From GRIT to GRAT to Great GRAT

Estate Planner Mar-Apr 1997

Like most techniques used in shifting wealth from one generation to the next, the grantor retained annuity trust (GRAT) is a currently approved version of an old estate planning tool.

The GRAT is the successor to the grantor retained income trust (GRIT), in which the value of the gift to trust could be significantly reduced by the transferor’s retention of the right to receive income for a term of years. The GRIT was so successful in leveraging gifts that Congress changed the Internal Revenue Code to negate its effectiveness for making gifts to children.

But, Congress did permit the value of a gift to a trust to be reduced by the present value of the transferor’s retention of the right to receive an annuity amount for a term of years — the GRAT. In theory, the transferor will receive annuity payments from the trust equal to the value of the retained annuity interest. These payments will earn income or appreciate and be part of the transferor’s estate. The only gift is the current value of the remainder interest. If the transferor dies during the term, some portion will be included in the estate, but arguably not 100%.

How GRATs Work

The present value of the annuity rights is determined by Internal Revenue Service (IRS) valuation tables (Section 7520 rate), which can change monthly. If the GRAT assets only grow at the Section 7520 rate or less, then the gift has not been leveraged. Accordingly, the GRAT is best used when there is a basis for optimism that the growth of trust assets will markedly outperform the Section 7520 rate.

The value of the gift of the remainder interest in the GRAT is influenced by the amount of the annuity payment and the term over which payments will be made. Higher annuity payments and longer payout periods reduce the amount of the gift.

While the retained annuity interest cannot reach 100% (meaning the value of the gift is zero), it is possible to get the value of the gift close to zero — in fact, close enough to conclude that the only thing you have to lose by trying is the cost of the transaction.

How To Create a GreatGRAT

Accordingly, if we have a nothing-to-lose GRAT which can be funded with assets that have an enhanced ability to out-perform the market, there is the potential for a highly leveraged (low gift tax cost) transfer of wealth to the next generation — the GreatGRAT. Several types of assets can be considered for the GreatGRAT:

  • Stock in a closely held company that could be subject to an initial public offering in two or three years, or
  • Stock that could be valued using lack-of-marketability, lack-of-control or minority-interest discounts, such as:
  • S corporation shares that can generate cash flow to pay the annuity and are discountable, and
  • Minority limited partnership interests from a family limited partnership.

Can a GRAT Work for You?

GRATs can be a highly effective wealth transfer technique. All you have to do is to find the right asset, make projections and run the numbers. You will know right away whether this plan can work for your situation.