Use Grantor Retained Annuity Trusts (GRATs) for Business Succession
Grantor retained annuity trusts (GRATs) are a popular way to pass along appreciated gains and avoid estate taxes. Many executives, entrepreneurs, and wealthy individuals use these special trusts. Startup founders and key employees can use GRATs to minimize the tax impact of their highly appreciated stock. GRATs can also provide a loophole for high-net-worth individuals. Those individuals can pass wealth to their heirs and avoid paying estate taxes.
How GRATs Work
The mechanics behind GRATs are relatively straightforward. Here’s how they work: a “donor” or “grantor” funds a GRAT trust with high income-producing assets or assets they believe will substantially appreciate. These assets often include stock from a company the donor owns or is affiliated with in some way. The stock can be public or private company stock. Interestingly, GRATs are one of a few trust types that can hold shares of S corporations, partnerships, and LLCs.
The donor will receive an annual fixed income stream from the trust; the “annuity interest”. The trust pays out the annuity interest for a designated period. This is referred to as the GRAT term.
Once the GRAT term expires, the trust distributes the remaining assets to the donor’s beneficiaries. The trust names the beneficiaries. This distribution will be free of gift and estate tax. The GRAT can also be structured to make distributions to beneficiaries before the GRAT term ends.
An Illustrative Example
As an illustrative example, assume an individual puts $100 million worth of stock into a GRAT. If the stock rises to $140 million afterwards, the beneficiaries will receive $40 million in profits free of gift and estate taxes. In other words, the heirs receive the gains on the investments above the principal amount tax-free.
It’s attractive to set up a GRAT in a low interest rate environment. If the assets make returns that exceed the IRS interest rate, the beneficiaries receive any additional appreciation at the end of the GRAT term. If the investment underperforms and returns stay below the IRS interest rate, the donor will still receive back most of the assets without penalty.
History of GRATs
The modern estate tax was first enacted by Congress in 1916. Today, gift and estate taxes are only applicable for individuals who possess more than $11.7 million or couples who possess more than $23.4 million. However, new legislation could lower this threshold.
Congress accidentally created GRATs in the 1990s while attempting to close an estate tax loophole. Some politicians have raised awareness of how individuals use GRATs to avoid estate taxes, Yet the loophole remains in place.
In 2000, the GRAT structure sustained a challenge in U.S. tax court. In the case Walton v. Commissioner, a member of Walmart’s Walton family brought a lawsuit against the IRS to avoid a large gift tax liability for a money transfer to her children using a GRAT. The court ruled against the IRS and allowed a tax-free transfer. This ruling helps GRATs survive further challenges.
“I don’t blame the taxpayers who are doing it,” stated Daniel Hemel, a University of Chicago Law School professor. “Congress has virtually invited them to do it. I blame Congress for creating the monster and then failing to stop the monster once it became clear how much of the tax base the GRAT monster would eat up.”
Estate Planning and Startup Exits
Following an exit event like an IPO or sale to another company, startup founders and key employees can contribute company stock they expect to appreciate to a GRAT. This can help protect a portion of the startup’s newly generated wealth from taxes.
GRATs are typically structured as “zeroed out GRATs.” This means that during the GRAT term, the present value of the annuity stream will be equal to the principal amount that the donor placed into the GRAT. Therefore, the IRS considers the value passed from donor to beneficiaries to be a zero-value gift.
Usage by Billionaires
A detailed look into IRS records reveals that billionaires frequently use GRATs as an estate tax-free way to pass fortunes to their heirs. According to research data, over half of the 100 wealthiest Americans have established GRATs.
For tax lawyers and accountants who serve ultrawealthy clients, this is a well-known strategy. Michael Kosnitzky, co-head of the private wealth practice at the law firm Pillsbury Winthrop, considers GRATs a plain vanilla estate tax plan. “This is an off-the-shelf solution,” Mr. Kosnitzky stated. “Almost every wealthy person should have one.”
GRATs are sometimes disclosed in securities filings with the Securities and Exchange Commission (SEC) or in lawsuits. For example, securities filings have disclosed GRATs held by Meta (formerly known as Facebook) co-founders Mark Zuckerberg and Dustin Moskovitz, as well as Chief Operating Officer Sheryl Sandberg. However, some GRATs are only disclosed in private IRS filings.
Three are many familiar names among the individuals who have used GRATs and other special trusts. They include Michael Bloomberg, Oprah Winfrey, Stephen Schwarzman, Leonard Lauder, and Laurence Powell Jobs. According to tax records, Jacqueline Mars, heir to the Mars candy company fortune, held more than 15 GRATs.