GRATs Explained: Passing Asset Growth to Heirs Tax-Efficiently

A grantor retained annuity trust, commonly called a GRAT, is an estate planning tool used to pass the future growth of assets to heirs while minimizing gift taxes. GRATs are popular among business owners, executives and investors who hold assets expected to appreciate significantly. While the concept is relatively straightforward, GRATs involve technical rules that must be followed carefully.

The problem GRATs help solve

The federal government imposes gift and estate taxes on transfers of wealth above certain exemption amounts. For people with substantial estates, assets that grow significantly in value can create large future estate tax liabilities. Giving assets to heirs during your lifetime can remove future growth from your estate, but large gifts may use up your lifetime gift and estate tax exemption or trigger gift taxes.

A GRAT offers a way to transfer the future appreciation of assets to heirs while using little or none of your lifetime exemption.

How a GRAT works

The process generally involves three steps. First, you transfer assets, such as stock, shares of a business or other investments, into an irrevocable trust. You are the grantor. Second, the trust pays you an annuity, a fixed payment, each year for a set number of years, called the GRAT term. Terms are often two years or longer. Third, at the end of the term, any assets remaining in the trust pass to your beneficiaries, often your children or a trust for their benefit.

Because you retain the right to receive annuity payments, the value of the gift to your beneficiaries is calculated as the value of the assets you put in the trust minus the present value of the annuity payments you’ll receive.

The key idea: beating the hurdle rate

To calculate the value of the gift, the IRS uses an assumed interest rate called the Section 7520 rate, which is published monthly and based on market interest rates. This rate essentially serves as a hurdle rate.

If the trust’s assets grow faster than the Section 7520 rate during the GRAT term, the excess growth passes to your beneficiaries free of gift tax. If the assets grow slower than the rate, little or nothing passes to beneficiaries, but you generally receive your assets back through the annuity payments.

GRATs are often structured so that the annuity payments equal nearly the full value of the assets contributed plus the assumed interest, making the taxable gift very small or close to zero. These are sometimes called zeroed-out GRATs. In that case, any growth above the hurdle rate transfers to heirs with minimal gift tax consequences.

GRATs tend to be more attractive when the Section 7520 rate is low, since a lower hurdle makes it easier for assets to outperform it, though they can be useful in various rate environments depending on the assets’ expected growth.

Risks and limitations

Mortality risk is one of the most significant considerations. If you die during the GRAT term, the assets, or a portion of them, may be included in your estate for estate tax purposes, eliminating much of the benefit. Choosing a term you’re likely to outlive helps manage this risk, which is one reason shorter terms are popular.

Investment performance risk means that if assets don’t grow faster than the IRS rate, little passes to heirs. However, the downside is generally limited, since you receive your assets back through the annuity, minus the costs of setting up and administering the trust.

The rules are technical and must be followed carefully. Annuity payments must be made on time and in the correct amounts, valuations must be accurate, and the trust must meet specific legal requirements. Failure to follow the rules can jeopardize the GRAT’s tax benefits.

Setup and administration costs, including legal fees, appraisals for hard-to-value assets and trust administration, should be weighed against potential benefits.

GRATs generally aren’t effective for passing assets to grandchildren because of generation-skipping transfer tax rules.

The tax treatment of GRATs has occasionally been the subject of proposed legislative changes, so it’s important to stay informed about current law.

Who uses GRATs

GRATs are often used by business owners or investors with assets expected to appreciate significantly, such as stock in a company before an initial public offering, shares in a rapidly growing business or concentrated stock positions with high growth potential.

Some people use a series of short-term rolling GRATs, creating a new GRAT each year with the annuity payments received from previous GRATs. This strategy can help capture growth in volatile assets while managing mortality risk, since each GRAT has a short term. If an asset performs poorly in one GRAT, it doesn’t offset strong performance in another.

How GRATs fit into estate planning

A GRAT is one of several estate planning tools for transferring wealth tax-efficiently. Others include annual exclusion gifts, intentionally defective grantor trusts, dynasty trusts, family limited partnerships and charitable trusts. The right combination depends on your assets, goals, family situation and the current tax law.

During the GRAT term, the grantor generally pays income tax on the trust’s income, since GRATs are typically structured as grantor trusts for income tax purposes. This can effectively allow additional wealth to transfer to heirs, since the trust’s assets aren’t reduced by income taxes.

Get expert help

GRATs require precise setup and administration. Work with an experienced estate planning attorney and tax adviser to determine whether a GRAT fits your goals, structure it properly and coordinate it with your overall estate plan.