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GRAT Expectations: Why More Investors Are Turning to Grantor-Retained Annuity Trusts

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Jeff Brown, CFA

Director, Institutional Portfolio Manager (emeritus)

With potential tax hikes on the horizon, wealthy families are exploring how they can use grantor-retained annuity trusts (GRATs) to achieve substantial estate and gift tax savings.

Today’s low interest rates and potential tax-law changes are creating a rare opportunity for families to take advantage of a powerful wealth transfer tool—grantor-retained annuity trusts. GRATs can help reduce estate and gift taxes by removing assets and their appreciation from the grantor’s estate. If used correctly, GRATs can allow grantors to gift appreciated assets free of tax. 

What are GRATs?

GRATs are irrevocable trusts that allow individuals to transfer wealth without paying gift or estate taxes.

To create a GRAT, a grantor establishes an irrevocable trust that exists for a set period. The grantor funds the GRAT with assets that have substantial growth potential—such as pre-IPO stock or private equity holdings. The trust then pays the grantor a fixed annual amount—an annuity—for the life of the trust.

When the term of the trust ends, the beneficiaries receive the assets remaining in the GRAT free of gift and estate tax.

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Why are GRATs popular wealth transfer tools?

Depending on a GRAT’s cash flow and the appreciation of its assets, the grantor and their beneficiaries stand to achieve substantial estate and gift tax savings. 

To begin with, GRATs can be structured so the value of the annuity equals the value of the initial gift. This is known as a zeroed-out GRAT, and it means no taxable gift is created at the trust’s inception. The value of the grantor’s taxable gift isn’t the value of the assets transferred to the GRAT but rather the current value of the beneficiaries’ right to receive the assets in the future. The gift value of the annuity payment is determined by the IRS 7520 rate. As of May 2021 that rate sits at 1.2%.

If the GRAT’s investment return exceeds the IRS 7520 rate over its lifetime, there may be significant assets left in the trust when it ends. Those assets then transfer tax free to the beneficiaries while simultaneously removing the value of the appreciated assets from the grantor’s estate. That’s why GRATs are frequently funded with assets that have significant anticipated appreciation, such as IPOs, private equity, and public equity.

How does a GRAT work?
Let’s say a grantor transfers $1 million to a GRAT, which will pay them an annuity of roughly $106,700 for each of 10 years. At the end of that term, if the grantor is still alive, their children will receive the trust’s remaining funds. Assuming the IRS 7520 rate for the month of the gift is 1.2%, the present value of the grantor’s retained annuity payments for gift tax purposes is the entire $1 million, and the value of the taxable gift—the remaining interest to the beneficiaries—is zeroed out.

Now let’s assume this GRAT earns an annual investment return of 6% on the $1 million. At the end of 10 years, the grantor’s children will receive tax-free assets worth more than $384,000. They’ll also receive any growth or income from this amount between the end of the GRAT term and the grantor’s death.

However, if the grantor dies before the term ends, the federal estate tax would be $153,600, assuming a rate of 40%

Tax affects performance, so we pay close attention

What are the income tax implications of a GRAT?
For income tax purposes, the grantor is considered the GRAT owner, which results in income tax implications. During the term of a GRAT, the grantor will be taxed on all the income and capital gains earned by the trust without regard to the annuity amount. However, the grantor’s income tax payment is an additional tax-free gift to the trust’s beneficiaries since the trust’s assets can grow without income tax dilution.

GRATs can provide for a substitution power, meaning the grantor can exchange assets of like value for those in the trust. This can be done to lock in appreciation or to substitute low-basis holdings for high-basis holdings, which helps reduce future capital gains taxes incurred by the beneficiaries. Since these assets are outside the grantor’s estate, they don’t get a step-up in basis. Here too it falls to the grantor to pay capital gains taxes on these appreciated holdings.

Thankfully, advisors can give grantors a break. Asset choice and tax management can help mitigate the income tax load on the grantor and their beneficiaries. One option is to transfer marketable securities such as equities, which are particularly attractive due to their liquidity, readily available valuations, flexibility relative to annuity payments in kind, and capital gain and loss realization. Proper tax management can lower the drag to the grantor and the beneficiaries while achieving market-like returns.

The bottom line
Because GRATs have the potential to provide the largest tax benefits when interest rates are low, today’s interest rate environment makes it an opportune time for families to consider GRATs. A GRAT’s IRS 7520 rate never deviates from the one that was in place when the trust was created, and the rate for May 2021 sits at 1.2%.

Additionally, tax hikes may be looming. President Biden has discussed raising tax rates for those families with adjusted gross incomes of more than $1 million. How the final bill takes shape, including a clause addressing the step-up in basis, will require communication with the client’s tax advisor. Any long-term planning should consider this possibility. 

Working with an estate attorney, an accountant, and a financial advisor, high-net-worth investors can decide whether a GRAT is right for them. Partnering with a team of trusted professionals, families can develop a plan to grow their assets, minimize taxes, and efficiently transfer wealth to their heirs.

GRATer things: For a fuller perspective on GRATs and how a Parametric Custom Core® SMA can enhance the tax management of a GRAT, download our insight.

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