Using GRATs and Other Tools to Transfer Business Interests Efficiently

Overview

A Grantor Retained Annuity Trust (GRAT) is a tax planning tool often used to move the future appreciation of business interests out of an owner’s taxable estate. The grantor funds the GRAT with assets (for example, LLC membership interests or S‑corp shares), receives fixed annuity payments for a defined term, and at the term’s end any remaining trust assets pass to the named beneficiaries. When a GRAT is “zeroed out”—that is, the retained annuity equals the asset’s present value under IRS rules—the taxable gift reported at funding can be close to zero while the beneficiaries keep appreciation beyond the IRS assumed rate.

This article explains how GRATs work, when they make sense for business owners, alternatives and complementary strategies, practical setup considerations, common IRS issues, and a short implementation checklist you can discuss with your advisor or estate planning attorney.

How GRATs work in practice

• Funding: The grantor transfers an ownership interest (or convertible shares, partnership units, etc.) into an irrevocable trust. The gift is subject to gift tax rules but the taxable gift is computed using IRS interest tables (the Section 7520 rate).
• Annuity stream: The trust pays the grantor a fixed annuity each year (or more frequently) for the stated term. The annuity amount is set so the present value of the retained interest approximates the value transferred—this is how a “zeroed-out” GRAT has little or no taxable gift at funding.
• Remainder to beneficiaries: If the trust assets outperform the Section 7520 rate used at funding, the excess value remains in the trust for the beneficiaries after the annuity term ends, often free of additional gift tax.
• Grantor trust status: A GRAT is typically a grantor trust for income tax purposes; the grantor pays income tax on trust income, which lets the trust assets grow undiminished for beneficiaries.

Key point: the strategy depends on the asset appreciating more than the IRS assumed growth (the 7520 rate). The grantor must survive the GRAT term for the remainder to pass outside the taxable estate.

Sources: IRS guidance on the Section 7520 rate and gift taxation (see IRS.gov for current rates and Form 709 reporting requirements).

Why business owners use GRATs

• Move appreciation out of the estate with little upfront gift tax cost.
• Retain income and control during the GRAT term.
• Keep business continuity: structuring the trust to hold minority or economic interests can preserve operating control while shifting economic gain.
• Income tax benefit: because the grantor typically pays the trust’s income taxes, more wealth accrues to beneficiaries, effectively using after‑tax dollars to shift appreciation.

In my practice, GRATs are particularly attractive when an owner expects materially above-market growth in the near term (for example, a company about to scale or complete a sale where proceeds are expected to increase the asset value quickly).

Common alternatives and complementary tools

GRATs are one tool among several for transferring business interests. Consider these alongside—or instead of—a GRAT depending on objectives:

• Sale to an Intentionally Defective Grantor Trust (IDGT): the owner sells the business interest to a grantor trust in exchange for an installment note; future appreciation passes to beneficiaries free of estate tax if structured properly.
• Family Limited Partnership (FLP) or family LLC with minority-interest discounts: combine gifting with valuation discounts to transfer ownership economically (note IRS scrutiny).
• Installment sale to a third party or to family members: spreads tax and can help achieve stepped transfer of control.
• Charitable lead or remainder trusts for owners with philanthropic goals and tax planning needs.
• Direct gifting: simple for smaller blocks of shares but may use up annual exclusions or lifetime exemption.

For background on how trusts compare to direct gifting, see FinHelp’s guide on Using Trusts vs Direct Gifts: Comparing Control, Taxes, and Flexibility (Using Trusts vs Direct Gifts)). For gift tax mechanics, see Gift Tax Basics (Gift Tax Basics)).

