What is a GRAT?
A grantor retained annuity trust (GRAT) is a special type of trust which can allow you to transfer to your beneficiaries with little or no gift and estate tax, that portion of the appreciation on the value of the assets contributed to the trust in excess of an assumed growth rate required by Internal Revenue Code (IRC) Section 7520, which is announced monthly by the Internal Revenue Service (IRS). We suggest that you discuss with your legal and tax advisors whether a GRAT is appropriate for you.
Why Should I Do This Now?
Although interest rates rose in 2022 and may continue to rise, they remain relatively low compared to historical rates. Accordingly, in many instances, the GRAT can be an efficient way to transfer wealth.
For a GRAT to be successful, the assets in the GRAT must produce a total return greater that the interest rate required by IRC Section 7520.
How Does It Work?
You would transfer assets to the GRAT and retain the right to receive a series of annuity payments from the GRAT for a specified term of years. For gift tax purposes, the amount of the gift would be the fair market value of the assets transferred to the GRAT less the actuarial present value of your annuity interest.
If the GRAT provides for sufficiently high annuity payments (or a sufficiently long annuity term), then the present value of your annuity interest can approximate the fair market value of the assets transferred to the GRAT, in which case the gift tax will be minimized or potentially eliminated. This is known as “zeroing out” a GRAT.
The IRS assumes that the assets contributed to the GRAT will produce a total return equal to the interest rate required by IRC Section 7520 over the term of the annuity. As a result, if the actual total return earned by the GRAT’s assets during the annuity term exceeds the interest rate required by IRC Section 7520, the IRS will have undervalued the gift. The amount of the undervaluation (that is, the total return realized by the GRAT’s assets in excess of the interest rate required by IRC Section 7520) will pass to your beneficiaries at the end of the annuity term free of any gift tax.
What are the Downsides?
The GRAT doesn’t work if you die while the annuity is being paid to you. Were that to occur, generally, the value of the GRAT would be included in your gross estate and possibly subjected to federal estate tax. Nevertheless, you would be no worse off than if you had done nothing except for your transaction and tax return filing costs.
You must pay the income tax on the income earned by the assets in the GRAT, even though you don’t own them. However, you may be able to fund such tax payments from the annuity paid to you. Also, when you pay the income tax on the GRAT’s income, it is like you are making an additional gift to the GRAT that is not subject to gift tax.
GRATs may not be appropriate for plans that intend to skip generations (such as a plan that creates long-term trusts for many generations of your descendants) due to rules regarding how your exemption from the generation-skipping transfer tax is allocated.
Should I Do This?
If you have assets that are appreciating and would like to freeze the growth of some of your estate, or if you would like to transfer wealth to your beneficiaries without using your exemption from the gift and estate tax (or without gift tax if you have used your exemption), perhaps a GRAT is right for you.
As with any wealth transfer strategy, you should consult your personal attorney or other tax advisors to determine if that strategy is appropriate for your circumstances.
To learn more about GRATs please contact your PNC Private Bank team, and we would be glad to discuss with you and your advisors whether a GRAT is appropriate for you.