In the realm of estate planning the initials GRAT stand for “grantor retained annuity trust,” and these trusts are commonly used to transfer the appreciation of volatile assets to your heirs with little or no gift tax liability while you gain estate tax efficiency. The way that the grantor retained annuity trust works is that you fund the trust, perhaps using securities, real estate, and/or interests that you may hold in a business or businesses. You also set a term for the trust, and this term can be any length of time you choose, but the assets in the trust will go back into your estate if you die before the term has been completed so you want to keep this in mind when you are setting the term. You as the grantor or donor will receive annuity payments out of the trust during its term.
This initial funding of the trust is considered to be a gift and it is taxable as such. But, the IRS Federal Midterm Rate will be used to determine the present value of the trust for tax purposes, and this is essentially the present value of the assets in the trust coupled with the anticipated interest that these assets will earn. The way that you minimize your gift tax exposure is through a “zeroed out” GRAT, meaning your annuity payments over the term of the trust are calculated to comprise the entire total value of the trust as it stood on the day you created it. Since your retained interest is the entire value of the trust you owe no gift tax.
What makes a grantor retained annuity trust successful is when the assets in the trust appreciate beyond the original valuation by the IRS. Any such appreciation that remains in the trust after its term has expired is transferred to your beneficiary free of the gift tax.