Grantor retained annuity trusts

In short

A friend of mine once said that the best gift is the one that costs the giver almost nothing and still lands in good hands. A grantor retained annuity trust, which people call a GRAT, tries to do just that for a family. The grantor puts assets into a trust and gets a fixed stream of payments back for a set number of years. Whatever the trust earns above a rate set by the IRS passes to the heirs with little or no gift tax. The setup suits assets that may grow fast. It fails if the grantor dies before the term ends. A lawyer must draft it, and an appraiser must value what goes in.

The whole of it

What it is

I once watched an old rancher hand his son the keys to a truck, then ask the boy to drive him to town every Sunday. That is the whole shape of a GRAT, more or less. The grantor is the person who creates the trust. The grantor moves assets into it, such as shares of a private company. The trust then pays the grantor a fixed annuity each year for a term of years, and when the term ends, whatever is left goes to the heirs, or to trusts set up for them.

The idea rests on a rule in the Internal Revenue Code, Section 2702, and the regulations that go with it. Those rules value a gift that comes with a kept income stream in a particular way. The gift to the heirs is counted as the value of what goes in, minus the value of the annuity the grantor keeps. If the annuity is set high enough, the counted gift can be near zero. People call that a zeroed out GRAT.

You have probably heard the phrase estate freeze. A GRAT is one tool people use for that purpose. It does not shrink the grantor's estate by magic. It moves growth above a set rate out of the estate and into the next generation's hands.

How it works

If you are weighing a GRAT, picture a small race. The IRS publishes a monthly rate, called the Section 7520 rate, and it acts as the hurdle. The trust must pay the grantor back the original value plus interest at that hurdle rate. If the assets grow faster than the hurdle, the extra is left over for the heirs. If they grow slower, the trust simply pays everything back to the grantor, and the heirs get nothing. Little is lost except the cost of setting it up.

The grantor picks the term. Many planners use short terms and set up several trusts in a row. The reason is plain. A short term cuts the odds that the grantor dies before it ends. If the grantor dies during the term, part or all of the trust assets are pulled back into the taxable estate. That is the main risk, and it is a real one.

The annuity is paid each year, in cash or in shares. Paying with shares is called an in kind payment, and it lets the trust keep its growth assets working. The regulations require that the annuity be a fixed amount, or a stated percent that rises by no more than a set limit each year. That yearly rise is capped at the current figure, which the official source publishes each year. A trust that breaks the cap loses its special valuation. Hard stop.

The trust is usually a grantor trust for income tax purposes. That means the grantor pays the income tax on what the trust earns. It sounds like a burden, but it can work in the family's favor, because the trust keeps all its growth while the grantor's tax payments shrink the grantor's estate further without counting as a gift.

The numbers, and where to find yours

I have learned that a plan is only as good as the numbers under it. Three figures matter most. The first is the Section 7520 rate for the month the trust is funded. The IRS posts it each month in a Revenue Ruling, and the Treasury Department also posts it on its website. The second is the federal gift and estate tax exemption, which is the current figure, which the official source publishes each year. The third is the top federal estate and gift tax rate, which is the current figure, which the official source publishes each year.

A fourth number is the date of funding. The hurdle rate is locked in on that day. A low rate month is friendlier to a GRAT, because the hurdle is lower and the odds of beating it go up. An estate lawyer can pull the rate for any month from the IRS. Form 709, the federal gift tax return, is where the trust is reported, even when the taxable gift is zero. Filing it starts the clock on the IRS review period, so skipping it is a poor idea.

A worked example

Let me tell you about a woman named Margaret. She founded a small software company and owns shares worth $10,000,000. She believes the company will grow, but she is not sure. She sets up a two year zeroed out GRAT and puts the shares in.

Say the hurdle rate that month is 5 percent. To zero out the gift, the annuity must repay $10,000,000 plus 5 percent interest over two years. For a level annuity, the payment factor at 5 percent over two years is about 0.5378. So $10,000,000 times 0.5378 gives $5,378,000 a year, rounded. Two payments of $5,378,000 total $10,756,000. That is the original $10,000,000 plus interest at the hurdle rate.

Now suppose the shares grow 12 percent each year. After year one, the trust holds $10,000,000 times 1.12, which is $11,200,000. The trust pays Margaret $5,378,000, leaving $5,822,000. After year two, that balance grows to $5,822,000 times 1.12, which is $6,520,640. The trust pays Margaret $5,378,000 again, leaving $1,142,640. That amount goes to her children, free of gift tax, and the taxable gift at the start was zero.

Compare that to a bad outcome. If the shares grew only 3 percent, the trust could not beat the hurdle. Margaret would receive all her shares back as payments, and her children would get nothing. She would be right where she began, minus the legal fees.

Where it goes wrong

I would be a poor friend if I only told you the sunny side. The first problem is death during the term. If the grantor dies early, the trust assets return to the estate, and the whole effort is wasted. The second problem is weak growth. The trust has to beat the hurdle rate, or the heirs get nothing at all.

A third problem is valuation. If the assets going in are private shares, an appraiser must value them, and the IRS can challenge that value. Another trap is the generation skipping transfer tax. A GRAT is a poor fit for gifts to grandchildren, because the exclusion rules for that tax work against it. The grantor also may not add assets to the trust after it is funded. Each new contribution needs a new trust.

Rules about GRATs can change, and lawmakers have discussed limits on them from time to time. A reader should ask a lawyer what the law says today, and check the IRS pages on Section 2702 for the current text. Careful drafting matters too, since small errors can undo the tax result.

Questions to answer before you leave this page

Have you asked what the assets might realistically earn compared with the current Section 7520 rate? Do you have an estate lawyer who has drafted these trusts before, and an appraiser the IRS will respect? What happens to your family's plans if you die during the term, and have you made peace with that risk? Could you live without the annuity payments, or must they come from assets you still need? Is your estate large enough that the the current figure, which the official source publishes each year will not cover it, so the effort pays off? Would a series of short trusts suit you better than one long one? And have you talked with the people who will receive what is left, so that nobody is surprised?