In this article we will explain Grantor Retained Income Trusts, Grantor Retained Annuity Trusts, and Grantor Retained Unitrusts (“GRITS, GRATs and GRUTs”) for estate tax planning, including: “what are GRITs, GRATs and GRUTs?,” and “how do GRITS, GRATs and GRUTs work with respect estate tax and gift tax?”
Grantor Retained Income Trusts, Grantor Retained Annuity Trusts, and Grantor Retained Unitrusts (GRITs, GRATs, and GRUTs), are three similar types of irrevocable trusts that are used in sophisticated estate plans in order to allow an individual to remove assets from his or her taxable estate while continuing to receive a monetary benefit of the asset during his or her lifetime.
In a Grantor Retained Income Trust (“GRIT”) strategy, the creator of the trust (known as the “grantor”) will transfer ownership of an asset from his or her individual name to ownership by the trust. Once transferred to the trust, the asset is effectively removed from the grantor’s taxable estate. While the grantor loses the ability to sell or transfer the asset, the grantor retains the right to receive payments of income that the asset generates for a set number of years.
A Grantor Retained Annuity Trust (GRAT) functions much like a GRIT except that rather than receiving income from the asset owned by the trust, the grantor will receive fixed payments on a regular basis based on a percentage of the fair market value of the asset at the time it was transferred to the trust.
A Grantor Retained Unitrust differs from GRITS and GRATS in that, rather than receiving all income or a fixed annuity payment, the grantor will receive a fixed percentage of the fair market value of the trust assets. The fair market value of trust assets is calculated on an annual basis. This means that although the percentage is fixed, the amount paid from the trust to the grantor will vary based on the changing value of the asset.
In our article Irrevocable Trusts for Estate Tax Planning we explain in detail how irrevocable trusts are used to minimize estate tax. We will provide a brief summary here for foundation.
Estate Tax is taxed on a federal and state level on all assets owned by a deceased person over and above that individual’s federal and state lifetime estate and gift tax exclusion limit. Federally, the lifetime exclusion is approximately $11.5 million. Illinois’ lifetime exclusion is $4 million. This means that federal and Illinois estate tax applies to the extent an estate is valued above these respective amount.
In order to prevent people from transferring their major assets to their children before they pass away with the purpose of avoiding estate tax, a gift tax is charged on lifetime gifts over a certain dollar amount. Any gifts over and above the annual gift tax exclusion ($15,000.00 per recipient) will serve to reduce the giver’s lifetime estate tax and gift tax exclusion limit. The upshot is that if your exclusion limit is reduced to zero during your lifetime, any future gifts above the annual exclusion limit ($15,000.00) will be subject to gift tax. Further, the more your lifetime exclusion limit is reduced, the more of your estate will ultimately be subject to estate tax.
Transfers to irrevocable trusts remove assets from your taxable estate, but they are also subject to gift tax. This means that if you transfer a piece of real estate valued at $1 million to an irrevocable trust, it will not be subject to estate tax when you pass. However, it will reduce your lifetime Illinois gift and estate tax exclusion from $4 million to $3 million.
This is not necessarily a zero-sum game, because the asset can now accumulate in value without the accumulated value being considered part of your estate for estate tax purposes. So, in our example, if the real estate grows in value from $1 million to $3 million before you pass, you will have reduced your lifetime exclusion by $1 million but will have passed $3 million to your beneficiaries. In this scenario you have passed $2 million in accumulated value to your beneficiaries free of any estate or gift tax consequences.
Thus far, we have been discussing estate tax planning using generic irrevocable trusts. So where do GRITs, GRATs and GRUTs come in? GRITs, GRATs and GRUTs have two primary benefits: (1) reducing the amount of the initial transfer that will be subject to gift tax; and (2) allowing the grantor to retain some financial benefit from the asset.
Here is how GRITs, GRATs and GRUTs work:
So, GRITs, GRATs and GRUTs are a gamble. The grantor is betting he or she will outlive the payment schedule. If he or she does so, the trust assets will pass to beneficiaries in one of the most tax efficient manners possible. However, if the grantor dies prior to this schedule expiring, the assets will be subject to estate tax.
GRITs, GRATs and GRUTs are used most often for assets like real estate and closely held businesses that the grantor wants to keep in the family and does not foresee ever wanting to sell. These types of trust allow the grantor to continue to receive some income from the assets while still removing the assets from his or her taxable estate.
Because of the tradeoffs involved in a GRIT, GRAT, or GRUT strategy, these types of trusts are usually used in more sophisticated estate plans after strategies such as AB Trusts and Irrevocable Life Insurance Trusts have already been employed or explored.