Wealth Insights

Tax Benefits of Passing Down Assets with GRAT

How do long-time business owners pass the fruits of their labor to younger generations without triggering substantial gift taxes? 

One technique worth considering — especially for those not ready to hand over the reins completely — is establishing a grantor retained annuity trust (GRAT). A GRAT is a commonly used estate planning strategy that allows you to essentially freeze the value of your business assets by transferring future appreciation to descendants with minimal gift tax consequences. It can be a particularly useful strategy if you expect the value of your business to grow, such as through higher revenues or a sale.

The Basics

How it works: You make a one-time transfer of assets, such as company stock, into a GRAT, which carries a term of two or more years. In return, the GRAT pays you an annuity based on a rate chosen by you and your financial advisor. It can be a fixed annual percentage of the initial contribution or a fixed dollar amount that increases at regular intervals. The GRAT is irrevocable, meaning you cannot change the conditions or funding amount once it is established.

You are subject to gift taxes on the difference between the present value of the annuity payments and the value of the initial transfer of the business interests (or other assets). But GRATs are often designed so that the annuity pays back all of the contributed assets plus a small amount of interest.

That means the GRAT is “zeroed out,” and you will owe no gift tax on the amount transferred to family members or other descendants. As long as the assets grow beyond the IRS’s Section 7520 “hurdle” rate — which for 2018 is 2.8% — the appreciation passes to your heirs tax-free, either directly at the end of the term or through another trust. But if you die before the expiration of the GRAT term, the assets are returned to your estate and treated like any other assets subject to estate tax.

These rules can make it attractive for business owners to use shorter-term GRATs, in order to minimize risk of the grantor’s death and capture the greatest period of the business’s appreciation. An alternative is using “cascading GRATs,” or consecutive short-term GRATs, which allow you to continually reap the GRAT benefits with lesser risk.

The Opportunity

Today’s economic climate may be ideal for establishing GRATs. The ultra-low IRS hurdle rate allows business owners to transfer more of their assets to descendants. Moreover, possible changes to gift and estate tax rules and exemptions could make GRATs less effective in the future.

Owners who expect their business will recover nicely as the economy recovers, or are planning to sell or go public at a generous profit, could capture that appreciation within the GRAT so they can avoid owing gift taxes on the transfer to descendants.

Considerations

Not every business owner will benefit from a GRAT, of course, and other estate-planning techniques for reducing estate tax obligations may be better suited to you depending on your long-term goals. If the assets inside the GRAT do not appreciate, they will revert back to you with no estate-planning benefit reaped. That’s not a huge risk beyond the time and money spent establishing the GRAT.

It’s in your best interest, however, to make sure you’re establishing a GRAT at the right time and that it aligns with your total wealth management strategy.

Consult an investment, legal or tax professional as to how this information applies to your specific legal, financial or tax situation.