Quick overview
A Grantor Retained Annuity Trust (GRAT) is a tool designed to transfer future appreciation of assets to heirs while minimizing current gift-tax cost. You transfer assets into the GRAT, the trust pays you a set annuity each year for a fixed term, and at the end of that term the remaining assets go to the named beneficiaries. If the assets grow faster than the IRS’s assumed rate (the Section 7520 rate), most or all of that excess appreciation will pass outside your estate with little or no gift tax.
This article explains the mechanics, tax math, common structures, when a GRAT makes sense, practical drafting tips, and pitfalls I’ve seen in my practice over the last 15 years advising clients on GRATs.
How GRAT tax mechanics work (simple math)
- When you fund a GRAT, the IRS treats the transfer as a gift whose value equals the fair market value of the assets transferred minus the present value of your retained annuity. The present-value calculation uses the IRS Section 7520 rate in effect for the month the GRAT is created (see Form 709 filing rules).
- If the trust assets appreciate more than the Section 7520 rate, that excess appreciation passes to beneficiaries free of additional gift tax (or with only a small taxable gift at inception).
- If assets underperform (or you die during the GRAT term), the strategy can fail — the remaining trust value may be included in your estate or you may not transfer any net wealth to beneficiaries.
Key IRS resources: guidance on gift tax and Form 709 are found at the IRS gift-tax pages and Form 709 instructions (see: https://www.irs.gov/businesses/small-businesses-self-employed/gift-tax and https://www.irs.gov/forms-pubs/about-form-709).
When a GRAT makes sense
GRATs are most effective when all of the following are true:
- You expect significant appreciation in the funded asset (for example, founder stock, private business interests, or land expected to rise in value).
- You can fund the GRAT with assets that are likely to compound faster than the Section 7520 rate set for the month you create the trust.
- You can tolerate the annuity payments and the irrevocable transfer for the chosen term.
- You are comfortable with the risk that a premature death during the GRAT term will pull the remaining trust value back into your estate.
Common candidates include closely held business interests, highly-appreciating stock, and select real estate. In my practice I’ve seen many founder-led companies use short-term rolling GRATs to move value to the next generation while retaining control.
Typical GRAT structures and variations
- Zeroed-out (or near-zero) GRAT: The annuity is sized so the calculated gift at inception is effectively zero. The goal is that all meaningful value transferred to beneficiaries is appreciation above the 7520 rate. Zeroed-out GRATs are common but require precise math and timing.
- Short-term GRAT (2–5 years): Short terms reduce the risk the grantor dies during the term and are often used in rolling strategies where the grantor funds a series of consecutive GRATs.
- Long-term GRAT (5–10+ years): Longer terms may capture more appreciation but carry higher mortality and performance risk.
- Rolling GRAT: The grantor funds a new GRAT each year (or every few years) while previous GRATs mature; this can magnify transfers of appreciation over time if assets continue to outperform.
A practical example: a 5-year zeroed-out GRAT funded with founder stock. If the grantor receives annuities that just equal the present value of the assets under the Section 7520 assumptions, any outperformance passes to the beneficiaries.
Real-world example (simplified)
Suppose you fund a 3-year zeroed-out GRAT with $2 million of stock. The Section 7520 rate in the month of funding is 2.0%. The annuity stream is calculated so that the present value of annuity payments equals nearly all of the $2 million asset value. If the stock doubles over the 3-year term, beneficiaries receive the excess appreciation with minimal gift tax. If the stock falls in value, the GRAT may return little or nothing to beneficiaries.
Practical drafting and operational tips (from practice)
- Time the funding month with the Section 7520 rate in mind. Historically, lower 7520 rates improve the odds a GRAT succeeds because the hurdle (assumed growth) is lower.
- Choose assets with high upside and low dividend/ordinary income distributions inside the trust, because large cash distributions to pay the annuity can force liquidation and reduce transfer efficiency.
- Use non-grantor trusts to hold residual interests only if the grantor is comfortable with the tax consequences. Note: Most GRATs are intentionally drafted as grantor trusts for income-tax purposes so the grantor pays trust income tax; that preserves more trust assets to pass to beneficiaries.
- Consider successor investment plans: if you fund with illiquid business interests, plan ahead for valuation, buy-sell agreements, or alternative ways to satisfy annuity payments without forced sales.
- Keep records of valuations and supporting appraisals for the initial funding and for any in-kind transfers.
In my experience, drafting details (annuity formula, how income and principal are applied, payable dates) make the difference between a successful GRAT and a dispute or unintended tax outcome.
