In times of economic uncertainty, many investors instinctively tighten their grip on their wealth, waiting for stability to return. However, a declining market presents successful individuals and families who are willing to transfer assets the opportunity to implement wealth transfer strategies that can generate significant tax savings. Depressed asset values create increased leverage, allowing those with long-term planning in mind to transfer wealth more efficiently, reduce estate tax exposure, and position themselves for significant long-term advantage. One compelling strategy to consider is a “Grantor Retained Annuity Trust,” or GRAT.
What is a Grantor Retained Annuity Trust (GRAT)?
A GRAT is a type of trust that is used to transfer appreciation out of one’s taxable estate without having to utilize any gift tax exemption. This planning technique is particularly appealing for those who are not looking to deplete their nest egg but who are comfortable transferring away future appreciation on their assets.
How do GRATs work?
Funding a GRAT involves transferring property to the trust, while retaining an annuity interest in the contributed property over a defined period of years. The annuity amount is calculated such that the entire initial contribution is returned to the grantor (creator of the trust) by way of the annuity payments. This calculation also assumes that the initial contribution will grow at a specific rate of return set forth by the Internal Revenue Service (the “IRS hurdle rate”), and this appreciation is baked into the annuity amount. Therefore, if the GRAT’s investments outperform the IRS hurdle rate (currently 5%), all the excess appreciation will pass to the grantor’s intended beneficiaries—for example, his or her children and other descendants.
Why are GRATs effective?
Since the success of a GRAT is predicated on beating the IRS hurdle rate, a market recovery following an economic downturn can produce exactly the kind of returns that make a GRAT effective. Stated differently, if the value of the assets in the GRAT rebounds, most of the appreciation as a result of the rebound will pass through to the intended beneficiaries with minimal transfer tax consequences.
GRATs in action
Investor creates a two-year GRAT and funds it with $1,000,000 of equities in April 2025 with a 5% IRS hurdle rate. At the end of years 1 and 2, Investor receives annuity payments equal to the present value of her initial contribution—in this example, Investor receives approximately $490,000 back at the end of year one and another $590,000 at end of year two. Suppose the market recovers from its current dip, equities perform well, and the assets earn 15% annually over the two-year period. At the end of the trust term, all investment growth above 5% is distributed to the beneficiaries free of estate and gift tax. At this point, the GRAT ends and Investor can continue to enjoy using the original principal. No further action is required.
What is the risk of an unsuccessful GRAT?
If the assets transferred into the GRAT do not beat the IRS hurdle rate, the GRAT will be unsuccessful from a gifting standpoint. As a result, all the assets transferred to the trust will be returned to the grantor. Aside from the costs for setting up the GRAT, it’s as if the GRAT never happened—meaning there is a fairly low “cost” associated with an unsuccessful GRAT.
For further questions and to explore how you can take advantage of the current market conditions using GRATs and other wealth transfer techniques, contact your Nixon Peabody attorney.