In order to understand the workings of a GRAT, you must first have an accurate definition of an irrevocable trust.
The Social Security Administration defines a trust, often called a trust fund, as “a legal arrangement regulated by State law in which one party holds property for the benefit of another.”
Put more simply, it’s a financial vehicle that grants a third party — called a trustee — the authority to control assets, including cash, liquid assets or property, for a beneficiary.
GRATs are irrevocable trusts. The grantor places assets, such as stocks or a business, into a trust that is set for a specified number of years. The trustee is usually a relative, such as a child of the grantor.
The grantor receives regular payments from the trust over the duration of the trust agreement, which is typically two to 10 years. The annuity is a percentage of the value of the principal of the trust, plus an interest rate set by the Internal Revenue Service, known as the 7520 rate. As of September 2022, the rate was 3.52%. The annuity in a GRAT is not the same as a traditional annuity issued by an insurance company.
The assets in the trust, including all appreciation, go to the beneficiaries at the end of the GRAT term.
Grantor retained annuity trusts are complex and best guided by an experienced estate planning attorney. But the result is often an inheritance tax exemption for the very wealthy. And although GRATs are specifically authorized by the tax code, the IRS includes a description of them on its webpage for Abusive Trust Tax Evasion Schemes – Special Types of Trusts, which explains how promoters use GRATs and other legitimate trusts to “hide the true ownership of assets and income or to disguise the substance of transactions.”
The IRS offers their abusive scheme toolkits to external stakeholders as a way to educate the public about tax avoidance schemes and protect taxpayers from promoters.
The existence of these abusive trust schemes make it all the more necessary for business owners to consistently improve their financial literacy and work with trusted advisors who take their fiduciary responsibilities seriously.
As the IRS states: “Taxpayers should be aware that abusive trust arrangements will not produce the tax benefits advertised by their promoters and that the IRS is actively examining these types of trust arrangements.”
According to the Washington Post, GRATs are a tax loophole accidentally created by Congress and unsuccessfully challenged by the IRS. The Post reported in 2013 that Congress created the GRAT while trying to stop another tax-avoidance scheme: the grantor retained income trust, or GRIT. GRIT was developed by the same lawyer who would then pioneer GRATs.
Taxpayers should be aware that abusive trust arrangements will not produce the tax benefits advertised by their promoters and that the IRS is actively examining these types of trust arrangements.
Internal Revenue Service, Small Business and Self Employed Division
Avoiding Gift Taxes
An “annual exclusion gift” refers to a gift that qualifies for the annual exclusion from federal gift taxes. The IRS determines this amount on an annual basis and releases updates in early November for the following year. For example, for 2022, you can give up to $16,000 in cash or property value per person without incurring gift tax.
When a grantor creates a GRAT, the grantor is technically responsible for paying gift taxes on the value of the trust to the trustee. If the GRAT is set up correctly, however, that value should be calculated as zero or close to zero, and consequently, little or no gift taxes are due. That’s because the value of the trust, including the interest rate determined by the IRS, is supposed to be returned to the grantor over the number of years it exists.
Ideally, the assets in the trust will grow faster than the interest rate because any appreciation of the trust amount beyond the annuity payments is passed to the beneficiaries tax-free. If the assets in the trust grow at a lower rate, then the trustees don’t get any benefit from the trust. For this reason, GRATs work best when interest rates are lower.
Another potential downside is if the grantor dies before the end of the GRAT, the remaining assets become part of the taxable estate. For this reason, some people set up multiple, or laddered, GRATs. Each lasts two years, minimizing the chance that the grantor will die before the trust has ended. Each successive trust is funded with the annuity payments from the previous trust.
GRATs & Estate Taxes
The New York Times called GRATs “one of the tax code’s great gifts to the ultrawealthy” because they enable these families to pass wealth through generations without paying estate taxes. The estate tax applies to property worth more than $11.2 million for single people and up to double that for married couples.
The Times published an investigation in October 2018 showing how President Donald Trump’s parents used GRATs to pass their estate to Trump and his siblings while avoiding estate taxes.
According to the investigation, Trump’s parents put half their properties into a GRAT in the mother’s name and the other half in a GRAT in the father’s name. They then gave their children two-thirds of their assets in their GRATs. The children purchased the remaining third by making annuity payments to their parents for two years.
This allowed Trump and his siblings to take ownership of a majority of their parents’ estate without having to pay any estate taxes.
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Transferring Ownership of a Company
According to Craig Smalley, author and certified estate planner, a GRAT allows an S corporation owner to keep control of the business and “freeze the assets’ value and to remove it from the owner’s taxable estate.” But, Smalley notes, if the owner dies during the term of the GRAT, the current value of the stock is transferred back to the owner’s estate and will be subject to taxes.
A GRAT may be appropriate for a business owner whose company is rapidly growing in value or is expected to do so. A GRAT may also make sense for a business owner who’s expected to live longer than the GRAT term, or for a business owner who wants to maintain an income stream from the business but is fine with separating from its appreciation.