What is a Grantor Retained Annuity Trust, or GRAT?

A Grantor Retained Annuity Trust, or GRAT for short, is a special type of irrevocable trust that allows the Trustmaker/Grantor to gamble against the odds and, if the Trustmaker/Grantor plays their cards right, then a significant amount of wealth can be moved down to the next generation for virtually no estate or gift tax dollars.

How Does a GRAT Work?

Here is how a GRAT currently works:

1. The Grantor/Trustmaker transfers specific assets into the name of the GRAT and, as the name suggests, retains the right to receive an annual annuity payment for a certain number of years. When the term of the GRAT ends, what is left in the GRAT is distributed to the trust beneficiaries (children or other beneficiaries of the Grantor's/Trustmaker's choice).


2. The amount of the annuity payment that is required to be paid to the Grantor/Trustmaker during the term of the GRAT is calculated by using an interest rate that is determined monthly by the IRS called the section 7520 rate. The section 7520 rate for February 2010 was 3.4% and the rate for March and April 2010 is only 3.2%, very low indeed.


3. The Grantor/Trustmaker can set the annuity payment so that it will be exactly equal to the section 7520 interest rate, meaning that theoretically all of the assets that have been transferred into the GRAT will be returned to the Grantor/Trustmaker in the form of the annuity payments and nothing will be left for distribution to the children or other beneficiaries when the GRAT ends. While ordinarily the transfer of assets owned by someone into an irrevocable trust for the benefit of someone else would be deemed a gift for federal gift tax purposes, with a GRAT since theoretically all of the assets transferred in could come back to the Grantor/Trustmaker, the value of the gift to the beneficiaries of the GRAT will be at or close to $0. This is called a “zeroed-out GRAT.”


4. So why would someone do this - set up a trust for the benefit of someone else but get all of the assets back in the form of annuity payments? This is where gambling against the odds comes into the picture - because the Grantor/Trustmaker is really betting on the fact that the assets transferred into the GRAT will appreciate in value above and beyond the section 7520 interest rate, so while the Grantor/Trustmaker will receive the annuity payments, the beneficiaries of the GRAT will receive the underlying GRAT assets at their value that has appreciated over and above the section 7520 rate.

What Are the Drawbacks of Using a GRAT?

With the section 7520 rate being such a low 3.2%, assets that are expected to highly appreciate in value above and beyond a mere 3.2% can be transferred into a GRAT and in turn move a significant amount of property down to the beneficiaries of the GRAT when the term ends. There are, however, two downsides to using a GRAT:

1. The assets transferred into the GRAT could grow at a rate lower than the section 7520 rate. If this is the case, then the Grantor/Trustmaker will simply receive back the trust property at its depreciated value and will only be out the legal fees that were paid to set up the GRAT.


2. The Grantor/Trustmaker could die during the term of the GRAT. If this is the case, then all of the property transferred into the GRAT would revert back into the estate of the Grantor/Trustmaker and be taxable for estate tax purposes, and the Grantor/Trustmaker will also be out the legal fees that were paid to set up the GRAT.

GRATs are not for everyone or just any type of asset. The Grantor/Trustmaker must be willing to take a gamble and bet that the property transferred into the GRAT will outperform the section 7520 rate, that the Grantor/Trustmaker will live to see the end of the term of the GRAT, and that the Grantor/Trustmaker will not need the gifted property later in life to live on. Speak with your estate planning attorney to determine if a GRAT is right for you and your family.