A Grantor Retained Annuity Trust (GRAT) is an estate-planning vehicle designed to transfer asset
appreciation to heirs free of gift and estate taxes. It leverages the difference between the actual growth
rate of the trust’s assets and the IRS-assumed growth rate, known as the IRC §7520 hurdle
rate.
The mechanics of a GRAT operate as follows:
1.
Funding and Retained Annuity: You transfer appreciating assets (such as private stock,
pre-IPO shares, or public equities) to an irrevocable trust. In return, you retain the right to
receive annual annuity payments for a specified term of years (typically two to five years).
2.
Zeroing Out the Gift: The annuity payments are structured so that their cumulative present
value—discounted using the monthly IRC §7520 rate—exactly equals the fair market value of the
contributed assets. Under IRC §2702, the taxable gift value of the remainder interest is reduced
to zero.
3.
Tax-Free Transfer of Upside: If the assets grow faster than the IRC §7520 rate, all
appreciation exceeding that hurdle rate passes to the beneficiaries (or to a continuing grantor
trust) at the end of the term without incurring gift tax or depleting your lifetime exemption.
A Worked Example
Suppose you fund a zeroed-out, two-year GRAT with $10 million of private stock when the IRC
§7520 rate is 4.0%, and the stock appreciates 25% per year. The annuity is set so its present
value at 4% exactly equals the $10 million contributed—roughly $5.30 million per year—which
zeroes the taxable gift and consumes none of your lifetime exemption. Table 23.4 tracks the cash
flows.
Everything above the 4% hurdle—about $3.7 million—passes to your children free of gift and estate tax, for the
cost of zero exemption. Had the stock merely matched the hurdle, the trust would have exhausted itself paying
your annuity and the strategy would simply fail, returning your capital with no gift-tax cost. That
asymmetry—heads you transfer millions, tails you are no worse off—is why GRATs are run as rolling two-year
series on volatile, concentrated positions.
Two major risks govern this strategy:
Mortality Risk: If you die during the annuity term, the assets in the GRAT revert to your gross
estate under IRC §2036, and the tax benefits are lost. To mitigate this risk, employ short-term,
two-year GRATs.
Underperformance Risk: If the assets fail to beat the IRC §7520 rate, the trust is depleted
to pay your annuity. The strategy fails, but you are no worse off, as you recover all contributed
assets, and no lifetime gift exemption was wasted.
Because a GRAT is a grantor trust, the annuity payments can be made in-kind (using stock rather than cash)
without triggering capital gains taxes (Rev. Rul. 85-13). You also remain responsible for paying the trust’s
income taxes, allowing the assets to compound tax-free. In low-interest-rate environments, GRATs are highly
effective vehicles for concentrated equity positions.