Reflections

Guide to GRATs: Estate Planning for Business Owners

By Sean Condon, CFP®

Preparing for a liquidity event? These estate planning strategies can provide large reductions in taxes

How you plan your estate can have a significant impact on how much your family must pay in taxes. This is especially true if you have substantial assets that may be subject to estate taxes, or own assets that you expect to appreciate substantially.

A Grantor Retained Annuity Trust, or GRAT, is an appealing option for passing down assets to the next generation, especially in today’s low-interest rate environment.  It can allow business owners to retain control, receive cash flow, minimize estate tax and preserve family history.  Here’s a guide to how it works.

Basics of a GRAT

A GRAT allows you to freeze the value of an asset for tax purposes and receive an annuity payment in return.

Currently, estates above $11.58 million held by an individual ($23.26 million for a married couple) are subject to federal estate tax.  These limits will expire in 2026 down to approximately half of current levels.  At a hefty Federal tax rate of 40%, and many states adding additional state tax, a substantial portion of a wealthy family’s assets are likely to go toward taxes rather than to their heirs.  Most of the future appreciation of an asset in a GRAT escapes the estate tax and gift tax.

Here is how a GRAT mitigates these taxes:

  • You, as the grantor, deposit assets you expect will appreciate to an irrevocable trust.
  • The principal you give to the trust, plus interest, must be returned to you over a set period.
  • To accomplish this, you receive annuity payments drawn from the trust assets each year.The payments are determined by the current Section 7520 rate, a figure set by the IRS, which is currently hitting all-time lows, at 0.6% as of the time of this writing.1
  • At the end of the set term, any growth in assets above the returned principal and interest is transferred to your beneficiary outside of your estate, avoiding estate taxes.

Assets with a low current valuation compared to their expected future value (such as stock in a privately held firm) are particularly well suited to putting into a GRAT.  This is because assets with the potential for great appreciation also have the potential for triggering large estate tax liabilities, and a GRAT allows you to bypass these future taxes.

The currently low interest rates make a GRAT especially appealing right now, as it creates a smaller payment requirement and therefore leaves more of your appreciated assets to pass estate-tax free to your heirs.¹

Source: Kitces.com

¹ https://www.irs.gov/businesses/small-businesses-self-employed/section-7520-interest-rates

GRAT Risks and Potential Downsides

A GRAT is only a smart option if you have enough assets to achieve your desired lifestyle beyond what is given to the trust.  As an irrevocable gift, you cannot get a “do over” and take the assets back for personal use as needed.

The largest uncontrollable risk in GRAT planning is life expectancy.  If you die before the trust’s term expires, your assets in the trust will be included in your estate and pass to your heirs without any additional tax benefit.  This would make the entire strategy ineffective.  It therefore requires a strategic balance between keeping a GRAT term short, versus keeping it longer so your assets have more time to grow and maximize the benefit.

Intentionally Defective Grantor Trust (IDGT) Alternative

One way to get around the life expectancy risk of a GRAT is to utilize an Intentionally Defective Grantor Trust (IDGT)as an alternative.  Just like in GRAT planning, you place an asset into an irrevocable trust, which is then removed from your taxable estate.  However, with an IDGT, you sell your asset to your trust, in exchange for a promissory note from the trust that agrees to make interest-only payments for a defined period.  Because a promissory note is more flexible than a fixed annuity payment (as required by a GRAT), this strategy can offer several benefits:

  • If you die before the trust expires, the assets remain outside of your estate and the strategy continues to meet its tax-savings goal.
  • The repayment of the principal asset can be deferred and paid over a longer period.This means you can wait to have the trust pay you back until there is a liquidity event creating adequate cash flow.

For the sale of your ownership stake to an IDGT trust to be legitimate, the trust must already have some liquid assets.  Therefore, it is common practice to “seed” at least 10% of the expected purchase price into the IDGT as a separate gift before the sale transaction occurs. This “seeding” is subject to gift tax.

The “intentionally defective” part of the trust’s name comes because it was created by an attorney with a design “defect” that ensures the trust grantor continues to pay taxes on the income generated by assets in the trust.  This defect is a good thing, because when the grantor pays the trust’s income taxes: 1.) the trust is growing tax free for the beneficiaries; and 2.) the dollars used to pay taxes will be removed from your taxable estate.

Exploring Your Estate Planning Options

Creating your estate plan is a deeply personal and complex decision.  Along with our network of qualified attorneys, we can explore the benefits of a GRAT or IDGT or the many other trust options to determine the best option for your family.  We are available to answer your questions, and we would enjoy the opportunity to see if we are a good fit for helping you reach your financial goals.  You can reach us by calling (844) 377-4963 or emailing windgate@windgatewealth.com. You can also book an appointment online here.

Perritt Capital Management, Inc. is the Registered Investment Advisor for Windgate Wealth Management accounts and does not provide tax advice. Consult your professional tax advisor for questions concerning your personal tax or financial situation.

Windgate Wealth is not responsible for, and expressly disclaims all liability for reliance on any information contained in these third-party sites.  No guarantee that information provided in these sites is correct, complete, and up to date.

Data here is obtained from what are considered reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed.

First published September 2020.

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