A Grantor Retained Annuity Trust, or GRAT, is a trust that allows someone to transfer assets at a severely reduced tax rate. The trust is short-term and sends annuity payments that are funded by the interest gained on the assets to the creator of the trust. At the end of the term, the remaining assets left in the trust are released to the beneficiary of the trust. The advantage of this type of trust is that the payment at the end to the beneficiary is tax-free.
GRATs are somewhat controversial because they’re often seen as a way to hide assets from taxes. There have been moves to eliminate the final tax-free payment — this strategy of making the remaining assets part of the final payment is called zeroing out — and extend the minimum time a trust must be in effect. Because of this, these trusts shouldn’t be set up without the help of an estate-planning attorney who knows what has been happening with regard to the proposed changes.
The trusts are completely legal and are convenient ways to make intergenerational transfers that might otherwise be subject to high taxes. The way a GRAT works is that the grantor sets up the trust and transfers assets into the trust with provisions for a retained “annuity” payment. An IRS determined interest rate applies to the annuity payments; however, the interest rate is typically very low. The key, therefore, to the success of a GRAT is that the assets held by the trust need to appreciate at a rate higher than the interest rate established for the annuity payments – a feat that is not usually difficult to accomplish. The interest that is retained after the annuity payments is then transferred to a beneficiary at the end of the trust term tax-free. The math isn’t hard to calculate. Imagine putting $10 million into a trust that appreciates at the rate of 7.4 percent per year – not an unrealistic rate of return with skilled trust administration.
Assume further that the IRS prescribed 7520 rate (the required annuity interest rate) is at 2.4 percent. The trust will net $500,000 in tax-free interest in the first year alone.
The only real risk to a GRAT is the death of the grantor. Everything in the trust immediately becomes part of the estate of the grantor after his or her death — the beneficiary of the trust receives nothing other than what he or she is supposed to get from the estate – and becomes subject to gift and estate taxes. However, the assets would have been part of the taxable estate anyway had the trust never been set up.
The benefits to including a GRAT in your comprehensive estate plan can be extensive; however, the success of a GRAT is found in the details. A GRAT must be set up perfectly to ensure that it complies with federal tax laws. Consult with your estate planning attorney if you think a GRAT would work in your estate plan.