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Understanding Grantor Retained Annuity Trusts (GRATs)

Grantor Retained Annuity Trusts, or GRATs as they are commonly known, are a powerful tax-saving tool used by estate planners to shift assets with significant potential appreciation to beneficiaries without utilizing their lifetime gift tax exemption. When creating a GRAT, your assets are placed within an irrevocable trust which expires after a set period while you retain the right to receive a stream of income for that same period.

Assets within a GRAT appreciate while the trust pays out yearly annuities to the grantor, ensuring that your beneficiaries receive their inheritance with minimal estate tax or even estate tax-free. The popularity of GRATs has increased in recent years as the federal interest rates remain historically low while the financial markets have experienced record highs.

Read on to learn more about how GRATs operate, how they can be used to avoid estate and gift taxes, and to find out if now is the right time for you and your loved ones to establish this type of trust as part of your estate plan.

How Grantor Retained Annuity Trusts Are Created

GRATs are funded by assets with high growth potential; generally stock and equity holdings. Over time, the GRAT provides the grantor with annuity payments which are calculated based on the value of the assets transferred into the trust at the beginning of the GRAT term—when the assets are projected to be at their lowest value. Over the lifetime of a GRAT, the grantor retains the right to receive a stream of annual payments which are calculated as a “subtraction” against the initial value of the assets within the trust which minimizes the gift transferred.

One concern is that if a grantor passes away before the GRAT expires, the estate tax benefits are lost. This is one reason that early planning is important.

Another way to minimize tax liability that survives the death of the grantor is if the grantor passes the right to receive the GRAT’s annuity payments to their surviving spouse. This strategy makes use of the unlimited marital deduction, which allows for tax-free asset transfers between spouses.

How Grantor Retained Annuity Trusts Save Gift and Estate Taxes

GRATs are often used by individuals whose estates are expected to be subject to state and federal estate taxes. As of 2022, estates worth more than $12.06 million will face federal taxation upon the death of the estate holder. Maryland estate tax applies to estates worth more than $5 million.

GRATs use actuarial calculations to “freeze” the value of the grantor’s assets without using the lifetime estate and gift tax exemption for the grantor’s estate. GRATs are often recommended when a grantor holds assets that are expected to see significant growth over time and push the value of the estate into the taxable territory. The value of the gift to the remainder beneficiaries is weighed against the value of the annuity payments made to the Grantor and minimizes the “gift”—or even zeros out the gift entirely.

Additional Considerations

Per the IRS calculations, assets owned by the GRAT are expected to generate returns according to the monthly Section 7520 Interest Rates when the GRAT is established and funded. However, assets that are unable to outperform Section 7520 interest rates can be returned to the grantor free of consequence. Assets can be swapped during the GRAT term if the replacement asset has the same value. These swaps typically are reserved for assets whose value has not met expectations or even declined. Current tax laws allow grantors to replace an asset with another one, and the grantor may even be able to use the original asset to establish a brand new GRAT.

Depending on the structure of GRAT, these trusts can be established in a way that provides additional value for the grantor. Annuity payments from a GRAT can stay steady or be structured to increase in value by up to 20% per year.

Due to the substantial wealth which GRATs can transfer across generations, these specific trusts have often been the subject of debate in Washington. As always, we here at Sessa & Dorsey promise to keep our clients up to date on any legislative changes that may affect their estate.

Talk to an Estate Planning Attorney Today

Current tax laws and financial conditions mean that individuals currently possess several options to leverage GRAT strategies to build future wealth while avoiding estate tax liability. Establishing multiple GRATS simultaneously, utilizing creative asset substitutions, and freezing asset values are all powerful tools at the disposal of those willing to take the time to learn how careful planning can pay huge dividends in the long run.

As with any type of trust or estate planning tool, an experienced planning attorney and trusted financial advisor can evaluate your assets and walk you through the best course of action to maximize and preserve their value for your family. For more information about GRATs and the planning strategies that they provide, do not hesitate to reach out to our office.

At Sessa & Dorsey, we consider the bigger picture at hand and advise our clients on the best estates and trusts for their specific needs and desires. If you have questions, please contact us at (443) 589-5600.

Related blog posts:

What Are Gift Tax Returns and Who Needs to File Them?
Best Practices for Irrevocable Trusts
Estate Planning 101: Who Should I Choose as My Trustee?
How to Reduce Estate Tax Exposure for Business Owners
When to Consider Using a Qualified Charitable Distribution (QCD) to Reduce Taxes