Understanding The GRAT

GRAT stands for “grantor retained annuity trust”, and it is one heck of an estate planning technique. Utilized properly, individuals can significantly lower the value of their total estate by gifting (irrevocably) assets to a trust. Once the trust owns the property, the trust then uses those assets to make regular payments (hence the word, “annuity”) back to the grantor. Once the trust “dies”, then the remainder of the trust assets are then transferred, estate tax-free, to the trust’s remainder beneficiaries.

To begin the process, the donor, or grantor, makes a donation into a trust. This specific trust needs to be set up as an annuity; the donor will receive an annual payment from the trust for a fixed period of time.

Let’s say its five years…

For five years, the donor receives a fixed stream of income from the annuity as this is an attempt to deplete the annuity within that 5 year period. Most of the time, the assets in the trust are appreciating assets, like stocks or real estate, and the IRS knows they are probably going to continue to grow throughout those 5 years. Therefore, for purposes of determining if there will be gift tax owed, the IRS assumes the trust will automatically grow at a rate known as the “7520” rate.

The 7520 rate, also known as the “discount” or “hurdle” rate, is set each month by the IRS, and is essential to the construction and execution of a GRAT. The rate is calculated by taking 120% of the midterm applicable federal rate, which is calculated monthly.

Essentially, the applicable federal rate is lowest interest rate you can use without something being characterized as a gift.

If you’re unfamiliar with these federal rates, it’s worth noting that they are typically considered to be very low interest rates. Since the assets are growing at the 7520 rate in the eyes of the IRS, chances are that they are going to grow at a faster rate than the 7520 rate. Therefore, at the end of the 5 years there is most likely going to be some money left inside the GRAT. This money then slides into the pocket of the beneficiary(s) of the GRAT tax free.

However, for this strategy to be most effective, the donor must remain alive until the GRAT is fully paid out. If the donor dies before the GRAT is empty the entire amount will be included in his/her estate. This risk can be mitigated by making a whole bunch of different GRATs beginning at different times. Think of it like making a series of small bets; while some GRATs may fail at least some of the funds got through.