In recent months, the number of conversations that we are having with clients about federal gift and estate taxes has increased dramatically. These discussions had largely disappeared after 2017 for most clients when the federal estate exemption was increased to more than $11 million per person from more than $5 million per person. Now that the sunset of this increase (at the end of 2025) is on the horizon, and with questions about the tax consequences of the upcoming election on people’s minds, estate taxes and how to reduce them are now a more frequent topic of conversation. We talk about several different strategies with clients (most of which have 4-letter acronyms, by the way), but this article will cover one of our favorites, the Grantor Retained Annuity Trust, or GRAT, for short.
A GRAT is a simple concept with some very favorable gift tax consequences, especially in today’s low interest rate environment. Here are the basics:
- A person (the Grantor) makes an irrevocable gift of assets to a trust that includes a provision that requires the trust to make an annual (or more frequent) payment of a specified amount back to the Grantor during the term of the trust. This is the “Retained Annuity” part of the trust.
- The GRAT will last a term of years, and at the end of the term, any assets remaining in the GRAT will be paid to the GRAT’s beneficiaries, which are usually the Grantor’s heirs or another trust for the benefit of those heirs.
- For gift tax purposes, the Grantor has made a gift equal to the value of the assets transferred to the GRAT, less the “present value” of the annual payments retained by the Grantor under the terms of the trust.
- This present value of the annuity stream is the lump sum amount, invested at an assumed interest rate, that would produce enough money over time to make the required annual payments with a zero balance at the end.
The annual payments can be set at any amount, but typically, the Grantor sets the annual payments so that the present value of these payments roughly equals the value of the assets transferred. In that case, the gift to the GRAT will have a near-zero value for gift tax purposes and as a result will use little or none of the Grantor’s lifetime gift and estate exemption. We call this a “zeroed-out GRAT.”
You may ask why anyone would make a gift that has no value. The answer is in the way the present value of the annuity payments is calculated. The assumed interest rate is set by the IRS monthly based on current rates. For August and September 2020, that rate is an astonishingly low 0.40%. If the assets in the GRAT earn a total return of more than 0.40% over the term of the trust, that excess return will pass to the heirs free and clear of any estate or gift tax.
Here’s an example. The Grantor transfers $1,000,000 worth of stocks to a GRAT with a 5-year term. To “zero-out” the value of the gift, the annuity paid the Grantor is set at $202,405 per year. If the trust assets earn 6% a year, the GRAT will still hold $197,252 after the last payment is made. So, in this example, the Grantor has transferred nearly $200,000 to their heirs without using any lifetime exemption.
What can go wrong? Two things. First, if the Grantor does not survive until the end of the term, any assets in GRAT will be included in the Grantor’s taxable estate. Second, if the GRAT assets do not perform, the annual payments might exhaust the GRAT before the end of the term. In both cases, the result is the same as if the Grantor did nothing (other than pay a lawyer to draft the documents).
A few other nuances to this strategy:
- A GRAT is not an income tax strategy. The GRAT is an ignored entity for income tax purposes and the taxable income of the GRAT will flow through to the Grantor’s personal tax return. This is a good result because it increases the estate tax savings potential.
- It is possible, within limits, to backload the annuity payments to allow the assets more time to grow.
- A GRAT strategy can be highly effective when the Grantor funds the GRAT with closely held business assets with positive cash flows. In this case, additional leverage can be obtained through valuation discounts for gifts of minority and non-controlling interests.
- Often, Grantors will set up a series of GRATs with different terms, increasing the chances that one or more of the GRATs will have successful investment outcomes and increasing the chances that the Grantor will survive the term of one or more of the GRATs.
- We have also seen Grantors set up a series of GRATs each with its own specific investment strategy. For example, rather than holding a diversified basket of stocks in a single GRAT, each GRAT in the series holds stocks in a single sector. If one sector underperforms, that GRAT might implode, but the other GRATs would not be affected by the loss.
There is much more to discuss on this topic and we are happy to start a conversation about this or any other planning concept.