Grantor Retained Annuity Trusts (GRATs)

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 23.9 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.

Three 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.
• You Cannot Make It a Dynasty Trust: The estate tax inclusion period rule of IRC §2642(f) bars allocating GST exemption to GRAT property until the annuity term ends—by which point the appreciation you were trying to move for free has already happened, and sheltering it costs exemption on the grown value. A GRAT moves wealth one generation. If the goal is a multi-generational, inclusion-ratio-zero vehicle, use a sale to an IDGT instead (section “Intentionally Defective Grantor Trusts (IDGTs)”, section “Dynasty Trusts”).

Because a GRAT is a grantor trust, the annuity payments can be made in-kind (using stock instead of 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.

GRAT or Sale to an IDGT? These two structures do the same job—move future appreciation out of your estate for less than it is worth—and advisors tend to have a favorite instead of a rule. The rule is in Table 23.10, and it turns on three questions: how confident are you in the asset, are you willing to spend exemption, and does this need to last past your children.

The short version: a GRAT is a free option and an IDGT sale is a leveraged bet. If you have no conviction—you hold a volatile position that might triple or might halve—run rolling two-year GRATs, because the downside costs you nothing and each series captures whatever spikes occur. If you have conviction and a multi-generational goal, sell to an IDGT: you pay the seed gift for a lower hurdle rate, a mortality risk limited to the note, and the GST treatment a GRAT structurally cannot deliver. Nothing stops you from running both, and large estates typically do—GRATs on the liquid portfolio, an IDGT sale on the operating company.

The Third Option: A Preferred Partnership Freeze Both structures above need the asset to throw off cash—a GRAT must pay you an annuity, an IDGT must service a note—which rules them out for illiquid holdings, and both get harder as the IRC §7520 rate rises. The preferred partnership freeze is the answer when the asset is real estate or an operating business that cannot fund a fixed annuity out of the gate. You recapitalize the entity into two classes: a preferred interest paying a fixed cumulative coupon, which you keep, and a common growth interest, which you gift or sell to the next generation. Your estate is frozen at the face value of the preferred; every dollar of growth above the coupon belongs to the common.

This is the transaction IRC §2701, “Special valuation rules in case of transfers of certain interests in corporations or partnerships” was written to police, so the drafting is not optional. The default rule values your retained interest at zero—which would make the entire entity a taxable gift—unless the preferred is a qualified payment: a cumulative distribution payable at a fixed rate, on a fixed schedule, and actually paid. Miss payments and IRC §2701(d) imposes a compounding deemed-gift catch-up when the interest is later transferred or you die, so the four-year grace period for late payments represents a planning tolerance, not a recurring habit. Two further constraints: the junior common equity must be at least 10% of total equity value (the “10% minimum value rule”), and the coupon must be set at a defensible market yield for a comparable preferred instrument, which is an appraisal question and typically lands well above the IRC §7520 rate. That last point is the trade: you accept a higher hurdle in exchange for a structure with no mortality risk, no note to repay, and no requirement that the asset perform on a two-year clock. Freezes suit a stabilized real estate portfolio or a mature operating company; they are the wrong tool for a volatile public position, which belongs in a rolling GRAT.