Transferring Wealth with a Grantor Retained Annuity Trust
Grantor retained annuity trusts (GRATs) are a tax-efficient strategy to transfer wealth to beneficiaries — especially if you anticipate having an estate valued at more than the federal estate exemption.
How a GRAT Works
A GRAT is an irrevocable trust with a defined term that you establish, typically two years. During the term, you as the grantor receive an annuity that consists of an amount you choose plus the IRS published Section 7520 rate. When the trust’s term ends, any remaining assets pass to your named beneficiaries with no additional estate, gift or income tax.
| The IRS 7520 rate is used to value certain interests, including the annuities in GRATs. The rate for a particular month is the rate that is 120% of the applicable federal midterm rate (compounded annually) for the month in which the GRAT is funded. That rate is then rounded to the nearest two tenths of 1%. |
Establishing the Trust
A GRAT is funded with a one-time transfer of assets. This often is a single security, basket of correlated securities, or assets with strong short- to mid-term growth potential, including undervalued securities, and shares of a family business.
After the GRAT is funded, you receive an annuity payment throughout the trust’s term. Tax rules allow the “backloading” of annuity payments so that they are lower at the beginning and increase up to 20% per year throughout the term. You can also establish a “rolling GRAT” program by using the annuity stream. As each annuity payment is received, it is “rolled” into a new GRAT, and the annuities from the new GRAT are rolled into additional new GRATs.
No income tax is imposed on transfers into or out of the GRAT. Gift tax is triggered on the difference between the value of the funded assets less the value of the retained annuity. Typically, this is engineered to be a nominal amount, such as $100 or less, or even $1.
Remaining Assets Pass to Your Beneficiaries
When the term expires, the trust remainder — that is, the remaining assets and appreciation earned in the trust less the amount paid as the annuity — pass tax-free to your beneficiaries or into a trust for them. Be mindful that assets transfer with a carry-over tax basis, not a stepped-up (or stepped-down) basis as with most inherited assets. Beneficiaries are liable for any taxable gain should those assets be sold later.
The remainder is excluded from your gross estate on the condition you outlive the GRAT term. You remain liable for income tax on sales and other income within the GRAT. This can provide two additional estate tax benefits: When
you pay the tax for the trust, it leaves more assets inside the trust for the beneficiaries. It also reduces the assets that otherwise would be subject to estate tax upon your passing.
GRATs are permitted, but not efficient, for generation-skipping asset transfers. The estate-tax inclusion period rules prevent allocating the generation-skipping transfer exemption until after the expiration of the term, and thus allocation of the GST exemption is on a dollar-for-dollar basis.
Capturing Swings in Value
You can choose to swap assets with the GRAT during its term. You may consider doing so if:
- There is exceedingly rapid appreciation early in the GRAT term. You can replace the appreciating asset with cash or other assets and thus “freeze” the value inside the GRAT.
- Assets decline in value. You can replace them and then fund them into a new GRAT, creating an opportunity for success as the assets regain normal values.
Potential Risks
GRATs have several risks, including:
- Mortality: If you die during the trust’s term, the value of some or all assets will be included in your estate.
- Underperformance: If the assets in the GRAT decline in value below the IRS’s assumed rate of return, it will negate any tax benefits. There will be no appreciation to transfer to beneficiaries, and all property in the trust will revert to you as the grantor. As noted above, the swap power may be a solution.
- Rate headwind: When interest rates increase, there is a concomitant bump in the IRS 7520 rate. Thus, a rolling GRAT program could face higher hurdles in the future.
- Legislative: GRATs have often been identified as a “loophole for the wealthy,” making them a potential target for future tax reform legislation.
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To protect against the IRS 7520 rate rising dramatically, or the law changing to prohibit new short-term GRATs, you could consider a “shelf” GRAT. These GRATs are initiated by funding with low volatile assets, then essentially “placed on a shelf.” If and when needed in the future, you can swap in volatile assets.
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This material provides information of possible interest to Glenmede’s clients and friends, and does not provide investment, tax, legal or other advice. Any opinions, recommendations, expectations and/or projections expressed herein may change after the date of publication. Information obtained from third-party sources is assumed to be reliable but may not be independently verified, and the accuracy thereof is not guaranteed. Any potential outcome discussed, including but not limited to performance, legislation or tax consequence, ultimately may not occur due to various risks and uncertainties. Clients are encouraged to discuss any matter discussed herein with their tax advisor, attorney or Glenmede Relationship Manager.