Grantor Retained Annuity Trusts (GRATs)
A Grantor Retained Annuity Trust or “GRAT” is one of the most powerful and tax efficient wealth transfer tools available today. A GRAT allows a person to share the future appreciation of an asset with the next generation with virtually no gift tax.
A GRAT is a trust with a specific life or term, i.e., 5 years, 8 years, etc. The grantor transfers assets to the GRAT and retains an interest in the trust. This income interest will be stated as an annuity percentage of the original assets transferred to the GRAT. Each year the GRAT will pay the grantor the required payment.
At the end of the GRAT term, any remaining assets will be distributed to the named beneficiary or beneficiaries. The gift will be calculated using the subtraction method. The present value of the annuity payments to the grantor will be subtracted from the original value of the assets placed into the GRAT.
Dad holds $1,000,000 of a stock that pays a 10% dividend. Dad establishes a GRAT with a 13 year term and transfers the $1,000,000 of stock to this GRAT. Each year the $100,000 dividend is paid to the GRAT and the GRAT then pays the required $100,000 annuity to Dad/grantor. The value of the gift may be as low as $13,710. This is a gift of the future interest and does not qualify for the annual exclusion. Dad/grantor must use part of his $1,000,000 lifetime gift exemption or pay a gift tax.
At the end of the GRAT term or 13 years, Dad would have received $1,300,000 ($100,000 per year x 13 years) in annuity payments. The remainder value in the GRAT is the stock and would still be valued at $1,000,000 assuming no appreciation. The stock would then be distributed to the remainder beneficiaries, usually Dad’s children. In this case, the children will have received an asset worth $1,000,000 but Dad only had to report a gift of $13,710.
The term of a GRAT can be as short as two years or as long as the grantor chooses. However, if the grantor dies during the GRAT term, the IRS says “the technique fails and the assets inside the GRAT are included in the taxable estate”. For this reason, most GRATs are kept to shorter term.
If the GRAT term is shortened, the annuity payout rate must be increased or a larger reportable gift will occur. It is important to note that the GRAT annuity payment does not have to be made from income. The annuity payment can be satisfied with principal or the assets that were originally transferred into the GRAT.
To illustrate both a short term GRAT and using principal to satisfy the annuity obligation, consider the following. Dad transfers $1,000,000 of non-dividend paying stock into a two year GRAT. Dad retains a 53.17167% annuity interest. If the stock grows 10% each year, the GRAT must pay $531,716.70 of value to Dad each year for two years. This payment can be made by distributing the appreciated stock to Dad. If the trust does this for two years, the trust will have $93,395 of stock remaining after the last payment to Dad. According to the Walton Tax Court Decision, Dad made a taxable gift of under $1.