GRAT: Grantor Retained Annuity Trust

The most significant wealth transfer in history will happen over the next two decades: about $30 trillion will pass from Baby Boomers to Millennials. However, the estate tax can be a significant barrier to passing wealth between generations: You may pass on $12.92 million (or $25.84 million if married) free of federal taxes, but every additional dollar gifted will be taxed 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 taxes.

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?

GRAT stands for 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.

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. As of 2022, Phil Knight reportedly managed to pass on $6.1 billion Nike shares to his heirs tax-free via GRATs. Had he waited until he passed away, his heirs would have lost nearly half of 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. By the end of the term, the original principal (plus some interest) 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 the principal plus growth that is based on the government’s statutory interest rate. If the trust’s assets grow faster than that interest rate (which it typically does), money will be left in the trust at the end of the term. That amount may go to the grantor’s beneficiaries estate 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 an asset you would 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 — who will receive the amount left over in the trust at its end. It could be a child, partner, relative, or another 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, you will receive about 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 estate tax-free.
• Distribute the remainder to the beneficiary. In the final year of the trust, whatever remains after your payouts is distributed to your named beneficiaries, free of the estate tax. And if your investments don’t outpace the expected growth rate and everything in the trust is distributed back to you, 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 and you can just set up more GRATs; 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 will pay those taxes. It allows the beneficiary to receive tax-free proceeds and enables the person who set up the GRAT 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 for a 10-year trust. She 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% is 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 of her business and savvy re-investing, the assets 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 estate tax free. 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. Zeroed-Out GRAT

‍With a zeroed-out GRAT, you can achieve 100% tax-free gifting by ensuring that the current (or 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 distributions equal to what you contribute to the trust, the IRS expects the amount left for your beneficiaries to equal $0. Since the expected value of the remainder of the GRAT asset in the IRS eyes, or what is left in the trust is zero, 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.

We know this (and the associated calculations) may sound complicated but don’t worry we take care of all these calculations.

2. Back-load the annual payments

‍GRATs are required to make annual distributions to the grantor. The only requirement, for a zeroed out GRAT, 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. Critically because the IRS inflation rate tends to be lower than historical investment growth rates, the longer you can defer distributions to yourself the more value you leave behind in the trust tax free to your heirs.

‍3. Rolling GRAT‍

Long-term GRATs, or GRATs set up for a long time come with some risks, including the chance that one bad investment year may mean your total growth may not keep up with the statutory interest rate or that you could pass away before the trust’s term ends. Both of which would reduce the benefits of GRATs.

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 and more upside. If your trust investments have a bad year, you can just set up a new GRAT in less than 2 years and start the process over!

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. 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.