GRAT Tax Rules for Gift, Estate, and Income Tax

A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust used in estate planning to pass the future appreciation of assets to beneficiaries while minimizing gift and estate taxes. An individual, known as the grantor, places assets into the trust for a specific period. During this time, the grantor receives a fixed annual payment, or annuity, from the trust. If the assets within the trust grow at a rate higher than a specific interest rate set by the IRS, the excess value can be transferred to the beneficiaries with little to no tax liability.

How a GRAT Functions

A Grantor Retained Annuity Trust involves three parties: the grantor, the trustee, and the remainder beneficiaries. The grantor is the individual who creates the trust and contributes the initial assets. The trustee is responsible for managing the trust’s assets. The remainder beneficiaries are the individuals who will receive the assets remaining in the trust after its term expires.

The process begins when the grantor transfers assets into the irrevocable trust. The assets chosen are those with strong potential for appreciation. In exchange for this transfer, the grantor is entitled to receive a fixed annuity payment from the trust for a predetermined number of years, known as the GRAT term. This term is specified in the trust agreement and is often set for a shorter duration, such as two to five years, to mitigate certain risks.

The success of a GRAT hinges on the performance of its assets relative to a specific benchmark known as the Section 7520 rate. This rate, published by the IRS, acts as a “hurdle rate” that the trust’s investments must outperform. If the total return on the assets—including income and appreciation—exceeds this rate, the excess value accumulates within the trust.

At the end of the specified term, if the grantor is still living, the process concludes. Any remaining assets, which represent the growth that surpassed the Section 7520 hurdle rate, are then distributed to the remainder beneficiaries. This transfer of the appreciated value occurs without incurring additional gift or estate tax.

Determining the Taxable Gift

When a grantor funds a GRAT, the transfer of assets into the trust is considered a taxable gift to the remainder beneficiaries. The value of this gift, however, is not the full fair market value of the assets placed into the trust. Instead, it is calculated as the initial value of the transferred assets minus the present value of the annuity payments that the grantor is scheduled to receive over the trust’s term.

The calculation of the annuity’s present value is determined using the Section 7520 interest rate for the month in which the GRAT is funded. This rate allows for an actuarial valuation of the stream of payments the grantor will retain. A lower Section 7520 rate results in a higher present value for the retained annuity, which in turn reduces the calculated value of the taxable gift. This is why GRATs are particularly effective in low-interest-rate environments.

Many GRATs are structured to be “zeroed-out,” a strategy that aims to minimize the taxable gift to a nominal amount. This is achieved by carefully setting the annuity payments so that their total present value is nearly equal to the fair market value of the assets initially transferred to the trust.

To illustrate, consider a grantor who transfers $2 million of stock into a two-year GRAT. The annuity payments are structured so their present value equals $1,999,950. The taxable gift reported would be just $50. If the stock appreciates to $2.5 million over the two years, after the annuity payments are made back to the grantor, the remaining $500,000 of growth passes to the beneficiaries without any further gift tax.

Income and Estate Tax Implications

For income tax purposes, a GRAT is classified as a “grantor trust.” This designation means that the trust itself is not a separate tax-paying entity. The grantor is treated as the owner of the trust’s assets for income tax purposes and is personally responsible for paying taxes on all income, dividends, and capital gains generated by the trust during its term. This tax payment by the grantor is not considered an additional gift to the beneficiaries, allowing the trust’s assets to grow without being diminished by income taxes.

The estate tax implications of a GRAT are determined by whether the grantor survives the entire trust term. If the grantor outlives the term of the GRAT, the remaining assets in the trust pass directly to the designated beneficiaries. These assets are excluded from the grantor’s taxable estate. This means the appreciation achieved within the trust is transferred free of any estate tax.

If the grantor dies before the GRAT term concludes, the tax benefits are largely nullified. In this scenario, the Internal Revenue Code requires that a portion, or all, of the trust’s assets be included in the grantor’s gross estate. The amount included is the value of the assets at the time of death. This mortality risk is a primary consideration when selecting the length of the GRAT term; shorter terms reduce the risk of the grantor not surviving but may offer less time for assets to appreciate.

Creating and Reporting a GRAT

The grantor must select the appropriate assets to fund the trust, such as assets that have a high potential for significant appreciation like pre-IPO stock or shares in a family business. The grantor must also determine the length of the trust term and appoint a trustee to manage the assets, as well as name the remainder beneficiaries. An attorney specializing in estate planning is required to draft the formal trust document.

Once the GRAT is funded, the grantor has a mandatory reporting obligation. The grantor must file IRS Form 709, the United States Gift Tax Return, for the calendar year in which the asset transfer occurred. This is required even if the GRAT is “zeroed-out” and the resulting taxable gift is minimal. This disclosure starts the clock on the statute of limitations for the IRS to challenge the reported value of the gift. Properly filing the return ensures that, after a period of three years, the valuation used for the gift cannot be contested.