The Grantor-Retained Annuity Trust (GRAT) has emerged as a popular strategy in the estate planner’s toolkit. The idea is that a grantor places assets in a trust while retaining the right to receive payments from the trust. When the term of the trust expires, any assets remaining in the trust pass to a beneficiary, typically a family member.
The value of that future transfer is subject to the federal gift tax in the year the GRAT is funded. However, the larger the value of the retained income interest, the smaller the taxable value of the remainder becomes. In fact, it has become routine to set the retained interest high enough that the value of the remainder is zero. The future value also depends upon market interest rates, as reflected in tax code section 7520. The current 7520 rate is 3.4%. That means that today a two-year zeroed-out GRAT would pay the grantor 47.9% in the first year and 57.5% in the second year, according to a recent item in Tax Notes magazine.
When the grantor retains an interest this large, what is actually happening is the tax-free transfer of excess appreciation in the underlying assets.
Although the use of two-year GRATs has become fairly routine, the advent of a temporary doubling of the amount exempt from federal estate tax has inspired a new approach in some quarters. The idea is to match the term of the GRAT to the expiration date of the higher exemption at the end of 2025. Increasing the term of the trust increases the amount of appreciation that may be transferred tax free.
However, if the grantor of the GRAT dies before the term ends, the entire value of the GRAT will be subject to the federal estate tax. All the hoped-for tax benefits will be lost. Lengthening the term of the trust necessarily increases that risk.
That’s where the larger exemption comes in. An estate of under $5 million won’t be subject to federal estate tax in any event, whereas an estate of up to $11 million and change won’t be taxable until after 2025. If a person with $10 million in assets creates a GRAT and dies before the end of the trust term, the larger tax exemption still protects the property from taxation.
At The Trust Company of Kansas, we help people. We promise to minimize the burden of wealth management and bestow the freedom to enjoy everything else. The officers at The Trust Company of Kansas are always willing to discuss your goals for your estate and help you to create a plan that is well-aligned with your wishes. Trusts are one of our core competencies. If you have a specific question about wealth management or trusts, please contact us at (800) 530-5254 or visit tckansas.com/contactus, and one of our Certified Trust and Financial Advisors will be happy to assist you.