Transferring Future Appreciation on Business Interests to Beneficiaries: A Discussion of Grantor Retained Annuity Trusts and Sales to Grantor Trusts

August 27, 2015
Wealth Planner Anne Warren discusses grantor retained annuity trusts (GRATs) and sales to grantor trusts as planning techniques for owners of businesses that are expected to increase in value significantly over the short-term.

The first two issues of Owner to Owner provided a broad overview of the benefits and mechanics of gifting interests in privately-held businesses to loved ones and charities.  This article will examine two popular and effective techniques for transferring the future appreciation on assets to beneficiaries, or trusts for their benefit, at little or no gift tax cost: grantor retained annuity trusts (GRATs) and sales to grantor trusts.  These planning techniques are ideal for the owner of a business that is expected to increase in value dramatically over the next few years. 


A GRAT is an irrevocable trust designed to transfer a portion of the future appreciation on the trust assets to family members or other beneficiaries.  A successful GRAT is one of the most tax-efficient vehicles for transferring assets to the next generation.  Interests in a privately-held business that are expected to increase in value significantly during the term of the trust are ideal assets for funding a GRAT. 

How a GRAT Works

A grantor (in this case, the business owner) transfers a portion of his interests in the business to a GRAT in return for a stream of annuity payments during the term of the GRAT.  GRAT terms can be as short as two years and as long as 99, but generally shorter terms of two to five years are advisable in order to capture an increase in the asset value without significant risk that the assets will decrease during the term of the GRAT.  Another reason to use a shorter GRAT term is that the grantor must survive the term.  If the grantor dies during the term, all or a portion of the GRAT assets will be included in the grantor’s estate.

During the term of the GRAT, the grantor receives back the full value of his initial contribution plus statutory interest in the form of annuity payments.  The stream of annuity payments is calculated using the applicable rate published by the IRS at the time the GRAT is funded.  GRATs are particularly attractive when interest rates are low, as they have been for years.  The August 2015 rate applicable to GRATs is 2.2%.  If a business owner funded a two-year GRAT in August with interests in his business that appreciate at a rate greater than 2.2% over the next two years, all of the excess appreciation would be transferred to the business owner’s beneficiaries, or trusts for their benefit, free of gift tax.   

GRATs are usually structured so that the grantor does not make a taxable gift.  Under current law, if the value of the annuity payments is equal to the property transferred to the trust, plus applicable interest, no gift tax will be due when the GRAT is created because the value of the gift is effectively reduced to zero.  This is a called a “zeroed-out” GRAT.

During the term of the GRAT, the trust is a “grantor trust” for federal income tax purposes.  This means that the business owner grantor continues to be treated as the owner of the trust property and pays any income and capital gains taxes associated with the property.  While this may sound like a negative result for the grantor, it is actually very beneficial. The assets in the trust grow “tax-free” during the trust term, thereby increasing the likelihood that there will be assets remaining at the end of the GRAT term to be transferred to beneficiaries.

Below is an illustration of a four-year GRAT established in August 2015.

Image showing the progression of a four-year GRAT established in August 2015, showing the process it undergoes from grantor to beneficiary.


In addition to being incredibly tax-efficient when they are successful, GRATs carry little downside risk when they are unsuccessful.  If the interests in XYZ Company (see GRAT example) failed to appreciate at a rate greater than 2.2%, all of the assets would be returned to the grantor through the annuity payments and the beneficiaries would receive nothing.  The cost to the business owner grantor would have been the cost of creating the GRAT and obtaining an appraisal of the business interests.  Since he did not use any of his gift tax exemption when he created the GRAT, he would not have wasted any exemption if the GRAT proved unsuccessful.

Sales to Grantor Trusts

A second technique, similar to a GRAT, is a sale to a grantor trust.  When structured properly, sales to grantor trusts can be even more powerful than GRATs in transferring future appreciation at a low gift tax cost.  As discussed later, sales to grantor trusts, unlike GRATs, are also effective in leveraging generation-skipping transfer (GST) tax exemption. 

How Sales to Grantor Trusts Work

The business owner sells assets to a grantor trust in exchange for a promissory note bearing interest at the minimum fixed rate published by the IRS.  A typical note would pay interest only for a period of years with a balloon payment of principal at the end of the term.  For so-called “mid-term” loans of between three and nine years made in August 2015, that rate is 1.82% per year. 

This structure allows the business interests time to appreciate within the grantor trust before the trust is required to pay back the balance of the loan.  If the value of the business interests increases at a rate greater than the relatively low interest rate on the note, that excess appreciation remains in the trust for the benefit of the business owner’s beneficiaries.

Because the trust is a grantor trust and the grantor is treated as the owner of the assets for income tax purposes, the sale of assets to the trust is disregarded and no capital gains tax is due on the sale.  The interest payments to the business owner grantor during the note term also are disregarded for income tax purposes. 

Sales to grantor trusts are particularly ideal for business owners who have funded irrevocable trusts for their children or grandchildren in the past because, prior to the sale, the trust should contain assets equal in value to at least 10% of the business interests to be sold to the trust.  If the trust’s debt-to-equity ratio is too high, the IRS may view the transaction as a gift rather than a bona fide sale.  The 10% seed money increases the likelihood that the trust will be viewed as having the ability to repay the note at the end of the term.  If the business owner has not already funded a trust for beneficiaries, he may create a new one and make a seed gift to the trust using a portion or all of his $5.43 million lifetime gift tax exemption. 

An additional benefit of a sale to a grantor trust is that a business owner grantor can leverage his $5.43 million lifetime GST tax exemption.  The grantor can allocate a portion of his lifetime GST exemption to the initial gift to the trust.  Once the note is repaid, all of the assets remaining in the trust will be exempt from GST tax.  If the business interests sold to the trust have appreciated significantly, the grantor will have successfully transferred that appreciation at little or no gift or GST tax cost.  With GRATs, the grantor cannot allocate GST exemption to the trust until the end of the trust term, thereby eliminating the ability to leverage GST tax exemption.

Below is an illustration of a sale to a grantor trust in August 2015 in exchange for a four-year promissory note.

Image showing an illustration of a sale to a grantor trust in August 2015 in exchange for a four-year promissory note, showing the process from grantor to beneficiary.

A successful sale to a grantor trust can be more powerful than a GRAT in transferring future appreciation due to the lower interest rates and the ability to let the assets remain and grow in the trust for a longer period.  However, sales to grantor trusts involve greater risks as well.  GRATs are a statutorily-sanctioned technique, while sales to grantor trusts, though widely used and accepted by practitioners, are not.  In addition, if the business interests sold to a grantor trust decrease in value before the promissory note is repaid, the assets of the grantor trust will have to be used to repay the note, thereby moving those assets back into the grantor’s taxable estate.  With rates remaining relatively low, the risk of underperformance is unlikely, but business owners should be aware of the risk before moving forward with a sale to a grantor trust.   

One final note on valuation.  Both of the techniques discussed previously require the business owner to obtain an appraisal of the business interests before they are transferred or sold to the trusts, and sometimes during the trust term if GRAT annuity payments must be made in the form of privately-held business interests.  These appraisals can be costly, but are necessary in order to support the stated value of the business interests initially, correctly determine the value of any gifts, and accurately calculate payments back to the grantor.  


If the value of your business continues to increase and you are thinking about ways to pass on some of that appreciation to your children and future generations, talk to your BBH Wealth Planner about whether a GRAT or a sale to a grantor trust makes sense for you.  With interest rates expected to rise in the near future, these techniques may become less attractive.  In addition, Congress may propose legislation to limit the effectiveness of these techniques.  The time to act is now.

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