If you own a business that you wish to pass on to your heirs, a Grantor Retained Annuity Trust (GRAT) can offer tax savings and other advantages.

  • A GRAT is a popular method of transferring property tax -efficiently, such as stock in a closely-held business, to a trust in exchange for an annual payment (or annuity) for a term of years.
  • GRATs allow a business owner to maintain control of the business, while passing along appreciation to the beneficiaries in the form of closely-held stock.
  • They also keep the transfer of ownership from becoming public and  may offer protection against creditor claims.

Succession planning can be an exciting, satisfying process for owners of closely held businesses, but it also involves difficult issues that must be tackled head on. One of the major challenges that entrepreneurs encounter is determining the best way to pass on the ownership of their business to their children or other heirs.

The business owner can choose any number of methods of transferring ownership of a company, while simultaneously minimizing gift and estate taxes and probate costs. One vehicle that may be useful is a form of grantor trust called a GRAT. A GRAT may be appropriate for business owners who:

  • Have a business currently or likely to appreciate rapidly
  • Would like to maintain control of the business and interested in passing shares of the business (with the underlying economic interest of those shares) to their beneficiaries
  • Wish to maintain an income stream from the business but is comfortable parting with growth in the value of the business
  • Would like to take advantage of the difference in gift tax value and the fair market value of the business through minority, marketability, and control discounts
  • Would like to keep the transfer of ownership from becoming public
  • Are interested in protecting the business against the claims of creditors
  • Have a life expectancy that likely exceeds the GRAT term

How does a GRAT work?
In this case, the business owner—known as the grantor or settlor— would make a gift of company stock to the GRAT. A GRAT is an irrevocable trust, meaning it cannot be changed or revoked, and the trustee is given sole control of the trust.

The grantor would receive an annuity from the trust for a certain number of years. The annuity may be paid in a fixed dollar amount or as a specific percentage of the initial value of the trust’s assets. If income from the GRAT each year is not enough to pay the annuity, trust principal must be used to make the payments. This ensures that the grantor receives a steady stream of income.

At the end of the GRAT term, the assets in the trust, including all appreciation, go to the beneficiaries.  For example, shares of the business that were not needed to pay the annuity will pass either outright or in further trust to the GRAT beneficiaries free of any  gift and estate taxes. 

When the GRAT is initially funded, the Internal Revenue Service considers it to be a gift to the beneficiary of a remainder interest. To value the remainder interest, the property in the trust is assumed to grow at a federally established rate, set monthly, called the 7520 rate.  Other valuation factors may include the age of the business owner when the trust is created, the number of years that the owner will receive the annuity, and whether the remainder beneficiaries are members of the owner’s family. A GRAT is a powerful tool in a low-interest rate environment.   Let’s look at an example.

Example:  The business owner transfers $2,000,000 of closely-held stock, valued at $1,500,000 for gift tax purposes after discounts of 25% for minority; marketability and or control are taken.  The 7520 rate (what rate the trust is assumed to grow) is 2.2% (December 2015) and the business actually grows at 8%.  The activity in a 2-year GRAT follows:

Year

Trust Property

Annual Appreciation  8%

Annuity Payment

Trust Remainder

1

$2,000,000

$160,000

$1,033,110

$1,126,888

2

$1,126,888

$90,151

$1,033,110

$183,982

Summary

$2,000,000

$250,151

$2,066,220

$183,928

*Data produced by NumberCruncher 2015.00

If the business owner survives the GRAT’s term, the remaining $183,928 passes to the trust beneficiaries free of gift and estate tax.  Had the business appreciated at say, 20%, the trust remainder would be $607,155.  The value of the remainder for gift tax purposes or the actual gift tax cost of this strategy is only $.02.  A GRAT is a tremendous way to make a large gift with an extremely low gift tax cost to the business owner.  Where the business owner exhausted or otherwise has limited lifetime gift exemption remaining, a GRAT could be a solution.  This strategy can be repeated by creating new GRATs to gradually transfer additional shares of the business to the business owner’s beneficiaries over time while maintaining an income stream to meet the owner’s lifestyle needs.

It should be noted that a valuation of the closely-held stock must be completed for purposes of establishing a GRAT.  It may also be required if the GRAT distributes closely-held stock back to the grantor to meet the annuity payment (if the business is appreciating rapidly but not paying a shareholder distribution or dividend). It is a complex process that requires expert advice.

If you own a business that you wish to pass on to your heirs, a GRAT is certainly worth taking a look at. But keep in mind that a GRAT is just one of any number of tools that can be used as part of a broader strategic estate planning process, and you should be sure to consult with your estate, tax, and financial planning professionals.

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, investment, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.

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