Grantor Retained Annuity Trusts (GRATs)

Grantor Retained Annuity Trusts (GRATs) are a powerful estate planning tool for very wealthy individuals whose priority it is to transfer assets to the next generation in a tax-efficient manner.

As of this writing, the law grants each American the right to give away property free from transfer taxes, a term that encompasses gift, estate, and generation-skipping transfer (GST) taxes, up to a generous cap of $11,580,000. Adjusted annually for inflation, this unified exemption is available for all non-charitable gifts made during life and at death.

Charitable donations do not use up any unified exemption. Assume there is no change to current law and an individual passes away in 2021; if the total of his or her lifetime gifts and the value of the estate left to non-charitable recipients is less than $11,700,000, no transfer taxes will be due. For those with assets in excess of this unified exemption, GRATs present an opportunity to convey additional wealth without triggering transfer taxes. GRATs may also remain an effective tool if Congress reduces the unified exemption amount under forthcoming legislation.

Why Planning Matters Despite Large Exemption

Because the current unified exemption is so high, very few people face the prospect of owing transfer taxes. According to the Joint Committee on Taxation, 99.8% of taxpayers owe nothing. However, being aware of methods to transfer value in excess of the unified exemption remains important for two reasons.

The first reason is that the unified exemption amount is by no means set in stone. Since the 2000’s, the unified exemption has expanded massively from as low as $675,000 in 2001. The 2017 Tax Cuts and Jobs Act doubled the base amount on which the inflation-adjusted unified exemption is calculated. Thus, on January 1, 2018, the unified exemption leaped from roughly $5.5 million to $11 million overnight. However, there is reason to believe this upward trend will not continue. Without new legislation from Congress, the current doubled exemption is slated to ‘sunset,’ or revert to roughly half its current amount in 2026. Further, nothing limits Congress from passing a new law, reducing or even eliminating the unified exemption much sooner than 2026. This prospect looms especially large in 2021, as Democrats control both the White House and Congress.

The second reason is that, for the two ultrawealthy individuals out of 1,000 that trigger transfer taxes, the tax rate is a hefty 40% on amounts over the unified exemption. These taxpayers will save forty cents on every marginal dollar they can generate for heirs outside of the taxable estate. One popular technique to accomplish this is to use GRATs.

How GRATs Work

GRATs can be complicated, but their basic mechanics are logical. This section lays out these mechanics, and an illustration follows in the next section. The grantor (i.e. creator of the trust) contributes property to the GRAT in exchange for a stream of annuity payments over a predetermined number of years, often two years for reasons explained below. Usually the annuity payments are made using a portion of the property transferred to the GRAT.

Each month, the IRS prescribes an interest rate known as the Section 7520 rate (or just 7520 rate). Using this rate, the grantor can calculate exact annuity amounts such that the IRS considers the grantor as having made no gift at all; the GRAT will return to the grantor annuity payments for the full value of the trust property plus interest. This is known as a ‘zeroed-out GRAT.’ The effectiveness of GRATs as a wealth transfer tool rests upon the GRAT property generating a larger return than the conservative 7520 rate. The excess return goes gift-tax free to the individuals or trusts the grantor specifies in the GRAT agreement.

The ‘grantor-retained’ element of GRATs means that the grantor remains responsible for the income taxes due on the trust’s income. This provides an additional means of advancing wealth free from transfer taxes, as the grantor’s payment of the trust’s income tax liabilities relieves the beneficiaries from having to pay them. The grantor should plan carefully before executing a GRAT to have funds available to pay income tax.

The current interest rate environment is favorable for GRATs, as the 7520 rate remains at a low 1.2% as of August 2021. The trust property only needs to generate an annual return greater than 1.2% for the grantor to have successfully transferred value, free of gift tax, to heirs! For reference, since the 1950s, the S&P 500 index has eclipsed that rate with an average annual return of roughly 8%.

A GRAT Illustration

As an example, assume Gary Grantor owns $5,000,000 in marketable securities, a portion of which he’d like to give to his daughter Glinda without paying transfer taxes.

Gary decides to fund a two-year GRAT to benefit Glinda. On August 1, 2021, Gary executes a GRAT agreement and funds the new trust with $1,000,000 in the form of 100,000 shares of Stardust Inc. with a current market value and tax basis of $10 per share. Stardust is a publicly traded space tourism company that anticipates aggressive growth. Applying the applicable length of two years and the August 2021 7520 rate of 1.2% to calculate “zeroed out” annuity payments, Gary knows from the time of funding that the 2021 GRAT will owe him two payments of $509,009: one in August 2022 and the other in August 2023. As mentioned above, the term “zeroed out” means that the annuity payments have been calculated to produce no taxable gift remainder, thus using none of his unified gift and estate tax exemption.

On August 1, 2022, the GRAT’s stock has doubled to $20 per share on news that Stardust’s CEO made a successful trip to the moon. Because the GRAT was funded with stock, the trustee can either sell shares and distribute cash or distribute approximately 25,450 shares to Gary or to cover the $509,009 annuity payment due. Assume for simplicity that Stardust’s share price remains $20 per share on August 1, 2023. The final annuity payment for Gary’s 2021 GRAT will be due, so the trustee will distribute cash or another 25,450 shares to Gary.

