Grantor Retained Annuity Trusts (GRATs): What are They?
A powerful tool to accomplish your wealth transfer goals
Author: Eric Metzger, Vice President and Director, Business Transition Advisor, Fifth Third Private Bank
The Grantor Retained Annuity Trust ("GRAT") is one of the most powerful estate planning tools available to high–net–worth families to efficiently transfer wealth to the next generation. The GRAT strategy allows an individual (the "grantor") to "freeze" the value of appreciating assets and pass future income and appreciation on those assets to the next generation—without incurring gift or estate taxes. However, GRATs have come under scrutiny in recent years and may not survive future estate and gift tax legislation. Leveraging the variations of this technique today could provide a solution for many clients who seek to reduce estate tax liability, transfer wealth and hedge against potentially adverse tax legislation.
GRAT fundamentals
- GRAT creation. A GRAT is an irrevocable trust to which the grantor transfers assets as a gift. Assets that are expected to generate a high level of income or appreciation, and assets that are subject to valuation discounts (such as closely held business interests that generate income) are particularly good candidates for a GRAT.
- Annuity payments. For a term of at least two years, the grantor will receive a fixed annual payment (or "annuity") from the GRAT. The grantor is paid this annuity plus interest based on an IRS–established rate (the "§7520 rate") in effect when the GRAT was created. Conceptually, a GRAT is a "success" when its assets outperform the applicable §7520 rate¹, so a lower §7520 rate is better.
- Income taxes. During the term of the GRAT, the grantor will include the GRAT’s taxable income on the grantor’s personal income tax return and will pay the tax that is due on that income. At first glance, this treatment may seem to be a disadvantage, but it has the beneficial effect of allowing the GRAT’s assets to grow undiminished by income taxes each year.
- Remainder interest. Upon the end of the GRAT’s term, the GRAT’s remaining assets will be distributed—without incurring gift or estate taxes—to the identified trust beneficiaries (e.g., grantor’s children), either outright or in further trust.
Common variations
- Zeroed–out GRATs. A GRAT will often be structured so that the present value of the stream of annuity payments is equal to (or almost equal to) the value of the assets that are gifted to the GRAT, which is known as a "zeroed–out GRAT." Since this structure results in no gift (or only a small gift) for gift tax purposes, it is particularly attractive to taxpayers who have used most or all of their gift and estate tax exemption amount.
As an example, a two–year zeroed–out GRAT funded with $1,000,000 in November 2023 would use a §7520 rate of 5.6%. Over the term, the trust would make two annual annuity payments of $542,387.59 to the grantor. As long as the underlying assets outperform that 5.6% threshold, the GRAT is successful in transferring wealth to the beneficiaries. For example, a 9% return would result in a remaining balance of $54,509.94 at the end of the term, which would be distributed to the beneficiaries—free of estate and gift taxes. - Rolling GRATs. Clients who engage in this strategy often establish a "rolling GRAT" program, in which assets are contributed each year into a two–year GRAT, and as annuity payments are made, those payments are systematically "rolled" into a new GRAT and the process begins anew.
- Isolating asset classes. Another popular technique is to establish multiple GRATs focusing on different sectors of the economy (e.g., one GRAT for each of Energy, Financials, Industrials, etc.) to hedge against underperformance in any particular sector jeopardizing or mitigating the success of the GRAT.
- Exercising swap power. Critically, a grantor does not have to wait until the end of the GRAT term to lock in upside performance of GRAT assets. In fact, the grantor has the ability to "freeze" gains at any time by swapping assets. For example, if the grantor establishes a GRAT in the Energy sector and within the first six months, the underlying portfolio is up 20% from GRAT inception, the grantor can "swap" the Energy portfolio with equivalent cash and lock in that initial 20% gain. If the grantor so chooses, he or she could immediately establish a new two–year GRAT with the same underlying Energy portfolio and restart the clock.
- If executed in a low interest rate environment, it protects against interest rate hikes. The §7520 rate will remain fixed as of the date of creation.
- It provides a hedge against future legislative action in that a GRAT in existence before the date of enactment barring such GRATs would potentially be "grandfathered" and not subject to the new law.
- It is possible that a portion of the GRAT will not be includible in the grantor’s taxable estate if the grantor dies before the end of the 99–year term.
99–Year GRAT. With the recent legislative targeting of popular gift and estate tax strategies, it is fair to wonder whether the rolling GRAT option will continue to be available long term. There is a variation to the shorter term GRAT known as a "99–Year GRAT." As part of this strategy, the term of this variation is set at 99 years. This has several key benefits and advantages over a "rolling" GRAT program:
Under the right set of circumstances and economic conditions, the 99–Year GRAT can result in significant estate tax savings, particularly for older clients who have utilized much of their estate tax exemption amount.
Challenges
Legistlative Challenges - As part of President Joe Biden’s Build Back Better legislation, a new proposal was submitted that would ban zeroed–out GRATs, effectively eliminating GRATs as a viable wealth transfer tool. While this proposal was ultimately tabled and did not make it into the "final" iteration of the draft bill, the core concept was reintroduced in Biden’s 2024 Greenbook. Specifically, GRAT remainder interests would be required to be at least 25% of the value of the assets transferred to the GRAT or $500,000, whichever is greater, effectively eliminating the "zeroed–out" GRAT as a wealth transfer technique. Further, the Greenbook proposed that GRATs must have a term of at least 10 years. The Greenbook proposals specifically only applied to GRATs that would be established after enactment of the proposal, and GRATs created pre–enactment could potentially be grandfathered under the proposed law.
Rising Interest Rates - Further, the success of the GRAT strategy is tethered in part to the applicable §7520 rate, which is reflective of applicable federal interest rates at the time the GRAT is funded. In theory, GRATs perform best when interest rates are low, and when the difference between the §7520 rate and the rate of return on the underlying assets is greatest. However, there is some evidence that for short–term GRATs, the current interest rate is far less important than the nature and growth of the assets used to fund the GRAT. Specifically, a GRAT is most impactful when funded with assets with the highest short–term growth potential (e.g., shares of a closely held business temporarily impacted by the COVID-19 pandemic or other depressed sectors of the stock market). In the event a GRAT "fails," that is, the assets fail to appreciate over and above the §7520 hurdle rate, the grantor may simply swap the underlying assets for cash and immediately roll these assets into a new GRAT. In these failed GRAT scenarios, virtually the only cost to the grantor comes in the form of the legal fees incurred to establish the GRAT.
Parting thoughts
Even in the face of rising interest rates, GRATs remain a powerful tool to accomplish tax–efficient wealth transfer goals. With the recent legislative targeting of this strategy, GRAT planning is worthy of consideration for many affluent families both to provide a hedge against this risk and reduce estate tax exposure.
For more information, contact your Fifth Third Private Bank advisor.