What's That? A GRAT Can Save on Estate Taxes?

A GRAT? What’s that? A GRAT – or Grantor Retained Annuity Trust – is a trust that enables high net worth investors to minimize the estate taxes they pay on wealth passed onto the next generation.

A GRAT starts with a donation to an irrevocable trust. The trust is set up as an annuity, giving the donor an annual payment for a set period of time. At the end of the term of the annuity, the remaining value of the trust is passed on as a gift to a beneficiary. The IRS requires that the beneficiary is a family member of the donor.

The gift value of the GRAT is calculated when the trust is established. The IRS subtracts the annuity payments through the end of the term from the initial contribution and anticipated interest earned. The interest rate used in the calculation is determined by an IRS formula setting the rate at 120 percent of the federal mid-term rate during the month the GRAT is established. The value of the gift passed on to heirs is deemed close to zero when the annuity payments are close in value to the initial contribution and anticipated interest.

“Thus, the taxable gift to a GRAT is always less than the fair market value of the asset used to fund the trust,” according to experts at Morgan Stanley Smith Barney, who created a “Strategic Thinking” report on the estate planning tool. “In many instances, taxes owed on the gift to a GRAT can be partially or fully offset by the grantor’s applicable lifetime gift-tax exclusion amount.”

When a grantor survives the term of the annuity, assets remaining in the trust – including earnings in excess of the anticipated interest rate – pass to the beneficiaries with no additional gift tax and provide “significant gift-tax savings to the grantor,” explains Morgan Stanley Smith Barney.

The current economic environment - with its historically low interest rates and liberal gift tax allowances - offers particular advantages to investors who are thinking about establishing a GRAT, according to the experts. A calculation based on relatively low interest rates will result in a lower taxable gift. Current estate tax also increase the chances that gifts will fall below the current lifetime thresholds set by the federal government – but those thresholds are temporary and set to expire at the end of 2012.

Despite its tax advantages, a GRAT might not be right for every investor, warns Morgan Stanley Smith Barney. The irrevocable nature of a GRAT means that investors give up control of the assets and cannot use the wealth for any other purpose. “Only persons who have sufficient assets and income, and are willing to irrevocably gift the assets to the next generation should consider a GRAT,” said Morgan Stanley Smith Barney.

Despite the tax advantages offered by GRATs and other types of trusts, the majority of wealthy investors prefer not to hold assets in the legal structure of a trust. About 44 percent of Ultra High Net Worth investors – those with investable assets of $5 million to $25 million – hold assets in the legal structure of the trust. Less affluent Millionaires and non-Millionaire investors are even less likely to hold assets in trusts. Only 31 percent of Millionaires with $1 million to $5 million have trusts. The share is 12 percent for Mass Affluent investors, who have a net worth of $100,000 to $1 million, not including primary residence.