Common mistakes and how to avoid them
- Underestimating the importance of the Section 7520 rate: create the GRAT when rates are favorable or use a rolling approach.
- Funding with assets that produce high current cash outflow: assets that generate large ordinary income or require operating capital can undermine the trust’s ability to meet annuity payments.
- Ignoring the grantor trust income-tax treatment: many clients prefer the grantor-pay-tax approach because paying income tax outside the trust increases wealth transferred to beneficiaries (but get clear advice from your tax advisor).
- Poor valuation documentation: inadequate appraisal support for private-company interests invites IRS scrutiny and potential disputes if Form 709 reports a substantial gift.
What happens if the grantor dies during the GRAT term?
If the grantor dies during the GRAT term, the assets remaining in the trust are generally includible in the grantor’s gross estate for estate tax purposes. That is why shorter-term GRATs and rolling strategies are popular — they reduce mortality risk and the chance the GRAT will fail due to death.
Alternatives and complementary strategies
- Intentionally Defective Grantor Trusts (IDGTs): another technique for shifting appreciation outside the estate while using grantor trust income-tax treatment.
- Family Limited Partnerships (FLPs) or LLCs: using entity discounts or control transfers together with GRATs can be effective but increase complexity and scrutiny.
- Annual exclusion gifts and Crummey powers: smaller annual plans may work alongside GRATs for multi-year wealth transfer.
See related write-ups on transferring business interests using GRATs: Using GRATs and Other Tools to Transfer Business Interests Efficiently and a short glossary entry on the basic concept: Grantor Retained Annuity Trust (GRAT).
Frequently asked questions
Q: Are GRATs taxable when created?
A: Yes — the IRS treats the transfer as a gift, but with a zeroed-out or small taxable gift if the annuity is sized to consume most of the initial value. The grantor reports the transfer on Form 709 (United States Gift (and Generation-Skipping Transfer) Tax Return).
Q: Who pays income tax on trust earnings?
A: Most GRATs are intentionally structured as grantor trusts. That means the grantor pays the trust’s income tax on earnings, which can be advantageous because it lets trust assets grow undiminished for beneficiaries.
Q: Do I lose control of the assets?
A: You give up legal ownership when you fund a GRAT. However, you can retain economic use through the annuity and potentially keep control of voting/management in closely held interests via separate agreements. Carefully draft to avoid estate inclusion or self-dealing issues.
Practical checklist before you set up a GRAT
- Confirm the Section 7520 rate for the funding month.
- Select assets with high expected appreciation and manageable cash flows.
- Decide on term length and annuity formula (level dollar vs. fixed percentage).
- Obtain qualified appraisals if funding with private-company interests or real estate.
- Coordinate estate, gift, and income tax planning with your attorney and tax advisor.
- Prepare to file Form 709 for the year of the transfer and document valuation support.
Risks, IRS scrutiny, and recent considerations
GRATs are well established but attract IRS scrutiny when used aggressively — for example, when taxpayers repeatedly create near-zeroed GRATs or rely on optimistic valuations of private interests. It’s critical to document valuations, avoid self-dealing, and ensure the annuity formula and term have a bona fide economic purpose.
Current IRS guidance on gift tax and reporting remains the controlling administrative source; always confirm rules with your tax advisor and the IRS website (https://www.irs.gov/businesses/small-businesses-self-employed/gift-tax and https://www.irs.gov/forms-pubs/about-form-709).
Conclusion and professional note
GRATs can be a powerful, low-cost method to shift appreciation out of an estate when assets are likely to outperform the IRS hurdle rate and when the grantor can tolerate the irrevocability and annuity payments. In my practice, the most successful GRAT outcomes combine conservative valuation, careful asset selection, short terms (or rolling GRATs), and coordination between estate counsel and tax advisers.
This article is educational and not individualized tax or legal advice. Before implementing a GRAT, consult an experienced estate planning attorney and a tax professional to model results under current law and your personal situation.
Sources and further reading
- IRS — Gift Tax (overview) and Form 709: https://www.irs.gov/businesses/small-businesses-self-employed/gift-tax and https://www.irs.gov/forms-pubs/about-form-709
- IRS — Estate and Gift Taxes: https://www.irs.gov/businesses/small-businesses-self-employed/estate-and-gift-taxes
- Investopedia — Grantor Retained Annuity Trust (GRAT): https://www.investopedia.com/terms/g/grantor-retained-annuity-trust-grat.asp
- Practical planning articles and case law summaries — consult your attorney for authority on specific structures.
Professional disclaimer: This content is for educational purposes only and does not constitute legal, tax or investment advice. Consult qualified professionals for guidance tailored to your facts and current law.
