Identify GRAT opportunities for clients with appreciating assets

Written in partnership with Vanilla.

Wealthy clients often own assets they expect to appreciate significantly over time, such as concentrated stock positions, interests in privately held businesses or other high-growth investments. While that appreciation can create substantial wealth, it can also increase the portion of a client's estate that could eventually be subject to estate taxes. This article explains how a grantor retained annuity trust (GRAT) may help certain clients preserve more of their wealth for the people they care about.

Attorneys draft the documents and tax professionals advise on tax implications, but advisors are often the first to recognize potential valuable estate and tax planning opportunities. By identifying clients who may benefit from a GRAT before significant asset appreciation occurs, you may create opportunities to transfer future growth more tax efficiently and strengthen your value as an advisor.

What is a grantor retained annuity trust (GRAT)?

A GRAT is an irrevocable trust designed to remove future appreciation of transferred assets out of the grantor’s estate while using little or none of their lifetime gift tax exemption. Unlike trusts intended to exist until or after a grantor’s death, a GRAT has a specified term of at least two years but can be for any duration.

How does a GRAT generally work?

The grantor funds their GRAT with assets they expect to appreciate significantly in value during the term of the trust. The GRAT pays the grantor a fixed annual annuity for the duration of the trust in an amount that is based on the value of the assets transferred and U.S. Internal Revenue Code (IRC) section 7520 rate, often called the ‘hurdle rate.’

The trust is structured as a grantor trust for federal income tax purposes, meaning that the grantor is deemed to be the owner of the trust for income tax purposes. All items of income, deductions, gains and losses that are recognized within the trust are reported on the grantor’s federal income tax return, which may further reduce the value of the grantor’s estate.

At the end of the trust term, if the assets have grown faster than the hurdle rate, the remaining assets may pass to the beneficiaries with little or no gift tax consequences. If the assets did not outperform the hurdle rate, generally no assets pass to the beneficiaries; however, the grantor is only out the costs of creating and administering the GRAT, which may be small relative to the potential benefits when a GRAT is successful.

Is funding the GRAT subject to gift taxes?

GRATs are usually structured so that little or none of the transfer to the trust is subject to gift tax. Let’s unpack that.

When a GRAT is funded, the grantor is considered to have made a taxable gift to the remainder beneficiary equal to the value of the assets transferred less the value of the grantor’s annuity payments. If the present value of the annuity payments nearly equals the value of the transferred assets, the GRAT essentially pays back to the grantor 100% of the transferred assets plus the hurdle rate, and the value of the remainder interest has been ‘zeroed-out.’

What are the benefits and tradeoffs of a GRAT?

Like most sophisticated estate planning strategies, a GRAT offers potential benefits as well as tradeoffs that should be carefully considered alongside a client’s personal circumstances.

When might a GRAT make sense?

GRATs may be appropriate for clients who:

• Own assets with substantial appreciation potential, including concentrated stock positions or privately held business interests.
• Have already exhausted or want to preserve their lifetime gift tax exemption.
• Are comfortable placing assets into an irrevocable trust for a specified period.

Because GRATs involve complex tax and legal considerations, it is important to collaborate with qualified professionals to evaluate the strategy as part of a client’s overall wealth transfer plan.

How Jane’s advisor helped her preserve wealth: a hypothetical example

Jane owns $10 million of concentrated stock that she believes has strong long-term growth potential. She wants to transfer wealth to her children but would also like to preserve as much of her lifetime gift and estate tax exemption as possible. Her advisor, in coordination with an estate planning attorney and tax professional, helps Jane establish a two-year GRAT and transfer her concentrated stock into the trust.

During the term of the GRAT, Jane will receive fixed annuity payments from the trust, which she may receive in cash (funded by the liquidation of, or income generated from, the shares), in-kind payments of her stock, or a combination of both. If the stock returns exceed the IRC Section 7520 rate, the remaining assets at the end of the trust’s term may pass to her children with minimal use of her gift and estate tax exemption.

If the stock returns are lower than expected, however, little or no wealth may ultimately transfer through the GRAT because much of the trust's value is returned to Jane through the annuity payments. While simplified, this example illustrates why GRATs are generally funded with assets that have significant appreciation potential.

The opportunity is greatest before appreciation occurs

Clients holding assets with high-growth potential have more planning flexibility before the value of those assets increases. Beginning the conversation early allows you to help clients evaluate whether a GRAT fits within their broader financial plan before important planning opportunities narrow.

Expand your estate planning toolkit with GRATs

For the right client, a GRAT can be part of a coordinated strategy to transfer future appreciation more efficiently while preserving wealth for future generations. Recognizing when a GRAT may be appropriate for a client allows you to deliver more comprehensive guidance, which helps you attract wealthier clients and grow your practice.