High Net-Worth Individuals Find Tax Perks In “GRAT Lifestyle”

One well-heeled couple in Florida, who own a private real estate development business, are passing on hundreds of millions in wealth to their two daughters free of gift and estate taxes. Their method: shuffling buildings, stocks, and other investments through more than two dozen short-term trusts. They use grantor-retained annuity trusts, which have three major tax benefits: Grantor Retained Annuity Trusts move assets out of a taxable estate, they don’t trigger any gift taxes for the donor, and they “freeze” the value of contributed assets, making their future appreciation free of the 40% gift tax and estate tax.

By setting up a GRAT so that assets can be swapped in and out, a taxpayer can extract declined stocks and substitute them with stable Treasury bills. The impacted shares are then placed into a new GRAT, restarting the two-to-three-year clock to give them time to bounce back. But even when a GRAT goes “under water” because a battered asset doesn’t bounce back, the grantor comes out ahead if the trust allows asset substitutions, which means GRATs are like a free pull at a slot machine. If the GRAT ‘hits,’ assets are transferred to the beneficiaries free of gift tax. If it doesn’t, the grantor is in the same tax situation as before the GRAT was executed. Advisors see the recent market drop as an attractive opportunity to play those odds and avoid estate taxes. Taxpayers don’t pay that levy until their estates reach just over $24 million for married couples, half that for single persons. The levels are set to revert to half those amounts come 2026.

Once a taxpayer puts stocks, bonds, or stakes in funds or businesses into a GRAT they control, the vehicle pays them a yearly annuity, calculated as slightly more than the contributed property or cash value. At the end of the trust’s life, typically two or three years, whatever is left over goes to the trust’s heirs free of gift tax. The donor, known as the grantor, doesn’t owe gift tax because they retain control of the trust during its lifetime and thus doesn’t owe that levy on transfers to themself. The annual payments back to the grantor have to clear what the IRS calls its 7520 hurdle, which is 3% for May 2022. The trick is to put in an asset whose value is expected to boom, like property or stock in a startup, or has declined but is expected to pop back, like shares in Amazon. This is because it’s easy to outpace the low interest rate hurdle, and the excess gains eventually pass to heirs tax free. When the total payments back to the grantor equal the original value of what was put into the trust — even though that number has subsequently swelled — the vehicle is called a “zeroed-out GRAT.” 

Since its inception in 1990, GRATs have been periodically attacked by Democratic lawmakers as an unfair loophole that allows the ultra-affluent to funnel tax-free wealth to the next generation. President Joe Biden’s federal budget proposal in March revives some of the curbs, including forcing trust owners to pay capital gains tax on unrealized appreciation when the trust goes to beneficiaries and requiring it to hold at least $500,000 or 25% of the value of assets contributed, whichever is greater. That latter amount would be taxable. Biden would also require GRATS to have a minimum life of 10 years and end their tax-free asset swaps. While there would be exceptions for heirs who are spouses, those recipients would owe capital gains tax when they die or sell a GRAT’s assets. Many financial advisors are skeptical that Biden’s proposed curb will win approval.

Though your options are virtually limitless, proper estate planning, deciding on the “who, what, when, and how”, and executing this with the least amount paid in taxes, legal fees and court costs can be a challenging and emotional affair to wrestle with alone. For more information, contact Talley LLP today.