GRANTOR RETAINED ANNUITY TRUST
When created a Grantor Retained Annuity Trust (GRAT) the donor makes a gift into a trust from which he or she receives an annual payment from the trust for a fixed period of time (the term). At the end of the term, any remaining value in the trust is passed on to a beneficiary of the trust as a gift. The beneficiary must be a family member of the donor. If the donor dies before the end of the term, then the value of the trust at that time is passed on to the beneficiary.
The United States Internal Revenue Service has a number of regulations governing how the remaining value of the trust at the end of the term (or at the death of the donor) is taxed. When the GRAT is first set up, a "gift value" of the GRAT is calculated. The gift value is set equal to the initial contribution to the GRAT plus an assumed interest rate expected to be earned on the principal (based on 120% of what is known as the mid-term applicable federal rate) minus the annuity payments that would be made through the end of the term.
To realize a tax benefit, the sum of the scheduled annuity payments of a GRAT are set to be about equal to the principal plus assumed interest. Thus, for tax purposes, the initially calculated gift value is zero, since what will be paid back to the donor in annuity payments is anticipated to be about equal to what the donor invested, plus interest. If a GRAT is funded with assets that appreciate and grow in value, it is possible that the actual interest earned on the assets will be substantially higher than the IRS theoretical interest. Thus at the end of the term, the value remaining in the GRAT may still be large, even though the initial IRS calculation suggests that it should have been zero. This remaining value is then passed on to the beneficiary without incurring a gift tax.
