A Grantor Retained Annuity Trust or a GRAT is an agreement between you and a trustee to hold assets for a term. During the term of the GRAT the trustee will distribute an annuity to you at a rate determined by you. At the end of the term, the GRAT’s remaining assets will be distributed to the individuals or trusts you have named as remainder beneficiaries. Because you may serve as Trustee, creation of a GRAT allows you to retain control and use of your property but transfer the property’s upside appreciation to the remainder beneficiaries tax-free.

The term of the GRAT may be for life or any period of time not less than two years that you determine at the inception of the GRAT. If you die during the GRAT term, the GRAT assets will be included in your estate for federal estate tax purposes.

A GRAT may be structured so that its creation has no gift tax consequences. The value of the gift that results from the funding of a GRAT is determined by subtracting the value of the annuity from the value of the property transferred. Since you can manipulate the value of the annuity by selecting the term and rate, you can insure that the transfer results in a gift valued at zero. With no taxable gift at the creation of a GRAT, there is no downside to its use. If the value of the transferred property grows more than the amount required to pay your annuity, the excess growth will pass to the remainder beneficiaries free of gift tax. If the GRAT assets perform poorly, nothing is lost and the technique may be tried again.

A GRAT is a grantor trust for federal income tax purposes. This means that the grantor is taxed on all income and realized gains even if these amounts are greater than the annuity payments. This further enhances the GRAT’s effectiveness as a family wealth shifting and tax saving technique since the grantor essentially is making a tax free gift of the income taxes.

Example

Greg Grantor transfers $5,000,000 of stock to a two-year GRAT. Greg sets the annuity amount sufficiently high so that no gift results from the funding. Greg names his daughter, Greta, as the remainder beneficiary. Assume that the value of the stock appreciates at an annual rate of 6.5%. Based on the assumptions the following results:

‘Investment’ in GRAT $5,000,000
Gift on creation of GRAT $0.00
Annual annuity payable to Greg (based on the applicable IRS rate) $2,666,240
Total amount paid back to Greg over the life of the GRAT $5,332,480
Amount distributable to Greta at end of year 2 free of tax $165,339

Use of the GRAT as illustrated above does not deplete Greg’s estate, but it does facilitate the removal of future growth and income. If the assets selected for the GRAT do not grow as expected, nothing is gained but nothing is lost. The technique may be repeated until favorable results occur.

Note that a Grantor Retained Unitrust (GRUT) operates similarly to a GRAT except that the retained annuity interest is stated as a percentage of GRUT assets each year rather than once at inception. If highly appreciable assets are used to fund a GRUT, the grantor’s annuity will increase each year. This results in more appreciation being retained by the grantor and less being transferred to the remainder beneficiaries. Because the estate-planning goal is to shift as much appreciation as possible to the heirs, GRUTs are not as popular as GRATs.