A grantor retained annuity trust (GRAT) is a gift and estate tax planning tool that a grantor can use to transfer appreciating assets to the next generation while incurring little to no gift taxes.

A grantor creates a GRAT by contributing assets to a fixed-term irrevocable trust. Under the trust agreement, the grantor retains an annuity, whereby the trust pays the grantor an annuity amount each year until the trust terminates.

The annuity amount is either a fixed dollar amount or a percentage of the value of the assets transferred to the trust.

The annuity amount must be paid every year regardless of whether the trust generates sufficient income to cover the yearly obligation. In many cases, the annuity payment consists of trust income and principal.

Example GRAT Arrangement

John Doe is a wealthy individual with one daughter, Mary Doe. John Doe wants to set up a GRAT with a fixed term of 12 years. John funds a GRAT with $7 million cash and the right to receive an annuity of $600,000 for 12 years. At the end of the 12-year period, the trust distributes any remaining trust assets to John’s daughter, Mary Doe.

Using the relevant Section 7520 rate of 4.6% for a 12-year term, the annuity factor is 9.0666, which values the annuity stream at $5,439,960 (i.e., $600,000 times 9.0666). If the trust assumes a 4.6% growth rate per year with 12 annuity payments of $600,000 each, the remaining assets available for the beneficiaries will be $2,676,142. The present value of the remainder interest is $1,560,040 (i.e., $7,000,000 minus $5,439,960).

When the remaining trust assets eventually pass to the beneficiary in 12 years, the present value of the remainder interest ($1,560,040) will be the amount subject to gift tax, even though $2,676,142 will pass to the beneficiaries. This provides the grantor to transfer a greater sum of assets than what will actually be subject to gift tax.

What About the Zeroed-Out GRAT?

A grantor may choose a zeroed-out GRAT to keep the present value of the remainder interest at or near zero to limit the future gift tax exposure. The drawback, however, is that for the grantor to accomplish this, the trust agreement must increase the annuity payment to the grantor, which could leave little to no assets available at the end of the trust term for the beneficiary.

In keeping with the example above, if the annuity payment is $772,060 instead of $600,000 per year, the estimated remaining assets available to the beneficiary will be $17 at the end of year 12. The present value of the remainder interest is now under $10. The grantor has effectively established a “zeroed-out GRAT” by increasing the annuity payment and still assuming the 4.6% annual growth.

Key Things to Remember About GRATs
  1. Additional Contributions. Once the grantor funds the GRAT, no additional assets can be contributed to it. If a grantor wants to transfer multiple assets, rather than simultaneously transferring them to the same GRAT, the grantor creates a separate GRAT for each asset.
  2. Annuity Payment Dates. The trustee must make the annual annuity payment within 105 days following the anniversary date each year. The trustee cannot make the payment before the anniversary date each year. For example, the grantor funds a GRAT on June 30, 2020. The trustee must make the first annuity payment on or within 105 days following June 30, 2021 (i.e., payment made between June 30, 2021 and October 13, 2021). So long as the trustee makes the annual payments within this window, the GRAT agreement does not violate the applicable U.S. federal tax rules.
  3. Increasing Annuity Payments. A standard GRAT uses a fixed dollar amount each year, such as the above example. A GRAT could provide for increasing payment amounts each year; however, those yearly increases should be at most 20% from one year to the next.
Federal Income Tax Treatment

A GRAT is typically structured as a grantor trust for federal income tax purposes. As a grantor trust, the grantor is responsible for reporting the trust’s income on his federal tax return and paying federal income taxes on the earnings. The grantor pays the income taxes using funds not inside the GRAT, which helps to further reduce his taxable estate while preserving the assets within the trust.