GRATs: The long and short of it

The grantor retained annuity trust (GRAT) can be a powerful estate planning tool. But the appropriate length of a GRAT’s term is at times a source of confusion among people planning their estates and a subject of debate among experts.

The issue, as with many financial strategies, boils down to economics: Which type of GRAT — long-term or short-term — is more likely to produce the greatest tax-free transfer of wealth to your family?

How GRATs reduce taxes

A GRAT is an irrevocable trust that you fund with a one-time contribution of assets. The trust pays you an annuity for a specified term of years, after which any remaining assets are transferred tax free to your children or other beneficiaries.

The annuity is either a fixed dollar amount or a fixed percentage of the initial contribution’s value. You can also design a GRAT with increasing annuity payments — a back-loaded GRAT. Bear in mind that the scheduled annuity amounts aren’t permitted to increase more than 20% from the prior year.

When you establish a GRAT, your initial contribution is subject to gift tax based on the present value of your beneficiaries’ remainder interest in the trust. If you set the annuity payments high enough, you can reduce the value of the remainder interest to zero — a “zeroed out” GRAT.

To determine the present value of the remainder interest, the Section 7520 rate — a conservative rate published monthly by the IRS — is applied. The Sec. 7520 rate is merely an assumed rate of return, however — so, to the extent the trust’s growth outperforms that rate, the excess passes to your trust beneficiaries gift-tax free.

It’s important to bear in mind mortality risk. GRATs work only if you survive the trust term. If you don’t, the GRAT assets will be included in your taxable estate.

Short-term isn’t short on advantages

It’s unusual to set up just one short-term GRAT. The typical strategy is to set up rolling GRATs — a series of short-term GRATs (typically one or two years) in which each new GRAT is funded with annuity payments from the previous ones.

Short-term GRATs have several advantages, such as:

• Minimizing mortality risk, because the shorter the trust term, the more likely it is you’ll survive it,

• Allowing you to transfer wealth to your beneficiaries more quickly,

• Providing you with greater control over the amount of wealth you transfer,

• Allowing you to lock in a two-year bull market gain, and

• Typically performing better than long-term GRATs, particularly in volatile markets.

The last advantage listed is probably the most significant one. Suppose you establish a 10-year GRAT when the applicable Sec. 7520 rate is 5%. If the trust’s growth rate averages 5% or less during the 10-year term, the GRAT will fail — that is, it will not generate any tax savings.

If, instead, you use a series of rolling two-year GRATs, all it will take is one GRAT outperforming the Sec. 7520 rate for your strategy to be a success. Suppose that in Year 5 you establish a two-year GRAT in a month when the Sec. 7520 rate has dropped to 4%. If that GRAT achieves a 7% return, you’ll transfer a significant amount of wealth tax free, even if all of your other short-term GRATs fail.

Long-term is long on benefits

Long-term GRATs also have several important advantages, including:

• Allowing you to lock in a favorable Sec. 7520 rate when interest rates are low,

• Taking advantage of back-loaded annuity payments, which can boost their performance over time, and

• Generally, benefiting more effectively from valuation discounts than short-term GRATs. (See “The power of valuation discounts”.)

Long-term GRATs might also have an advantage in the event Congress takes action to reduce or completely eliminate the benefit of this planning strategy. If that happens, it’s likely that existing GRATs would be grandfathered in, but new ones would be disallowed.

Consider the economics

To decide between long-term and short-term GRATs, look at the relative likelihood that they’ll achieve your objective of transferring wealth to your beneficiaries tax free. To do that, consider a variety of factors, including the current Sec. 7520 rate, your age and health, the nature and projected performance of the assets you plan to contribute, the availability of valuation discounts, and your risk tolerance. Your estate planning advisor can use financial modeling techniques to help you determine the best strategy. •