A GRAT can make sense for some estate plans, even in when the estate will not need to pay estate taxes.
First, a basic definition: a Grantor Retained Annuity Trust , known as a GRAT, is created by a “grantor” who transfers assets to the GRAT for a specific period of time. A recent article in AccountingWeb, “The Beauty of Grantor Retained Annuity Trusts,” notes that the GRAT, which often contains stock or closely-held business interests, typically holds assets for a specific period of time, which is usually between five and ten years. A GRAT could also be set up for a shorter time period, like two years.
The language of the GRAT will be written, in many instances, to provide that a parent retains the right to receive back, in the form of annual fixed payments (an annuity), 100% of the initial fair market value of the assets transferred to the GRAT.
The grantor will also receive a rate of return on those assets based upon the IRS-prescribed interest rate, which is called the “7520 rate,” after the Internal Revenue Code Section 7520. Section 7520 specifies the way in which this rate is to be calculated. For example, the IRS’s 7520 rate for November 2016 is 1.6%.
An excellent feature of a GRAT is that any asset remaining in the GRAT at the end of the trust’s term will pass to the named beneficiaries without any additional gift tax. The named beneficiaries in many cases will be the grantor’s children. This type of GRAT is often called a “zeroed-out GRAT” because it doesn’t end up with the grantor making a taxable gift due to the retention of an annuity equal to 100% of the assets contributed to the GRAT.
To illustrate this further, the stock of a family business is placed into a GRAT for a term of ten years, and the value of that stock is $500,000. (Note: if you put the stock of an S corporation into a GRAT, you are required to refile the S-election under the QSub rules.) The term of the GRAT is 10 years, and the 7520 rate is 1.6%. Based on these assumptions, you would pay the grantor $50,000 a year, plus 1.6% in interest.
What the GRAT does is freeze the asset—so in ten years, after the GRAT has zeroed out, the appreciated value would remain in the GRAT and pass to the beneficiaries, gift-tax free.
There is a risk associated with the GRAT that needs to be factored into the decision to use it: if the grantor dies during the term of the GRAT, the assets stay in the grantor’s taxable estate and the amount does not avoid any gift taxes.
This simply means that each person has to make an informed decision about whether or not a GRAT could be useful for removing assets from an estate. An experienced estate planning attorney who is familiar with GRATS and their pros and cons, will help you determine if a GRAT is right for you.