A Grantor-Retained Annuity Trust (GRAT) is a tool used for transferring wealth to your children gift tax-free. The technique involves the owner of cash or stock, the Grantor, gifting the asset to an irrevocable trust, but taking back, or retaining, an annual payment from the trust for a period of years. The transfer avoids a gift tax because the amount retained through the annual gifts is equal to the value of the gifts plus interest based on an assumed low growth rate. As the invested asset grows in value, it makes the annual payouts to the Grantor and after the term has expired, the remainder goes to the trust beneficiaries tax-free.
There are several drawbacks to the GRAT. First, the Grantor must outlive the term, otherwise the entire amount is included in the Grantor’s estate. Second, if the property doesn’t appreciate fast enough, then the principal remainder will be paid out through the annuity payments and there will be nothing left for the beneficiaries. Finally, due to the exploitation of short-term GRATS and rolling GRATs that attempt to workaround the risk of Grantor death during the GRAT term, this technique has been under Congressional attack for years. It seems likely that eventually GRATs will see increased restrictions, including a potential mandated minimum 10-year term, which is a much longer term than for which most GRATs are drafted.
The best alternative to a GRAT is the self-settled spendthrift trust, otherwise known as the Nevada Asset Protection Trust (NAPT). Once a sale of assets to the trust is completed, the asset value is frozen. As payments are made on the promissory note, the estate value shrinks. If a hard asset is sold to the trust, like real estate or a business, then valuation discounts reduce the value of the estate upon the sale even more. Additionally, the NAPT offers superior asset protection.