The objective of the GRAT is to remove appreciation on the transferred assets from the grantor’s estate. The structure of the GRAT also allows this removal of appreciation to be done at minimal or no gift tax cost.
The grantor transfers an asset with high appreciation potential to the GRAT, which is an irrevocable trust. In return, the grantor retains a qualified annuity interest for a specific term of years. Common terms of years for annuity trusts range from 2-10 years. The initial GRAT term must be at least two years, but it may be 20 years or longer. In a particularly low-interest rate environment, a shorter term GRAT may be preferred. The longer the term of the GRAT, the more likely that positive performance and poor performance will offset each other, which reduces the chance that the GRAT will beat the assumed growth rate (discussed below).
After the initial annuity term ends, the grantor’s interest in the trust terminates and the remaining trust assets (the “remainder interest”) pass to the beneficiaries named in the trust instrument. The remainder interest may pass outright or in further trust, depending on how the GRAT is drafted.
Technically, a gift is made when a GRAT is created. The value of the gift is determined by calculating the remainder interest. To determine the remainder interest, subtract the current value of the grantor’s annuity interest from the value of the entire asset transferred to the trust. The greater the value of the annuity interest, the lower the value of the gift.
The Treasury tables assume an expected growth rate equal to 120% of the federal mid-term rate (AFR). When that rate is lower than the annuity rate used in the GRAT, it is assumed that corpus of the GRAT is consumed each year to make up the difference. This reduces the gift tax value of the remainder interest. If the property’s actual rate of return exceeds the Treasury table rate, the remainder beneficiaries will receive substantially more property than the Treasury tables assume.
The Treasury table rates fluctuate monthly, so the timing for implementation of a GRAT is important. The rate is typically published on the 21st of each month for the next month, so it is possible to anticipate and react to rate changes before they occur.
GRATs provide a qualified annuity interest, or an absolute right to receive a fixed dollar amount. In each case, the payment must be made at least annually and may be made in kind. Since the retained interest gift being contemplated is an annuity, the annual payments are fixed since they are based on the value of property when it is initially transferred to the trust. Transfers of additional property to a GRAT during the term of the retained interest are prohibited.
First, a GRAT freezes the value of the property at the time it is transferred. If the grantor survives the trust term, the property passes to their beneficiaries without further gift or estate tax.
Second, under a GRAT, the value of the annuity can be made to approximate the value of the transferred property (zeroed-out), thereby virtually eliminating a taxable gift when the trust is funded. Because a gift to a GRAT is a remainder (or future) interest, and therefore not eligible for the annual exclusion from gift tax, the entire value of such interest is subject to gift tax, to the extent that the grantor(s) have exceeded both of the unified credit equivalents using other planning vehicles. However, using a zeroed-out GRAT technique will result in no gift tax.
Generally, the requirement that a GRAT pay trust income and principal to the grantor causes them to be the owner of the trust property during the initial term for income tax purposes. All taxable income generated by GRAT property is taxed to the grantor whether the income is actually distributed or accumulated for the benefit of the beneficiaries. The IRS may seek to treat the payment of tax by the grantor on income accumulated in the GRAT for the benefit of their children as an additional gift to the GRAT. Since additional gifts to the GRAT are not permitted, the IRS may take the position that the GRAT is disqualified if the GRAT income taxable to the grantor exceeds the annuity. So, it is imperative that annuity payments owed to the grantor are actually made.
If the grantor dies during the term of the trust, all or a substantial part of the trust will be included in their gross estate. Therefore, the initial term of the GRAT should be one that they can realistically survive. On the other hand, had the grantor not created the GRAT, the property would be includible in their estate anyway. Furthermore, strategies can be used in conjunction with a GRAT to hedge against a grantor’s premature death, such as using term life insurance to insure the grantor’s life for the GRAT term to cover the estate tax cost.
If they were to live beyond the specified term of each GRAT, there should be no further transfer tax since the gift was complete when the trust was funded. More importantly, 100% of post-gift appreciation in the property’s value escapes gift and estate tax. This makes a GRAT an excellent “estate freezing” device with respect to post-transfer appreciation.