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For wealthy individuals, having an advanced estate planning strategy to maximize wealth transfer to their beneficiaries is a pillar of a successful financial plan.
This can be difficult for owners of estates valued above the lifetime exemption amount (which for 2022 is $12.06M for single individuals or $24.12M for married couples) because of a looming 40% gift and estate tax on assets above that threshold. The good news is there’s a solution. A grantor-retained annuity trust, more commonly referred to as a GRAT and specifically a zeroed-out GRAT, can remove potential appreciation out of an estate’s value in a relatively low risk, low-cost manner and with minimal use of a client’s lifetime exemption amount.
Current economic conditions combined with the anticipation of a substantially reduced lifetime exemption (scheduled to sunset at the end of 2025 absent any change by Congress) of about half the current amount ($6.02M Single / $12.04M Married couple) and relatively historically low interest rates warrant considering a grantor-retained annuity trust (GRAT).
A GRAT is an irrevocable trust into which the grantor places a lump sum of assets, determines the term length (usually between 2-10 years), and the ultimate beneficiary, such as a family trust for future generations. During the term, the grantor receives regular annuity payments to total their original funding amount plus an interest rate set by the Internal Revenue Service, known as the 7520 rate or hurdle rate. Since the grantor receives their full contribution amount plus interest, there are no gift tax implications. At the end of the term, the remaining assets transfer to the designated beneficiary free of gift and estate taxes.
In January 2022, I fund a 2-year GRAT with $2M of highly appreciable publicly-traded stock. Over the next two years, I will receive $2M plus interest (at the Section 7520 rate) via annual annuity payments. Using the current Section 7520 rate and assuming a 20% growth rate in annual annuity payments, this would equate to receiving payments in the amount of $931,619.15 (Year 1 Annuity Percentage Payout 46.58095750%) in January 2023 and $1,117,942.98 (Year 2 Annuity Percentage Payout 55.8971490%) in January 2024 for a total of $2,049,562.13. If the assets within the GRAT increase to $2.33M (assuming 8% annual growth) at the end of the GRAT term, $284,000 would remain and transfer to my family trust without any gift or estate taxes being owed.
Since GRATs are treated as Grantor Trusts, all taxable income generated by the trust, most commonly through dividends and interest, is attributed to the grantor and reported on their individual tax return. Annuity payments however are typically in-kind distributions and often are not taxable. It’s important to be aware of the requirement for the grantor to pay capital gains taxes levied on the GRAT using outside assets. Individuals will need to report the funding of a GRAT on a gift tax return (even though no tax is due at funding) and should work with an accountant or CPA who has experience in this field.
There are constraints when establishing a GRAT that are important to consider. Annuity payments can only be received after the anniversary date each year, which could cause cash flow constraints. If considering funding with privately held assets, a third party valuation is needed on an annual basis and at the end of the term, which can be expensive. It’s also important to remember GRATs are funded with a lump sum value of assets and cannot accept additional contributions. There are also costs to establishing a GRAT which include the initial fees for establishing the GRAT, establishing a trust for residual distributions and filing a gift tax return.
A GRAT could fail if the grantor dies within the term because the assets would go back to the grantor’s taxable estate and the beneficiary receives nothing.
Lastly, GRAT assets passed to beneficiaries retain the grantor’s original cost basis. As such, there could be capital gains tax implications for the beneficiary when the assets are sold. Your beneficiaries may end up paying more in taxes in comparison to traditional methods such as a step-up in basis at the owner's death.
To implement a successful GRAT, please work with your Kovitz Wealth Advisor, tax professional and estate attorney to assess the following considerations. First, the assets selected for GRAT funding need to be clear of obligations in the near-term. It’s often wise to add cash within the account for fees and administration expenses to avoid selling holdings to cover these costs.
When deciding between outright gifts to your beneficiaries versus establishing a GRAT, typically larger GRATs are found to be more effective because if small, the end-of-term appreciation amount to the beneficiary is likely to be small and using your annual gift exclusion of $16K single / $32K married couple for 2022 may be more cost-effective.
There can also be a timing component of establishing a GRAT in times of volatility. This is done by creating a GRAT within the current historically low Section 7520 rate environment before a potential future increase takes effect since the rate is adjusted monthly. Obtaining a low hurdle rate creates a lower bar that the GRAT assets need to appreciate above. We expect market volatility to increase as the Fed plans to cease quantitative easing in March and steadily increase interest rates throughout the year, while balancing the impact of a global pandemic. Which means that if you time the funding of a GRAT with the event of a market downturn, you will take advantage of highly appreciable assets starting at a depressed amount.
Ideally, you want to fund a GRAT with easy to value assets with high appreciation potential such as publicly-traded stock. Remember, even if the stock price falls and the GRAT fails (i.e., no appreciation is available to pass along to your beneficiaries), the shares would be given back to the grantor as if the GRAT never existed. Heads you win, tails you tie.
Your Kovitz Wealth Advisor, Estate Planning Attorney and Tax professional can help you decide whether this estate planning technique makes sense for you. Given the economic environment, this may be an optimal time to transfer significant amounts of wealth to your family members using this tax-efficient tool.