Grantor retained annuity trusts (GRATs) are a type of irrevocable trust designed to pass assets to beneficiaries in a tax-optimized way. These trusts pay an income (or annuity) to the grantor or trustor—the person who set up the trust—for a specified duration, usually a few years. After that period, the assets in the trust pass to the named beneficiaries.
To help you understand how GRATs work, and how they can help you manage taxes ahead of a big-money event, let’s walk through an example. Remember, these examples are purely hypothetical and meant to be educational.
- You have 1,000 shares of company stock worth $100.
- You put those shares into a GRAT for two years.
The IRS assumes those shares will return a certain amount (usually pegged to current interest rates) while they’re in the trust. So:
- You set up the trust to pay you $54 per share per year.
- $5,400 in year one; $5,400 in year two.
- As far as the IRS is concerned, $10,000 went in, and $10,800 came out; this which exceeds the roughly 3% annual return the IRS expects in 2025.
In the meantime, your company IPOs and the shares skyrocket in value to $1,000 per share.
- $89,200 in the trust passes tax-free to the beneficiaries and doesn’t count toward your lifetime gift tax exclusion.
- $1,000 per share (times 100 shares) less the $108 per share paid out to you, the trustor, during the trust’s two year life cycle.