However, it isn’t right for everyone. Factors such as life expectancy, asset performance expectations, cash flow needs and overall estate planning objectives should all be carefully evaluated. We can help you determine if a GRAT is right for you.
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We highly recommend you confer with your Miller Kaplan advisor to understand your specific situation and how this may impact you.
