Using GRATs and IDGTs for Estate Planning

In our continuing series of blog posts on planning for possible tax changes under the Biden administration, we would be remiss if we did not take some time to discuss grantor retained annuity trusts (GRATs) and intentionally defective grantor trusts (IDGTs). These estate planning tools are not as well-known to the general public as living trusts, but they may offer significant advantages for individuals with large estates who are concerned about the prospect of estate tax after their death. Read on to learn more about GRATs and IDGTs, and whether one of these estate planning tools might be right for your needs.

What is a GRAT and How Does it Work?

Like most trusts used to minimize estate tax, a GRAT is an irrevocable trust, meaning the creator (called the “grantor” or “trustmaker”) cannot reclaim assets once they have been placed in the trust—which removes those assets from the grantor’s taxable estate, reducing its size. The GRAT is designed to last for a term of years; often just two to five years, but sometimes longer.

The grantor retains the right to receive, over the trust’s term, the original value of the assets placed in the GRAT with a rate of return determined by the Internal Revenue Service. This rate is called the §7520 rate (sometimes called the “hurdle rate”) after the section of the Internal Revenue Code in which it is described, and it is based on the value of the assets in the trust at the time the GRAT is created. The rate is published monthly, and the rate for the GRAT is established as of its creation. As of this writing, the hurdle rate is 1.2%.

If the performance of the assets in the GRAT equals or falls below the hurdle rate, the assets in the GRAT are returned to the grantor, and it is as if the GRAT never happened. The only loss would be your legal fees in setting up the trust. However, if the performance exceeds the hurdle rate, the excess value is transferred to your beneficiaries at the end of the GRAT term free of estate or gift tax (the beneficiary can be, and often is, another trust). With low interest rates (and hurdle rates), GRATs are an attractive option for individuals with appreciating assets.

If you are thinking that a GRAT would be a great vehicle to pass to your beneficiaries assets that are likely to appreciate significantly over the trust’s term, you are not alone. GRATs are popular with owners of start-up companies whose stock has a modest value when placed in the trust, but appreciates wildly during the trust term. The annuity paid to the grantor is based on the §7520 rate, and appreciation beyond that amount passes to beneficiaries free of gift tax.

In fact, Mark Zuckerberg, founder of Facebook, placed his shares of the company’s stock in a GRAT prior to Facebook’s IPO. In so doing, it is estimated that he passed $37,315,513 to his beneficiaries free of gift taxes after a five-year GRAT term.

In summary, the upside of a GRAT is that it provides a grantor a steady stream of income from the annuity, and allows a grantor to give a beneficiary much more than the annual gift tax exclusion rate (currently $15,000 per donor) free of gift tax. The downside is that in order to maximize tax-free giving, a grantor should choose a longer trust term; if he or she dies during that term, the trust assets revert to the grantor’s taxable estate, and the beneficiary gets nothing.

What is an IDGT and How Does it Work?

It may sound counter-intuitive to create something that is intentionally defective. But an intentionally defective grantor trust, better known as an IDGT, can lead to significant estate tax savings under the right circumstances.

What makes a trust “intentionally defective?” Structuring it so that the grantor continues to be liable for paying income tax on income generated by trust assets, while removing those assets from his or her taxable estate. Thus, trust assets pass to beneficiaries, typically children or grandchildren, free of estate tax. The value of the assets placed in the trust is “frozen” for estate tax purposes; beneficiaries ultimately receive the appreciated assets unburdened by the income tax which has been paid by the grantor.

Like a GRAT, an IDGT is an irrevocable trust. Unlike a GRAT, the grantor typically “sells” assets to the trust rather than gifting them, in order to avoid triggering gift tax. Assets sold to an IDGT are not considered to give rise to a capital gain, which means that no capital gains tax is owed. The sale is often structured as installments over the course of several years, usually with a low rate of interest.

There are multiple advantages to an IDGT. Beneficiaries of the trust benefit from the appreciation of trust assets without paying increased transfer taxes. Grantors use the IDGT to remove assets from their taxable estate. An IDGT also gives a grantor greater rights to enjoy and control trust assets than do most irrevocable trust. The obvious downside to these trusts is that the grantor must continue to pay income tax on income generated by the trust.

Both GRATs and IDGTs can offer significant opportunities for tax savings if properly structured. These trusts are complex and require the guidance of an experienced estate and tax planning attorney. If you are concerned about minimizing your taxable estate, we invite you to contact Gudorf Law to schedule a consultation to discuss your options.