What is a GRAT?
A GRAT is an irrevocable trust where the trust creator (called the “grantor”) transfers assets to a trust, in exchange for a fixed payment, or annuity, for a specific term of years. Because the trust makes fixed payments back to the grantor, which can be used as income by the grantor, the gift tax on the transfer can be avoided, without using any of the grantor’s gift tax exemption. The trust term can be as short as two years, and typically range between 2 and 5 years. Although the term is typically measured by a fixed number of years, it may also be measured by the grantor’s life. The end result is that you can remove the transferred asset from your taxable estate, and the growth in value of the asset is estate and gift tax free! It works great for cryptocurrency.
Isn’t an Irrevocable Trust a bad thing?
Definitely NOT! Modern trust law has dramatically changed the concept of “irrevocable”. Under old rules, “irrevocable” was a scary word because it gave the message of a complete give-up of control over an asset. There was such a permanency about irrevocable trusts that people feared losing the asset forever, and heard horror stories of exactly that. But with modern trusts we can structure them in a way that you do not lose control. Even if you appoint someone as “trustee” of the trust, who can sign documents for the trust, we can typically reserve you the right to remove and add trustees at any time. By controlling who the trustee is, you control the trust.
GRATs have several advantages:
- They eliminate gift tax liability on transfers to family members, even if you give more than the IRS-allowed $16,000 per year.
- The legal and administrative costs are minimal when compared to the resulting tax savings. The cost of doing nothing is much higher!
- Grantors can exchange assets with the GRAT without income tax or capital gains consequences
- They are an IRS-sanctioned wealth transfer vehicle.
- They can also aid in business succession plans.
- It can be used to "lock-in" lower values of assets for estate and gift tax purposes. This is especially beneficial for assets that are expected to grow in value over time.
- It can be used to avoid GST tax (Generation Skipping Transfer Tax) when leaving assets directly to grandchildren or anyone more than one generation away from you.
Here’s an example of how the GRAT works:
The example works better with large round numbers, so we will start with a figure of $1 Million, but know that you don’t need to have $1 Million for the GRAT to work for you!
A good way to see the benefit is to think about assets like shares of stock (though in most cases, if you have cryptocurrency, you can substitute that for stock in this example). The expectation when buying stock is that the value will go up over time (hopefully!). If you transfer $1 million worth of stock to a GRAT. If the stock value grows at a modest rate of return of 4% per year, then after the next 15 years, it will be worth $1.8 million at the end of the term. If you were to look at a shorter term, like 10 years, the value at the end of the term would be $1.48 million. The first $1 million will could be taxed as a gift, or the gift tax can be avoided if based on the amount of the annuity payments. Regardless of whether or not there is gift tax on the original amount, the remaining growth passes to your beneficiaries estate and gift tax-free! For the 10 year term, your beneficiaries would receive close to half a million dollars, and for the 15 year term, over $800,000!
What Are the Other Requirements of a GRAT?
A GRAT is a complex trust that should only be done by expert-level attorneys. There are many technical requirements whenever we are talking about taxes, especially estate and gift taxes. Other than the technical aspects of drafting the trust document itself, there are some other practical requirements:
- Only the grantor can receive annuity distributions during the annuity term.
- The annuity payments must be made at least annually.
- Upon completion of the annuity payment term, the GRAT’s remaining assets pass to the beneficiaries, either outright or in trust. No additional contributions to the trust are permitted.
- The grantor must outlive the annuity term in order for the trust to be effective
How does the “annuity” part work?
Once the asset is put into trust, annuity payments must be made back to the grantor. An annuity is just a schedule of payments based on the value of the original asset. The trust must make payments back to the grantor, at a set rate of interest that’s at least as high as a rate set by the IRS. If the annuity payments over the term of the trust are equal to the value of the original asset, then the transfer to the trust is not a gift, because the money going in to trust is the same as the money coming out. But the appreciation on the asset passes to the beneficaries and the growth is free of estate and gift tax.
That sounds pretty technical – is it worth it?
That’s a question for your estate planning attorney. But in the example above, the value of the asset grew by hundreds of thousands of dollars, and the growth was free of estate and gift tax. In Massachusetts, where the estate tax threshold is only $1 million, it can make a huge difference in the estate taxes that your beneficiaries would have to pay.
There are other technical aspects of the trust, but your estate planning attorney should be able to tell you if the GRAT is right for you. If your estate planning attorney doesn’t know what a GRAT is, or how it works, then find a new estate planning attorney!