"Turning Complexity into Confidence."

WHAT ARE GRATS

 

General Overview

  • The "freeze" strategy aims to fix the estate's asset value for tax purposes by locking in the value at the time of the gift, capping future estate tax on the asset's appreciation. When an asset is gifted, it is valued either at the time of transfer or at the owner's death. By making an inter vivos (lifetime) gift, the value of the asset is effectively frozen, so future appreciation is excluded from the taxable estate.

  • The "discount" strategy leverages valuation reductions on partial ownership interests within an estate, often used in family businesses. This can include a market illiquidity discount, possibly paired with a lack of control discount, or a time-value discount, which applies to split-interest gifts where the giver retains certain rights (such as income for a specific period) while the remainder interest passes to others.

  • "Depletion" reduces the estate tax base in two ways: anticipated consumption and arbitrage by paying income taxes at a rate lower than the estate tax rate. Often, this involves creating grantor trusts, where the trust creator pays income taxes on the trust's assets, decreasing the taxable estate.

 

Grantor Retained Annuity Trust (GRAT) Basics

A GRAT is a common estate planning tool using a time-value discount. The trust creator must survive its term, and the assets must appreciate at a rate higher than the IRS’s Section 7520 rate, which is based on 120% of the federal interest rate rounded to the nearest 0.2%. GRATs contain two parts: (1) retained income interest, structured as a fixed annuity based on the asset’s initial fair market value and payable over several years, and (2) residual interest, which usually benefits family members directly or indirectly through another trust.

 

Economic Functionality of GRATs

The IRS 7520 rate determines two key aspects of a GRAT: the minimum annuity payments required and the likelihood of the creator outliving the GRAT. For a GRAT to achieve its “freeze” objective, the creator must survive its term; otherwise, the assets may be subject to estate tax. The recommended minimum GRAT term is two years, though longer terms may be more favorable when considering annuity payments and potential interest rates.

 

GRAT Asset Selection and Market Risks

Assets best suited for a GRAT are often liquid securities that are easy to value, though certain hard-to-value assets may also be considered. If the GRAT fails to meet the IRS 7520 rate, the assets may revert entirely to the creator. Additionally, the annuity payments must meet at least the 7520 rate for the month the GRAT is established, with longer GRAT terms often helping reduce estate tax more effectively.

 

Who Benefits from GRATs?

GRATs are typically best suited for clients with high-growth portfolios and a strong likelihood of surviving the GRAT term, often younger clients or business founders. It is also ideal for those with remaining gift tax allowances who intend to benefit their children rather than grandchildren due to Generation-Skipping Transfer (GST) tax constraints.

 

Potential Pitfalls of GRATs

GRATs require careful maintenance, including regular annuity distributions, often needing the support of investment advisors for asset valuation and timing. Moreover, GRATs do not receive the same GST tax discounts as other strategies, making accurate tax reporting essential. When implemented effectively, GRATs can help achieve the goal of freezing, reducing, and depleting estate assets while minimizing tax exposure, though this approach requires detailed knowledge and a high level of client commitment.

 

A well-structured GRAT can be a powerful estate planning strategy, but its success hinges on rigorous asset selection, careful balance of annuity terms, accurate reporting, and proactive maintenance. Both practitioners and clients should be aware of these nuances before committing to this approach.

 

Copyright: This article is original and copyright © Alphakey Advisory LLC. This article may not be reproduced, copied or used in any way, in whole or in part, without permission. The information provided here is general in nature and should not be regarded as legal, accounting, or tax advice from Alphakey Advisory LLC. Readers are advised that this material may not apply to or suit their specific circumstances, and additional considerations—both tax and non-tax—may be necessary before undertaking any action based on this content.