With the seemingly infinite amount of different types of irrevocable trusts, it can be quite confusing to wrap your mind around what they are and what they are used for. Irrevocable trusts are best understood and defined by what goals they can accomplish for your estate planning needs and what risks are involved in the use of such a strategy. One type of trust that is often used to reduce the size of the taxable estate (or “freeze” the estate) is the Grantor Retained Annuity Trust (or “GRAT”). A GRAT has certain risks but can also be an effective way to transfer wealth to your loved ones while avoiding or reducing estate and gift taxes.

With a GRAT, you (the “grantor”) would transfer property to an irrevocable trust in exchange for a stream of payments (an “annuity”) over the course of several years (the “annuity term” or “GRAT term”). The idea is that this transfer is treated as a sale rather than a gift. In order for the IRS to treat the transfer as a sale, and thus not subject to gift taxes, the present value of the stream of annuity payments the grantor is to receive over the course of the GRAT term must be equal to the value of the property transferred to the trust. The present value is calculated by using the rate established by the IRS in section 7520 of the Internal Revenue Code. If the transfer meets these requirements, then the IRS will assume that the trust is going to “zero-out” and that there will be nothing left in the trust at the end of the annuity term.

So why would you even do this? Why would you pay an attorney to set up a trust for you to transfer property to that you are just going to get back over the course of the next ten years or so? The idea is that you transfer high-growth assets to the trust; assets you believe will appreciate much more than the 7520 rate. Then, at the end of the GRAT term, the property left in the trust is distributed to beneficiaries you named in the trust when you set it up. Because the 7520 rate is often quite low (currently 1% in January 2013), there is a good chance this is possible.

A GRAT can go a long way to transfer a significant amount of value out of your estate, however, a GRAT is not for everybody and there are risks you should be aware of. GRATs only work if the assets transferred into the trust grow at a rate higher than the section 7520 rate. If they do not, then the trust will zero out in reality and you will not have transferred anything to the remainder beneficiaries. You will be out the costs of setting up and administering the trust. Also, if you die before the GRAT term ends, the entire value of the trust is included back into your estate. Again, you will be out the costs of setting up and administering the trust. You can mitigate this risk by establishing a series of short-term rolling GRATs. The downside of using rolling GRATs is that you risk having the section 7520 rate increase rather than locking in a low rate with one long term GRAT.

Before you decide whether or not to establish a GRAT, you should consult with an experienced estate planning attorney to help you weigh the costs, risks, and benefits of a GRAT.

For additional reading:

A Grantor Retained Unitrust (GRUT)

Irrevocable Life Insurance Trusts

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