Grantor Retained Annuity Trusts (GRATs)
A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust designed to transfer asset appreciation to beneficiaries with minimal or no gift tax cost. The grantor transfers assets to the trust and retains the right to receive fixed annuity payments for a specified term. At the end of the term, any remaining assets pass to the beneficiaries. If the assets outperform the IRS assumed rate of return, the excess growth transfers gift-tax-free.
GRAT Mechanics
The GRAT structure involves three key elements:
1. Initial transfer: The grantor transfers assets to an irrevocable trust.
2. Annuity payments: The trust pays the grantor a fixed annuity for a specified number of years. The annuity is typically structured as a percentage of the initial contribution.
3. Remainder transfer: At the end of the annuity term, any assets remaining in the trust pass to the named beneficiaries (typically children or a trust for their benefit).
Gift tax calculation:
The taxable gift equals the value of assets transferred minus the present value of the retained annuity interest. The IRS publishes monthly interest rates (Section 7520 rates) used to calculate these present values.
If structured correctly, the present value of the annuity payments can equal or nearly equal the value of assets transferred, resulting in a minimal or "zeroed-out" taxable gift.
The Section 7520 Rate
The IRS Section 7520 rate is published monthly and equals 120% of the applicable federal mid-term rate. This rate serves as the assumed rate of return in calculating the present value of annuity payments.
December 2024 Section 7520 rate: 5.0% (rates fluctuate monthly)
How the 7520 rate affects GRAT planning:
- Lower 7520 rates favor GRATs: When the assumed rate is low, a smaller annuity is needed to "zero out" the gift, leaving more assets to potentially pass to beneficiaries.
- Higher 7520 rates require larger annuities: More of the trust assets must be returned to the grantor as annuity payments, reducing the potential transfer to beneficiaries.
- Actual returns matter: If trust assets earn more than the 7520 rate, the excess passes to beneficiaries gift-tax-free. If returns fall below the 7520 rate, fewer assets (or nothing) pass to beneficiaries.
The grantor can lock in a favorable 7520 rate by creating the GRAT in a month with a lower rate, as the rate in effect at trust creation applies for the entire term.
Zeroed-Out GRATs
A "zeroed-out" GRAT is structured so the present value of the retained annuity equals (or nearly equals) the value of assets transferred. This results in a taxable gift of approximately zero, meaning no gift tax is owed and no lifetime exemption is used.
Advantages of zeroed-out GRATs:
- No gift tax liability
- Preserves lifetime gift tax exemption for other planning
- Transfers all appreciation above the 7520 rate to beneficiaries
- If the GRAT "fails" (returns below 7520 rate), no gift tax was paid
The "zeroed-out" structure:
Because IRS regulations require a minimum remainder interest, a perfectly zeroed-out GRAT is technically not possible. In practice, the gift is structured to be de minimis—often just a few dollars or a fraction of a percent of the transferred value.
GRAT Term Considerations
The annuity term affects both the gift calculation and the mortality risk.
Shorter terms (2-3 years):
- Lower mortality risk (grantor more likely to survive the term)
- Require higher annuity payments to zero out
- Less time for appreciation to accumulate
- More commonly used in practice
Longer terms (10+ years):
- Greater mortality risk
- Lower annuity payments needed to zero out
- More time for appreciation to accumulate
- Generally less attractive due to mortality risk
Rolling GRATs strategy:
Many practitioners recommend a series of shorter-term GRATs (2-3 years each) rather than one long-term GRAT. At the end of each GRAT term, any remaining assets can fund a new GRAT. This approach:
- Reduces mortality risk
- Allows resetting to current 7520 rates
- Captures appreciation in successive trusts
Mortality Risk
If the grantor dies during the GRAT term, the trust assets are included in the grantor's taxable estate—partially or fully negating the estate planning benefits.
Full inclusion rule: If the grantor dies during the annuity term, the portion of trust assets necessary to produce the remaining annuity payments is included in the estate.
Mitigation strategies:
- Use shorter GRAT terms to reduce the probability of death during the term
- Consider the grantor's health and life expectancy when selecting term length
- Structure GRATs when the grantor is in good health
- Use rolling GRATs to restart the mortality clock periodically
Grantor Trust Status
GRATs are grantor trusts for income tax purposes. This means:
- The grantor pays income tax on all trust income
- No capital gains tax is triggered on the initial transfer to the GRAT
- Annuity payments from the GRAT to the grantor are not taxable income
- The grantor's payment of trust income taxes is an additional transfer to beneficiaries
Ideal Assets for GRATs
GRATs work best with assets expected to appreciate significantly during the trust term.
