If you expect to use your entire lifetime exemption (i.e., you think your estate will one day surpass ~$11.7M), you have a tax incentive to move assets outside of your estate earlier in your lifetime. One leading technique for transferring such assets without using up your lifetime exemption is to leverage a Grantor-Retained Annuity Trust (GRAT).
GRATs are particularly helpful for holders of quickly appreciating stock (e.g., shares of a startup) who want to transfer assets to the next generation with little-to-no gift or estate tax consequences.
A GRAT is created when the trust creator (known as the “grantor”) contributes assets to a fixed-term, irrevocable trust while retaining the right to an annuity income stream back from the trust over the stated term. The growth of the asset occurs therefore outside of the grantor’s estate. At the end of the term, any remaining assets (i.e., the trust’s growth) are distributed to non-charitable beneficiaries known as the “remainder beneficiaries.” Very commonly these remainder beneficiaries will be the grantor’s children, effectively avoiding gift taxes on the GRAT’s sum.
Typically, GRATs are structured in such a way that the value of the annuity stream during the term equals the value of the property used to initially fund the GRAT, a structure known as a “zeroed-out GRAT.”
With a zeroed-out GRAT, since the grantor retains an annuity that is equal to what they contributed to the GRAT, the IRS deems the gift to have been of zero-value (and therefore does not count it against the lifetime exemption from federal gift tax). If there are any assets remaining in the GRAT after the final annuity payment is made (and there should be if the GRAT’s investments make any money), those assets can pass to the remainder beneficiaries free from gift tax.
To avoid gift taxes, the GRAT must pay an annuity back to its grantor according to an interest rate called the “IRS section 7520 rate.” If the assets in the GRAT grow faster than the IRS hurdle rate, the excess can be transferred free of federal gift tax. If the GRAT assets do not appreciate more than the prescribed hurdle rate ( meaning the GRAT “fails”), the GRAT will be unable to transfer funds to its beneficiaries. In this case, the grantor simply takes back all the assets in the GRAT (through the annuity payments) and has lost the legal fees and costs for setting up and administering the trust. Since the low interest environment after the 2008 financial crisis, the IRS hurdle rate has been between 1% and 4%.
If you own pre-IPO shares of a company that is going to have a public listing, they will likely appreciate far in excess of the hurdle rate, making a GRAT a very effective means to transfer assets without incurring gift tax.
More broadly, if you have any assets raising your net worth above the lifetime exemption that are growing faster than the hurdle rate, you may want to explore a GRAT. Remember, however, that moving assets into an irrevocable trust is a permanent decision that has many consequences.