Grantor Retained Annuity Trust (GRAT)

WHAT IS A GRAT?

One of the most widely used wealth transfer techniques, the GRAT shifts the future growth of assets away from your estate to heirs, potentially inoculating that growth from gift and estate tax. At the same time, it allows you, as the grantor, to retain the initial value of the asset in the form of an annuity stream that is paid to you over the time frame that you assign the GRAT. In other words, with a GRAT you can give it away, and keep it, all at the same time.

If you are an entrepreneur whose business is growing swiftly in value (or is presently highly undervalued), the GRAT lets you lock in the current asset level for estate tax planning purposes, by transferring any future growth of the shares to family members, away from your taxable estate. If you are a corporate executive or an investor you can do the same with a large, concentrated stock position. The trust will then revert to you, over the term of the GRAT, the equivalent of that initial value, plus a small interest payment. Should the asset grow in value over time, that appreciation (less than interest payment) accrues to your heirs, again, free of gift and estate tax. For these reasons, this technique is known as an estate “freezing” strategy.

If the anticipated appreciation occurs prior to the end of the GRAT’s term, you may want to lock in the gain and protect the GRAT from a subsequent drop in valuation. This is possible, with a technique known as “immunization,” in which the appreciated assets are replaced with less volatile ones, e.g., short-term fixed-income securities, or possibly even sold for cash.

SETUP AND FUNCTION

Here’s how it works. Working with an estate attorney, you set up your trust. You then make a gift of the asset to a trust, usually short-term in nature, and decide on an investment plan for those assets. The trust, as mentioned, includes a mechanism that returns to you – in its most popular form, known as a “zeroed-out GRAT” – the amount of your original gift (the principal) as an annuity over the term. Throughout this time, the asset can – with good planning and some good fortune, appreciate in value – and that growth will later transfer to your children or whomever you’ve named as beneficiary.

There is a “but,” however. Tax law requires that you not only take back what you contributed but also an additional percentage. That percentage is based on something called the “7520” rate. Set by the IRS and fluctuating over time, the lower that rate when you establish your GRAT (it remains fixed over the GRAT’s term), the less you have to take back as an annuity. The less you have to take back as an annuity, the more that remains to transfer to your children free of gift and estate tax. For this reason, the 7520 rate is often referred to as the “hurdle rate.” (If you make graduated payments – each annual payment up to 120% larger than the previous year’s – you may see an even more attractive result.)

A more advanced approach to this strategy is to create “rolling’ or “cascading” GRATs. Here you create a series of short-term GRATs and roll each year’s annuity payout into another subsequent short-term GRAT. This has the advantage of minimizing the risk that good performance in one year is offset by poor performance in another year. (Really, another “immunization” strategy.) It also protects against the risk of the grantor dying before the end of a longer-term GRAT.

It is important to realize that there is really no downside: if the assets transferred into the GRAT don’t appreciate, their initial value is simply returned to the grantor by way of the annuity payments. There is only one caveat, generally adhered to without complaint: you must outlive the term of the GRAT for it to be effective.

SOMETIMES TIMING IS EVERYTHING

The technique works best if established when interest rates and asset valuations are low. Low-interest rates mean low 7520 rates, reducing the amount that must be reverted to the grantor, thus maximizing the tax-free transfer. Moreover, when valuations are low on assets expected to appreciate over time, it can be highly beneficial to your heirs.

Today, in the age of COVID-19, we find ourselves in a historically unique time, with the lowest 7520 rates in history, and asset volatility creating valuation opportunities for those ready to move quickly.

The GRAT is a classic, “middle of the fairway” planning technique, which carries no financial risk and is relatively simple and inexpensive to set up. Note, however, that all GRATs are irrevocable. Once it is done it is not a simple matter to undo it. With proper planning, however, you may design it with a degree of flexibility in the event that circumstances might dictate, for example, the ability to substitute assets in the GRAT.

If you would like to learn more about GRATs and other techniques that might be applicable to your circumstances, talk to your Fieldpoint Private advisor about a complimentary estate plan review.

GRAT Terms

• 5-year term

• $10 million contribution to GRAT

• $2,048,257 fixed annual annuity

• 8% assumed growth rate

• 0.8% IRS 7520 rate (May 2020)

• Zeroed-out GRAT (no taxable gift)

Other Assumptions

• Grantor survives the 5-year term of GRAT

• No valuation discounts on contributed assets (simplifying)

• GRAT is “grantor trust” for income tax purposes (so grantor pays income taxes on GRAT income during term)

About Fieldpoint Private

Fieldpoint Private is a boutique private banking firm established at the onset of the financial crisis by 31 individuals including former Chairmen and CEOs of some of the most well-known and successful financial and consumer firms in America. Their intent was not to craft a firm that would emulate the large, established institutions, but to serve as an alternative. Dedicated to meeting the comprehensive financial needs of highly successful individuals, families, businesses and institutions, Fieldpoint Private offers a powerful combination of private personal and commercial banking services in partnership with our clients’ most trusted advisors. In 2021, Fieldpoint Private founded Fieldpoint Private Trust, increasing the breadth of capabilities available to serve our clients in both sole trustee and co-trustee capacity.

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Trust services offered through Fieldpoint Private Trust, LLC, a public trust company chartered in South Dakota by the South Dakota Division of Banking.