Family wealth is passed down
With individual retirement accounts, whether Roth or original, you pay taxes at some point. Have you ever wondered if there was a similar vehicle, exempt from inheritance tax? There is: a grantor-retained annuity trust, or GRAT. We learn more about GRATs from Darius Gagné, Director of Investments at Quantum Financial Advisors, LLC based in Santa Monica, California.
Larry Light: GRATs are generally considered part of advanced estate planning. Can you explain further why we should take note of this?
Darius Gagne: Yes, advanced estate planning generally refers to strategies to reduce estate taxes, an issue that only applies to individuals with assets exceeding $12.92 million, or estate tax exemption in 2023, double that amount, $25.84 million, for couples. These trusts can have terms that typically last up to 10 years. Estate assets include homes and real estate as well as investment and retirement accounts.
And under current law, the exemption, which increases each year with inflation, will be cut in half in 2026, since a provision of the Tax Cuts and Jobs Act (TCJA) of 2017 is set to expire to this date. So, estate tax considerations could become a planning concern for more people if that happens, without the extension of the higher exemption or the passage of new law.
Light: The GRAT vehicle aims to remove future appreciation from the taxable estate. Explain this, please.
Won : This could include increases in the market value or income of an investment portfolio, or appreciation of other assets, such as real estate. But the situation where a GRAT offers the best value is for assets that are expected to appreciate sharply, such as stock or options granted in a private company or startup.
Light: Can you give an example of how this works?
Won : Imagine that the grantor – the person who creates and funds the trust – creates the GRAT with the help of an estate planning attorney and funds it with $5 million worth of stock in a startup. The start-up does well and goes public, and the value of the shares reaches $50 million.
The rules for GRATs require that the initial funding of $5 million, plus interest currently assumed to be around 5%, be repaid to the grantor over the term of the GRAT, which can be anywhere from two to 10 years, as an annual annuity. . So in this example, the total interest on a 10-year GRAT would be approximately $2 million. That leaves $43 million in the GRAT at the end of the 10-year term. At this point, the GRAT typically distributes all of its remaining assets to remainder trusts for children or other heirs. As long as you survive the GRAT, these final trusts are exempt from estate tax upon your death and potentially upon the deaths of future generations.
Light: In a nutshell, could using a GRAT shelter some of the money from inheritance tax?
Won : If you have an asset that you expect to appreciate significantly over the next two to ten years and your financial plan indicates that you will not need to draw on it, then using a GRAT could protect a share significant portion of your estate from inheritance tax. It is important to emphasize here that the GRAT does not make the original value of the asset exempt from estate tax. This value, increased by the interest paid by the GRAT to the grantor, is always considered as part of the estate. The GRAT only removes from the estate the appreciation in excess of the threshold interest rate on the asset.
Light: But it is not uncommon for individuals to transfer shares of a private company to a GRAT and for that company to subsequently experience a liquidity event, such as an IPO or acquisition. Then the stock value increases by several multiples, essentially eclipsing the value of the original stock.
Won : Any capital gains on the assets of the GRAT are realized, i.e. the investments held by the trust are sold at a profit, this capital gain will then be subject to income tax, in particular to capital gains tax. The “grantor” part of the GRAT acronym has several implications, including that income tax from the assets of the GRAT will be reported on the tax return of the grantor, who is the person who created the GRAT and who owned the assets that went into it.
Although the GRAT gives rise to tax-free treatment on the inheritance of appreciation assets, this does not result in an exemption from income tax. Conversely, although withdrawals from a Roth IRA receive income tax-free treatment, the account is not estate tax-exempt.
Light: Why would anyone sell the GRAT’s appreciated assets and subject themselves to potentially millions of dollars in capital gains taxes?
Won : In the case of a private company going public, where the value of the trust’s assets increases significantly, this would create a major concentrated asset as part of the investor’s overall net worth. Prudent financial planning in most cases suggests diversifying the investment as early as possible, even at the cost of paying capital gains taxes. This is not only because the crisis might be temporary, but also because any business, especially a new and still relatively small business, is subject to all sorts of idiosyncratic risks for which investors may not be compensated.
