Grantor Retained Annuity Trusts (GRATs): How the Estate Planning Strategy Works

Grantor-Retained Annuity Trust (“GRAT”)

Most Americans don’t have to worry about federal estate taxes. In 2026, only estates worth $15 million or more ($30 million or more for a married couple) are liable for federal estate taxes, and only a small percentage of individuals have accumulated that much wealth. But for very high-net-worth or business owner clients, gift and estate taxes may still be a concern. Assets may be transferred by a gift during lifetime or left in an estate through a will or trust. In general, assets transferred by estate or gift are subject to a federal tax of 40% on amounts above the combined estate and gift tax exemption. Separate state-level estate or inheritance taxes may also apply with much lower exemptions depending on where you live. For this reason, experts have been devising tax-efficient ways for wealthy individuals to pass assets to the next generation.

Estate Freezing:

Many tax-efficient wealth transfer strategies involve an “estate freeze” that caps the taxable value of assets at their current fair market value. With estate freeze techniques, clients are not gifting an entire asset, but rather the future appreciation. These gifting structures are intended to “freeze” the value of the asset in the client’s hands as of the date of the transfer, thereby removing the future appreciation from the estate. By locking in today’s value, you stop future growth from adding to your estate tax bill. All future financial gains pass directly to the heirs (through a trust), reducing the overall tax burden.

Grantor-Retained Annuity Trust (“GRAT”):

One of the most effective freeze techniques is the grantor-retained annuity trust (“GRAT”), where the grantor gifts assets and receives back predetermined payments from the trust over a set number of years leaving excess assets to heirs while minimizing estate or gift tax liability.

Since the grantor receives substantially equivalent value in return, the transfer is not deemed a gift. The present value of the annuity, discounted at the typical relatively low discount rate, offsets the gift. If the assets in the GRAT grow faster than this rate, assets will remain in the trust after the payment of an annuity.

GRATs are most useful to wealthy individuals who face significant estate tax liability at death, particularly when they own assets they expect to appreciate substantially. The best assets to use with this technique are real estate, securities and concentrated business such as private company stock or pre-IPO stock. The primary benefit of a GRAT is to freeze the value of the property transferred to the trust, so that the future appreciation is transferred in a tax-efficient manner.

GRAT Mechanics:

The basic mechanics of a GRAT are simple. The grantor is person who transfers personal assets into the trust. The trust pays the grantors an annuity for a certain term of years. The total annuity payments equal the starting value of the transferred assets plus interest at an IRS-mandated rate. At the end of the term (typically two to three years, but it could be longer), all the assets remaining in the trust pass to the grantor’s named beneficiaries.

The GRAT strategy can be broken down into the following mechanical steps:

1. A GRAT is created when a grantor contributes assets to a fixed-term, irrevocable trust.
2. The grantor then receives back an annuity stream over the trust’s term; the payments consisting of principal plus the IRS-imposed interest rate known as the Section 7520 rate.
3. The present value of the annuity payments is calculated to offset the value of the contributed assets to create a zero or nominal gift.
4. At the end of the term, the remaining assets are distributed to the grantor’s beneficiaries free of estate tax and without using the grantor’s lifetime gift exemption.

Zeroed-Out GRAT:

The grantor’s initial gift to the GRAT is taxable gift. A gift occurs whenever there is a transfer of property without the transferor receiving full and adequate consideration. But if the grantor receives consideration equal to the fair market value of the property, the gift tax potential is eliminated. Therefore, a zeroed-out GRAT is implemented to offset the value of the gift at the time the trust is created. By setting the GRAT annuity high enough to create a zero or nominal gift and contributing appreciating assets, assets can be passed on to heirs without paying either a gift or estate tax.

The Interest Rate:

The Section 7520 interest rate is used to discount the value of annuities, life estates, and remainders to present value, and is revised monthly. The GRAT strategy works best when the Sec. 7520 rates are low because in discount methodology the value of the gift is higher. Putting it another way, the strategy works best when interest rates are low because that lowers the IRS “hurdle rate” that the trust assets must beat to transfer wealth tax-free.

