Wealthy families that wish to preserve family wealth and pass it to future generations have a multitude of strategies from which to consider. The most popular strategies focus on saving transfer taxes. Before evaluating which strategies may be most appropriate for a family to adopt as part of their overall wealth management and estate plan, the necessary prerequisite in almost all cases is a desire to share wealth with others.  The Grantor Retained Annuity Trust (GRAT) is a classic wealth transfer planning tool that if utilized properly will permit sharing of assets and avoidance of transfer taxes. In families with means that look to implement sophisticated techniques, sometimes it can be helpful to begin having conversations about family wealth well in advance of actual implementation.  This can help create a sense of awareness, responsibility and eventually an attitude of gratitude for the wealth that could be coming their way.

So, What is a GRAT?

A GRAT is an effective tool for wealthy taxpayers to help transfer wealth - particularly when using rapidly appreciating assets.  A GRAT is typically utilized by some of the wealthiest families to efficiently mitigate estate or gift tax concerns while transferring value to another party – typically a family or a loved one.  Given the Federal unified estate and gift tax exemption of over $11 Million per taxpayer, the need for a GRAT has decreased for most. However given the political hot potato that is the estate and gift tax system and a recent change in leadership in Washington, it would come as no surprise if the exemption returns to levels as low as $1 Million per taxpayer - closer to what it has been historically.  For those that are unfamiliar, the unified gift and estate tax exemption means that any U.S. citizen taxpayer has a roughly $11+ Million figure that they can transfer to other either during life or at their death. For those with significant wealth, if the $11+ Million figure is not sufficient, they need to consider wealth transfer techniques or risk being taxed. If the exemption figure does decrease, and the rest of the tax code around estate and gift taxes stays the same, expect GRATs to be a common technique. Whether a taxpayer is what many would consider high or ultra-high-net-worth with estate and gift tax sensitivities or simply would like to be informed, a fundamental understanding of a GRAT can be helpful.

How and why a GRAT works

The GRAT transfers wealth, by a grantor making an irrevocable transfer of an asset to a trust in exchange for periodic annuity payments of a set amount or percentage of the trust’s value.  At the end of the trust term, the residual value that was not required to be paid to the grantor will be distributed outright or into a remainder trust, for remainder beneficiaries (possibly family).  For every dollar of a present interest gift in excess of $15,000 to each donee each year, the unified exemption (that $11+ Million referenced above) must be utilized or gift tax must be paid. 

The real opportunity with a GRAT is in how the valuation of the annuity and remaining interest of the trust is valued for gift & estate tax purposes compared with actual annuity and remaining values of the trust. When a grantor gifts (seeds) money into a GRAT, they will get an annuity back to them every so often for a period of time based on the value of the trust, and at the end, the remaining amount will go to a remainder beneficiary. For determining how much of that portion should be exposed to transfer taxes the IRS deems that a calculation is performed to determine - in the year of the gift - how much is gifted to the remainder beneficiary. In reality however, the ultimate amount received as an annuity each year during the trust and the ultimate amount passing to the remainder beneficiary can deviate quite significantly from the tax calculation.

If the retained interest of the grantor (the annuity payments) are large enough, the calculation of the present value of the remainder interest (the gift) to the ultimate beneficiaries at the end of the trust term, may be minimal or even zero. Therefore, the GRAT strategy looks to efficiently move wealth and minimize gift tax erosion by taking advantage of arbitrage opportunities between a gift’s present value for gift tax liability calculation purposes and the remainder value’s eventual real future value when the trust term actually ends. This difference in valuation for tax purposes, and valuation in real economic terms create opportunity to transfer wealth in a tax-free manner.

Further, a GRAT is a grantor trust and as a result all income tax liabilities are typically paid by the grantor. Most trusts will permit the grantor to also receive their annuity as an in-kind transfer as well, eliminating the need to sell the underlying stock to create cash for the annuity (and thus triggering taxable gain) and instead passing stock back to the grantor. This avoids the need to incur further income taxes to create cash, in order to receive a GRAT distribution.

An Example

So what does this all mean in reality?  Lets consider a very basic example.  Consider a successful business owner with a business valuing $6 Million.  The business owner also owns a $1 Million primary residence, $500,000 vacation home, $1.5 Million 401(k) and $2 Million in a taxable investment account.  The owner also have a cash balance of nearly $1 Million.  Therefore the entire estate equals $12 Million, just in excess of the Federal estate and gift tax exemption threshold. With time for assets to grow, this individual may possibly be interested in creative wealth transfer ideas to have wealth retained in the family rather than taken by taxes at death.

Assume the owner recently invested $1 Million from their taxable investment account in lesser known opportunity that they expect to materially appreciate over the next several years. The owner is presently willing to make an investment/gift to a close relative as both a) they are fond of this relative and b) it can help reduce unnecessary estate tax exposure. 

By taking the $1 Million investment and transferring it to a GRAT, the grantor has made a gift.  If the Valuation is $10/share at the moment, the GRAT would own 100,000 shares.  If the trust term is set for 2 years and the investment increases 50 percent each year, the following may result.

Actuarial Calculation for Transfer Tax Purposes

Present Value of Annuity Interest = $999,979.12 (The gift tax value deemed as paid back to the grantor)
Present Value of Gift Interest = $20.88 (The gift tax value of the remainder interest, deemed gifted to a beneficiary).

Actual Activity*

*Amounts are illustrative and subject to change based on interest rates , investment performance, and other actuarial assumptions used at the time the GRAT occurs.

Based on the strong investment performance of the assets held by the trust, despite the trust making two sizeable distributions back to the grantor each year the remaining beneficiaries receive over $932,000 at a gift tax liability to the grantor of only $21! For those with sizeable estates that may be subject to either Federal or state level estate taxes, this strategy can be a powerful way to efficiently transfer and preserve family wealth by minimizing tax liability.

What if the Value Doesn’t Increase?

If the value of the investment in question were to remain stagnant and experience no growth (or even possibly lose value), then the grantor would essentially receive a return of their capital via their annual annuity. There would be no remainder interest passing to the end beneficiaries, while the grantor would only incur a gift value of $20.88 for tax purposes.

What’s the catch?

For wealthy families with the appropriate profile and opportunities, a GRAT may be as close to a “no-lose” option as possible when attempting to transfer wealth tax-efficiently. There are still, however, inherent risks with this approach. For example, If the grantor of the trust does not outlive the trust-term, there is potential for estate-inclusion. This means that if in the example above, if the grantor were to pass away during year 1, the entire value of the asset gifted to the trust (equal to the initial present value of the trust’s annuity interest) will be included in his estate. As the figures involved increase, the risk becomes more impactful. If a larger asset were included in a grantor’s estate due to premature death it could have a material impact on the wealth that was otherwise intended to be transferred to loved ones. With a Federal estate tax rate of 40% and many states imposing their own estate tax regime, there is a risk of loss of family wealth.

A potential workaround that many savy wealth advisors and attorneys often recommend is layering GRATs with a “rolling GRAT” strategy. If the timeline involved fits the families financial needs this approach has two benefits. First, by having several short-term GRATs (say, five 2-year GRATs rather than a single 10-year GRAT), it may be possible to move a highly appreciating asset out of the grantor’s estate over time while limiting the risk of estate exposure due to premature death if approximately 20% (or more) can be pushed out of the estate via a GRAT every 2 years. Additionally, if it is unknown when exactly the investment will experience it’s appreciation, having rolling GRATs can better accommodate the unpredictable nature of positive valuation events.

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