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Wealth Planning

Grantor Retained Annuity Trusts

Grantor retained annuity trusts (GRATs) can serve as an efficient way to transfer wealth with little or no gift tax liability.

One of the primary uses of a Grantor Retained Annuity Trust (GRAT) is to move asset appreciation from the grantor to remainder beneficiaries, reducing the value of the grantor’s assets that will ultimately be subject to estate tax.

What is a GRAT? What is its primary purpose?

A GRAT is a type of trust that consists of two distinct terms: (i) a term of years (the GRAT term) during which the grantor of the GRAT receives an annuity payment based on the IRS rate in effect during the month the GRAT is funded and the fair market value of the assets used to fund the GRAT, and (ii) the remainder term, which is the period of time after the end of the GRAT term while property is still held in trust. During the GRAT term, the grantor is the only beneficiary of the trust, and the annuity payments are the only distributions made from the GRAT. After the GRAT term, and once the final annuity payment is made, any property remaining in the GRAT may be held in a continuing trust for the benefit of family members and others (or distributed outright to them).

Typically, GRATs are structured in such a way that the present value of the annuity stream during the GRAT term as of the date of funding equals the total value of the property used to fund the GRAT. This is called a “zeroed-out GRAT.” With a zeroed-out GRAT, since the grantor retains an annuity that is equal to what he or she contributes to the GRAT, the value of the remainder interest (the amount left over after the GRAT term) is 0. This is what the grantor gives to the beneficiaries, and since this is a zero-value gift from the IRS’s perspective, it doesn’t use any portion of the grantor’s lifetime exemption from federal gift tax. This way, any assets remaining in the GRAT after the final annuity payment is made will pass to the remainder beneficiaries gift-tax free.

When are GRATs popular?

In a low interest rate environment, many individuals use GRATs to pass asset appreciation to their family members. So long as the appreciation of the assets contributed to the GRAT exceeds the IRS hurdle rate, the grantor will be able to transfer the excess free of gift tax. The IRS hurdle rate is an interest rate that changes monthly; the lower the rate, the lower the appreciation necessary to pass value to the beneficiaries.

In addition, the financial downside to a GRAT is often limited to the transaction costs of creating it (legal, accounting and, if funding it with illiquid assets, appraisal fees). Even if the GRAT assets do not appreciate more than the prescribed hurdle rate, the only consequence is that the grantor will take back all the assets in the GRAT (in the form of the annuity payments), and the GRAT will not have transferred any assets to the remainder beneficiaries.

In recent years, Congress has proposed legislation to mitigate some of the benefits of a GRAT. Although none of these proposals have been enacted so far, individuals may want to capitalize on this strategy now, in case legislation is passed in the future.

Funding a GRAT

The best types of assets to contribute to a GRAT are those that have a low valuation relative to their intrinsic value and those that are expected to appreciate in value over the GRAT term. To the extent that the value of an asset can be discounted (because of lack of marketability or control, or certain restrictions), the annuity stream will be determined based on the discounted value, thereby making it easier for the contributed assets to beat the relevant hurdle rate (assuming the annuity is paid with undiscounted assets).1

In addition, if asset values have declined, or if the grantor owns an asset he or she believes is undervalued, a GRAT can be used to take advantage of the low valuations.

Finally, if you have a GRAT that is still in the GRAT term and is successful (assets that you contributed have appreciated more than the IRS hurdle rate), you can consider whether it makes sense to lock in the appreciation (and therefore the benefit to your beneficiaries) by swapping its assets for lower-volatility assets for the remainder of the GRAT term. This technique is complicated and you should consult with your legal and tax advisors if you are in this situation.

Additional considerations when using a GRAT

If the grantor dies during the GRAT term, then the GRAT assets will be included in the grantor’s estate for estate tax purposes. It is primarily for this reason (and for others as well) that grantors typically create short-term GRATs (e.g., two- to three-year GRAT terms), and roll each year’s annuity payment into a new GRAT (so-called “rolling GRATs”).

From an income tax perspective, during the GRAT term, the GRAT’s income tax liability flows through to the grantor; during the remainder term, the tax liability will either flow through to the grantor or be paid by the trust, depending on how the remainder term is structured. This allows the GRAT’s assets to grow on an income tax-free basis during the GRAT term but prevents the grantor from escaping taxation on any realized appreciation during that time.

Contact your J.P. Morgan Advisor to discuss this strategy further and help you decide if a GRAT makes sense for you.

Example of the inflows/outflows of a GRAT2

Results calculated using "NumberCruncher" software and J.P. Morgan Securities calculations. J.P. Morgan Securities LLC is not a legal or tax advisor.

1. If the annuity needs to be paid to the grantor “in kind,” the benefit of the discounted value will be reduced.
2. Results calculated using “NumberCruncher” software and J.P. Morgan Securities calculations. J.P. Morgan Securities LLC is not a legal or tax advisor. Hypothetical examples are not intended to serve as a projection of any result.






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