Tax Strategies for Grantor Retained Annuity Trusts (GRATs)

A GRAT, or Grantor Retained Annuity Trust, is a useful tax strategy if you want to transfer money to a family member without being subject to the gift tax.

After a taxpayer has given away $1 million in excess of the annual gift limits (currently $13,000 to any number of people) he or she will have to start paying income taxes on additional large gifts. Therefore, simply transferring one’s wealth to family members in order to avoid the estate tax is not, on its own, a very viable tax strategy. (Though the estate tax is repealed for the 2010 tax year, it will return in 2011 with rates and rules identical to 2001.)

An alternative tax strategy is to set up a GRAT, a trust fund started by an initial donation. This trust is an annuity, meaning that the donor receives an annual payment from the fund until the annuity expires. At that point, anything remaining in the fund is transferred to a designated recipient. This recipient must be a family member of the donor. If the donor expires before the term does, the beneficiary of this tax strategy receives what is left in the trust.

If you set up a GRAT with your financial planner, you will calculate not only the value of the initial contribution, but the interest that the principal will earn, with the annuity payments taken out. On paper, since the GRAT is supposed to pay itself out over its term, these payments should add up to the principal plus interest, giving the GRAT a value of zero for tax purposes. Herein lies the popularity of this tax strategy: if assets which are expected to appreciate at a high rate are used to fund the GRAT, its value will not, in fact, be zero, but potentially much larger. After the scheduled annuities, which do not exhaust the GRAT’s actual value, have been paid back to the donor, the remaining amount will go to the beneficiary with no gift tax strings attached, which many high net worth individuals have found to be a useful tax strategy.

The Small Business Lending Fund Act of 2010, passed by the House of Representatives and currently being considered by the Senate, aims to crack down on this tax strategy by re-attaching the gift tax to the GRAT as well as requiring a minimum 10-year term for the life of the fund. Individuals hoping to gift some of their wealth to family members may want to take advantage of the GRAT tax strategy, while it is still advantageous to do so.

---