GRATS: Meaning, Examples, Calculator & All You Need

grats
grats

Wealthy people that have valuable resources or properties may have issues or find it difficult to pass them along to their beneficiaries or family members without accumulating estate and gift taxes for them. Of course, there are a few ways to successfully pass these properties and assets to their beneficiaries without accumulating taxes on them. One way is through GRATs (Grantor Retained Annuity Trusts). Below, we discussed with examples the meaning of GRATs and everything you need to know about grats trust

So, grab a bottle of your favorite drink, and let’s discuss GRAT in detail.

What is GRAT?

GRAT, an acronym for Grantor Retained Annuity Trust is a fiscal tool utilized in estate planning to reduce taxes on big financial gifts to family relations. It is based primarily on interest rate assumptions.

GRATs became very popular in 2000 as a result of a judgment in favor of the Walton family of Walmart Inc. by the U.S. Tax Court. The court ruled in favor of her use of two GRATs which led the Internal Revenue Service (IRS) to review its regulations.

Since then, rich people utilize GRATs to halt the value of their estate while moving any future accumulation without tax to the younger generation.

They make use of assets that are likely to gain them more than the Internal Revenue Service’s measuring standard (the section 7520 interest rate) during the GRAT term in an effort to pass the appreciation in the assets to the beneficiaries of the trust-free of gift and estate tax.

If you also have in your possession assets that you are confident would appreciate over the next couple of years. A GRAT can be a suitable and effective means to transfer that appreciation to your family.

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How Does a GRAT Work?

Asides from paying annuities, GRATs are majorly used for their ability to minimize your tax liability.

For estate planning purposes, a GRAT is a type of gifting trust that enables individuals to transfer high-value or high-yielding property assets(typical shares of stocks) to a beneficiary with low gift or estate tax.

In addition, the trust also pays out an annuity to the grantor every year, which can be a part of your retirement income strategy.

GRATs Trust

Under GRATs trust, the grantor establishes an irrevocable trust for a certain period of time (e.g., 5 years, 10 years, 15 years). It must make or contribute set payments into the account as a lump sum at arrangements agreed upon which is usually yearly.

For instance, if one sets up GRATs with $200,000 and a fixed annuity of 5%, the person would receive $10,000 yearly, regardless of how much is remaining in the trust in the following years.

The grantor has the right to collect the yearly allotments over the period of the trust. The assets of the trust at the end are then distributed to the children or grandchildren of the individual that established it (grantor) as the beneficiaries of the GRATs trust.

Being beneficiaries of this GRATs trust prohibits the children or the grandchildren of the grantor from being named as beneficiaries of another estate value freeze tool.

Let us observe that the grantor collects the yearly allotments not the proceeds of the trust. This is because the grantor does not retain the sole right to receive the income of the trust.

In the event that the trust does not bring on enough income. Then the trustee must foray into the principal of the trust to make the yearly set payments.

GRATs trust is honestly really utilized for its ability to reduce your tax liability by a significant percentage.

A well-organized GRAT will be handled as a grantor trust for capital and proceeds purposes, which brings about a lot of advantages.

To begin with, all proceeds, profits, and losses are paid to the grantor. Proceeds tax payments made by the grantor in relation to income from the GRATs are not handled as extra gifts to the trust. 

Seeing that GRAT could be represented as an incomplete gift, it is not a proper tool to use in a generation-skipping transfer (GST). This is because the value of the skipped gift cannot be known until the end of the trust term.

The chance to capitalize on GST tax exemption is lost in the structure of the GRAT. The assets transferred to the beneficiaries will have a carryover basis instead of a stepped-up basis.

Knowing this, higher-basis assets are more suitable to contribute to a GRAT than low-basis assets.

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Examples of GRATs

Below are some of the major examples of GRATs.

#1. Increasing Payment GRATs

GRATs can be made to provide extra value. Regs. Sec. 25.2702-3(b)(1) This allows for the annuity payment to increase by up to 20% per year.

As one of the examples, this implies that the grantor can receive smaller annuity payments in the early years of the GRAT term, allowing more assets in the GRATs to increase over time.

However, the downside to this type of GRAT is that the gift tax is usually settled at the beginning of the GRAT term.

Hence, if the proceeds of the GRAT fail to increase at the Sec. 7520 rates (rate of return as specified by the IRS). The grantor would be required to pay gift tax on the current value of the remaining interest while sending a few assets to the beneficiaries.

#2. Zeroed-Out GRAT

Also known as Walton, GRAT. This type of GRAT was made possible as a result of the holding in Walton, 115 T.C. 589 (2000).

With this, the grantor can set the annuity payment in such a way that the current value of the annuity stream is equal to the value of the property sent into the trust. This results in a valuation of zero (or close to zero) for gift task purposes.

A Zeroed-out GRAT gives the grantor access to send or transfer any excess increase of the Sec. 7520 (rate of return as specified by the IRS) without using any of the grantor’s lifetime exemptions.

#3. Zeroed-Out GRAT With Increasing Payments

It is practicable to combine the two structures mentioned above – a zeroed-out GRAT with increasing annuity payments.

In this structure, the grantor would contribute property to the GRAT and create a payout structure where the payments increase by 20% each year. Additionally, the present value of the payment stream equals the value of the property transferred to the trust.

This would result in no (or little) taxable gift and allow more assets to appreciate within the trust during the early years.

