The Grantor Retained Annuity Trust (GRAT)

This is an irrevocable Trust, good for shifting some of the value of an asset out of the estate. The Grantor places assets in Trust for the ultimate benefit of the children (i.e., they have a remainder interest), but retains the right to an annual pay out for a period of years.

Example: Grantor creates a GRAT and transfers $300,000 in mutual fund shares into it. The Trust provides that the Grantor will get a $6,000 annual pay out for 15 years, after which the Trustee will make a complete and final distribution of the shares to the Grantor’s children.

At this point, there has been a taxable gift-but not of the full $300,000, because there are “strings” attached. After all, the money is not available to the children for 15 years. This is how tax savings are possible. At the end of 15 years-if the Grantor is still alive-the value of the mutual fund shares, including any price increase, will have been removed from Grantor’s estate and will not be subject to tax upon his death. The GRAT is also a good way for the owner of a growing, closely held business to retain an income for himself, while passing the business along to his heirs before any more (taxable) growth occurs.

By accepting some gift tax liability at the time the GRAT was set up, the Grantor has reduced his estate tax liability later, and the heirs end up with more. If the grantor dies within the term of the Trust, all property is included in the estate, and there are no tax consequences-just as if nothing had been done.

The key to the GRAT technique (and the Charitable Remainder Trust) is the relative values given the two interests involved: The gift of the remainder interest in the Trust principal, and the value of what the Grantor has retained-the present right to collect a certain cash pay out from the Trust each year for “X” years. There is a financial calculation that depends on the current interest rate published by IRS, the number of years during which Grantor will take the Trust payout, and the amount of the payout. The greater the annual pay out, and the number of years of payments, the greater will be the value the Grantor has retained for himself, and the smaller will be the value the IRS gives to what is left over, which is the taxable gift. (In the CRT, of course, “what is left over” goes to charity, so there is no taxable gift. This value will therefore be the amount of the donation and current income tax deduction.)