A Grantor Retained Annuity Trust, GRAT, is an irrevocable trust in which the grantor retains the right to receive a fixed dollar amount annually for a set term of years. At the end of that period, any remaining property passes as provided in the trust, either outright to designated beneficiaries or in further trust for their benefit. For a GRAT to be successful, the grantor must survive the annuity term. If the grantor dies during the term, all or a substantial portion of the value of the GRAT will be included in the grantor's estate under Section 2036 of the Internal Revenue Code.
The transfer of property to a GRAT constitutes a gift equal to the total value of the property transferred to the trust, less the value of the retained annuity interest. The value of the annuity interest is determined using the valuation tables under code Section 7520 and the applicable interest rate for the month of the transfer. The grantor of a GRAT is treated as making an immediate gift when the trust is funded, but the value of the gift is a fraction of the total value of the property because it represents a future benefit. Therefore, if the grantor survives the annuity term, there is an opportunity for property to pass to the designated remaindermen at a reduced transfer tax value.
EXAMPLE: Mary, age 55, transfers $500,000 of assets to a GRAT and retains the right to receive an annuity of $43,750 per year, payable annually, for 15 years or her prior death. Under the IRS tables, if the Section 7520 rate is 3.2%, the value of Mary's retained annuity interest is $467,820, so the amount of the gift upon creating the GRAT is $32,180. If the trust assets provide an average return of at least 5% annually there will be $96,950 in the trust at the end of 15 years. That property will pass to the remaindermen for an initial gift of $32,180. If the trust assets provide an average return of at least 10% annually, there will be at least $706,460 in the GRAT at the end of the term.
The annuity does not have to be an equal amount each year. It can be defined as a fixed initial amount, increased by up to 20% in each subsequent year.
Most GRATs provide that the annuity payout amount must be satisfied from trust principal to the extent trust income in a given year is insufficient. The IRS has ruled privately that the GRAT is a grant trust when the annuity may be satisfied out of trust income or principal. See e.g., Ltr. Rul. 9415012 (January 13, 1994). This is an important additional benefit. It means that a GRAT can be funded with stock or partnership interests or real estate, and that asset can be paid back to the grantor to satisfy the annuity obligation without the distribution of the asset being treated as a sale.
One advantage of retaining the property in trust is that the grantor's spouse can be a beneficiary, thereby permitting the couple to have some access to the property during the spouse's life and causing the trust to continue to be a grantor trust.
GRATs have a significant advantage over other gifting techniques because of the ability to define the retained interest as a percentage of the initial value of the gifted property "as finally determined for federal gift tax purposes". Thus, if the gift value is doubled, so is the retained annuity, and there is little or no increase in the amount of the gift.