Practical setup considerations for business interests

1. Valuation: Obtain a credible, defensible business valuation at funding. The IRS carefully scrutinizes minority interest and lack-of-marketability discounts for business interests. Use a qualified appraiser who documents methodology.
2. Term length: Short-term GRATs (e.g., 2 years) are common when owners expect near-term appreciation; longer terms reduce the risk of grantor death during the term but can reduce the present-value advantage.
3. Annuity schedule: Annual vs. more frequent payments affects cash flow. Many advisors use annual payments timed to the company’s distributions.
4. Zeroing out: A zeroed-out GRAT sets the annuity to consume nearly the full initial value per IRS tables, leaving only future appreciation for beneficiaries. This minimizes the reported gift.
5. Survival risk: If the grantor dies during the GRAT term, the remaining trust assets are generally included in the grantor’s estate.
6. Operating governance: If transferring membership units or shares, document voting and buy-sell mechanics to maintain business operations and avoid governance disputes.
7. Income tax effects: Because a GRAT is usually a grantor trust for income tax purposes, the grantor continues to report trust income on their return—plan for cash needs to pay that tax if trust income is not distributed.

Example (illustrative, not prescriptive)

Assume a business owner transfers a $1,000,000 interest into a two‑year GRAT. The annuity is set so the present value of the annuity equals the asset value under the Section 7520 rate used at funding, producing a negligible taxable gift. If the business appreciates to $1.6 million by the end of the term, the beneficiaries receive the excess value (roughly $600,000) subject to the trust terms and any applicable estate/gift wrap. If the asset underperforms the 7520 rate, the remainder may be small or zero, and the strategy offers limited benefit.

IRS scrutiny and common pitfalls

• Discounts and valuation: The IRS often challenges aggressive discounts for minority interest and lack of marketability. Rely on a qualified valuation expert and contemporaneous documentation.
• Regranting and successive GRATs: Some taxpayers use “rolling” GRATs (short-term, repeatable) to compound transfers. While common, these techniques require careful legal drafting and attention to anti‑abuse doctrine.
• Gift tax reporting: Funded GRATs typically require filing Form 709 (United States Gift (and Generation-Skipping Transfer) Tax Return) for the year of funding—don’t skip reporting (see IRS Form 709 instructions).
• Estate inclusion risk: Grantor death during the term collapses the benefit. Consider term length and life expectancy when planning.

When a GRAT is NOT the right tool

• When the business is illiquid and unlikely to produce meaningful short-term appreciation.
• If the owner needs the asset’s cash flow for retirement; annuity design must preserve income needs.
• If transferor’s lifespan is uncertain and they cannot accept the mortality risk of losing the out‑of‑estate transfer.

Step-by-step checklist before funding a GRAT

• Define objectives: control, income, tax shifting, or a mix.
• Run valuation scenarios: best-case, base-case, and conservative growth assumptions vs. current 7520 rate.
• Consult an estate attorney and valuation expert; prepare legal documents and appraisals.
• Decide term length and annuity schedule; confirm cash-flow to pay annuity and income tax.
• File Form 709 in the funding year and coordinate with tax preparer.
• Monitor business performance and consider follow-up moves (e.g., subsequent GRATs or sale to an IDGT).

Frequently asked implementation questions

• Who pays income tax on a GRAT? Usually the grantor pays income tax on trust income because the GRAT is treated as a grantor trust for income tax purposes.
• Are GRAT transfers irrevocable? Yes—GRATs are irrevocable once properly funded, so plan carefully.
• Can multiple assets be placed in a single GRAT? Yes; however, mixing illiquid and liquid assets can complicate distributions and valuation.

Final considerations and professional perspective

GRATs are a powerful, cost-efficient technique for shifting future appreciation of business interests out of an estate when you expect significant near-term growth. In my practice, GRATs work best when paired with solid valuations, clear governance documentation, and a plan for income tax payments. They’re not a one-size-fits-all solution; alternatives like IDGTs, FLPs, or direct gifting may be superior depending on liquidity, family dynamics, and discount opportunities.

For more detailed comparisons of trust-based strategies and gifting mechanics, see FinHelp’s resources on trusts and gift tax (links above).

Disclaimer: This article is educational and does not constitute legal, tax, or investment advice. The rules governing GRATs, gift tax, and valuation are complex and change over time. Consult a qualified estate planning attorney, CPA, and valuation professional to apply these strategies to your circumstances. For IRS forms and current Section 7520 rates, consult the IRS website (https://www.irs.gov) and review Form 709 instructions.