A GRAT is an irrevocable trust with a specific term used to achieve the goal of transferring future appreciation of an asset to family members while incurring little or no gift tax. GRATs must satisfy certain requirements under the Internal Revenue Code. To establish a GRAT the Grantor identifies property he or she believes will appreciate significantly over time, such as stock, or closely held business interests (including S Corporations). The Grantor transfers this property into the trust, which is set up as an annuity, but retains the right to receive payments, at least annually, for a fixed term of years (i.e. 2 years or longer). The annual payments that the grantor will receive are generally calculated so that in their entirety they are equal to the fair market value of the asset(s) originally transferred into the GRAT plus interest at a prescribed interest rate set by the IRS (the prescribed IRS interest rate changes monthly). The prescribed IRS interest rate for September 2011 is 2% per year.
By calculating the payments in this manner, the annuity payments of the GRAT term will equal or almost equal the value of the property originally contributed to the GRAT (called “zeroing out”). Since the IRS focuses on the prescribed interest rate, not the actual interest rate, the assets in the GRAT that grow at an interest rate that surpasses the prescribed IRS interest rate can be passed on to trust beneficiaries tax-free at the end of the GRAT term.
Although the assets pass to beneficiaries tax free, setting up a GRAT can trigger a tax. If the calculation results in additional assets left over at the end of the GRAT term, the transfer of those assets is a taxable event.
Generally, GRATs are a wealth transfer tool to be used in a low interest rate environment because the lower interest rate increases the chance that the gift will be larger. Please note that this is a very simplified explanation of a complicated topic. GRAT planning is particularly complex and there are certain risk factors, including tax law risks, valuation risks, and the possibility that the grantor might die during the term of the trust, that must be reviewed and analyzed in each individual case.