Estate planning includes using various methods to reduce gift and estate taxes, as described in a recent article titled “Grantor Retained Annuity Trust Questions Answered” from Entrepreneur. GRATs are one type of irrevocable annuity trust used by estate planning attorneys to reduce taxes.
An annuity is a financial product, often sold by insurance companies, where you contribute funds or assets to an account, referred to as premiums. The trust distributes payments to a beneficiary on a regular basis. If you have a Grantor-Retained Annuity Trust (GRAT), the person establishing the trust is the Grantor, who receives the annuities from the trust.
The GRAT payments are typically made annually or near the anniversary of the funding date. However, they can be made any time within 105 days after the annuity date. Payments to the GRAT may not be made in advance, so consider your cash flow before determining how to fund a GRAT. For this to work, the grantor must receive assets equal in value to what they put into the GRAT. If the assets appreciate at a rate higher than the interest rate, it is a win. At the end of the GRAT term, all appreciation in the assets is gifted to the named remainder beneficiaries, with no gift or estate tax.
Here is a step-by-step look at how a GRAT is set up.
- First, an individual transfers assets into an irrevocable trust for a certain amount of time. It is best if those assets have a high appreciation potential.
- Two parts of the GRAT value are the annuity stream and the remainder interest. An estate planning attorney will know how to calculate these values.
- Annuity payments are received by the grantor. The trust must produce a minimum return at least equal to the IRS Section 7520 interest rate, or the trust will use the principal to pay the annuity. In this case, the GRAT has failed, reverting the trust assets back to the grantor.
- Once the final annuity payment is made, all remaining assets and asset growth are gifted to beneficiaries, if the GRAT returns meet the IRS Section 7520 interest rate requirements.
The best candidates for GRATS are those who face significant estate tax liabilities at death. An estate freeze can be achieved by shifting all or some of the appreciation to heirs through a GRAT.
A GRAT can also be used to permit an S-Corporation owner to preserve control of the business, while freezing the asset’s value and taking it out of the owner’s taxable estate. Caution is required here, because if the owner of the business dies during the term of the GRAT, the current stock value is returned to the owner’s estate and becomes taxable.
GRATs are most beneficial in transferring large amounts of money to beneficiaries, while paying little or no gift tax. A GRAT allows you to give a beneficiary more than $16,000 without triggering a gift tax, which is especially useful for wealthy individuals with healthy estates.
There are some downsides to GRATs. When the trust term is over, remaining assets become the property of the beneficiaries. Setting a term must be done mindfully. If you have a long-term GRAT of 20 years, it is more likely that you may experience serious health challenges as you age, and possibly die before the term is over. If the assets in the GRAT depreciate below the IRS’s assumed return rate, any benefits of the GRAT are lost.
Reference: Entrepreneur (March 17, 2022) “Grantor Retained Annuity Trust Questions Answered”
Sims & Campbell, LLC – Annapolis and Towson Estate Planning Attorneys