GRATs Under IRS Scrutiny: Planning Opportunities and Potential Risks

Understanding how grantor-retained annuity trusts can support wealth transfer strategies and the key considerations for high-net worth individuals

For high-net-worth individuals looking to transfer wealth to the next generation, a grantor-retained annuity trust (GRAT) can be a valuable estate planning tool. When structured appropriately, a GRAT may allow future appreciation on certain assets to pass to beneficiaries with limited gift and estate tax consequences.

GRATs require sophisticated planning, and their effectiveness depends on careful administration to meet tax objectives while following applicable rules and guidance. When GRATs are not properly administered, they may be subject to IRS scrutiny.

What is a GRAT?

A GRAT is an irrevocable trust designed to transfer appreciating assets to beneficiaries while the individual who established the trust, known as the grantor, retains the right to receive annuity payments for a specified period. At the end of the term, any assets remaining after required annuity payments pass to the designated beneficiaries.

For gift tax purposes, the value of the gift is generally based on the value of the assets contributed to the GRAT, reduced by the present value of the grantor’s retained annuity interest. The calculation of present value is based on an interest rate established by the IRS under Section 7520 of the Internal Revenue Code.

If the assets in the GRAT appreciate at a rate greater than the Section 7520 rate, excess appreciation may ultimately pass to beneficiaries without using additional gift tax exemption. This potential for tax-efficient intergenerational wealth transfers make GRATs particularly relevant when an individual holds assets that are expected to appreciate after the initial funding of the trust.

Why are GRATs used in wealth transfer planning?

GRATs can provide an opportunity to transfer future asset appreciation while minimizing the taxable value of the initial gift.

In some cases, the annuity payments can be structured so that the actuarial present value is approximately equal to the value of the property initially contributed to the trust. This is commonly referred to as a “zeroed-out” GRAT because the resulting taxable gift is minimal.

Since the appreciation of the assets held by the GRAT in excess of the defined Section 7520 rate pass to named beneficiaries, assets with significant appreciation potential may be ideal choices for funding a GRAT.

If the assets in the GRAT do not outperform the applicable rate, there is no property remaining to transfer to beneficiaries at the end of the GRAT term. In these cases, the grantor simply receives the property back through the required annuity payments over the term of the trust.

What should individuals consider before establishing a GRAT?

Although the basic concept of a GRAT is relatively straightforward, executing the strategy can be complex. Several factors can affect whether a GRAT accomplishes its intended objectives.

• Asset valuation: Accurate valuation is critical, particularly for closely held business and other assets without readily available market values
• Expected appreciation: Assets with greater potential to outperform the Section 7520 rate may provide greater wealth transfer opportunities.
• Length of the GRAT term: The appropriate term depends on the assets involved and the grantor’s planning objectives.
• Mortality risk: If the grantor dies during the GRAT term, trust assets may be includable in the grantor’s taxable estate, which can negate the gift/estate tax benefits.
• Administration and documentation: Required annuity payments, proper documentation, and ongoing administration are important to maintain the intended tax treatment.

Recent IRS scrutiny highlights the importance of careful planning

GRATs have historically been the subject of legislative discussions when estate and gift tax reforms are considered. The Treasury Department and the IRS have scrutinized certain uses of GRATs and the significant transfer tax benefits they provide. The Biden administration proposed changes that would have limited some of those benefits, including requiring a minimum 10-year GRAT term and a minimum taxable remainder interest. Those changes ultimately were not enacted in legislative changes, but they may provide a barometer for potential direction of future legislation.

More recently, GRATs have received attention because of an ongoing U.S. Tax Court dispute involving Chuck and Trisha Elcan. The IRS is challenging aspects of GRAT transactions involving publicly traded stock and promissory notes. In this case, promissory notes were exchanged for stock held by the trust, and the promissory notes were forgiven to satisfy the annual annuity payment back to the grantor. The case remains pending, but the additional attention on GRATs highlights a clear message from the IRS – proper administration of GRAT strategies is critical.

Incorporating GRATs into a broader estate plan

A GRAT should not be considered an estate plan in isolation. For high-net-worth individuals and families, it is one of several strategies that may be available for transferring wealth, managing potential estate and gift tax exposure, and accomplishing long-term family objectives.

Whether a GRAT is appropriate depends on factors such as the composition of an individual’s assets, expected appreciation, available gift and estate tax exemption, cash flow needs, and broader estate planning goals.

GRATs can be a great educational tool for teaching the next generation about overlapping income/estate tax objectives while also giving them a slice of family wealth if assets in the trust appreciate substantially.

Because GRATs involve overlapping tax, estate planning, and potentially valuation considerations, coordination among advisers is important. Reviewing the strategy before assets are transferred can help identify valuation concerns, administrative requirements, and other issues that could affect the intended tax treatment.

Keiter’s tax professionals can help you evaluate wealth transfer strategies and help determine how a GRAT may fit into your broader tax and estate plan.