Has your family decided that making gifts from a senior generation to younger ones is a core component of your financial plan? If so, you may be able to achieve some, or all, of this goal using a GRAT and its special features. For many years, many families making large gifts to children have often chosen to use GRATs as one of their tools.
A GRAT is an irrevocable trust that takes advantage of a well-established combination of federal trust, gift, and estate tax rules and concepts.
It does so in ways that may create valuable tax advantages for the family while potentially removing assets from the estate of the person who creates the trust (the grantor). The family member who created the trust can control the amount of gift tax on the assets placed in the trust, usually making choices that result in a gift tax of zero.
The beneficiaries also benefit because they might receive assets from the GRAT that are not reduced by federal estate or gift tax.
A so-called “successful” GRAT is one that captures investment returns over the annuity period that will be sufficient for the trust to pay all annuity payments, as well as deliver a remainder distribution to the children. This can sometimes result in a tax-free transfer of assets to trust beneficiaries. There is no guarantee this can be achieved in any given situation. Nevertheless, GRATs are popular because they can be designed so there is no significant downside for the grantor if the GRAT “fails” to deliver a significant distribution to the children.
The Basic Concepts & Building Blocks
GRATs are widely used in family wealth transfers. They pay a fixed rate of return to the grantor for the term of the trust. It is a fixed annuity amount based on a stated percentage of the initial value. If the trust assets and returns on those assets exceed the annuity payments, there will be assets left to pass on to the beneficiaries. The distribution of the remaining trust balance is not a taxable event, so the donor’s children receive these assets free of tax. Any assets distributed to the beneficiaries are not part of the grantor’s estate and therefore not subject to estate tax in the grantor’s estate—so long as the grantor survives the term of the trust.
What assets should the grantor transfer to the trust? Any asset used to fund the trust must be valued for gift tax purposes.
Marketable securities are perhaps the easiest assets to value and transfer, in our view, but they may have limited potential to outpace the annuity payments and leave a pool of assets for distribution to the beneficiaries.
Other types of assets such as closely held businesses or commercial real estate can be difficult to value and transfer, but they have otherpossible attractions. A grantor may have special insights about the cash flow or appreciation potential of their closely held assets and, therefore, may believe they can achieve a successful GRAT. In addition, valuation discounts may be available for some closely held assets, allowing the assets funding the trust to be discounted. This creates some leverage between the payment amounts and value of the trust assets, and that may improve the probability of a successful outcome.
Next the grantor must consider the term of the trust and annuity rate. Interplay between the two will determine whether your gift to the trust is a taxable gift or has zero value for gift tax purposes. As the grantor, you are giving away an asset but retaining a right to receive payments from it for a period of time. This means you are only giving away a portion of the asset you have transferred to the trust. The annuity payment you receive is the retained interest. The other portion of the transferred assets is the remainder interest. The interplay between the term and the annuity rate also affects the probability of there being a remainder value to distribute to the remainder beneficiaries.
Let’s look at the following hypothetical example. Suzanne has decided she wants to use the GRAT technique. She recently sold her closely held high technology company to a publicly traded firm in the same industry. She now has a large concentration in the purchasing company and anticipates those shares will appreciate rapidly over the next few years. She decides to commit a $10 million block of shares to a GRAT. In consultation with her advisors, she chooses trust terms that should result in her contribution to the trust having a value of zero for gift tax purposes and will pay her an annual annuity rate of just under 11.4%, or about $1,135,000 per year for 10 years. If we assume an average return of 6% for the term of the trust, at its termination there will be just over $2,960,000 remaining. This amount will be distributed to the named beneficiaries, or held in further trust, free of any gift tax.
Low Interest Rates Bode Well for GRATs
GRATs are particularly attractive during periods of low interest rates such as those experienced today. Tax rules define the method for determining the gift tax value of a transfer into a GRAT, and interest rates have a substantial impact on that calculation. A GRAT established at a time when rates are low can be especially effective in delivering wealth to children in a tax-efficient manner.
- GRATs provide a proven method that has the potential of transferring assets to the next generation free of estate or gift tax.
- They may allow for favorable gift tax outcomes.
- Modest costs could be incurred to establish and maintain the GRAT.
- There is little downside if the strategy fails.
- There is no guarantee of achieved remainder distribution to children.
- Mortality risk may exist.