A grantor retained annuity trust (“Grat”) is a type of irrevocable trust that allows the creator (the “Grantor”) to avoid or minimize gift and estate taxes while retaining the right to receive an annuity payment.
How Does a GRAT Work?
Here’s a high-level overview of how a GRAT operates:
- The Grantor transfers assets to an irrevocable trust.
- The trust pays the Grantor an annuity during the trust’s term (a defined period of years).
- When the trust terminates, the assets remaining in trust are distributed to the trust’s beneficiaries either outright or via another trust. The beneficiaries are typically the Grantor’s children.
What are the Benefits of a GRAT?
A Grantor can put assets that he believes will significantly appreciate in value in the trust and essentially “freeze” the value of the asset.
The annuity is calculated using the Internal Revenue Code Section 7520 rate (commonly referred to as the hurdle rate). The current hurdle rate—at the time this article was drafted—is 4.6%. If the assets appreciate at rate greater than the hurdle rate, the GRAT will be considered a success.
Here’s an example, A Grantor creates a GRAT with an initial contribution of $1,000,000 and a ten-year term in January 2023. If we assume a 7% annual rate of return and the January 2023 hurdle rate is 4.6% the Grantor would receive $127,000.25 annually in annuity payments and could ultimately transfer $212,458.96 to heirs free of estate taxes following the termination of the trust.
In the above example, if the hurdle rate was considerably lower, say 2.4%, the Grantor would receive $113,668.66 annually and would be able transfer $396,654.29 to his heirs at trust termination. As you can see, the lower the hurdle rate the better the GRAT’s performance.
At the end of the trust term (10 years in the above example), the remaining trust assets are transferred to the beneficiaries free of gift and estate taxes.
What are Some Disadvantages of a GRAT?
When the hurdle rate is low (it was as low as 0.8% in March 2021), the likelihood of success is greater. Remember, the Grantor retains an annuity stream not an income stream. If the asset does not appreciate at a rate greater than the hurdle rate, the trustee must invade the principal to pay the annuity stream to the Grantor.
For the appreciation in the GRAT to pass to beneficiaries without estate and gift tax, the Grantor must be alive at the end of the GRAT term. If the Grantor dies, the GRAT assets and appreciation on the assets will be included in the Grantor’s estate for estate-tax calculation purposes.
Because GRATs are such an effective wealth transfer tool, several legislative and regulatory attempts have been made to impose restrictions. These restrictions have not yet been implemented and the GRAT is still a viable option (especially when the hurdle rate is low), but GRATs have been targeted by Congress and their effectiveness may be curtailed in the future.
Where can I Learn More?
To determine whether a GRAT is right for you and your family, you should contact a California estate planning attorney. For a confidential consultation, call the Law Office of Jonathan Alexander at (949) 334=7823. Mr. Alexander has two decades of legal experience and can help you establish an estate plan that protects you, your family and your legacy.
To learn more about Mr. Alexander, his firm, and his estate planning philosophy visit his bio linked here.
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