Estate planners who want to maximize their estate for their beneficiaries but reduce their estate for tax purposes have a wide range of tools to choose from. Trusts are one of the many ways to transfer money from an estate into separate mediums for the beneficiaries.
Although we’ve discussed many of these different trusts before, a lesser-known type is called the grantor retained annuity trust or GRAT. Like many trusts, the grantor transfers assets from the estate into the trust, but for a set amount of time.
How a GRAT Works
Like many trusts and other estate planning tools, the goal is to “freeze” a portion of the estate’s value at today’s rate. This allows for further appreciation of the assets to pass to the beneficiaries in a tax-free state. The initiator of the trust, called the grantor, receives an annual distribution as a stream of income. This is ideal for families or individuals who own assets expected to appreciate in value, but they prefer to keep and not gift to others. By using a GRAT, the beneficiaries receive the potential future growth of the assets rather than gifting the assets themselves.
GRATs are especially effective during periods of low-interest rates. When interest rates increase, so do the values of the assets and the remainder of the trust’s assets distributed to the beneficiaries.
Transfer Of Assets
Like many trusts, appreciable assets and property are transferred into the GRAT. The grantor must give up his or her control of the assets for the duration of the trust in return for receiving a regular annuity payment. The appreciation of these assets passes to the beneficiaries free of estate or gift taxes.
A “Zeroed-Out GRAT” is one in which all assets added into the trust are returned to the grantor and annuity payments, leaving little to nothing to the beneficiaries. It is already planned that the assets are depleted from the trust prior to the end of the term. But if the assets that have been conveyed into the trust outperform the 7520 rate, there will in fact be a remainder left in the trust and this remainder would be transferred to the beneficiary free of taxation.
It is possible to structure the trust so that the grantor doesn’t use any of their lifetime gift and estate tax exclusion. The total value of the contributed funds is not removed from the Grantors estate, because the annuity payments are income that returns to the estate. But with a proper setup, potential asset growth can remain outside of the estate as well.
The trust only lasts for a specific period, usually no more than 10 years. The annuity payments to the grantor during the term of the trust are calculated using a so-called “hurdle rate,” better known as the IRS Section 7520 rate. The idea is that it is a gift of future earned interest when the asset appreciates higher than the IRS’s rate. That valuation for January 20, 2022, is 1.6%.
The idea is that assets will appreciate past the 7250 interest rate, and that appreciated value is what is passed on to the beneficiaries through the trust.
Advantages And Disadvantages
The obvious advantage is that a grantor’s estate can be reduced for the purpose of probate. It will also reduce future federal estate tax for the beneficiaries.
Another advantage is that it generates cash flow for the grantor in the form of an annuity. However, multiple short-term GRATS can be created to use in conjunction with each other. Each would hold a different type of asset to isolate individual assets that could produce a high return which would lead to more distribution to the grantor’s beneficiaries.
Individuals who are involved in startups find GRATs particularly helpful. Stock prices for IPO shares frequently excel the IRS’s 7250 rates of return. So, the GRAT both lowers a tax burden as well as leaves more assets to beneficiaries. They also leave their lifetime exemption gift and estate taxes intact.
However, the assumption is that the assets will appreciate faster than the IRS’s 7250 rates over the term of the trust. If the assets do not outpace that rate, they are returned to the grantor. Additionally, the annuity payments will be taken from the principal. If the grantor does not outlive the GRAT, everything that was previously transferred into the trust will be returned to the grantor’s estate. The assets would again become taxable.
Interested in a GRAT?
If a GRAT is something you believe would be beneficial to your estate, work with an estate planning attorney who understands these and other trusts. James C. Provenza is an Illinois estate planning attorney with years of experience helping clients with their estate planning to make sure their wishes are carried out. Call our firm today at (847) 729-3939, or use our online contact form.