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Grantor Retained Annuity Trust (GRAT) – Heads You Win, Tails You Tie

What are Grantor Retained Annuity Trusts (GRATs)? In short, they are a type of trust that allows you to transfer assets to beneficiaries without gift or estate taxes. Developing a GRAT has become increasingly popular in recent years as a way to pass on large sums of money to beneficiaries while minimizing the amount of tax paid on those transfers. But why?

The largest wealth transfer in history is expected over the next two decades: About $30 trillion will pass from Baby Boomers to Millennials. As this happens, both generations will be looking at how best to pass on and receive those assets as efficiently as possible – that is, to ensure that as much as possible passes to their heirs 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 be taxed at rates up to 40%. And that’s just the federal estate tax; almost half of the states have their own levies that can tack on an additional tax of between 10% and 20%.

Fortunately, there are well defined strategies, like GRATs, that can help people with large estates minimize their taxes and maximize their families’ returns. In this article, we will explore what is a Grantor Retained Annuity Trust, 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 powerful estate planning structure is focused exclusively 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 American’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?

Take Phil Knight as an example. As of 2022, his reported net worth is around $50 billion. Between 2009 and 2016, he managed to shift $6.1 billion worth of Nike shares to his heirs tax free via a GRAT. Had he waited until he passed away to make this transfer, his heirs would have lost at least 40% — $2.44 billion! — 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 and a portion of that principal is returned to the grantor every year so that, by the end of the term, the original principal has been returned to the grantor.

But wait: If the grantor is just getting the original principal back, what’s the point? The magic of a GRAT is in the difference between what the grantor is required to withdraw as an annuity and how much the assets actually grow while they’re in the trust. The IRS requires that the trust pays the grantor an annuity that grows with the government’s statutory interest rate. If the trust’s assets grow faster, then there will be money left in the trust at the end of the term. And that amount may be sent 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 choose an asset that 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. This could be a child, partner, or relative, or even another trust.
  • Receive an annual distribution. You will receive an annual payout from the GRAT based on how many years the trust is set up for. 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 is left after your payout is distributed to your named beneficiaries, free of estate tax. And if your investments don’t outpace the expected growth rate, you simply pay nothing out to your beneficiaries. This 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 pay them. This allows the beneficiary to receive proceeds entirely tax free and enables the person who set up the trust to reduce their future taxable estate as well.

But you can check out this post to know more strategies for GRAT investments.

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 assets are comprised of $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. Sam has decided to use a GRAT.

Setting up and funding the trust. Sam has decided that she’ll invest in a GRATs trust. She wants to set up a 10-year trust, given that her kids are relatively young. She could choose any term length she wants — it’s entirely up to her — but 2-3 years is most common. Sam is contributing a significant portion of her current net worth, $15m of her company’s stock.

Preparing for annual distributions. Because Sam set up a 10-year trust, she will receive a distribution 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.)

Investing 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.

Distributing the actual remainder. The government expects the assets to grow to $17.5 million over 10 years (at 3% annual growth), but, with a successful exit and savvy re-investing, they actually 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 GRATs trust? Sam’s approach has the virtue of simplicity, but you can do better. We cover advanced GRAT Strategies in a separate post.

How Long does GRAT last?

Typically, a gratuitous release agreement will last for a fixed number of years. This time frame can be set by the person creating the GRAT or by a court in the event of a dispute. In most cases, the GRAT will terminate upon the death of the person who created it, but there are some variations to this rule. For example, a “dynasty trust” can be created which allows assets to be transferred to future generations without being subject to estate taxes.

Next Steps

It’s amazing 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, you can reach out to our team to know 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.