When to Freeze a Failing GRAT

Senior Wealth Planners Alison Hutchinson and Stacia Kroetz share why it may be beneficial to “freeze” a GRAT in today’s market environment.

A grantor retained annuity trust (GRAT) is an estate planning technique that is very versatile. Creating a GRAT during times of market stress and then “freezing” it when the market recovers can be a tax-efficient way to transfer wealth free of gift or estate tax. Although GRATs created during periods of high interest rates will have to outperform a higher hurdle rate to be successful, there are still a lot of opportunities in a robust market if you are diligent in keeping track of performance and freezing when it makes sense.

What is a GRAT?

A GRAT is a type of irrevocable trust to which the creator of the trust (the grantor) transfers specific assets and retains the right to receive an annual annuity payment for a designated number of years. The total of the annuity payments is equal to the value of the assets transferred to the GRAT plus interest calculated at a rate determined by the IRS for the month of the transfer (the hurdle rate). The hurdle rate (or 7520 rate) is 5.8% for GRATs funded in December 2023.1

Any appreciation experienced by the transferred assets in excess of the hurdle rate will pass to the beneficiaries designated by the grantor without the imposition of any transfer tax (assuming the grantor survives the term of the GRAT). Consequently, the best assets with which to fund a GRAT are those that are likely to appreciate significantly over the trust’s term (often two years).

A Closer Look at GRATs

GRATs are used to minimize federal estate and gift tax. To create a GRAT, a grantor makes a gift to a trust. The trust agreement says the trust will last for a certain number of years, and that the trustee must pay an annuity back to the grantor over that timeframe – this is the “grantor retained annuity” part of the trust. The grantor funds the GRAT account, while the trustee is responsible for making timely annuity payments and transferring the balance (if any) to the beneficiary, or to a trust for his benefit. For example, assuming a trust term of two years, after two annuity payments back to the grantor anything remaining in the trust passes tax-free to a trust for the grantor’s descendants.2

If you are planning to create a GRAT, consider the following:

  • Health of the grantor: If the grantor dies during the trust’s term, the GRAT assets are included in her estate.
  • Who you want to help: Appropriate beneficiaries for a GRAT include children, siblings, parents, and non-generation skipping transfer (GST) trusts.
  • Timing: A GRAT does not give beneficiaries immediate access to assets.
  • Tax considerations: GRATs can be great for clients who have used their lifetime exemption because they can be “zeroed out” and have no gift tax consequences.

GRAT Examples

For example, if Olivia transferred $1 million of Stock X to a two-year GRAT in April 2020, the hurdle rate would have been 1.2%, and the two annuity payments, due on the first and second anniversaries of the funding of the GRAT, were $462,995 and $555,593, respectively. Assuming Stock X generated a total return of 8% per year, the remaining trust assets in April 2022 would have been $110,772. If the appreciation was instead 20%, the remaining assets would be worth $328,813.

When the markets are volatile and the assets in the GRAT either lose significant value or  gain significant value, this presents an opportunity for planning. In these instances, we recommend “freezing” the GRAT.

As an example, assume that instead of funding the GRAT in April 2020, Olivia funded it in January 2023 with $1 million of Stock Y. The hurdle rate would have been 4.6%.

On the first anniversary, assuming Stock Y performed similarly to the S&P 500, the GRAT would have increased by around 24% and would be valued at $1,240,000. At the same time, an annuity payment of $487,140 would be due back to Olivia. Once Olivia makes that required annuity payment, the GRAT is left with a value of $752,860 (current GRAT value minus the annuity payment). We also know that in February 2025, we have to make the last annuity payment of $584,567 back to Olivia.

This would be a great time to consider freezing the GRAT! We know that if we froze the GRAT today, Olivia’s beneficiaries would receive $168,293 (current value of the GRAT minus the required 2025 annuity payment) free of transfer tax. If, instead, we let the GRAT continue, we run the risk of the stock reverting to prior values, reducing the amount that is left after that required annuity payment. If the stock falls precipitously, we run the risk of the GRAT falling below $584,567, meaning the entire value would be paid back to Olivia as the final annuity, with nothing passing to the beneficiaries by the end of the term.

Even if Olivia thought it was impossible for the stock to fall that far, and believed there was more upside to the stock, she could freeze the current GRAT to lock in the accumulated appreciation and roll the investment into a new GRAT to capture any additional upside.  

When to Freeze a GRAT

Although it depends on the type of asset in the GRAT, it usually makes sense to freeze “underwater” GRATs around the time of the first annuity payment and re-GRAT those assets if you believe they will appreciate moving forward. It also makes sense to freeze GRATs when the underlying assets have appreciated significantly over the hurdle rate.

What does it mean to “freeze” a GRAT? It means that the grantor utilizes a provision found in most GRATs allowing the grantor to substitute or swap assets of equivalent value in and out of the trust. Typically, the grantor will swap cash or a similarly stable asset (some attorneys even suggest a promissory note) into the GRAT in exchange for the remaining GRAT assets. As outlined in the example above, the grantor can then “re-GRAT” those assets by funding a new GRAT with the same assets. This allows you to start over if prices have declined, or lock-in your appreciation if prices have gone up and stay invested with a new GRAT to capture any additional upside.

The two key takeaways are:

  • If you currently have a GRAT, you should check the value of the assets in the GRAT and work with your relationship team to evaluate whether or not freezing the GRAT makes sense.
  • If you don’t have a GRAT, you should consider whether creating one might help accomplish one or more of your wealth transition goals.

If you wish to discuss this technique in further detail or to review your investments, we encourage you to reach out to your BBH relationship team.

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1 To find the current rate, see the latest monthly IRS revenue ruling with the applicable federal rate tables (see Table 5 of the revenue ruling), or consult the IRS's “Section 7520 Interest Rates” webpage.
2 The remainder to beneficiaries may also be income tax-free if the grantor has swapped assets prior to termination. 

This material is for general information and reference purposes only and does not constitute legal or tax advice. Please consult with attorney, accountant, and/or tax advisor for advice concerning your particular circumstances.

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