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GRAT: Grantor Retained Annuity Trust

What are Grantor Retained Annuity Trusts (GRATs)? They allow you to transfer assets to beneficiaries without gift or estate tax. Why?

The most significant wealth transfer in history will happen over the next two decades: About $30 trillion will pass from Baby Boomers to Millennials. Meanwhile, generations will look at how best to give and receive those assets. Therefore, ensure as many passes to their heirs as possible by minimizing the money lost to taxes.

The estate tax can be a significant barrier to passing wealth between generations: You may pass on $12.06 million (or $24.12 million if married) free of federal taxes, but every additional dollar gifted will tax at rates up to 40%. And that’s just the federal estate tax; almost half of the states have levies that can tack on an additional surcharge of 10% and 20%.

Fortunately, well-defined strategies, like GRATs, can help people with large estates minimize their taxes and maximize their families’ returns. This article will explore what a Grantor Retained Annuity Trust is, how it works, and why they have become so popular.

What is a GRAT?

A GRAT means Grantor Retained Annuity Trust. It’s a trust, or financial tool, that allows an individual to pass assets to others, usually their children or grandchildren, tax-free. This robust estate planning structure focuses on helping people maximize their legacy and pass assets on to the next generation.

Given the power of this approach, it is unsurprisingly popular amongst America’s wealthiest. Famous GRAT estate planning users include Facebook’s Mark Zuckerberg and Nike’s Phil Knight. So why has this GRAT estate planning structure become the tool of choice for the nation’s financial elite?

As of 2022, his reported net shifted to $50 billion. He managed to turn the $6.1 billion Nike shares to his heirs tax-free via GRAT. Had he waited until he passed away, his heirs would have lost that amount to taxes!

How do GRATs work?

The trust’s creator – the “grantor” – puts assets into the GRAT trust for a fixed period. Then, the portion of that principal is returned to the grantor every year. Therefore, by the end of the term, the original principal has been returned to the grantor.

If the grantor is getting the original principal back, what’s the point? The GRAT’s magic comes from the difference between what the grantor should withdraw and the assets growth in the trust period. The IRS requires that the trust pays the grantor an allowance that increases with the government’s statutory interest rate. If the trust’s assets grow faster, money will be left in the trust at the end of the term. That amount may go to the grantor’s beneficiaries tax-free.

Steps to Set Up A GRAT Trust

  • Set up the GRAT trust and choose an asset. You, the individual, set up the trust and select a purchase you’d like to contribute to the trust. The most common GRAT assets are those expected to appreciate quickly: Cash (reinvested once it’s in the GRAT), crypto, public equities, and alternative private assets.
  • Designate a beneficiary. You designate a remainder beneficiary — the person(s) who will receive the amount left over in the trust at its end. It could be a child, partner, relative, or even trust.
  • Receive an annual distribution. You will receive an annual payout from the GRAT based on how many years the trust lasts. We default to a 2-year GRAT — that length optimizes the return on investment while limiting any downside risk — which means that, at a minimum, you will receive 50% of the principal back each year.
  • Invest the assets within the trust. Once you’ve placed assets into the GRAT, you’ll be looking to maximize growth so that there is a significant amount left for your beneficiaries to receive tax-free.
  • Distribute the remainder to the beneficiary. In the final year of the trust, whatever remains after your payout is distributed to your named beneficiaries, free of the estate tax. And if your investments don’t outpace the expected growth rate, you pay nothing out to your heirs. It would put you in the same position you would have been in if you hadn’t set up the trust; this hedge is why the GRAT estate planning trust is known for creating a “heads you win, tails you tie” outcome.
  • Taxes paid. Any capital gains realized inside the trust are taxable, but the grantor may deliver them. It allows the beneficiary to receive tax-free proceeds and enables the person who set up the confidence to reduce their future taxable estate.

A GRAT Example

Let’s use Sam, 40 years old and a successful entrepreneur and investor who has accumulated $25m of assets at this point in her life. Her investments comprise $20m of stock in her own company plus $5m of liquid assets and a home. Although she is young, Sam already has enough assets to exceed the lifetime gift tax exemption and wants to start planning to maximize how much wealth she can transfer to her children. So Sam has decided to use a GRAT.

