A grantor retained annuity trust (GRAT) can allow you to avoid large amounts of gift or estate tax while transferring high-value investments to the next generation.
Changing Estate Tax Law
While most families don’t have to worry about estate taxes, they can put a serious dent in the inheritance that high-net worth families are able to pass on to their loved ones. Currently, the estate tax exemption is at a historic high—$11.58 million for 2020 and $11.7 million for 2021. However, this is a temporary bump brought about by the Tax Cuts and Jobs Act, and it’s set to expire in 2025. After that, it will go back to $5 million plus an adjustment for inflation, which amounted to $5.49 million in 2017. In addition to federal estate taxes, some states also impose their own estate and/or inheritance taxes, which can apply to much smaller amounts.
A GRAT is an irrevocable trust designed to last a certain period of years. The grantor funds the annuity trust with appreciable assets and, during its term, receives a stream of income from the annuity. At the end of the term, anything left in the trust is transferred to its beneficiaries (typically the grantor’s children). The Center on Budget and Policy Priorities estimates that GRATs have allowed wealthy estates to avoid as much as $100 billion in tax between 2000 and 2017—nearly a third of the total estate taxes collected during that period.
How does a GRAT avoid taxes?
Gift Tax-Free Appreciation
Technically, the grantor makes a gift for tax purposes at the time the GRAT is created. When determining the value of this gift to the GRAT’s beneficiaries, the IRS considers the grantor’s initial contribution to the GRAT, the expected rate of return on its assets, and the amount the grantor is scheduled to take back through the annuity. The current value of the grantor’s annuity interest is determined by multiplying the total payments by an amount found in IRS actuarial data, Publication 1457, Table B.
Only the difference between the grantor’s initial contribution and the present value of the grantor’s annuity interest is subject to gift tax. So, the greater the grantor’s annuity interest, the lower the amount subject to gift tax. As the investments grow during the annuity term, the grantor (as owner of the annuity assets) pays income tax on their earnings. After the term is up, anything remaining in the trust is distributed to beneficiaries free of gift tax.
An annuity’s expected rate of return is based on Section 7520 interest rates, which amounts to 120% of the federal midterm rate for the month of valuation, rounded to the nearest two tenths of a percent. This is the amount the IRS uses when calculating the value of the gift portion of the GRAT to beneficiaries. If the assets in the GRAT outperform the Section 7520 rate, then all of the excess appreciation passes to the trusts’ beneficiaries free of gift tax.
This is a key benefit in the current economic climate, as interest rates are at record lows. Back in 2006 and 2007, 7520 rates topped 6%. Although they declined in subsequent years, rates mostly remained above 2% until 2020. Since May of this year, the 7520 rates have been below 1%, and since August, they have been below 0.5%. This sets up a prime time for establishing GRATs, since all earnings above the current rate can be passed on free of gift tax.
No Penalty for Underperformance
In the event the assets in the trust actually underperform the 7520 rate, then the principal will be used to make the designated annuity payments. While there may be nothing left to pass on to beneficiaries in this case, the only loss to the grantor would be the administrative costs involved in setting up the GRAT. There is no penalty for a failed GRAT.
A strategy made famous by Wal-Mart’s Walton family is known as a “zeroed out” GRAT (also referred to as a Walton GRAT). This involves making the annuity amount the same as the original GRAT contribution plus the expected rate of return, essentially reducing the value of the gift to zero. In this way, large amounts of wealth can be transferred free of gift or estate tax.
Potential Disadvantages of GRATs
While a GRAT can deliver substantial gift or estate tax savings, there are some potential downsides to be aware of.
- A GRAT is an irrevocable trust, so once it’s in place, you can’t change it without permission of the beneficiaries.
- You must be prepared to pay income tax on the trust’s earnings.
- If the grantor fails to survive the term of the GRAT, the remaining assets become part of the grantor’s estate, and the beneficiaries do not receive anything from the GRAT.
GRATs can be attractive estate planning tools for those in pre-IPO companies because of the chance that the value of their company stock will increase dramatically, creating a large taxable estate. A GRATs can allow executives and employees of startup companies to set their children up for tax-efficient inheritance while they collect a guaranteed stream of income for themselves during the annuity period.
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