What Are Grantor Retained Annuity Trusts?
A Grantor Retained Annuity Trust, or GRAT, is a type of irrevocable trust administered by a third party and used to lower the value of your assets that will be taxed by the IRS for estate tax purposes. The GRAT’s characteristics are unique from other irrevocable trusts in that the IRS requires them to earn interest at 120% of the federal midterm rate that was in place during the month the GRAT was opened. Many investors choose to fund a GRAT with volatile assets, which may lead to a significant tax advantage at the end of the annuity’s term, and anyone considering this type of financial tool could benefit from working with an estate planning lawyer.
How Does a GRAT Work?
GRATs have two terms. The first term is the time period when the grantor receives a regular payment, which is the annuity. The amount of the payment depends on the fair market value of the assets funding the GRAT and the midterm interest rate when the grant was funded. The second term is the remainder. This is the time period when the assets are still held by the trust, and the only distributions are the annuities. The remainder term permits any remaining assets to be distributed outright to beneficiaries. The assets may also remain in the trust for any amount of time.
What Is the Purpose of a GRAT?
GRATs are theoretically set up to be zeroed out at the end of the term. The grantor keeps an annuity that equals what they contributed. The IRS estimates that the amount of funds left over should be $0. However, most GRATs still have interest in the account at the end of the term. Because those funds are purely interest and don’t consist of what the grantor added to the account, the IRS regulations state that they are exempt from the gift tax upon distribution to an heir. Beneficiaries pay $0 in tax on the funds they receive during the remainder term.
Who Uses GRATs?
GRATS are popular in high-net-worth individuals and families. Anyone who has assets that will appreciate over time can put them into a GRAT, and their family members don’t have to pay taxes on that appreciation. Even if the assets in the GRAT don’t substantially grow in value, there are no negative outcomes for the grantor or the beneficiary. Low or no growth simply means that the GRAT will be empty at the end of the term, and no remainder will be distributed to heirs or beneficiaries.
How Can a GRAT Be Funded?
Most individuals fund GRATs with assets valued low and likely to appreciate over the term. If an asset can be discounted, this is an ideal way to fund the GRAT. The annuity payments are based on the discounted value, which makes the trust more likely to have a remainder at the end of the term. Undervalued assets can also be used to fund a GRAT. While a GRAT is in term, you can swap assets to take advantage of the tax benefits.
What Happens If I Die During the GRAT Term?
If you die before the end of the GRAT term, the assets become part of your estate. They will be taxed like all other assets in your estate, and your beneficiaries won’t reap the gift tax benefits. Most investors choose GRATs with a short term in order to avoid the potential loss of the gift tax advantage.
Establishing grantor retained annuity trusts is a complicated endeavor. It’s best to consult with a tax advisor and estate planning attorney before deciding on an investment plan. To learn more about grantor retained annuity trusts, call one of our Hackensack, New Jersey estate planning lawyers at 201-996-1200 to set up a consultation. You may also complete our online contact form to have an associate from The Knee Law Firm reach out to you.