#4. Rolling GRATs

Another one of the GRAT examples is Rolling GRATs. A 10-year GRAT term comes with some risk. The assets need to appreciate faster than the Sec. 7520 rates over the term, and the grantor needs to live past the last payment in the term.

To reduce the risk of the grantor’s death during the GRAT term, he or she can set up a series of rolling, shorter-term zeroed-out GRATs.

Without the rolling GRATs, if the grantor dies during the trust term, nothing will pass to the beneficiaries. The remaining assets are included in his or her estate.

However, if the grantor establishes rolling GRATs and dies before the end of the 10-year term. Only the value remaining in the active GRATs will be included in his or her estate.

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GRAT Calculator

The United States Internal Revenue Service has a good number of ground rules that control the way the rest of the value of the trust at the end of the GRAT term is taxed.

The gift value of the GRAT is calculated as thus: the gift value is set to be equal to the initial value of the contribution to the GRAT added to a theoretical interest earned on the principal. Subtract the annuity payments that would be made at the end of the term.

The theoretical rate of interest is determined by IRS regulations. The rate is set up to be equal to 120% of the federal mid-term rate during the month that the GRAT is established.

Below is how a GRAT can be calculated:

DATE ESTABLISHEDMay 2020
IRS interest rate0.8%
Property transferred to GRAT$1,000,000
Term3 years  
Annual Percentage Payout (Yrs1-3)27.93998% 33.52797% 40.23356%
Annuity payments to Grantor (Yrs1-3)$279,400 $335,280 $402,336
TOTAL RETURNED TO YOU:     Assumed Annual Growth of GRAT Assets$1,017,016     Remainder to children (or trust) “tax-free”
5%$95,207
10%$221,783
15%$363,462
20%$520,993
  

Benefits OF GRATs

There are a number of benefits to setting up a GRAT. Some of them include;

  • The advantage of the tax-planning of GRAT can be improved by the fluctuating nature of a certain asset by noting an increase in value during the period of the trust, thereby increasing the profit.
  • It allows rich individuals to transfer huge sums of money to a beneficiary while paying very little gift tax.
  • The annuities could provide and become a regular source of income for those who may require it after retiring.
  • The profits can be locked in within the time leading to the end of the GRAT term by exchanging money or other fixed assets into the GRAT for assets with the equivalent value.
  • GRATs that have done well may be paid for with past GRAT annuity payments (rolling GRAT) to increase the chances of a successful transfer of wealth.
  • Finally, it gives a lot of flexibility that enables you to shift your strategy to align with the evolving world or the unstable market situations.

There should be no gift tax consequences upon the termination of the GRAT. This is because the grantors’ gift was complete for gift tax purposes. When the trust was created, the trust assets remaining in the GRAT upon the expiration of the annuity term are paid to the remainder beneficiaries. Without any additional gift tax imposed on the grantor.

Hence, if the trust property generates income and appreciation over the section 7520 rate used to value the annuity interest when the GRAT was created. The property will be transferred to the remainder beneficiaries without being subject to the gift tax.

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Cons of GRATs

The downside to using a GRAT is that when it is created, you set the lifetime of the trust. Once the term expires, the remaining assets go to your beneficiaries.

However, if you pass away before the term expires, all your assets will be transferred back to you and will be included in your taxable estate.

This is why setting the term of your GRAT can be a big risk. Longer terms allow more time for your assets to increase in value. Yielding a high capital gain is the main reason behind establishing a GRAT in the first place.

However, the longer you set the term, for example, 25 years, the greater the chance that you could have serious health issues that worsen as you age. The greater the risk that you may not live to see the end of the term.

Additionally, since you’re majorly avoiding gift tax on asset appreciation, it’s best to only stock your GRATs with high-yielding assets like shares of stock. If you’re not seeing significant appreciation with these assets. It might not be worth it to establish this type of trust.

When you consider the money and effort required for drafting a GRAT, the result may not be worth the struggle. You could get away with gifting these funds or assets through more traditional means.

Bottom Line

The truth is that GRAT is not a plan for everyone or just any kind of asset. It is really for those that have estate planning assets. Furthermore, it is for people who own shares in startup companies. As stock price appreciation for IPO will usually far outpace the IRS assumed rate of return.

This simply means that more money can be left for the beneficiaries without affecting the grantors’ lifetime exemption from estate and gift taxes. The grantor must make up their mind to take a gamble. The stake that their property that will be transferred into GRAT will do better than the section 7520 interest rate.

They must also make up their minds to also gamble that the grantor would not die before the end of the term of the GRAT because this would result in a situation where all the property is transferred into the GRAT. It would therefore be reverted into the estate of the grantor and become taxable for estate tax reasons.

GRAT FAQs

How do GRATs work?

GRATs are established for a specific number of years. When creating a GRAT, a grantor contributes assets in trust but retains a right to receive (over the term of the GRAT) the original value of the assets contributed to the trust while earning a rate of return as specified by the IRS (known as the 7520 rates).

Why are GRATs allowed?

Because the grantor may use a valuation formula, a GRAT allows the grantor to transfer a difficult to value asset without a significant risk of unexpected gift tax. The following is an example of how a valuation formula will reduce the risk of unexpected gift tax consequences when dealing with hard-to-value assets.

Do GRATs file income tax returns?

Concerning income taxes, the grantor is treated as the owner of the assets during the GRAT term and reports all income earned by the GRAT on his individual income tax return. To avoid having to file its own fiduciary income tax return, the GRAT should not apply for a separate taxpayer identification number.

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