A grantor retained annuity trust, or GRAT, is one of the few estate planning tools built almost entirely around a single number: the Section 7520 rate published monthly by the IRS. Understanding how that rate interacts with the annuity payments is the key to understanding why GRATs work at all.
The mechanics behind "zeroing out"
When you fund a GRAT, you retain the right to receive fixed annuity payments for a set term of years, and whatever is left in the trust at the end of the term passes to your beneficiaries. The IRS values your retained annuity interest using the Section 7520 rate in effect the month the trust is funded. If the annuity payments are structured so that the present value of those payments, discounted at the 7520 rate, equals the full value of the assets you contributed, the taxable gift to the remainder beneficiaries is reduced to close to zero. This is what practitioners mean by a "zeroed-out" GRAT.
The strategy succeeds economically when the assets inside the trust actually appreciate, or produce income, at a rate higher than the 7520 rate used to value the annuity. Any growth above that hurdle rate passes to your beneficiaries free of additional gift tax, because the gift was already valued (at or near zero) when the trust was created. If the assets underperform the 7520 rate, the annuity payments simply return the trust's value to you over the term, and little or nothing passes to the remainder beneficiaries, but you also haven't used meaningful gift tax exemption in the attempt.
Why the term length matters
- A shorter GRAT term reduces the risk that the grantor dies before the term ends, which would generally pull the trust assets back into the taxable estate
- A longer term gives volatile or growth-oriented assets more time to outperform the 7520 rate, but increases mortality risk
- Many practitioners use a series of shorter, overlapping GRATs rather than one long-term GRAT, sometimes called a "rolling GRAT" strategy
- The annuity payment schedule can increase over the term, within IRS limits, which changes the present value calculation and how much appreciation is needed to benefit the remainder beneficiaries
Where GRATs fit in a broader plan
GRATs are most attractive when the 7520 rate is low relative to the expected performance of the contributed assets, and they work best with assets that are volatile enough to plausibly outperform that rate, such as concentrated stock positions or interests in a closely held business. Because a GRAT is a type of irrevocable trust with specific drafting and administration requirements, it should be structured as part of a coordinated tax planning strategy rather than as a standalone document.
If you're considering a GRAT to transfer future appreciation on a concentrated asset, Marianna Schwartsman can help you evaluate whether the current 7520 rate and your asset mix make the strategy worthwhile. Schedule a free consultation or call (212) 518-3868.
