Grantor Retained Annuity Trust (GRAT)

A grantor retained annuity trust is an irrevocable trust to which the grantor transfers property and from which the grantor retains the right to receive a fixed dollar amount, the annuity, at least once a year for a term fixed at the outset. Whatever remains in the trust when the term ends passes to the remainder beneficiaries, usually the grantor's children or a trust for them. Because Internal Revenue Code section 2702 requires the retained annuity to be valued using the section 7520 rate in force for the month of the transfer, the taxable gift is the value of the property minus the value of the retained annuity, computed at the beginning and never revisited. The arrangement is a bet that the property will earn more than that assumed rate, and the excess is what actually moves to the next generation.

The name is descriptive and, unusually for a practitioner term, it is also Treasury's own. The regulation at 26 CFR 20.2036-1(c)(2)(i) names "a grantor retained annuity trust (GRAT) paying out a qualified annuity interest," so the full name and the acronym both come from the regulation rather than from the planning industry.

Section 2702 is the reason the annuity has to be drafted so precisely. The general rule of section 2702(a)(2)(A) is punitive: where someone transfers an interest in trust to a family member and keeps an interest for themselves, the retained interest is valued at zero unless it is a "qualified interest." Value the retained interest at zero and the taxable gift is the entire property, which defeats the whole exercise. Section 2702(b)(1) defines a qualified interest as one consisting of "the right to receive fixed amounts payable not less frequently than annually," and section 2702(a)(2)(B) then values it under section 7520. So the drafting requirements are not housekeeping; they are the difference between a gift of the growth and a gift of everything.

Treasury Regulation 25.2702-3(b) and (d) supply the specifics, and each one closes a way of taking value out early. The annuity is "an irrevocable right to receive a fixed amount," and "a right of withdrawal, whether or not cumulative, is not a qualified annuity interest." Issuing a note or an option in place of a payment does not count as paying it. The fixed amount may be a stated dollar figure or a fixed percentage of the property's initial value, and it may rise from year to year, but only to the extent it does not exceed 120 percent of the previous year's amount. The instrument must fix the term at the outset, must prohibit distributions to anyone other than the annuity holder during the term, and must prohibit commutation, which means the trust cannot simply buy the grantor out early.

The mortality risk is a calculation, not a coin flip. Consumer summaries usually say that if the grantor dies during the term, everything comes back into the estate and the strategy is wasted. The regulation says something more specific. Under 26 CFR 20.2036-1(c)(2)(i), where the grantor dies while still entitled to the annuity, the amount included in the gross estate is "that portion of the trust corpus necessary to generate sufficient income to satisfy the retained annuity or unitrust (without reducing or invading principal), using the interest rates provided in section 7520," and that amount "shall not exceed the fair market value of the trust's corpus at the decedent's date of death." In plain terms, the estate includes the capital it would take to fund the remaining annuity at the assumed rate, capped at what the trust is actually worth. When assumed rates are low the capital required is large and the answer can be the whole trust, which is why the shorthand exists. It is still a formula, and on a partly run term or a smaller annuity it can produce less than everything.

Two consequences follow from the front-loaded valuation. First, because the annuity is payable to the grantor, section 677(a)(1) generally makes the arrangement a grantor trust for income tax, so the grantor reports the trust's income on their own return and paying that tax is not itself a further gift. Second, the property that passes to the remainder beneficiaries was given during life rather than inherited, so it carries the grantor's basis forward instead of being revalued at death. A holding with a large embedded gain moves the estate tax problem and keeps the income tax problem.

The sequence, and then the arithmetic that decides whether it was worth doing.

1. The grantor funds an irrevocable trust with property expected to appreciate, most often concentrated stock or an interest in a closely held business.

2. The instrument fixes the annuity and the term. The annuity is a stated dollar amount or a fixed percentage of the initial value, payable at least annually, and may step up by no more than 120 percent of the prior year's payment.

3. The gift is computed once. The retained annuity is valued under section 7520 using the rate the IRS publishes for the month of the transfer, and the remainder, meaning the transferred value minus the annuity's value, is the reportable gift. Where the annuity is sized so that its value nearly equals the property transferred, the reportable gift is close to zero, which is what practitioners mean by a "zeroed-out" GRAT.

4. The trustee pays the annuity every year, in cash or by distributing property in kind at its value on the payment date.

5. The term ends. Whatever is left passes to the remainder beneficiaries or to a trust for them, with no further transfer tax.

A hypothetical, with the arithmetic set out. Priya transfers $1,000,000 of stock to a two-year GRAT and retains an annuity of $515,000 a year, an amount chosen so that the value of what she keeps is close to the value of what she put in and the reportable gift is nearly nothing. The dollar figures here are illustrative; the annuity that produces that result depends on the assumed rate for the month, which changes.

Suppose the stock returns 12 percent a year. Year one: $1,000,000 grows to $1,120,000, the trust pays her $515,000, and $605,000 remains. Year two: $605,000 grows to $677,600, the trust pays her $515,000, and $162,600 passes to her children, having used almost none of her lifetime exclusion.

Now suppose the stock returns 2 percent instead. Year one: $1,020,000 minus $515,000 leaves $505,000. Year two: $515,100 minus $515,000 leaves $100. Priya has her money back, her children have essentially nothing, and the cost of the attempt was the drafting and administration. That asymmetry, a real payoff when the property outperforms and a near-zero cost when it does not, is the reason the structure is usually built with a short term and repeated rather than run once over a long one.

Pros

• The taxable gift is fixed at the outset, so all appreciation after the transfer reaches the remainder beneficiaries without using additional lifetime exclusion.
• A failed GRAT is close to harmless: the annuity returns the property to the grantor and the exclusion used was small.
• Section 7520 supplies a published assumed rate, so the arithmetic is knowable in advance rather than a matter of appraisal judgment.
• Because the grantor generally pays the income tax on trust income under section 677, the trust compounds without an internal tax drag, and that payment is not treated as an additional gift.

Cons

• The grantor must survive the term for the plan to work as intended; otherwise the regulation pulls a computed portion of the trust back into the gross estate.
• It is a bet against a published rate, and in a high-rate month the property has to work much harder to leave anything behind.
• The property carries the grantor's basis to the remainder beneficiaries rather than being revalued at death, so a low-basis holding trades an estate tax problem for an income tax one.
• The drafting rules are unforgiving. A right of withdrawal, a note in place of a payment, a distribution to someone else during the term, or a commutation provision can disqualify the annuity and make the entire transfer a gift.
• Annual valuations, trustee administration and a gift tax return in the year of funding are ongoing costs, and they are the same whether the trust succeeds or not.