Silicon Valley Estate Planning Attorney Answers, “How Does a Grantor Retained Annuity Trust Work?”

When you create an estate plan, you might wonder how to avoid or reduce gift and estate taxes when your beneficiaries receive your assets. An irrevocable trust is an excellent option to accomplish this goal. More specifically, a Grantor Retained Annuity Trust (GRAT) could minimize estate and gift tax liability.

What Is a GRAT?

A Grantor Retained Annuity Trust is a type of irrevocable trust. The person who creates it is called the grantor. A grantor can transfer specified assets into a temporary trust to freeze the value of those assets (for tax purposes). This removes additional appreciation from the estate and allows heirs to receive the assets with minimal gift or estate tax liability.

The grantor receives an annuity throughout the term of the GRAT, so the assets transferred into a trust can be considered returned and avoid triggering a gift tax. Leftover assets, including any asset growth, pass down to named beneficiaries, mitigating the effects of estate taxes moving forward.

How a Grantor Retained Annuity Trust Works

Below is a breakdown of strategies used while creating and managing a GRAT:

• The grantor transfers assets with a potential for a high appreciation into an irrevocable trust and sets the term period.
• The value of a GRAT splits into an annuity stream and remainder interest, for purposes of taxation. Typically, the value of the annuity stream and the value of assets moved to the GRAT are equal. This equates to the GRAT being zeroed out (also known as a “Walton GRAT”).
• The GRAT pays annuities to the grantor at an expected minimum return based on the interest rates established by the Internal Revenue Service. If the grantor doesn’t receive annuity payments at the minimum rate, the trust can use principal to cover those payments, returning the assets held in trust back to the grantor.
• Suppose the GRAT returns don’t exceed the minimum interest rate during the trust term and the final annuity payment has been made. In that case, accumulated asset growth and any remaining assets transfer directly to the named beneficiaries as a tax-free gift.

What You Should Know About a GRAT

Although setting up a Grantor Retained Annuity Trust provides various tax benefits, it can create problems if not handled properly. If the grantor passes away before the term of the GRAT ends, any trust assets in the trust account would transfer back to the estate and be considered taxable.

Many people don’t realize this risk while creating a GRAT and might choose a longer period for the term. If you want to reduce the risk of mortality hindering this portion of your estate plan, choosing a short term, such as two or three years for your GRAT, would be beneficial.

You could even use a rolling strategy for annuity payments from one GRAT to transfer to a new one after specific periods. The assets in the active account are the only ones to move back to the estate if the grantor unexpectedly dies.

If you’re interested in exploring your options for setting up a Grantor Retained Annuity Trust, contact our law firm at 408-889-1290 to schedule an appointment with a Silicon Valley estate planning attorney. Our attorneys can provide you with the legal guidance necessary to create all aspects of an estate plan that work best for your circumstances.