Are Common Grantor Retained Annuity Trusts Coming to an End?

Klaus Gottlieb

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Is the Common GRAT Facing Extinction in 2025?

by: Klaus Gottlieb of Wealth Care Lawyer -

Friday, August 9, 2024

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The GRAT is not some cute furry critter in the Amazon rainforest, but as you probably suspected, the Grantor Retained Annuity Trust. Before we discuss the danger of it becoming extinct, let’s review what it is, how it works, and who benefits from it.

Non-charitable actuarial techniques, such as Grantor Retained Annuity Trusts (GRATs), Qualified Personal Residence Trusts (QPRTs), and Private Annuities, are estate planning tools used to transfer wealth efficiently while minimizing gift and estate taxes. These techniques involve the grantor retaining an interest (such as annuity payments or usage rights) for a specified term, with the remainder passing to beneficiaries. They all rely on actuarial calculations to value the retained and transferred interests, aim to reduce the taxable value of the gift, and carry the risk of estate inclusion if the grantor dies before the term ends.

GRAT Facing Extinction

Figure 1: The tax hunters are coming: Is the GRAT only endangered or does it face extinction in 2025?

GRAT (Grantor Retained Annuity Trust)

A Grantor Retained Annuity Trust (GRAT) is an estate-freezing technique authorized by statute (1) that can be associated with significant tax savings under the right circumstances. Its structure is similar to that of a Charitable Lead Annuity Trust (CLAT), which we previously reviewed (2).

How it Works

Transfer of Property: The grantor transfers property to the trust.

Retention of Annuity: The grantor retains an annuity payable for a term of years, or the shorter of the grantor’s life or a term of years

Term: The period for which the grantor retains the annuity is referred to as the “term.” This term should be shorter than the grantor’s life expectancy; otherwise, part or all of the trust property may be included in the grantor’s estate.

End of Term: At the end of the term, the trust property will remain in trust for, or pass directly to, the remainder beneficiaries provided in the trust instrument.

Example

The taxpayer establishes a GRAT with a term of twelve years.

They contribute stocks valued at $800,000.

They reserve an annuity of 6 percent, receiving $48,000 per year over the 12-year term.

At the end of the term, the trust assets will pass to their beneficiary(ies), which could include their children, trusts for their spouse or children, any combination of the above, or anyone else.

Tax Implications

Initial Transfer:

When the taxpayer transfers the stock to the GRAT, they make a taxable gift of the remainder interest’s value after the term.

Gift Valuation:

The gift amount is generally calculated using software that is based on the IRS actuarial tables

The valuation depends on:

The length of the term (twelve years)
The amount of the retained annuity (6 percent)
The 7520 rate at the date of transfer (in August 2024 - 5.2%)

A calculation with these values results in a value of the term certain annuity interest of $420,676.80; in other words, this is the value of the grantor’s retained interest (“Grantor Retained Annuity Trust”). The taxable interest is the funding amount (here $800,000) minus the retained interest, or $379,323.20 (Taxable Gift).

Grantor Trust Status:

During the term, the trust will be treated as a grantor trust. Please see also (3).

The taxpayer will report the trust’s income, deductions, gains, losses, and credits on their personal income tax return.

The grantors are not taxed directly on the annuity payments they receive; instead, they are taxed as if they owned the trust assets.

End of Term:

After the 12-year term, the property will transfer to the remainder beneficiaries without any additional transfer tax unless the beneficiaries are skip persons, in which case a generation-skipping transfer tax may apply.

Effect of 7520 rate

We have previously illustrated the effect the IRS 7520 rate has on the valuation of the income tax deduction in the context of CRTs (charitable remainder trusts) (4) and CLTs (Charitable Lead Trusts) (5). For a GRAT, a low 7520 rate is advantageous because it increases the term certain annuity interest; therefore, the difference between the initial investment and the retained interest, i.e., the taxable gift, is lower.

Back to our example: Keeping everything the same but decreasing the 7520 rate from 5.2% to 1.2% increases the valuation of the grantor’s retained interest from $420,676.80 to $533,476.80, and the taxable gift decreases correspondingly from $379,323.20 to $266,523.20 (6).

Benefits and Risks

Here is where the concept of estate freezing can be illustrated.

We have previously shown that there is no correlation between the IRS 7520 rate and equity returns (3). Moreover, the calculation to determine the value of the taxable gift is only made once (‘freezing’) using the IRS 7520 rate. If the assets in the trust grow at a rate higher than the 7520 rate, then the excess can be passed on tax-free to the beneficiaries.

Assuming that the investment returns are 8% and everything else is the same as in our example, we will have $1,103,634.00 as a remainder. Gift taxes have, however, only been paid (assuming a 7520 discount rate of 5.2%) on a taxable gift of $379,323.20.

Even more dramatic results can be achieved in the context of a pre-IPO where appreciation can be substantial and occur over a short period of time.

Who Benefits

While clients with moderate wealth might not immediately see the benefit of setting up a GRAT, the significantly increased gift and estate tax exclusion amount from 2018 to 2025 ($13.61 million in 2024 and $12.92 million in 2023) still makes using GRATs advantageous, particularly for minimizing state death taxes. Additionally, clients with more modest wealth should consider establishing GRATs if they anticipate living beyond 2025, when the higher estate exclusion amount might sunset, potentially exposing them to estate tax. Setting up a GRAT now offers a proactive strategy to address uncertainties around post-2025 exclusion amounts and estate taxation.

What Are The Risks?

