An Effective Wealth Transfer Tool
If you want to efficiently transfer wealth using little to none of your federal estate and gift tax exemption and you have an investment that you anticipate generating at least a modest rate of return on investment[1], then you should be having a conversation with your estate planning attorney about the benefits of a Grantor Retained Annuity Trust (“GRAT”). Low interest rates are not the enemy of estate and financial planners; they are opportunities for clients.
What is a GRAT?
A GRAT is a type of irrevocable trust to which a Settlor (the trust creator) transfers an appreciable asset in exchange for fixed annuity payments from the trust for a term of years. The Settlor must be paid back a portion of the amount paid to the GRAT plus an economic return equal to the 7520 Rate. The 7520 Rate is an interest rate set monthly that is equal to 120% of the midterm applicable federal rate (“AFR”) compounded annually.
At the end of the term of years, the remaining balance of the GRAT is paid to an individual or to a trust for the benefit of an individual (i.e., an irrevocable trust for the benefit the Settlor’s descendants) as a gift to the remainder beneficiaries. Since the duration of the GRAT and the rate at which the GRAT pays the Settlor are factors which are set by the Settlor; the Settlor can intentionally structure a GRAT to have a relatively low gift tax value.
Why Use GRATs in a Low Interest Rate Environment?
GRATs can be incredibly effective wealth transfer tools in a low interest rate environment because a lower AFR means it is easier for an investment to outperform the 7520 Rate or “hurdle rate”. To be effective, the assets held by the GRAT must appreciate at a rate in excess of the hurdle rate.
Low 7520 Rates create opportunity for estate planning attorneys to help clients efficiently transfer wealth to family members or trusts for the benefit of family members.
Below is a table showing how the 7520 Rate has changed over the past 20 years.
| Year | Month | 7520 Rate |
| 2022 | September | 3.6% |
| 2017 | September | 2.4% |
| 2012 | September | 1.0% |
| 2007 | September | 5.8% |
| 2002 | September | 4.6% |
What is a Zeroed-Out GRAT?
A Zeroed-Out GRAT is a GRAT in which the value of the gift is equal to or substantially close to zero. A Settlor can achieve this result by establishing a GRAT with a high annual annuity payout percent.
The examples below illustrate this concept.
$1m GRAT with a 5 Year Term and Assumed 5% Annual Growth
Annuity Percentage Payout: 7%
Taxable Gift: $884,839
| Principal | Growth | Required Payments | Remainder | |
| Year 1 | $1,000,000 | $50,000 | $70,000 | $980,000 |
| Year 2 | $980,000 | $49,000 | $70,000 | $959,000 |
| Year 3 | $959,000 | $47,950 | $70,000 | $936,950 |
| Year 4 | $936,950 | $46,848 | $70,000 | $913,798 |
| Year 5 | $913,798 | $45,690 | $70,000 | $889,487 to Beneficiary |
| $350,000 |
$1m Zeroed-Out GRAT with a 5 Year Term and Assumed 5% Annual Growth
Annuity Percentage Payout: 22.210869%
Taxable Gift: $0.05
| Principal | Growth | Required Payments | Remainder | |
| Year 1 | $ 1,000,000 | $50,000 | $222,109 | $827,391 |
| Year 2 | $ 827,891 | $41,395 | $222,109 | $647,177 |
| Year 3 | $ 647,177 | $32,359 | $222,109 | $457,427 |
| Year 4 | $ 457,427 | $22,871 | $222,109 | $258,190 |
| Year 5 | $ 258,190 | $12,910 | $222,109 | $48,991 to Beneficiary |
| $1,110,545 | [2] |
Whereas the first GRAT has a modest annual annuity percentage payout of 7% or $70,000 each year, the second GRAT has much larger annual required payments of 22.21%[3] or $222,109 each year. Although using a larger annual annuity percentage payout means that there is less of a remainder to pass to the ultimate beneficiaries at the end of Year 5, the Settlor has used no gift tax exemption amount ($0.05) in the second example and has the benefit of passing $48,991 to a trust for the benefit of the Settlor’s descendants.
Funding the GRAT – Asset Selection
Since the maximum benefit of the GRAT is achieved by beating the hurdle rate, Settlors want to choose assets that are likely to appreciate in excess of the hurdle rate to fund the GRAT.
For example, $1,000,000 invested in a conservative portfolio generating a predictable rate of return of 4% could have a greater chance of success to beat the hurdle rate than a portfolio of marketable securities in a down market. Alternatively, funding a GRAT with assets that have a great likelihood of appreciating in value may provide clients with greater opportunities to transfer wealth.
Rolling GRATs
To realize the benefit of market volatility, clients are typically advised to setup a series of short-term (i.e., two year) “rolling GRATs”. This series of trusts increase the likelihood that a particular GRAT will beat the hurdle rate and produce a benefit.
Power of Substitution
GRATs typically provide the Settlor with the power to substitute assets of equal value affording the Settlor greater flexibility in choosing which assets will fund a GRAT. A Settlor may develop a strategy with his or her attorney to initially fund a GRAT with illiquid or highly volatile assets while planning to later substitute the assets with more liquid or conservative assets.
Providing the Settlor with a power of substitution over the assets transferred to the GRAT will cause the GRAT to be taxed as a grantor trust for income tax purposes.[4] As a result, the Settlor will be responsible for the GRAT’s income tax liability. By paying the income taxes on behalf of the GRAT, the Settlor can allow the GRAT’s assets to continue to grow without the burden of annual tax payments.
What Happens if the GRAT Does Not Beat the Hurdle Rate?
The GRAT “fails” if the assets fail to appreciate at a greater rate than the hurdle rate. However, there is no penalty to the Settlor for failing to beat the hurdle rate. In this situation, the GRAT pays the Settlor the remaining value held by the GRAT with no payments to the remainder beneficiaries.
In this scenario, the cost to the Settlor is the out of pocket expense of establishing the GRAT.
Zero-ed Out GRAT Planning – Coming to an End?
Since the GRAT presents a Settlor with low-risk and the high potential for shifting wealth using little to no estate and gift tax exemption; GRATs are typically one of the targets of policy makers with respect to wealth transfer taxes.
For example, the “For the 99.5% Act”, introduced on March 25, 2021, specifically targeted the continued use of GRATs among other provisions in the bill. The terms of this bill would have significantly reduced the effectiveness of GRATs and all but eliminated the potential for a zeroed-out GRAT by requiring that a GRAT have a minimum term of 10 years and a required remainder interest payout exceeding 25% of the initial fair market value of the trust assets or $500,000.
Conclusion
Given the current Presidential administration and the makeup of Congress, a proposal to eliminate the use and/or effectiveness of GRATs is a real possibility in the near future. It is recommended to meet regularly with your attorneys to discuss the evolving tax planning considerations in 2022 and beyond.
To learn more about wealth transfer strategies that minimize use of one’s estate and gift tax exemptions, contact us, call Attorney John W. Donahue at 781-247-8005 or email John. John and the other trust and estate attorneys at WCN welcome the opportunity to assist you with tax planning and wealth transfer strategies including GRATs.
Learn more about our Private Client Services practice including trust and estate planning services.
This Article is not legal advice and should not be taken as such or relied upon as legal advice.
[1] 3.6% as of September 2022
[2] Note: Figures on chart have been rounded for convenience.
[3] 22.210869%
[4] IRC Sec. 675(4)(C)