The Grantor Retained Annuity Trust (GRAT)

How it works

A grantor retained annuity trust, usually shortened to GRAT, is an irrevocable trust my client funds with an asset while keeping the right to a fixed annuity for a set term of years. Whatever is left in the trust when the term ends passes to the beneficiaries named in the document, typically my client's children or a further trust for their benefit.

Section 2702 exists because Congress did not want a taxpayer retaining a generously valued annuity while understating what the family actually receives. Its default rule is blunt: a retained interest that is not a "qualified interest" is valued at zero, turning the entire amount contributed into a taxable gift, not just the portion my client actually gave away. A qualified interest is the escape hatch, defined in section 2702(b) as a fixed dollar amount or a fixed percentage of the trust's initial value, paid to my client at least annually and valued under the government's own published discount rate in section 7520, so the taxable gift equals the value contributed minus the present value of that annuity, rather than the full amount.

Because the retained interest is valued off a published rate rather than what my client actually expects the asset to earn, a drafter can size the annuity so its present value equals nearly the full amount contributed, pushing the reported gift toward zero. A "zeroed-out" GRAT reports a gift of close to nothing, so it uses almost none of the same lifetime exemption that outright gifting draws down. If the trust's assets then outperform the discount rate, every dollar of that outperformance passes to the remainder beneficiaries free of further gift tax, since the gift was already fixed on the day the trust was funded.

Why zeroing out is allowed

For years the IRS valued an annuity continuing to my client's estate on a mid-term death as if limited to the shorter of the stated term or my client's life expectancy, a life-contingent measure worth less and harder to zero out. In Walton v. Commissioner, 115 T.C. 589 (2000), the Tax Court rejected that as an invalid extension of section 2702, holding such an annuity valued for the entire stated term instead. The IRS acquiesced in Notice 2003-72, and Treasury conformed its regulatory examples in T.D. 9181, which is why current drafting continues the annuity to my client's estate on a mid-term death: it preserves the full-term valuation and pushes the reported gift as close to zero as the numbers allow.

The rate the trust has to beat

Section 7520 sets that discount rate monthly, at 120 percent of the applicable federal midterm rate, published by the IRS in a revenue ruling. A GRAT only shifts wealth to family to the extent the trust's actual return beats that published rate; nothing about the structure guarantees outperformance, only what happens on the gift tax side if it occurs.

The income tax side, and what it is worth in Florida

A GRAT is almost always a grantor trust for income tax purposes, so my client, not the trust, reports all of its income and gains every year under section 671, one reason being that the annuity itself is trust income that may be paid to my client under section 677(a)(1). Because the annuity also continues to my client's own estate on a mid-term death, that reversionary interest is often worth more than 5 percent of the trust's value at creation, independently triggering grantor status under section 673(a). The trust compounds before tax while my client carries the bill, and because Florida has no individual income tax, that bill is a federal-only cost for a Florida resident, not a combined one.

Who this applies to

There is no minimum net worth, income level, or required entity type here. What actually gates a GRAT is the family-member requirement built into the statute, and, practically, whether my client holds an asset with a real case for beating a published rate.

• The remainder has to go to family, as the statute defines it. Section 2702, and the zeroing-out technique it enables, applies only to a transfer in trust to, or for the benefit of, a member of my client's family under section 2704(c)(2): a spouse, an ancestor or descendant of my client or my client's spouse, a sibling, or the spouse of any of those. A GRAT for an unrelated beneficiary, or for a charity, falls outside section 2702 entirely, and outside the point of the technique.
• The real gate is the asset, not the balance sheet. There is no statutory net-worth or income threshold. What matters is whether my client holds a concentrated position with an asset-specific reason to expect it will outperform the current section 7520 rate, such as pre-liquidity equity, a closely held interest, or a volatile public stock. A diversified portfolio is a weak candidate, since there is no reason to expect it to beat the rate rather than track it.
• My client has to be able to fund the annuity every single year, in cash or actual property, never a note. That is routine for a liquid, income-producing portfolio, but a single illiquid position forces either outside liquidity or handing back a slice of the asset itself.
• My client should reasonably expect to outlive the term, since dying before it ends typically pulls most or all of the current trust value back into the estate, covered below. Older clients, or anyone with real reason to doubt they will survive the term, lean toward shorter terms and rolling structures.

A GRAT is also a weak vehicle on its own for leveraging generation-skipping exemption. Under section 2642(f), that exemption cannot be allocated to property during the estate tax inclusion period, any span after the transfer in which the property would still be included in my client's gross estate at death. A GRAT's own structure stays inside that period for the entire term, since a mid-term death causes inclusion under section 2036, so the exemption can only be allocated once the term ends, and appreciation during it is not shielded.

What it requires

Everything below is a condition the instrument has to satisfy, not a sequence of actions. Missing any one can take the qualified-interest treatment down with it.

