As responsible parents we set up a revocable living trust so that in case of our untimely demise, our son would be protected and taken care of. Going through public probate court is not only a hassle, but a violation of our financial privacy.
When I asked my centimillionaire friend what type of estate planning he does, since his net worth is well over the estate tax exemption amount per person of $11.4M, he said a main strategy he uses is the Grantor Retained Annuity Trust or GRAT.
If the GRAT is set up and executed properly, a significant amount of wealth can move down to the next generation with virtually no estate or gift tax ramifications.
Let’s learn how a GRAT works with a couple of examples that show how millions of dollars can be saved in estate taxes.
How Does A GRAT Work?
You, the grantor, transfer assets to a trust (GRAT) and retain the right to receive an annuity payment for a term of years. At the end of the term, the assets remaining in the GRAT are distributed to your children (or other beneficiaries).
The transfer to the GRAT will trigger a gift tax event. However, the value of the taxable gift is not the value of the assets transferred to the GRAT. Instead, the gift is reduced by the actuarial value of the annuity you retain.
If the annuity is structured properly, it equals the value of the assets, and there is no gift. This is referred to as a “zeroed-out” GRAT.
The amount of the annuity payment that is required to be paid to the grantor during the term of the GRAT is calculated by using an interest rate the IRS determines monthly called the section 7520 rate.
The section 7520 rate for January 2019 is 3.4 percent. Here is a chart of the historical annuity payments from the IRS.
The grantor should set the annuity payment equal to the section 7520 interest rate and no higher because a higher annuity payment simply means more taxable income.
The grantor’s goal is to make the spread between the 7520 interest payment and the annual return on the asset getting transferred into the GRAT as high as possible. This spread will ultimately be the value of the tax-free gift when the grantor passes away.
The grantor sets up a GRAT because s/he is betting the assets transferred into the GRAT will appreciate in value above and beyond the section 7520 interest rate.
So while the grantor will receive the annuity payments and pay taxes on those payments, the beneficiaries of the GRAT will receive the underlying GRAT assets at their value. It’s the value of those assets that will appreciate over and above the section 7520 rate.
A GRAT Example Using A Home
My friend set up a GRAT to pass his San Francisco home to his kids. He put his then $10 million home into a GRAT in 2010 when his kids were in elementary school.
At the time, the 7520 rate was 2%. He made a bet that his San Francisco home would appreciate quicker than the 2% annual annuity payment.
Given the historical annual appreciation of San Francisco property has been closer to 8% a year, my friend made a wise move. Check out the appreciation chart since 2010.
As of 2019, his $10 million home is now worth closer to $18 million, which is indeed about a 8% compound annual rate of appreciation.
Since the start of the GRAT, my friend has had to pay taxes on about $200,000 – $360,000 a year worth of annuity income for nine years = ~$2.5 million total annuity income X 40% effective tax rate = $1 million in taxes.
On the flip side, he has been gifting his kids 5% – 6% of appreciated value each year on average since 2010, or roughly $5 – $5.5 million worth of estate value tax-free for a $2 – $2.2 million tax savings.
There’s no free lunch. But there is $1-$1.2 million in estimated estate tax savings in this example. The longer the appreciation time period over the 7520 rate, the greater the tax savings.
If my friend decided to stop making a high income during the GRAT period, he could have paid a lower marginal tax rate on his GRAT annuity income, thereby saving even more in estate taxes.
A GRAT Example Using A Business
In addition to potentially high performing real estate, virtually any type of asset can be transferred into a GRAT which you think will outperform the annuity interest rate over the long term.
A stock portfolio could easily be another example given the S&P 500 has historically returned much higher than the section 7520 rate. But let’s talk about transferring a high growth business into a GRAT instead.
One popular option is to transfer non-voting stock in a closely-held business to the GRAT while retaining all (or a controlling interest in) the voting shares. This works particularly well with S-Corporation stock.
We know from the net worth composition by wealth chart the richer you are, the larger the Business Interests percentage is to your overall net worth. By the time you’re a billionaire, your net worth is comprised mostly of Business Interests.
For example, I could transfer Financial Samurai into a GRAT and put it in my son’s name. Given he’s too young to know anything about online media, he’ll get non-voting stock, and I would retain control of the business until he’s old enough to understand and want someday to take over the business.
Based on history, I shouldn’t have a problem outperforming the latest 7520 rate of 3.6% of the GRAT by a wide margin.
For illustrative purposes, let’s say Financial Samurai is worth $10 million today and the business grows in value by 20% a year above the 7520 rate of 3.6% for 10 years. In 10 years, the business would be worth $83,211,799.
I’d have to pay taxes on roughly $3,600,000 of annuity payments during this time period ($10M X 3.6% X 10 years), which would amount to $1,080,000 in taxes at a 30% effective tax rate.
However, I would be able to transfer $73,211,799 million in wealth to my son and other heirs estate tax-free once the term of the GRAT expires. That would be an estate tax savings of about $29,300,000!
Obviously, growing the value an already established small business by 20% a year over the 7520 rate of 2% – 4% is no small feat. But it’s always good to think big. With enough discipline, creativity, and courage, anything is possible. Pumped to start a business yet? Makes me want to start another!
Another reason for establishing a GRAT is if you foresee a sale of your business at a big premium in the next few years. The big premium could be from you undervaluing the value of your business in your estate or through a true market valuation multiple expansion from an interested suitor.
Note: the GRAT is considered a “grantor-type trust” by the IRS. Thus, the tax on any income generated on such a trust is your individual responsibility. This can enhance trust performance because trust income is not required to be used to pay the taxes on its generated income.
The Downside Of Using A GRAT
There are three downsides to using a GRAT:
1) The assets transferred into the GRAT could grow at a rate lower than the section 7520 rate. If this is the case, then the trustmaker/grantor will simply receive back the trust property at its depreciated value and will only be out the legal fees that were paid to set up the GRAT.
2) The trustmaker/grantor could die during the term of the GRAT. If this is the case, then all of the property transferred into the GRAT would revert back into the estate of the trustmaker/grantor and be taxable for estate tax purposes, and the trustmaker/grantor will also be out the legal fees that were paid to set up the GRAT.
3) Finally, setting up a GRAT takes research, time, and money. The estate attorney I use charges a couple thousand dollars to set up a GRAT. But as a percentage cost to your estate, it’s likely not that much.
Who Is The GRAT Best For?
The GRAT is great for those who have estates or anticipate having estates greater than the current and expected estate tax exemption amount.
Below is the historical gift tax exemption amount per person and its corresponding estate tax rate. As you can see, the Estate Tax Exemption is at an all-time high while the Estate Tax Rate is close to its historical lows.
If you expect to die with less than the estate tax exemption amount, it may be better to just create a revocable living trust instead.
If you, the grantor believes the asset transferred into the GRAT will outperform the section 7520 interest rate, that you will live to see the end of the term of the GRAT, and that you will not need the gifted property later in life to pay for living expenses or long-term care, then setting up a GRAT should be a good move.
Just know that the laws can change in the future. For example, President Obama sought to weaken GRATs as an estate reduction tool in his budget proposals throughout his time in office, but failed. The Tax Cut And Jobs Act should theoretically keep the rules in place until December 31, 2025, but you never know.
The next time you talk to your estate planning attorney, ask him or her about the GRAT. Show them this article and ask them to poke holes at my examples. Then come back and share your wisdom.
The only way to benefit is to learn and take action.
Related: Three Things I Learned From My Estate Planning Attorney Everyone Should Do
Readers, anybody with a GRAT and want to share how you are using it to save on estate taxes? If there are any estate planning lawyers, please chime in as I’m not one.