Living (Revocable) Trusts
Estate Taxation - Federal & Vermont
Estate Planning for IRA's/Pensions
Life Insurance Trusts
Grantor Trusts (GRATS & GRUTS)
Qualified Personal Residence Trusts
Charitable Trusts (CRATS & CRUTS)
Special Needs Trusts
GRANTOR TRUSTS (GRATS & GRUTS)
What are GRATS and GRUTS?
"GRAT" is an acronym standing for "grantor retained annuity trust." "GRUT" stands for "grantor retained unitrust." These types of trusts, specifically authorized by the Internal Revenue Code, are created by an individual (the "grantor"). The trustee can be the grantor or some other individual or institution. The trust is funded with assets that generate income -- such as real estate, cash, stocks, bonds, etc. In each case, the grantor retains the right to receive payments from the trust for a term of years or for the grantor's life. In order to qualify as a GRAT or GRUT under current tax laws, the trust must be irrevocable. When the trust ends, the assets pass to someone other than the grantor - usually the grantor's family members (i.e., his or her heirs).
A GRAT pays a fixed amount to the grantor. Payments must be made once a year, or more frequently, and are not dependent on the actual income earned by the trust. The payment must be equal to or greater than 5% of the assets contributed to the trust. The failure to make the required payment to the grantor results in disqualification of the trust as a GRAT. Once the GRAT is created and funded, no additional assets may be added to the trust.
A GRUT is a little different. This type of trust pays a fixed percentage (a minimum of 5% or more) of the trust assets to the grantor each year. If the assets appreciate, the required payment increases; if they depreciate, the payment goes down. The trust assets are revalued once a year in order to determine the correct amount of the payment. Like a GRAT, the failure to make the required payment to the grantor results in disqualification. Unlike a GRAT, the grantor can contribute additional property after the initial creation and funding of the trust.
(For a special type of grantor trust which involves the gift of a residence, visit the Qualified Personal Residence Trusts webpage.)
Why Create a Grantor Trust?
GRATS and GRUTS are generally used as gift and estate (transfer tax) planning tools. To understand the purpose of these trusts, it is therefore necessary to understand how they are taxed.
When a grantor trust is created, the grantor has essentially split the trust into two pieces: (1) the income stream (the "annuity") retained by the grantor and (2) the trust assets remaining when the trust term ends (called the "remainder"). Since the trust is irrevocable, the grantor has made a gift of the remainder which is subject to all of the usual tax rules governing gifts (see the Lifetime Gifts webpage). A gift tax return must be filed and, for most trusts, any resulting gift tax will be offset by the grantor's unified credit (currently sufficient to shield gifts up to $5,250,000) (2013). However, since the recipient of the gift must wait until the end of the trust term to receive the remainder, the value of the remainder is less than the value of the trust property -- for the same reason that a dollar is worth more today than it is ten years from now. Subject to some important exceptions discussed below, when the recipient eventually receives the remainder, there are no additional gift or estate taxes, even if the trust property has appreciated. In essence, a GRAT or GRUT will freeze the value of the trust property for transfer tax purposes on the date the trust is created.
If you have property which is expected to appreciate rapidly, and if your estate is large enough to be subject to estate taxation, a GRAT or GRUT can result in significant transfer tax savings. First, the present value of the gift (the remainder) can be significantly lower than the value of the property in the trust. The value of the remainder depends on a number of factors, including the length of the trust term, the amount or percentage of the payout, and current interest rates. Generally, a longer trust term and/or higher payout will result in a smaller remainder.
Second, if the trust property appreciates at a rate which is higher than the payout rate, the excess appreciation will pass to the beneficiary of the remainder free of tax.
An example illustrates the tax advantages of a grantor trust. Assume that a grantor establishes a GRAT in June of 2019. He has used none of his unified credit, and therefore can shield gifts of up to $11,400,000. He contributes $500,000 to the trust, and retains the right to receive $30,000 annually from the trust for a period of fifteen years (a 6% GRAT). When the trust terms ends, his children receive the remaining trust assets. The property appreciates at a 10% annual rate.
Assuming the grantor survives the term of the trust, the transfer tax results are as follows:
Value of gift made to children: $245,978
Value of trust assets after fifteen years: $1,135,449
Payments to the grantor: $450,000
Estate/gift tax due at trust termination: $0
As you can see, the grantor has transferred an asset which will eventually exceed $1 million in value, but has only made a gift of $245,978 for gift tax purposes (which would be shielded by the grantor's unified credit). After fifteen years, the children will receive the entire remainder free of further transfer taxes. In addition, the grantor will have received 15 payments of $30,000 ($450,000) total.
Disadvantages of GRATS and GRUTS
As the saying goes, there are no free rides. GRATS and GRUTS have some disadvantages which should be considered before they become part of your estate plan.
The major disadvantage with these types of grantor trusts is that they must be irrevocable in order to achieve the tax benefits described above. Irrevocable transfers should be approached cautiously -- if there is any possibility that the asset might be needed for the grantor's welfare, other estate planning options should be considered. Remember also that, with a GRAT, you cannot add assets to the trust (you can with a GRUT, but you are required to revalue the trust assets annually).
If the grantor dies prior to the end of the trust term (or if the trust is designed to last for the grantor's life), then the trust assets are included in the grantor's estate for estate tax purposes. This means that the major tax benefit -- avoiding transfer tax on the appreciation of the assets -- will be lost. However, if the grantor fails to survive the trust term, he or she is no worse off than if the transferred assets were simply retained (except for the costs of creating and administering the trust).
Transfers to a GRAT or GRUT do not qualify for the annual gift tax exclusion because such transfers are not considered "present interests." This means that every dollar transferred to a GRAT or GRUT will consume part of your unified credit.
Finally, assets transferred to a GRAT or GRAT do not qualify for a stepped-up tax income tax basis upon the grantor's death. The assets retain the tax basis that the grantor had immediately prior to transfer to the GRAT/GRUT. This means that if the assets are sold by the ultimate beneficiaries, they will pay tax on the built-up gain. However, since individual tax rates are usually lower than estate tax rates, a grantor trust will result in tax savings.
Income Tax Aspects of GRATS and GRUTS
If drafted properly, a GRAT or GRUT will be treated as a grantor trust for income tax purposes. This means that the income from the trust will be taxed to the grantor (and not paid by the trust). This is important because trust income tax rates are as high or higher than individual rates.
If the grantor is the trustee of the GRAT or GRUT, the trust will not be required to file a tax return. The grantor can report all of the income on his or her Form 1040.