Favorable assets:
- Closely held business interests (especially before anticipated liquidity events)
- Growth stocks or concentrated stock positions
- Assets with depressed current values expected to recover
- Private equity or venture capital investments
Less favorable assets:
- Stable, income-producing assets (returns may not exceed 7520 rate)
- Highly diversified portfolios with market-rate expected returns
- Assets expected to decline in value
Worked Example: $5 Million GRAT with 2-Year Term
Elizabeth, age 58, owns stock in a private technology company valued at $5,000,000. The company is planning an IPO in approximately 18 months, and Elizabeth expects the stock to double in value.
GRAT structure:
- Assets transferred: $5,000,000 in company stock
- GRAT term: 2 years
- Annuity rate: 54% of initial value per year
- Section 7520 rate at creation: 5.0%
- Beneficiaries: Elizabeth's two children
Annuity payment calculation:
| Year | Annuity Payment |
|---|---|
| Year 1 | $2,700,000 (54% of $5,000,000) |
| Year 2 | $2,700,000 (54% of $5,000,000) |
| Total | $5,400,000 |
Gift tax calculation:
- Value of assets transferred: $5,000,000
- Present value of annuity stream (at 5.0% rate): $4,999,500
- Taxable gift: $500
The GRAT is effectively "zeroed out" with a negligible gift.
Scenario A: Stock doubles in value
The company completes its IPO and Elizabeth's stock doubles to $10,000,000.
| Year | Beginning Value | Growth | Annuity Payment | Ending Value |
|---|---|---|---|---|
| Year 1 | $5,000,000 | $2,500,000 | ($2,700,000) | $4,800,000 |
| Year 2 | $4,800,000 | $2,400,000 | ($2,700,000) | $4,500,000 |
Remainder to beneficiaries: $4,500,000
Elizabeth transferred $4,500,000 to her children with a taxable gift of only $500. No gift tax was owed, and $4,500,000 of appreciation passed outside her estate.
Estate tax savings (at 40% rate): $1,800,000
Scenario B: Stock increases by 5% (matches 7520 rate)
| Year | Beginning Value | Growth | Annuity Payment | Ending Value |
|---|---|---|---|---|
| Year 1 | $5,000,000 | $250,000 | ($2,700,000) | $2,550,000 |
| Year 2 | $2,550,000 | $127,500 | ($2,700,000) | ($22,500) |
The trust would need to be structured to handle this situation, typically by returning the remaining assets as a final partial annuity payment.
Remainder to beneficiaries: $0
When returns match the 7520 rate, no assets pass to beneficiaries, but no gift tax was paid either. The GRAT "fails" with no cost.
Scenario C: Stock declines by 20%
| Year | Beginning Value | Decline | Annuity Payment | Ending Value |
|---|---|---|---|---|
| Year 1 | $5,000,000 | ($500,000) | ($2,700,000) | $1,800,000 |
| Year 2 | $1,800,000 | ($180,000) | ($1,620,000)* | $0 |
*Partial payment of remaining assets
Remainder to beneficiaries: $0
The GRAT returns all assets to Elizabeth through annuity payments. No gift tax was paid, and no assets transferred. Elizabeth can create a new GRAT with the returned assets when circumstances improve.
GRAT Planning Considerations
Advantages:
- Minimal or no gift tax cost (zeroed-out structure)
- Preserves lifetime exemption for other planning
- Transfers appreciation above 7520 rate to beneficiaries
- If unsuccessful, no tax cost (assets simply return to grantor)
- Grantor trust status provides additional income tax benefits
Disadvantages:
- Mortality risk during trust term
- No step-up in basis for remainder beneficiaries (if grantor survives)
- Assets must outperform 7520 rate to provide benefit
- Administrative complexity and legal costs
- Potential legislative risk (various proposals have sought to limit GRATs)
Legislative considerations:
Various legislative proposals have sought to impose minimum GRAT terms (typically 10 years), require minimum remainder interests, or otherwise limit GRAT effectiveness. While no such legislation has passed as of 2024, future changes remain possible. Individuals considering GRATs may benefit from acting while current rules remain in effect.
GRAT Planning Checklist
- Evaluate whether you have assets with high appreciation potential
- Consult with an estate planning attorney experienced in GRAT structures
- Review current Section 7520 rates and consider timing of GRAT creation
- Assess your health and select an appropriate GRAT term
- Consider shorter-term rolling GRATs to reduce mortality risk
- Obtain a qualified appraisal for non-publicly traded assets
- Structure the GRAT as zeroed-out to minimize gift tax
- Identify appropriate beneficiaries or a trust to receive the remainder
- Understand the income tax implications of grantor trust status
- Plan for annuity payment sourcing (trust may need to distribute stock or other assets)
- Consider combining GRATs with other estate planning techniques
- Monitor legislative proposals that could affect GRAT planning
- Review estate plan regularly and create new GRATs as appropriate
- Maintain records of all GRAT transactions for tax reporting