GRATs - What are they? How do they work? Who should be using them?
Grantor retained annuity trusts are trust that allow you to pass future appreciation onto your children or beneficiaries without being subject to estate tax.
For example, you put $1 million in a GRAT, and as long as the GRAT pays you back $1 million plus the interest rate set by the IRS (called the “hurdle rate” or “7520 rate”) anything above that amount passes onto your beneficiaries (or their trusts) free of estate tax.
WHAT ARE THE REQUIREMENTS OF A GRAT
The annuity payments must be a fixed dollar amount of percent of the value of assets initially transferred to the trust
Paid to the grantor at least annually
Payable for a fixed number of years (2,5, 10 years)
Such payments may only be made to the Grantor or the Grantor’s estate
Payments cannot be prepaid
Cannot be paid via loans
Cannot increase more than 20% from the prior years payment
No additional contributions allowed during GRATs fixed term
Any income taxes generated from the GRAT are paid by you (not the trust) which allows the GRAT assets to continue to grow unimpeded by taxes. The payments you make on behalf of the taxes paid for such income are not considered additional gifts to the GRAT.
POTENTIAL DOWNSIDES?
You must survive the term of the GRAT, otherwise it goes back into your estate
If you don’t exceed the hurdle rate, you don’t move additional assets outside the GRAT
Generally used for children, but shouldn’t be used for grandchildren because you cannot allocate the generation skipping transfer tax exemption at the beginning of the GRAT (in other words, you wouldn’t get the benefit of leveraging your gift)
Beneficiaries receive carry over basis, not stepped up basis on the assets. So this really only makes sense when the capital gains tax is lower than the expected estate tax rate.
Legislative risk - the IRS doesn’t like these trusts and they have been on the radar of politicians/legislators as something that should be changed - so even though you may commonly read about estate planners mentioning this option to their wealthier clients, there is no guarantee that these types of trusts will work indefinitely or and. no guarantee that they won’t be challenged later on.
Why would I want a 2 year GRAT and when would I want a 10 year GRAT?
If the hurdle rate or 7520 is historically at a low level, then you may want a longer term rate to lock in the low hurdle rate and thereby allow more appreciation to flow outside of your estate during the duration of the GRAT.
However, if rates are not historically low or if you expect them to get lower in the near future, then shorter term GRATs may be preferred.
This will also depend on how you expect the investment to perform over the term of the short term GRAT and your concerns about sequence of returns risk.
And most importantly, if you die during the period of the GRAT then it all comes back to you for estate tax purposes. This is why some clients prefer to do shorter term rolling GRATs in order to reduce mortality risk.
What else should I know about GRATs?
They allow you to swap out assets of equivalent value. So if you happen to create a GRAT and the investments outperform in the first year, then you could lock in that appreciation by swapping out the volatile asset with cash or cash equivalents or low risk bonds.
There is also some flexibility in payment options when structuring the GRAT. For example, you could increase later payments by as much as 20% in the later years to allow the investments time to grow/stabilize in the initial years of the GRAT.
This reduces the sequence of return risk or the risk that the investments poor return in the initial years will force you to pull out a disproportionately large share of the assets held in the GRAT in the early years which would make it much harder for the investments in GRAT to exceed the hurdle rate in later years (because you need to remember that the annuity payments in a GRAT are predetermined when you start the GRAT regardless of how the actual investments perform inside the trust during that time period).
There is something called a GRUT, which can adjust the amount paid on each year based on fixed percentages, but you generally wouldn’t want that if your goal is to get as much as possible above the hurdle rate meanwhile only receiving back the dollar amount fixed at the beginning when the GRAT was initially funded.
Questions or concerns? I’m always happy to help - you can schedule a call with me through the link below. Thank you!
