The Use of a GRAT (Grantor Retained Annuity Trust)

A GRAT (grantor retained annuity trust) is a technique for transferring property to members of the grantor’s family at a reduced transfer tax cost. A grantor creates a GRAT by transferring property to a trust and retaining a “qualified annuity interest” in the property. The trust lasts for a specified period of time that the grantor is expected to outlive(the trust “term”). At the end of the specified term, the trust property passes to the trust’s remainder beneficiaries (members of the grantor’s family).

GRATs take advantage of special IRS valuation rules which make tax savings possible. The grantor is treated as having made a gift of a remainder interest in the property, the value of which is determined under these special IRS valuation tables. For tax purposes the value of the interest passing to the grantor’s family (the gift) is less than the total value of the property at the time the trust is created because the value of the gift is deemed to be (1) the value of the property (2) as reduced by the value of the interest retained by the grantor. The grantor’s Applicable Credit against gift and estate taxes (currently $675,000, and increasing in phases to $1,000,000 in the year 2006) can be applied to the reduced gift to avoid or minimize the payment of gift tax on the transfer to the trust. If the trust does not qualify as a GRAT, the special valuation rules would not apply and,as a result, the value of the retained interest would be deemed to be zero, meaning that the grantor would have to pay gift tax (or apply his Applicable Credit) the entire value of the trust property at the time he created the trust.

When the grantor’s retained interest terminates, the property remaining in the trust passes to the grantor’s beneficiaries free of a gift tax, even if it has appreciated in value since the trust was created. If the grantor survives the trust term, the trust property won’t be includable in his estate for estate tax purposes when he dies because he will no longer have any interest in the property. If the grantor dies during the term, part or all of the trust property will be includable in his gross estate. But, he won’t be any worse off than he would have been if he hadn’t created the trust in the first place.