The remaining trust property will be distributed in accordance with the GRAT agreement. Let’s assume the trust calls for distribution of the remainder outright to daughter Glinda. To transfer additional wealth to Glinda, Gary asks the trustee to sell the trust’s remaining 49,100 Stardust shares in accordance with the trustee’s powers under the trust agreement (i.e. 100,000 shares less two annuity distributions back to Gary of 25,450 shares) at $20 per share before distributing proceeds. Because the trust is “grantor-retained,” Gary is legally indistinguishable from the trust for income tax purposes; that is, Gary is responsible for income taxes that the trust owes. The trustee will distribute to Glinda $982,000 in cash (i.e. 49,100 x $20/share), Gary will pay long-term capital gains tax of $116,858 on his personal income taxes (i.e. $10 of capital gain per share x 49,100 shares x 23.8% rate), and Gary will owe zero in gift taxes on the transfer! Gary has conveyed over $1,000,000 of value to his daughter transfer tax-free beyond his $11,580,000 unified exemption.

Note that Gary could avoid paying the capital gains taxes himself by having the trustee distribute the 49,100 Stardust shares to Glinda instead of cash. She would receive a carryover basis of $10 per share in the stock and would be responsible for capital gains taxes upon sale. This could be advantageous if Glinda is in a lower tax bracket or desires to hold the stock moving forward. If Gary received in-kind distributions of Stardust shares as annuity payments, his basis remains unchanged; legally, he’s effectively transferred the shares back and forth with himself with no income tax effect.

Potential GRAT Shortcomings

It’s important to consider downsides. The first issue is what happens if the GRAT’s return falls short of the 7520 rate. In the example above, Stardust’s shares enjoyed a meteoric 100% return over the course of the 2021 GRAT’s first year, dwarfing the 1.2% rate of return needed. But assume instead that the Stardust CEO’s trip to the moon was canceled at the last minute due to safety concerns, causing the stock to plunge to $5 per share on August 1, 2022. The trustee of the 2021 GRAT would owe Gary the predetermined annuity payment of $509,009. Since the trust only holds 100,000 shares, the GRAT would not have enough shares to meet the annuity payment (i.e. $509,009 / 5 = roughly 101,800 shares). The GRAT would “fail,” and the trustee would return all the shares to Gary. The only cost Gary has incurred (apart from the loss in share value) is the cost of setting up the GRAT. Nothing stops Gary from using his shares to fund a new GRAT to try again. Like many taxpayers, Gary might choose to fund a new two-year GRAT each year to create a sequence of “rolling GRATs.” Some of these may fail, but others may succeed.

Another concern is what happens if the grantor passes away during the term of the GRAT. If this happens, the grantor’s estate will have to include a portion of the trust property as determined by a complex calculation involving the 7520 rate at the time of death. This explains the reason why many choose two-year terms, the minimum allowable GRAT period. The shorter the term, the likelier it is that the grantor will survive, decreasing the risk of having a portion of the trust included as part of the taxable estate.

A third shortcoming to consider is that GRATs are not an ideal vehicle for wealth transfer to grandchildren and beyond. Although the intricacies of the generation skipping transfer (GST) tax are beyond the scope of this article, note that GST exemption cannot be allocated to a GRAT until the end of the trust term. As a result, the appreciation during the GRAT term remains exposed to GST tax. In other words, a greater amount of GST exemption will have to be allocated to cover trust asset appreciation. In the example above, say Gary Grantor wished the remaining 2021 GRAT property to go to his granddaughter rather than his daughter. He wouldn’t be able simply to allocate $1,000,000 of GST exemption upon funding the 2021 GRAT. Rather, he would have to apply GST exemption upon the conclusion of the GRAT in 2023 after the value of the stock had doubled.

Fourth, if Gary had a modest estate with a total value of $3 million, transfer taxes would not be a concern under existing law. In that case, minimizing income taxes would be his focus. Retaining the shares until death may produce better tax advantages, since the basis will be stepped up to fair market value at death, erasing built-in capital gains income taxes. Assuming Gary is in the top tax bracket, he would save 23.8 cents on the dollar in income taxes while still not being subject to any transfer taxes so long as the value of his lifetime gifts and estate remains below the unified exemption. Note this caveat: these considerations may soon change, as President Biden has proposed eliminating the basis step-up.

Finally, the example involving Gary Grantor’s GRATs simplifies a common issue: valuation. If Gary funds a GRAT with members units in an LLC he started or closely held shares in a corporation, there may not be a readily accessible market value for the trust property. Thus, a valuation firm will have to perform an annual valuation to determine the initial value of the trust property and to make the correct in-kind annuity payments. Gary should consider these costs in addition to attorney and accountant fees when deciding whether to make use of GRATs.

Conclusion

GRATs are a terrific estate planning tool for clients in the right situation. An LBMC estate planning professional can help clients consider the extent of their wealth and personal planning goals to determine if GRATs should be part of an estate plan tailored to meet the client’s goals.

Content provided by LBMC tax professionals, Barrett Thomas and Nicole Jeppesen.

LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.

Why Planning Matters Despite Large Exemption

How GRATs Work

A GRAT Illustration

Potential GRAT Shortcomings

Conclusion

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