A GRAT is an irrevocable trust, meaning neither the grantor nor the beneficiary can access its assets during the trust term. If the grantor dies before the trust ends, the trust’s principal may be included in the grantor’s estate. Additional contributions to the GRAT are prohibited once it is funded, though a new GRAT can be established, or assets of equal value may be swapped under a power of substitution. The trust is treated as a grantor trust for income tax purposes, making the grantor liable for all trust income taxes. The Generation-Skipping Transfer (GST) tax exemption cannot be effectively applied during the GRAT term, and high Section 7520 rates can make it difficult for the trust to meet its income requirements and increase the taxable value of the remainder interest. Additionally, the administration of a GRAT involves higher costs and complexity, and transferring appreciated assets to a GRAT results in a loss of the step-up in basis, potentially leading to higher taxes for beneficiaries when the assets are sold.

What are Zeroed-Out GRATs?

Figure 2: The subspecies of the zeroed-out GRAT is in the cross-hairs of the tax hunters.

In a Zeroed-Out GRAT, the annuity payments retained by the grantor are structured so that their present value is nearly equal to the value of the assets initially transferred to the trust, effectively “zeroing out” the gift. This means that the gift value (for tax purposes)—and consequently, the gift tax—is minimized or eliminated, often resulting in a nominal or zero-taxable gift.

Going back to our example, the taxpayer establishes a GRAT with a term of twelve years.

They contribute stocks valued at $800,000. The 7520 rate is 5.2%. The question is, which withdrawal percentage would make the present value of the gift at the end of the annuity term zero? Specialized software does that from any starting value using an iterative process analogous to the procedure used by the MS Excel solver. This process is often called ‘optimization’, but it may not be optimal for the purposes of an individual client.

Running these numbers gives an annual withdrawal rate of $91,281.44 which is 11.41% of the initial trust value. After 12 years the trust is exhausted (according to the tax calculation).

For our example, this means that the $800,000 in assets will generate annuity payments back to the grantor, effectively reducing the taxable gift. Any appreciation above the 5.2% hurdle rate that remains in the GRAT after the term ends will pass to the beneficiaries without incurring additional gift taxes provided the grantor survives the GRAT term.

2025 - An Extinction Event?

While former President Trump has proposed an increasing number of tax cuts that would add $4 trillion to the national debt over 10 years (7), Vice President Harris has not articulated a tax plan as of this writing. However, commentators believe that she may adopt many of the proposals of the Biden Tax Plan (Greenbook) for 2025 (8).

Biden’s Proposed Tax Law Changes for GRATs

Minimum Value Requirement for the Remainder Interest (No Zeroed-Out GRATs:

Proposal: The remainder interest in a GRAT, at the time the interest is created, must have a minimum value for gift tax purposes equal to the greater of 25% of the value of the assets transferred to the GRAT or $500,000 (but not more than the value of the assets transferred).

Effect on Taxpayer: This change would increase the gift tax liability for the grantor, making it more expensive to establish a GRAT. By requiring a significant minimum remainder value, this proposal aims to close the loophole that allows taxpayers to transfer significant wealth with minimal gift tax implications. As a result, taxpayers would no longer be able to zero out the taxable gift, and the use of GRATs would involve a higher upfront tax cost.

Prohibition on Decreasing Annuity Payments:

Proposal: The proposal would prohibit any decrease in the annuity during the GRAT term.

Effect on Taxpayer: This provision would prevent the use of “front-loaded” GRATs, where larger annuity payments are made early in the GRAT term, allowing smaller payments later. This change would force the annuity payments to be more consistent, which could reduce the effectiveness of the GRAT as a wealth transfer tool. Taxpayers might find it harder to remove substantial assets from their estates while ensuring that they receive enough income during the GRAT term.

Prohibition on Grantor’s Acquisition of Trust Assets Without Recognizing Gain or Loss:

Proposal: The proposal would prohibit the grantor from acquiring an asset held in the trust without recognizing gain or loss for income tax purposes.

Effect on Taxpayer: This provision targets the common practice where grantors repurchase appreciated assets from the GRAT without triggering capital gains tax. Under the new rule, any such repurchase would result in the recognition of gain or loss, thereby eliminating the tax-free exchange benefit. This would discourage the repurchase of assets by the grantor and make it less attractive to “reset” the basis of appreciated assets, leading to higher capital gains taxes when the assets are eventually sold or transferred.

Minimum and Maximum Term Requirements:

Proposal: The proposal would require that a GRAT have a minimum term of ten years and a maximum term equal to the annuitant's life expectancy plus ten years.

Effect on Taxpayer: By imposing a minimum term of ten years, this change increases the risk that the grantor could die during the GRAT term, which would bring the GRAT assets back into the grantor’s estate for estate tax purposes. This reduces the likelihood of a successful transfer of wealth out of the estate and discourages the use of short-term GRATs designed to minimize this risk. The maximum term provision ensures that GRATs cannot be extended indefinitely to defer estate taxes, thereby tightening the rules and making GRATs less flexible for long-term planning.

Imposing Downside Risk on GRATs:

Proposal: The overall provisions impose downside risk on the use of GRATs, making them less likely to be used purely for tax avoidance purposes.
Effect on Taxpayer: The combined effect of these provisions is to make GRATs a less attractive option for taxpayers seeking to reduce their estate and gift tax obligations through aggressive tax planning. By introducing minimum gift tax liabilities, increasing the risk of estate inclusion, and eliminating certain tax-free strategies, the proposals would reduce the ability of taxpayers to use GRATs purely as tax avoidance mechanisms, encouraging more cautious and conservative estate planning.

Conclusions

In conclusion, the Zeroed-Out GRAT is on the brink of extinction if Biden’s proposed 2025 tax law changes are implemented, while all GRATs are becoming increasingly endangered. The proposed restrictions—higher gift tax liabilities, reduced flexibility, and greater estate inclusion risks—threaten to diminish the appeal of GRATs as effective estate planning tools.