Sam has decided to invest in a GRAT faith. She wants to set up a 10-year trust. She could choose any term length, but 2-3 years is common. Sam is contributing a significant portion of her net worth, $15m of her company’s stock.

She was preparing for annual distributions. Because Sam set up a 10-year trust, she will receive an allotment each year equal to $1.75 million (in cash or shares), or 10% of the original amount contributed to the trust, plus 3% expected annual growth. (That 3% set by government regulation).

She is investing in the trust assets. If Sam sold some of his shares, she would have the opportunity to reinvest those proceeds as she sees fit. But let’s assume for this example that she holds on to her start-up shares in the trust and decides to let them appreciate as she continues to grow her business.

They are distributing the actual remainder. The government expects the assets to grow to $17.5 million over ten years (at 3% annual growth), but with a successful exit and savvy re-investing, they will grow to $217.5 million! That extra $200 million remaining in the GRAT at the end of the term would transfer to Sam’s heirs. Given the applicable estate tax rate of 40%, the family would save $80 million in estate taxes.

Are there ways to further optimize a GRAT trust? Sam’s approach has the virtue of simplicity, but you can do better.

Structure to Maximize GRAT Returns

There are three key ways to improve on the basic GRAT to increase your final returns substantially:

1. Back-load the annual payments

GRATs are required to make annual distributions to the grantor. The only requirement is that these distributions add up to an amount equal to the total value of the initial trust principal (in inflation-adjusted terms).

The basic approach might be to make equal annual payouts each year to reach that target number. But you can improve your returns by choosing an increasing payout schedule. By starting with a smaller payout in year one and growing it each year until the GRAT ends, you reach the same total payout, but you keep more assets in the trust to grow for longer.

2. Zeroed-Out GRAT

With a zeroed-out GRAT, you can achieve 100% tax-free gifting by ensuring that the present value of the trust’s annual distributions over the trust’s term equals the total value of the property used to fund the trust. Since you (the grantor) receive an annuity equal to what you contribute to the trust, the IRS expects the amount left for your beneficiaries to equal $0. Given this is a zero-value gift from the IRS’s perspective (though not in reality, because you expect your investments to grow faster than the IRS’s interest rate), you won’t be required to use any portion of your lifetime gift tax exemption. Instead, any assets remaining in the GRAT after the final annuity payment will pass to your remainder of beneficiaries tax-free.

‍3. Rolling GRAT‍

As we explained earlier, long-term, or rolling, GRATs come with some risks, including the chance that the trust’s investments will not keep up with the statutory interest rate or that you could pass away before the trust’s term ends.

The best practice to reduce those risks is to set up a series of short-duration trusts every year and for the annual distributions from each trust to “roll” into a new GRAT.

The Rolling GRAT strategy consists of successive short-duration Zeroed-Out GRATs established in sequence. The grantor designates an initial GRAT for a short duration – say, two years. The grantor will receive two payments from that GRAT, one each year of the trust’s term. At the end of year 1, the grantor will use that year’s distribution to fund a second, identical GRAT. The grantor will now have two trusts operating with the same strategy.

In this way, you can replicate the dollar value of a long-term GRAT but with much less of the risk we outlined above.

How Long does GRAT last?

Typically, a gratuitous release agreement will last for a fixed number of years. Any person creating the GRAT can set up this time frame or a court in case of a dispute. In most circumstances, the GRAT will terminate upon the death of the person who created it, but this rule has some variations. For example, a “dynasty trust” can be made, allowing assets to transfer to future generations without being subject to estate taxes.

But if you have more specific questions about GRATs, check out this article with all the answers you need!

Next Steps

It’s incredible how quickly your focus can shift from providing for yourself and your family now to ensuring that you leave a legacy behind. GRATs are a powerful tool for transferring wealth to your beneficiaries tax-free, and getting started early will allow you to maximize the effectiveness of these strategies with no risk. If you have any questions, contact our team to learn more!

About Valur

We built a platform to give everyone access to the tax and wealth-building tools of the ultra-rich like Mark Zuckerberg and Phil Knight. We make it simple and seamless for our customers to take advantage of these hard-to-access tax-advantaged structures so you can build your wealth more efficiently at less than half the cost of competitors. From picking the best strategy to taking care of all the setup and ongoing overhead, we make it easy and have helped create more than $500m in wealth for our customers.