With the estate and gift tax exemption scheduled to sunset at the end of 2025, now is an excellent time to consider whether your estate plan needs an adjustment. Or, if you don’t have an estate plan just yet, there’s no time like the present to create one. Given the sunsetting of the estate and gift tax exemption, if your estate is over $6 million (as an individual) or $12.4 million (as a married couple), a grantor retained annuity trust (GRAT) could be a practical, tax-advantaged tool to transfer assets to loved ones.
1. How a GRAT Works
A GRAT is an irrevocable trust where the grantor (its creator) contributes assets to the trust upfront and retains an annuity stream for a specified term. Then, at the end of the specified term, any assets left in the trust are transferred to the trust beneficiaries (typically your loved ones) free of estate and gift tax. [i] When the grantor transfers the assets to the GRAT, you can think of it as freezing the value of the assets and shifting the appreciation of those assets to heirs free of tax. [ii] In essence, GRATs can be an effective strategy to reduce future estate tax liability. [iii].
The annuity stream that the GRAT pays the grantor is a specified annual payment based partly on the IRS Section 7520 interest rate at the time the GRAT is established. A GRAT is expected to produce a minimum return for the grantor at least equal to the 7520 rate. This rate is published monthly and is currently 4.40% for March 2023. [iv] GRATs are considered successful when the earnings and appreciation on the assets placed in the GRAT outperform the Section 7520 rate. When the investment performance of the assets in the GRAT exceeds the 7520 rate for the annuity term, the assets in the trust at the end of the term can be distributed to the trust beneficiaries free of estate tax. [iii]
When the grantor establishes the GRAT and transfers assets into it, it is considered a taxable gift to the beneficiaries – taxable in the sense that the grantor could potentially use up some of their lifetime gift exemption. However, there are ways to structure the GRAT so that there is no gift, or a small gift, for gift tax purposes – i.e., a “zeroed-out GRAT.” To calculate the amount of the taxable gift, we use the subtraction method: the value of the grantor’s annuity interest, which is not a taxable gift, is subtracted from the value of the property transferred to the GRAT. [iii]
Said another way, you can potentially “zero-out” the taxable gift when the value of the annuity retained by the grantor is equal to the value of the property the grantor transferred into the GRAT.
2. A Simple GRAT Example [iii]
A $1,000,000 zeroed-out GRAT based on an IRS 7520 rate of 3.8% will pay the Grantor an annuity of $223,369 each year, for five years. If the GRAT earns 3.8% or less each year, the Grantor will receive all the trust property, and there will be nothing left after five years for the Grantor’s beneficiaries. Although this GRAT would not be successful, the Grantor would be in the same position as if the GRAT was never created.
However, if the GRAT outperforms the IRS 7520 rate by earning a 10% annual return, the Grantor would receive the same annuity payments described above, and there will also be $246,822 distributed to the grantor’s beneficiaries free of estate and gift tax.
3. Drawbacks of GRATs
GRATs are subject to the grantor’s mortality. If the grantor passes away during the term of the GRAT, the assets that remain in the GRAT typically become part of the grantor’s taxable estate – and the tax benefits of the GRAT would not be realized.
Additionally, GRATs are built on the assumption that the assets within them will appreciate. If the assets in the GRAT don’t appreciate at all or don’t appreciate enough, then there may be nothing (or very little) for the grantor to pass on to beneficiaries. Although the GRAT may not be successful in this scenario, there’s no actual loss other than the trust administration cost.
Final Thoughts
GRATs can be a helpful tax-saving strategy within a comprehensive estate plan. As you consider your legacy and how the upcoming sunsetting of the estate and gift tax exemption may affect you, we’d be happy to help evaluate your situation, understand your goals, and help bring your vision to life.
Disclosures: This information should not be construed as investment, tax, or legal advice. All statements and opinions expressed herein are based upon information considered reliable at the time of publication and are subject to change without notice.
[i]. Staff, WealthCounsel. “FAQs about Grats, Answered.” FAQs about GRATs, Answered, November 13, 2020. https://info.wealthcounsel.com/blog/faqs-about-grats-answered.
[ii]. Kagan, Julia. “Grantor Retained Annuity Trust (GRAT): Definition and Example.” Investopedia. Investopedia, October 11, 2022. https://www.investopedia.com/terms/g/grat.asp.
[iii]. Coulton, Marianne, and Ryland F. Mahathey. “Grat: Grantor-Retained Annuity Trust Planning.” EstatePlanning.com, July 18, 2008. https://www.estateplanning.com/grat-grantor-retained-annuity-trust-planning.
[iv]. “Section 7520 Interest Rates.” Internal Revenue Service, 2023. https://www.irs.gov/businesses/small-businesses-self-employed/section-7520-interest-rates.