A GRAT is a trust that is typically created by a grantor who transfers assets, like stock or closely-held business interests, to the GRAT for a specific period of time—usually between five and ten years. A GRAT, however, can also be set up for a two-year term, says AccountingWeb’s recent article, “The Beauty of Grantor Retained Annuity Trusts.”
The language of the GRAT will be written, in many instances, to provide that a parent retains the right to receive back, in the form of annual fixed payments (an annuity), 100% of the initial fair market value of the assets transferred to the GRAT.
The grantor will also receive a rate of return on those assets based upon the IRS-prescribed interest rate, which is called the “7520 rate,” after the Internal Revenue Code Section 7520. Section 7520 specifies the way in which this rate is to be calculated. For example, the IRS’s 7520 rate for November 2016 is 1.6%.
An excellent feature of a GRAT is that any asset remaining in the GRAT at the end of the trust’s term, will pass to the named beneficiaries without any additional gift tax. The named beneficiaries, in many cases, will be the grantor’s children. This type of GRAT is often called a “zeroed-out GRAT” because it doesn’t end up with the grantor making a taxable gift due to the retention of an annuity equal to 100% of the assets contributed to the GRAT.
To illustrate this further, the stock of a family business is placed into a GRAT for a term of ten years, and the value of that stock is $500,000. (Note: if you put the stock of an S corporation into a GRAT, you are required to refile the S-election under the QSub rules.) The term of the GRAT is 10 years, and the 7520 rate is 1.6%. Based on these assumptions, you would pay the grantor $50,000 a year, plus 1.6% in interest.
What the GRAT does is freeze the asset—so in ten years, after the GRAT has zeroed out, the appreciated value would remain in the GRAT and pass to the beneficiaries, gift-tax free.
Ding Ding…. Warning: there’s just one little issue with the GRAT. However, it is an important one. If the grantor dies during the term of the GRAT, the assets remain in the grantor’s taxable estate and the amount does not avoid gift tax.
Therefore, the GRAT isn’t absolutely perfect, but it can be used as an effective way to remove assets from an estate in most instances. Speak with an experienced estate planning attorney to learn if a GRAT should be considered for your estate plan.
Reference: AccountingWeb (November 18, 2016) “The Beauty of Grantor Retained Annuity Trusts”