GRAT: Estate plan gift gambling
A GRAT is a financial instrument for leaving a substantial gift to a beneficiary without paying any gift tax. “GRAT” stands for Grantor Retained Annuity Trust. It essential gambles against the IRS predictions of the economy, with the winnings going to your beneficiaries.
What exactly do you mean, “gamble”?
I mean exactly that. But before we explain that, we need to look at how a GRAT is created:
An irrevocable trust is formed and funded with assets (seed money) that are expected to appreciate in value. The trust is formed during the life of the Grantor.
For a set period of years, often two or five (the “annuity period”), the Grantor receives an annuity from the trust. An annuity is a fixed sum of money paid to the Grantor every year of the annuity period. The annuity paid is calculated to pay the entirety of the seed money back to the Grantor, plus an amount determined by the IRS. This amount is based on the Section 7520 rate, which is calculated every month by the IRS.
During this time, the seed money appreciates in value. The goal is that the GRAT earns more than the 7520 rate that was set when it was formed.
At the end of the two to five year annuity period, two things happen. First, the entire amount of the GRAT plus the IRS determined amount is paid back to the Grantor. Second, the beneficiaries receive whatever is left in the GRAT that wasn't paid to the Grantor.
Clear as mud? Let's look at an example of a GRAT
Joseph wants to give a gift to his grandchildren.
He forms a GRAT with $2 million that will last for five years with the grandchildren as the Remainder Beneficiaries.
When he forms the GRAT, the 7520 rate determines that at the end of the five years the trust should be worth at least $2.25 million.
Therefore, an annuity of $450,000 is to be paid to him every year for the five years of the annuity period.
Joseph, of course, believes that he can invest the money in the stock market and do better than a $250,000 return at the end of five years.
Joseph gets to investing and the GRAT starts earning money. By the end of five years, the GRAT earns $1 million, making the total trust value $3 million before payouts to Joseph. Of that $3 million, $2.25 million was paid to Joseph in annuity ($2 million seed money, $250,000 in investment return).
The remaining $750,000 is gifted to Joseph's grandchildren.
Why would anyone want a GRAT?
The reason to do a GRAT is that the amount that passes to the Remainder Beneficiaries above the 7520 rate is tax free. It does not trigger the gift tax. If you die during the annuity period, however, the amount in the GRAT is part of your estate. The gamble is that the GRAT will out earn the 7520 rate. If it doesn't, then your beneficiaries do not receive the tax free gift. It's a gamble, but if topping out the gift tax is an issue for you, it may be a gamble well worth it.
Notably, the GRAT is currently at marked lows. In June 2020 the 7520 rate is only 0.6. This is due to the decline in the stock market. As comparison, in 2018 the 7520 rate only once dropped below 2.0, and for four months was 3.0 or higher. In the year 2000, the 7520 rate never dropped below 7.0%
If you believe that the stock market will recover in the next five years, now may be a fantastic time to set up a GRAT.
Takeaway
GRATs are a financial instrument that allows you to take a gamble with gift giving. If you win the bet that you can outperform against the IRS, then you can get substantial gift tax savings. If you have questions about GRATs and whether they may be right for you, contact Signature Law for a free consultation.