Income Taxes:

A GRAT is structured as a “grantor trust” under IRS rules. This means the grantor, who created and funded the trust, pays the income taxes on any earnings generated by the trust assets. Because the grantor pays the taxes, the money inside the GRAT grows completely unreduced by income taxes, increasing the effect of the strategy.

Benefits:

GRATs are for clients with assets that are expected to substantially appreciate. They may have assets that are currently depressed or low in value but are otherwise expected to rebound or appreciate significantly. In this scenario GRATs are an effective estate freeze technique. The main benefit of GRATs is they allow clients to move assets out of their estate and do so without using up their estate tax exemption. As the assets grow, they grow outside the taxable estate. The popularity of GRATs shows how effective it is for bypassing estate and gift taxes.

Pitfalls:

There are some risks with GRATs. The grantor must survive the term of the trust to exclude assets from the estate. If the grantor dies during the term of the trust, the assets in the trust revert to the grantor’s taxable estate. To reduce this mortality risk, the grantor may set up successive short-term GRATs (called “rolling GRATs”) of two or three years. The annuity payments can be used to invest in successive GRATs. Regardless of the term, if the grantor dies, the result is no worse than not having created the GRAT at all.

Although successive short-term GRATs reduce the grantor’s risk of losing control of capital, long-term GRATs also offer an advantage. If the interest rate is expected to rise, the trust can lock in a low discount rate for the entire term. This low interest rate would increase the value of the annuity deduction compared with successive short-term GRATs, which use the interest rate at the time the GRAT is established.

The GRAT strategy works when the actual appreciation of the trust assets exceeds the hurdle rate used to calculate the present value of the annuity. The more the transferred assets grow, the greater the tax savings will be. But if the assets fail to appreciate or decline, this results in a “failed GRAT” because nothing goes to the beneficiaries. The transaction amounts to a can’t-lose bet with the IRS. If the trust’s investments make large enough gains, the excess goes to heirs tax-free. If not, the grantor simply receives the asset back and can try again with a new GRAT. There’s no adverse consequence other than the nominal cost of administering the GRAT.

Since the GRAT is an irrevocable trust, the grantor gives up direct control over the assets. Once placed in the trust, the grantor cannot arbitrarily take them back, change the trust terms, or act as the absolute master of the property. An independent trustee handles management. The grantor retains some power to replace the trustee or substitute assets of equal value for the trust assets. But otherwise, the trust is irrevocable and the grantor gives up control of the contributed assets. Again this risk can be managed by reducing the term of the trust.

Legal Status:

There is no recent data on the number of gifts to GRATs, although the number and size have apparently grown significantly. According to data from 2009, there were 1,946 gifts to GRATs amounting to $305 million. By the tax filing year 2021, gifts to GRATs amounted to about $25 billion. Tax data on wealthy individuals indicated that more than half of the 100 richest people in the United States used GRATs.

GRATs are by no means an illicit tax loophole. They are codified in federal law under Sec. 2702 of the Internal Revenue Code. The U.S. Tax Court has even ruled that Sec. 2702 permits GRATs, despite the IRS’s own challenge to the text. However, President Obama, members of Congress, researchers, and interest groups have all proposed limitations on GRATs. Specific proposals would impose minimum and maximum terms for annuities and required remainders or disallow the up-front deductions for annuities. Several proposals would impose minimum and/or maximum terms for GRATS and a minimum remainder value.

Summary:

Regardless of the pitfalls and potential reforms, GRATs remain enormously popular with wealthy individuals. Leaked tax data indicated that more than half of the 100 richest people in the United States used GRATs. If you’re a high net worth individual, it always makes sense to get assets out of your taxable estate and into trust for the benefit of your heirs, especially assets that will appreciate over time. And the sooner you do that, the more efficient the transfer because there is more “bang for the buck” at the lower value. A GRAT is a simple but powerful tool that allows individuals and families to minimize estate taxes as they pass assets on to the next generation.

Talk With a Cross-Border Tax Advisor

Benchmark International Tax Partners can help you assess how these rules may apply to your circumstances and identify practical next steps. Contact the team to discuss your tax position and planning priorities.