Great time for a GRAT: A grantor retained annuity trust can form the cornerstone of an estate plan.

Author:Burke, Megan M.

Grantor retained annuity trusts (GRATs) represent an opportunity for a client to transfer appreciating assets to the next generation with little to no gift or estate tax consequences. Wealthy families can use GRATs to freeze the value of their estate while transferring any future appreciation to the next generation free of tax. Additionally, GRATs have little downside.

Moreover, now may be an opportune time for taxpayers who can benefit from a GRAT to consider forming one, with their CPA tax adviser's help. There have been recurring proposals by some in the federal government to limit the benefits GRATs can provide. Also, while the estate tax exemption is now $11.4 million (for 2019), that figure is currently scheduled to revert to $5 million as adjusted for inflation, which was $5.49 million in 2017, the amount it was before the changes made by the law known as the Tax Cuts and Jobs Act, P.L. 115-97. This would make more estates potentially taxable. And, finally, the trusts work best when the Sec. 7520 interest rates are low, which is currently the case, but based on current interest rate trends, may not be for much longer.


A GRAT is created when a grantor contributes assets with appreciation potential to a fixed-term, irrevocable trust. The grantor then retains the right to receive an annuity stream over the trust's term. At the end of the term, the assets are distributed to noncharitable beneficiaries--typically, the grantor's children.

Note that the grantor receives the right to an annuity stream and not the income of the trust. If the trust does not generate sufficient income, the trustee must invade the principal to make the annuity payment. A taxable gift is calculated by subtracting the value of the grantor's retained interest from the fair market value of the property transferred into the trust.

The IRS assumes that the trust assets will generate a return of at least the applicable Sec. 7520 rate in effect for the month the assets were transferred to the trust. Any appreciation in excess of the Sec. 7520 rate passes to the beneficiaries free of gift tax. (This article uses for illustrative purposes the 3.4% rate in effect for January 2019. To find the current rate, see the latest monthly IRS revenue ruling with the applicable federal rate tables (see Table 5 of the revenue ruling), or consult the IRS's "Section 7520 Interest Rates" webpage, available at y62urq7f.)

If the assets in the GRAT fail to outperform the Sec. 7520 rate, the assets are returned to the grantor. The grantor would have paid little to no gift tax and only have incurred minimal administrative costs to establish and maintain the GRAT. There are no other adverse tax consequences of a substandard-performing GRAT.

Example 1: A client places $5 million in a GRAT (an irrevocable trust meeting the Sec. 2702 requirements) when the Sec. 7520 rate is 3.4%, with the right to receive an annuity of $500,000 for 10 years. At the end of 10 years, the remainder will be distributed to the grantor's children. Using the IRS Publication 1457, Annuities, Life Estates & Remainders, Table B factor of 8.3587, the annuity stream is valued at $4,179,350, and the remainder interest is valued at its present value of $820,650. If the assets appreciate at a Sec. 7520 rate of 3.4%, the grantor will receive a stream of 10 payments of $500,000, and the beneficiaries will receive $1,146,484 at the end of the 10-year term (the future value of $5 million, minus 10 annual payments of $500,000, and appreciating at 3.4% per year).

If the assets instead appreciate at a rate of 8%, with the same stream of payments, the beneficiaries will receive $3,551,344 (with a present value at 3.4% of $2,542,069). Only the present value of the remainder interest, or $820,650, would be subject to gift tax.

As this is a gift of a future interest, it is not a completed gift and does not qualify for the annual gift tax exclusion. Any appreciation in excess of this amount will transfer to the grantor's children free of gift tax consequences.

Since a GRAT represents an incomplete gift, it is not a suitable vehicle to use in a generation-skipping transfer (GST), as the value of the skipped gift is not determined until the end of the trust term. The opportunity to leverage the GST tax exemption is lost in the GRAT structure. The assets transferred to the beneficiaries will receive a carryover basis rather than a stepped-up basis. As such...

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