With historically low interest rates, potential upcoming tax law changes and pandemic-induced depressed business values, 2021 is a good year to look at your estate planning needs and leverage appropriate wealth transfer techniques.
One of those techniques is the grantor retained annuity trust (GRAT). A GRAT provides a powerful vehicle for parents to transfer appreciating assets to their children and reap significant estate and gift tax savings. Basically, a GRAT allows parents to freeze the value of their estate with respect to assets transferred to an irrevocable trust.
How a GRAT works
The grantor funds the GRAT with assets that appreciate over time, such as stocks or business interest, in exchange for a guaranteed annuity for a fixed number of years. The grantor can set the annuity to pay them a fixed amount each year for a set term (minimum of two years) or increase payments up to 20% over the preceding year for the length of the term.
When the trust term expires, the GRAT balance that remains is transferred tax free to the designated beneficiary/beneficiaries.
|Year||Beginning trust value||5.00% asset growth||2.00% annual income||Annuity to grantor||Remaining trust value|
|1||$ 1,000,000||$ 50,000||$ 20,500||$ 203,616||$ 866,884|
|$ 1,018,080||$ 233,720|
Above, you can see an example of a GRAT with a five-year term, projected annual growth of 5% and annual income of 2%. If $1 million worth of assets are placed into the GRAT at its inception, over $233,700 could be transferred to beneficiaries at the end of the term.
The GRAT’s term is generally based with the life expectancy of the grantor in mind — and for good reason. The grantor must survive the length of the term in order for the GRAT to successfully transfer the remaining assets out of their estate.
A shorter GRAT term means it’s more likely for the grantor to survive the term. However, generally, a longer GRAT term results in a higher remainder transferred to the grantor’s beneficiaries. That’s because the longer time you have to invest, the more time you have to withstand volatility. This is true whether the assets transferred are stocks or business interest. It’s important to create an investment policy at the inception of your GRAT so that you and your beneficiaries understand what the range of potential outcomes are.
Why set up a GRAT now?
There are three main reasons why right now could be a great time for you to set up a GRAT.
First, the COVID-19 pandemic has depressed the values of many businesses. If you own a closely held business and transfer an interest into the GRAT now when value is low, as the business’s value begins to rise again, that appreciation gets captured in the GRAT and keeps it out of your estate. This value appreciation not only ensures your annuity is funded each year (a requirement of the GRAT) but also transfers more of the business to your beneficiaries than the GRAT would have had you created it pre-pandemic when your business’s value was probably much higher.
Second, we’re in a historically low interest-rate environment right now. In the GRAT, the interest rate serves as a hurdle rate, so as long as your asset grows annually at a percentage that’s higher than that interest rate, your GRAT will successfully achieve what you need it to. Today’s incredibly low interest rates greatly increase your likelihood of GRAT success.
Third, a GRAT is a simple and low-risk technique to transfer wealth to the next generation. There is a low risk of challenge by the IRS, even when you create a zeroed-out GRAT.
What’s a zeroed-out GRAT? The grantor has the ability to determine the size of the guaranteed annuity and the annuity period. A zeroed-out GRAT is created so that the present value of the retained interest equals the value of the assets placed in the GRAT. If you don’t zero out your GRAT, you will potentially face a gift tax at its creation.
Are there any cons to setting up a GRAT?
We already discussed the fact that the grantor must survive the GRAT term for the remaining assets to successfully transfer tax-free to the beneficiaries. If the grantor does pass away during the term, the GRAT remainder will be included in their estate and thus could result in estate taxes. This risk can be mitigated with a shorter GRAT term or by naming whichever spouse has the longer life expectancy as the grantor.
The GRAT’s success also depends on continued cash flow. It must pay out the annuity every year of the term. Therefore, GRATs may not work for non-cash-flow assets like raw land.
GRATS are also generally not recommended for gifting to grandchildren due to the generation-skipping tax. They’re excellent for transferring wealth to your children, nieces and nephews, but they may not be appropriate for planning beyond one generation.
We should also discuss who GRATS are best suited for. Couples whose estates will face significant estate taxes upon their deaths will most benefit from setting up a GRAT. The federal estate tax exemption is currently $11.7 million ($23.4 million for a married couple) through 2025. Under current law, couples with assets under $23 million may not benefit from a GRAT as compared to other wealth-transfer techniques. However, in 2026, the exemption is scheduled to be cut in half. This reduction may also occur sooner based on Congressional action. As a result, more couples may face estate taxes in the future due to changes in the law or simply through growth of their estates. Couples who are actively spending down their estate may not be good candidates either.
Read more: Financial fundamentals of gifting to others
What do you need to know before setting up a GRAT?
One of the best things you can do is work with the right advisor to ensure your GRAT is most set up to your family’s benefit. This advisor can help you understand the income tax burden of ongoing activity until the end of the GRAT term, as well as the economic flow of the transaction at outset, during the term and at end of term.
- Identifying assets that may be a good fit for your GRAT.
- Modeling the GRAT under various assumption to determine your optimal term and payout structure.
- Establishing your investment policy at the GRAT’s inception.
- Selecting the trustee.
- Coordinating the drafting of the GRAT with an experienced attorney.
- Preparing your needed returns (e.g., personal tax return, possible trust return and gift tax returns).
- Planning holistically to review all the wealth-transfer techniques available to you so you and your beneficiaries are set up to successfully meet your financial goals.
Contact us to learn more or get started setting up your GRAT.
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