What is a Grantor-Retained Annuity Trust (GRAT)?

A grantor-retained annuity trust (GRAT) is an irrevocable trust set up to benefit the grantor’s family members (usually descendants).  It is a form of split-interest trust, meaning that different people have different interests in the trust. Specifically, the person who creates the trust (grantor) keeps the right to receive income in the form of a fixed annuity. The remaining trust assets pass to the remainder beneficiaries.

Rules Governing GRATs

Section 2702 of the Internal Revenue Code generally requires that the value of any interest retained by the grantor be valued at zero for purposes of determining the value of the transfer to the family member. The grantor is not allowed to reduce the value of the gift by the value of the interest retained by the grantor. The intent of this provision is to tax the full amount of the gift to the family member.

This rule does not apply if the interest retained by the grantor is a “qualified interest.”[1] Fixed annuities retained by the grantor are one form of qualified interests.  This means that, when valuing a grantor’s gift to a GRAT, the actuarial value of the annuity retained by the grantor is subtracted from the gross value of the gift.

A GRAT may provide for variations in the amount of the annuity, as long as the schedule of payments is set in the trust instrument and no annual payment exceeds 120 percent of the previous year’s payment.

If the grantor dies during the term of the GRAT, his taxable estate will include the value of principal that would have been required to produce the income to fund the annuity.[2] The value is determined using the current Code § 7520 interest rate (7520 rate), but it cannot exceed the value of the assets in the trust.

Because of the possibility that all income and principal can be returned to the grantor, GRATs should be considered grantor trusts for income tax purposes.  Additional provisions can be included to ensure grantor trust treatment.

Estate Tax Planning With Grantor Trusts

GRATs are usually funded with assets that are expected to appreciate in value. They are designed so that the grantor is likely to survive the term of the trust. When the trust ends, all of the assets are transferred or held for the benefit of the beneficiaries of the trust, who are usually children or grandchildren of the grantor.

The tax benefits of GRATs are essentially an exploitation of the fixed valuation assumptions of the Internal Revenue Code. The value of the gift to the remainder beneficiaries is based on the 7520 rate at the time of the GRATs creation. If the trust assets outperform the 7520 rate, the difference between the increased value and the 7520 rate is passed to the trust beneficiaries free of tax.

These tax benefits can be enhanced by manipulating the term of the GRAT and the amount of the annuity retained by the grantor so that the actuarial value of the remainder interest (the gift to the beneficiaries) is zero. This creates the so-called “zeroed-out GRAT.”

Zeroed-out GRATs are a low-risk, high-yield planning technique. If the assets transferred to the GRAT decrease in value, the trust principal is returned to the grantor in satisfaction of his annuity interest. This puts him in the exact same place as if the GRAT had never been established. But if the GRAT assets increase in value, all of the increase in excess of the 7520 rate will pass to the remainder beneficiaries free of estate tax.