Taking Advantage of Grantor Retained Annuity Trust (GRATs)
There are several ways to transfer investments that provide asset protection and estate tax planning benefits to the next generation – but one that may be particularly attractive during times of uncertainty and low interest rate environments is a grantor retained annuity trust (GRAT).
A GRAT is an irrevocable trust into which you, the grantor, can transfer assets and retain the right to receive – for a specified term – a series of fixed, or increasing, payments.
When your annuity stream ends, your beneficiaries then receive the remaining balance of the trust assets, either outright or in further trust.
With its ability to provide for significant transfers of wealth, this wealth planning tool can be attractive particularly during the time of COVID-19 because:
- Your annuity stream is based on a specific amount or a fixed percentage of the value of the trust's assets, allowing for any and all appreciation to be passed to your heirs.
- The combination of depressed asset values and extremely low interest rates has created an ideal environment for gifting.
- A GRAT would allow you to freeze the value of the asset gifted and gift substantially more than one could through transferring it at death when estate taxes may be due.
"You may be able to take advantage of downturns in the stock market by viewing them as opportunities to make gifts of assets with depressed values, which have tremendous growth potential," said Alan Wolberg, a senior wealth planner at City National Bank.
“Making a gift during these periods offers a low, if any, gift tax cost and an increased likelihood of future appreciation of those assets for your heirs."
Keep reading to learn how GRATs could serve as your next wealth planning opportunity in a depressed market environment.
What Is a GRAT?
A GRAT is classified as a “grantor trust" by the IRS. This refers to any trust that allows the grantor to retain some power to control the trust's assets, including the power to substitute assets of equal value for the assets held within the trust.
As a result, you, the grantor, can make gifts of substantial assets to a grantor trust and protect those assets – and any appreciation thereto – from future gift and estate taxes.
The grantor is responsible for paying income tax on any trust income generated during the term of the trust. This actually serves as an additional benefit to the trust beneficiaries because the trust is allowed essentially to grow income, gift and estate tax-free.
Value of GRATs in Uncertain Times
In the years since the COVID-19 pandemic began, IRS interest rates have been exceptionally low.
The IRS sets the interest rate that the GRAT has to exceed to be successful on a monthly basis, under Section 7520 of the Internal Revenue Code (IRC). This interest rate is called the “hurdle rate."
For example, in May 2020, the Sec. 7520 interest rate was set at 0.80 percent, down from 1.20 percent in April 2020 – the rate has since increased up to 2.0 percent in early 2022 and may continue to rise.
It is important to note that:
- The IRS assumes that a GRAT will grow at the interest rate set at the time you establish the trust. "The lower the interest rate set, the larger the potential gift tax-free transfer of assets when the trust term ends," said Wolberg.
- The IRS does not take into account the actual growth of the assets in the GRAT. This means any appreciation above the hurdle rate is passed on to trust beneficiaries both gift and estate tax-free.
- Outperforming an interest rate of less than one percent is a likely outcome for most investments. This is particularly true now during the pandemic, when most assets would be undervalued when gifted to the GRAT.
In the event that the assets in your GRAT do not outperform the hurdle rate, the assets will be returned to you, the grantor, without any adverse tax consequences, according to the Journal of Accountancy, a publication of the American Institute of CPAs.
How to Mitigate the Downsides
The major disadvantage is that the transfer made to the GRAT is irrevocable. With the uncertainty of COVID-19, you must feel confident in receiving the annuity stream set during your specified term and that the internal growth within the GRAT will exceed your interest rate.
In addition, the grantor must survive the GRAT's term – whether it be 2, 3, or 5 years – in order for the gift to be considered “completed" and for the assets in your GRAT to be removed from your estate.
Therefore, you will need to consider age, health and the current public health circumstances. If you do not survive the GRAT term, the assets will be returned to your estate as if the gift was never made.
There are, a variety of ways to structure a GRAT to maximize the tax planning and estate planning benefits.
Set Up GRAT Annuity Payment To Match IRS Interest/Hurdle Rate
If the assets appreciate and fail to generate an income that's large enough to pay the annuity, the annuity payment must be made from the principal value of the asset.
This is fine because the annuity payment can be made “in kind" from the assets held within the GRAT. Income is only secondary. What you are looking for is to transfer the appreciation within the trust to your heirs.
Set Up GRAT Annuity With Increasing Annual Payments
IRS regulations allow you to increase your annuity payment by as much as 20 percent per year.
Knowing this, you can give the assets in the GRAT time to increase in value by taking a smaller annuity payment at the beginning.
Establish a Rolling GRAT
While most GRATs are established for a two or three-year term to avoid the risk of the grantor passing away during the GRAT term, a Rolling GRAT sets up several short-term GRATs usually within a 10-year period. This mitigates the risk of the GRAT assets reverting back to the grantor.
If you, the grantor, pass away during one of the Rolling GRAT terms, you will have received the benefits of the earlier GRATS, and the future GRATs will not be funded. Only the assets remaining in the active GRAT would revert back to your estate.
Make the Most of GRATs
The ultimate goal of a GRAT is to transfer only those assets that are likely to increase in value. This way, the grantor can both:
- Receive the annuity payments
- Provide a large gift and estate tax-free remainder interest to the trust's beneficiaries – your heirs
Your wealth planner can provide more custom guidance on the types of assets to gift or transfer to a GRAT, such as:
- stocks that you expect to appreciate
- hedge fund investments
- closely-held business interests
- real estate
If you do not have an estate plan in place and are interested in setting up a GRAT, this may be a good time to start that process with your wealth planner.
“During economic downturns, we must be mindful not only of the unique dangers that face us all but also of the unique wealth transfer opportunities that may never come again," said Wolberg.
“In the time it takes for things to return to some measure of normalcy, there is an opportunity to make use of lower interest rates and lower asset values to plan for the future."
Your wealth planner, estate planner and tax advisor may want to consult collaboratively to establish a GRAT that meets your needs now and provides for your heirs in the context of the market.
Get in touch with a City National Bank wealth planner to start the conversation.
This article is for general information and education only. It is provided as a courtesy to the clients and friends of City National Bank (City National). City National does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors or persons quoted as of the date of the article with no obligation to update or notify of inaccuracy or change. This article may not be reproduced, distributed or further published by any person without the written consent of City National. Please cite source when quoting.
City National, as a matter of policy, does not give tax, accounting, regulatory or legal advice. Rules in the areas of law, tax, and accounting are subject to change and open to varying interpretations. You should consult with your other advisors on the tax, accounting and legal implications of actions you may take based on any strategies presented, taking into account your own particular circumstances.