Grantor Retained Annuity Trusts, commonly referred to as GRATs, are a financial instrument that allow a property or asset owner to pass appreciating assets to their heirs with minimal, if any, estate tax consequences. Affluent taxpayers often turn to GRATs (and capitalize on the higher estate tax exemption eligible under the Tax Cuts & Jobs Act of 2017) as part of a creative, proactive strategy in planning their estates.
So how can you benefit from a GRAT? The first step is for you, the grantor, to contribute an appreciated asset(s) to an irrevocable, fixed trust. You would then be entitled to receive an annuity from the asset during the term of the trust. Keep in mind, this annuity is not the same as the income generated by the asset. The grantor of the asset is eligible for an annuity based on the fair market value of the asset at the time it was put in trust, not simply the income generated from the asset.
From there, a “gift value” of the GRAT is determined, based on the value of the asset as principal plus a theoretical interest rate earned over the term of the trust, minus the annuity payments.
The IRS publishes a minimum rate of return required on the contribution & annuity stream. If the asset fails to produce enough income to meet or exceed this amount, then it is returned to you, the grantor. For reference, the current IRS rate for November 2020 (as documented in Section 7520 and Revenue Ruling 2020-22) is a mere 0.4%.
On the other hand, if the asset “overperforms” and earns higher interest than anticipated, the added value is passed on to the beneficiary of the GRAT with no gift tax incurred. This is due to one of the major points in favor of this instrument: the future interest in the property, which will be conveyed to the beneficiaries of the trust, is not a final, present gift. It’s a future gift.
Because it’s a future gift, the contributed asset is not subjected to the annual gift tax. Additionally, the gift also does not eat into any of your lifetime estate tax exemption. Once the property is transferred and the fixed term is completed, the property is no longer considered to be part of your taxable estate and is not taxed after your death.
However, should you (the grantor) pass away before the expiration of the GRAT term, the asset reverts back to you (the grantor), and the asset is included in the taxable estate at death (subject to the estate tax exemption).
So, when would you benefit from a GRAT? What are common examples and scenarios where a GRAT makes sense? Property or assets that are expected to rapidly appreciate in future years are best suited for a GRAT. Good examples include IPO stock, commercial property that will be leasing up in the coming months, or ownership interest in a company expected to grow tremendously in future years. If the founder of a company wants to receive an annuity for their interest without having the value of the interest included in his or her taxable estate at death, contributing that interest to a GRAT can make a lot of sense.
GRATs can also be used to pass along a residential home to your descendants, with minimal estate tax consequences. Some taxpayers will contribute their primary or secondary residence to a GRAT and name their kids or heirs as beneficiaries. This strategy can qualify under the GRAT rules during times of low-interest rates and rising real estate prices. Depending on where the residence is located, the appreciation on the property should far exceed the Section 7520 interest rate previously discussed. However, real estate markets are cyclical, and taxpayers should consider the risks of real estate values when contributing a residence to a GRAT.
One particularly well-publicized GRAT contribution was related to arguably the most anticipated IPOs in the history of the stock market. When Facebook went public with its stock in 2008, founder and then-CEO Mark Zuckerberg contributed millions in Facebook stock to GRATs to pass the shares on to his heirs & beneficiaries. Because Zuckerberg knew that the value of the stock would appreciate much faster than the required return in Section 7520, the Facebook IPO stock was a perfect fit for contribution to a GRAT.
Another well-documented user of GRATs is Shelton Adelson, CEO, and chairman of Las Vegas Sands. Adelson founded the casino real estate company, which owns and operates many luxury hotels in casinos in Las Vegas and around the world. According to the Washington Post, Adelson has used GRATs to give his heirs at least $7.9 billion of properties, ownership interests in various businesses, and equity investments.
However, you don’t have to be a billionaire to benefit from a Grantor Retained Annuity Trust. Because such uncertainty exists with regard to future estate tax exemption amounts and thresholds, taxpayers with a net worth at or near the current exemption ($11.18 million) should consider moving some of their assets to a GRAT. Should President Biden pass a tax reform bill increasing the top marginal tax rates and reducing the estate tax exemption, GRATs will become more popular than ever before.
If you have questions about GRATs or wish to establish a GRAT for your heirs, contact me and I will put you in touch with my advisors!
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