• A qualifying annuity, defined precisely. A fixed dollar amount or a fixed percentage of the trust's initial value, paid at least annually. A graduated annuity is allowed if no year's payment exceeds 120 percent of the year before, and the term must be fixed and ascertainable at creation: my client's life, a stated number of years, or the shorter of the two, with no regulatory floor on how short it can be.
• Continuation to my client's own estate on a mid-term death, the Walton-driven drafting choice described above, letting the retained interest be valued for its full stated term rather than a shorter, life-contingent one.
• Real payment, on time. Treasury Regulation 25.2702-3(d)(6) requires the document to prohibit satisfying the annuity with a note or other debt instrument; it has to be actual cash or property. Treasury Regulation 25.2702-3(b)(4) gives that payment 105 days from the trust's anniversary date, or the trust's own tax return due date on a taxable-year basis, and does not forgive a late payment.
• A gift tax return, even at close to zero. My client still has to file Form 709 reporting the transfer and the taxable gift, however small. An adequate description of how the annuity was valued is also what starts the limitations period under section 6501(c)(9) running on the IRS's ability to challenge that valuation; without it, the period never begins.
• A clean distribution at the end. When the term ends, whatever remains moves to the named remainder beneficiaries, or a further trust for them, with no additional gift tax due simply because the trust outgrew the rate assumed at funding. That outperformance is the entire point of the structure, and it was already accounted for when the gift was reported.

What you need to document

A contemporaneous appraisal of whatever is contributed

Needed to size the annuity and report the gift correctly, and it matters most for a closely held or illiquid position where no market price already exists.

The instrument's own qualifying language, in the document itself

The fixed-term definition, the cash-or-property-only payment clause, and the continuation of the annuity to my client's estate on a mid-term death. Valuation rests on what the trust document actually says, not on what anyone intended it to say.

Proof the annuity was paid, in full, on time, every year

Trustee and bank records showing actual cash or actual property moving within the required window. A missed or late payment is the single most common way this gets disqualified.

The gift tax return and its valuation disclosure

Form 709 showing the transfer, the section 7520 rate used, and a description of the valuation method detailed enough to count as adequate disclosure and start the limitations period running.

A record tying back to the rest of the estate plan

If this GRAT reports any deliberate residual gift, or is one of a rolling series, a running ledger of how much of the shared lifetime exemption has been used matters just as much as the trust paperwork itself.

Where it goes wrong

A GRAT built on the qualified-interest regulations is not a listed or reportable transaction. The risk here is mechanical failure and mortality, not a challenge to the underlying concept.

Dying before the term ends

Treasury Regulation 20.2036-1(c)(2) supplies the inclusion formula: divide the annuity amount by the section 7520 rate in effect on the date of death, and that is the corpus the law treats as necessary to keep generating that payment, capped at the trust's actual value that day. A zeroed-out GRAT's annuity was sized so its present value equals nearly the full amount contributed, so that formula almost always lands at or above whatever is left, and the cap controls: a mid-term death typically pulls the entire remaining balance into the gross estate under section 2036(a)(1), not a pro-rated share. Short terms and rolling GRATs, funding a new short trust every year or two, shrink this window without eliminating it on any single trust.

A zeroed-out GRAT's entire design is a bet that my client survives the term.

There is a genuine silver lining. Property required to be included in a decedent's gross estate, even property transferred before death, gets a stepped-up basis under section 1014(b)(9), the same as any other estate asset. A GRAT that runs its full term successfully is the opposite: the remainder passes to the beneficiaries with my client's own carryover basis under section 1015, no step-up at all. A failed GRAT is not a failure in every respect.

Missed or late annuity payments

The 105-day payment window is a bright-line rule, not a guideline. A trustee who pays late, underpays, or tries to satisfy the annuity with a promissory note instead of cash or property risks the retained interest failing the qualified-interest test entirely, which does not just cost the missed payment: section 2702's default then values the whole retained interest at zero, turning the entire original contribution into a taxable gift.

• Valuation and discount-rate risk both sit with my client. Zeroing out depends on an accurate appraisal at funding, since an understated one on a closely held or illiquid asset misstates the reported gift and the annuity's sizing alike. Separately, because the retained interest is valued off the published section 7520 rate rather than an assumed return, a GRAT funded when that rate is high, or an asset that underperforms it, can leave little for the remainder beneficiaries without creating any additional gift tax beyond what was already reported; the downside is opportunity cost and fees, not a larger tax bill.

A situation where this comes up

The client I have in mind holds one concentrated position, often stock in a business close to a sale or that has simply grown to dwarf the rest of the portfolio, with a real, asset-specific reason to expect it will outperform a modest government-set rate over the next couple of years. Funding a short GRAT with that asset lets its growth reach the children with little or no additional gift tax if my client is still around when the term ends.

What I look for before recommending this is whether my client can genuinely live with both outcomes, not just the good one: a modest, close to costless bet that pays off if the asset performs and my client survives the term, against a mid-term death that typically erases the freeze and pulls the trust's value straight back into the estate. A client who cannot sit with that binary, or who does not hold an asset with a genuine case for beating the discount rate, is usually better served by a steadier technique.