What Is a GRAT and How Is It Used in Estate Planning?

A Grantor Retained Annuity Trust, commonly known as a GRAT, is a specialized estate planning instrument. It aims to transfer wealth to designated beneficiaries with reduced gift and estate tax consequences. This type of trust is an irrevocable arrangement, meaning once established, its terms generally cannot be altered or the assets reclaimed by the creator. A GRAT’s primary objective is to leverage expected asset appreciation, allowing that growth to pass to the next generation outside the grantor’s taxable estate. It is useful for individuals with substantial assets seeking to minimize future tax liabilities on wealth transfers.

How a GRAT Functions

A GRAT involves several key parties and an operational structure. The “grantor” is the individual who creates and funds the trust by transferring assets into it. A “trustee” manages the assets within the trust according to its terms. The ultimate recipients of any remaining assets are the “remainder beneficiaries,” often the grantor’s children or other family members.

A GRAT is an irrevocable trust. This irrevocability is a fundamental aspect that allows for the intended tax benefits. The trust operates for a predetermined period, known as the “term,” which can range from a few years, typically two to ten years, or longer.

During this term, the grantor receives fixed annuity payments. These payments are typically made at least annually and are based on a percentage of the initial fair market value of the assets contributed. The Internal Revenue Service (IRS) mandates that these payments cannot increase by more than 20% from the prior year’s payment. These payments determine how much of the original principal and assumed growth are returned to the grantor.

A GRAT’s wealth transfer occurs if trust assets appreciate at a rate greater than the IRS Section 7520 rate. Any appreciation beyond this rate passes to the remainder beneficiaries free of additional gift tax. This strategy effectively “freezes” the value of gifted assets for tax purposes at the time of transfer, allowing future growth to bypass transfer taxes.

Valuation and Gift Tax Considerations

The tax efficiency of a GRAT relies on how the value of the grantor’s retained annuity interest is determined for gift tax purposes. The Section 7520 rate plays a central role. This rate, also called the “hurdle rate,” is published monthly by the IRS and is calculated as 120% of the applicable federal midterm rate, rounded to the nearest two-tenths of one percent.

A lower Section 7520 rate makes a GRAT more advantageous, as it lowers the assumed growth rate the trust must outperform, increasing the likelihood that the assets will appreciate sufficiently to benefit the beneficiaries. This rate is fixed for the entire duration of the GRAT once funded.

The taxable gift upon a GRAT’s creation is not the full value of transferred assets. It is calculated as the present value of the remainder interest, representing what is projected for beneficiaries after the grantor receives all annuity payments. This is done by subtracting the present value of the grantor’s retained annuity interest from the initial fair market value of the assets.

A common strategy is a “zeroed-out GRAT,” where annuity payments are designed to make the initial taxable gift as close to zero as possible. In this structure, payments are set high enough so their present value nearly equals the value of contributed assets. If assets grow only at the Section 7520 rate, the grantor receives back the entire initial contribution, leaving little to no gift for beneficiaries.

The benefit of a zeroed-out GRAT is that it uses little or none of the grantor’s lifetime gift tax exemption. If assets perform better than the Section 7520 rate, excess appreciation passes to beneficiaries without additional gift tax. An unsuccessful GRAT simply results in assets returning to the grantor without a significant taxable gift.

Managing a GRAT and Its Conclusion

Managing a GRAT involves the trustee overseeing trust assets and ensuring timely annuity payments to the grantor. The trust agreement outlines the payment schedule and operational details. Assets chosen are typically those expected to appreciate significantly, such as marketable securities or private business interests.

The grantor may retain the power to substitute assets of equal value into the trust. This allows for adjustments if initial assets do not perform as anticipated, enabling replacement with those having higher growth potential. During the term, the GRAT is treated as a grantor trust for income tax purposes, meaning the grantor pays income taxes on any earnings.

At the end of the GRAT term, annuity payments cease. Any remaining assets, known as the “remainder,” are distributed to the designated remainder beneficiaries. This can be outright or to a continuing trust for their benefit.