The annuity that zeroes out the gift, the remainder year by year, and why the result depends on volatility more than on the rate.
A grantor retained annuity trust (GRAT) pays the person who funds it a fixed annuity for a set term, sized so that the present value of the payments at the IRS section 7520 rate equals the assets contributed. The taxable gift is then about zero, and whatever the assets earn above the 7520 rate passes to the heirs free of gift tax. On an illustrative two-year GRAT funded with 10 million at a 5.0 per cent rate, the grantor takes back 5,378,049 a year; if the assets grow 12 per cent a year, 1,142,537 is left for the family, about 457,015 of federal estate tax avoided at the 40 per cent top rate if the estate is above the exemption.
Worked in full in The Family Office Professional by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
For a family office managing a US family with a taxable estate, the GRAT is one of the most used transfer tools, because it moves appreciation rather than principal and can be designed to use almost none of the lifetime gift exemption. Its economics are a single hurdle, and the arithmetic is short enough to check on one page before the lawyers draft anything.
| Input | Value |
|---|---|
| Assets contributed (for example, a stake in a private company) | 10,000,000 |
| Section 7520 rate at funding (120 per cent of the federal mid-term rate, rounded to the nearest 0.2 per cent) | 5.0% |
| Term | 2 years |
| Annuity paid at each anniversary | level |
| Growth of the assets, base case | 12% |
| Federal estate tax rate applied to the transfer (top rate, estate above the exemption) | 40% |
Annuity factor = (1 − (1 + r)−n) ÷ r = (1 − 1.05−2) ÷ 0.05 = 1.85941
Annual payment = assets ÷ annuity factor = 10,000,000 ÷ 1.85941 = 5,378,049
Taxable gift = assets − present value of the annuity = 10,000,000 − 10,000,000 = 0
In Excel: =PMT(5%,2,-10000000) returns the payment. In practice the annuity is often set a fraction lower so that the reported gift is a small positive amount, and the exact valuation tables are the IRS's.
The grantor will receive 10,756,098 in total over two years. That is the 10 million back plus a 5.0 per cent return on the declining balance: the 7520 rate is the hurdle the IRS assumes the assets earn.
| Year | Value before payment | Annuity paid | Value after payment |
|---|---|---|---|
| 1 | 11,200,000 | 5,378,049 | 5,821,951 |
| 2 | 6,520,585 | 5,378,049 | 1,142,537 |
| 10,756,098 | 1,142,537 |
The 1,142,537 left at the end goes to the remainder beneficiaries, typically a trust for the children. No gift tax is due, because the gift was valued at zero on the day of funding. Had the 10 million stayed in the estate, that growth would have been taxed at death; at 40 per cent the saving is about 457,015, measured on today's value and before any further growth or discounting to the date of death. The grantor also usually pays the income tax on the trust's income during the term, because a GRAT is normally a grantor trust, which shifts a little more value without a further gift.
| Annual growth | Remainder | % of assets contributed | Estate tax avoided at 40% |
|---|---|---|---|
| 0% | 0 | 0.0% | 0 |
| 5% | 0 | 0.0% | 0 |
| 8% | 477,659 | 4.8% | 191,063 |
| 12% | 1,142,537 | 11.4% | 457,015 |
| 20% | 2,568,293 | 25.7% | 1,027,317 |
| 30% | 4,530,488 | 45.3% | 1,812,195 |
At or below the 7520 rate the GRAT transfers nothing. It does not lose money either: at zero growth the annuity simply returns the assets to the grantor until they run out, and the cost is the legal and administration fees. That asymmetry is the whole design. A GRAT is an option on outperformance, which is why families fund them with their most volatile assets, such as a concentrated stock or a pre-exit private company stake, and run them in short, rolling series rather than one long trust whose good years would be offset by bad ones.
Rising annuity. The payments may increase by up to 20 per cent a year. Sizing them at 4,900,000 and then 5,880,000 still gives a present value of exactly 10 million at 5.0 per cent, but keeps more in the trust in year 1. At 12 per cent growth the remainder rises to 1,176,000, 33,463 more than the level annuity.
Illustrative, not tax advice. The figures apply simplified US federal rules: the section 7520 rate of the month of funding, a level or 20 per cent rising annuity, a 40 per cent estate tax rate on an estate above the exemption. State estate and income taxes, generation-skipping transfer tax, valuation and drafting can all change the result, and a GRAT should be set up with a qualified US tax adviser.
A zeroed-out GRAT transfers the growth above the 7520 rate and nothing else: on 10 million over two years at 5.0 per cent, 12 per cent growth leaves 1,142,537 to the heirs, while growth at or below the rate leaves nothing and costs little. Whether that is worth doing next to the family's other planning is a question of who runs the numbers. The Family Office Professional describes how single-family and multi-family offices invest and operate, and the free workbook for this case prices what a family office costs and when it pays. For the related question of selling a concentrated position, see whether diversifying a concentrated stock repays the tax.
The remainder is zero and the annuity simply returns the assets to the grantor; if they fall in value, the trust runs out before paying the full annuity. In the illustrative two-year GRAT, growth of 5 per cent or less leaves nothing for the heirs. The cost of a failed GRAT is mainly legal and administrative fees, which is why families run them repeatedly on volatile assets.
Because the transfer comes from growth above the hurdle in good years, and a short term captures a good year before a bad one can offset it. The grantor must also survive the term, or most or all of the assets come back into the estate. A series of rolling two-year GRATs keeps both risks small, at the price of more paperwork.
The annuity may increase by up to 20 per cent a year. Back-loading the payments keeps more assets in the trust longer, so more growth accrues to the remainder. In the example, payments of 4,900,000 and 5,880,000 instead of two of 5,378,049 raise the remainder from 1,142,537 to 1,176,000 at 12 per cent growth.
This article is one calculation from The Family Office Professional. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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