A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust into which you make a one-time transfer of property and then receive a fixed amount annually for a specified number of years (the annuity period). At the end of the annuity period, the payments to you stop and any property remaining in the trust pass to the persons you’ve named in the trust document as the remainder beneficiaries (your children). The property also can remain in trust for their benefit.
A GRAT is generally used to transfer rapidly appreciating or high income-producing property to heirs with the main goal of transferring (free of federal gift tax) a portion of any appreciation in (or income earned by) the trust property during the annuity period.
How a GRAT Works
Because a GRAT is an irrevocable trust, when you transfer property, you’re making a taxable gift to the remainder beneficiaries. The value of the gift is discounted because of your retained interest. The amount of the discount is calculated using IRS valuation tables that assume the property in trust will realize a certain rate of return during the annuity period. This assumed rate of return is known as the Section 7520 rate or discount rate. If the property in the trust grows more than the IRS assumes, the excess growth will pass to the remainder beneficiaries’ gift-tax free. This discount rate has been at historic lows for the past few months. It has ranged between 1.8 percent and 3 percent during 2010. This low interest rate means there may be more excess growth to pass to your heirs.
Because the transfer to the remainder beneficiaries is not a present interest gift, the gift will not qualify for the $13,000 annual gift tax exclusion.
GRAT Risks and Issues
- You may fail to outlive the annuity term. If you die during the GRAT term, all of the property in trust will be included in your gross estate for federal estate tax purposes. The advantages of the GRAT will be lost, and you will have incurred the costs of creating and maintaining the GRAT for nothing.
- The GRAT may fail to outperform the Section 7520 rate. If this occurs, there may not be any excess to transfer and no tax savings will be achieved (the trust may even be depleted), defeating the purpose. This outcome puts the grantor in the same position he or she would have been in had the GRAT not been created. However, the costs of creating and maintaining the GRAT will have been wasted.
- GRATs are generally not appropriate for generation skipping transfers since the generation skipping transfer tax exemption is not allocated to the transfer until the GRAT term ends.
- Remainder beneficiaries do not receive a step-up in basis in the property transferred. This is a different result than inheriting property where there is a step-up in basis.
- A GRAT is considered a grantor trust for income tax purposes. This means that all items of income and deductions flow through to the grantor. This is the case even if all of the income earned by the trust property is not distributed to the grantor. The grantor should have other property available to pay this liability.
Is this technique for you? Since everyone’s circumstances are different, we encourage you to call your Eide Bailly service provider to determine if this is a suitable strategy for you to consider.