We’ve written about Grantor Retained Annuity Trusts (GRATs, for short) a few times over the years, most recently in the third quarter of 2020 when very low interest rates made these trusts more attractive for estate tax reduction. While current interest rates are less attractive, the recent market sell-off creates a whole new set of opportunities. Therefore, we thought now is a good time for a reminder about the value of this strategy for estate tax savings.
First, some basics. A GRAT is a simple concept with some very favorable gift tax consequences.
- 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 payment 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 trust 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 them 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.
The magic of a zeroed-out GRAT comes from 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. If the assets in the GRAT earn a return greater than that assumed rate, the excess return is transferred to the beneficiaries. When we wrote about GRATs in 2020, the IRS rate was less than 0.5%. Now, the rate is around 3% (and rising each month). While that increased rate makes GRATs a bit less attractive, it’s still presenting a relatively low hurdle.
So, why do we think GRATs are still attractive now? If the Grantor owns stocks with depressed values, those stocks can be contributed to a GRAT (there are no income tax consequences from this transfer). Let’s say the market improves and these stocks gain 20% or 30% from their depressed values. All that gain, less the 3% assumed interest rate, is transferred to the Grantor’s heirs free of any estate or gift tax.
A few other nuances to this strategy:
- There is almost no downside to this strategy. It will fail only if the assets fail to perform better than the assumed interest rate or if the Grantor dies before the end of the term. In those cases, however, the Grantor is in the same position as they would be if they had done nothing (except perhaps for some legal fees).
- 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.
- The GRAT can be designed to allow the Grantor to substitute assets. Let’s say a Grantor contributes a depressed stock to a GRAT and the stock rapidly returns to higher levels. The Grantor can then lock in the estate tax savings by substituting low-risk assets for the stock for the remainder of the term.
- A GRAT strategy can also 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.