How To Reduce Estate Taxes

With individual retirement accounts, whether of the Roth or the original variety, you pay taxes at some point. Have you ever wondered if an analogous vehicle exists that is free of estate tax? There is: a grantor retained annuity trust, or GRAT. We learn more about GRATs from Darius Gagne, chief investment officer of Quantum Financial Advisors, LLC based in Santa Monica, Calif.

Larry Light: GRATs are commonly considered part of advanced estate planning. Can you explain more about why we should take note?

Darius Gagne: Yes, advanced estate planning generally refers to strategies aimed at reducing estate tax, a problem that only applies to individuals with assets over $12.92 million, which is the estate tax exemption in 2023, or double that amount, $25.84 million, for couples. These trusts can have terms that last generally up to 10 years. Assets in the estate include homes and real estate as well as investment and retirement accounts.

And under current law, the exemption, which increases each year with inflation, will be cut in half in 2026, since a provision of the Tax Cuts and Jobs Act (TCJA) of 2017 is scheduled to sunset at that time. So, estate tax considerations could become a planning concern for more people if that occurs, absent the extension of the higher exemption or the passage of a new law.

Light: The GRAT vehicle is all about removing future appreciation from the taxable estate. Explain that, please.

Gagne: This could include increases in market value or earnings from an investment portfolio, or appreciation in other assets, such as real estate. But the situation where a GRAT offers the most bang for the buck is with assets that are expected to highly appreciate, such as shares or options granted in a private company or start-up.

Light: Can you give an example of how this works?

Gagne: Imagine the grantor—the person setting up and funding the trust—creates the GRAT with the help of a qualified estate-planning attorney and funds it with $5 million worth of stock in a start-up company. The start-up does well and goes public, and the value of the shares pops to $50 million.

The rules for GRATs require that the original funding of $5 million, plus interest currently assumed at around 5%, is paid back to the grantor over the term of the GRAT, which can be anywhere from two to 10 years, as an annual annuity. So, in this example, the total interest over a 10-year GRAT would be about $2 million. This leaves $43 million left in the GRAT at the end of the 10-year term. At that point, the GRAT typically distributes all its remaining assets to remainder trusts for children or other heirs. As long as you outlive the GRAT, these final trusts are free of estate tax upon your death and potentially upon the death of future generations.

Light: In a nutshell, utilizing a GRAT could shelter a portion of money from estate tax?

Gagne: If you have an asset that you expect to appreciate significantly over the next two to 10 years, and your financial plan says that you won’t need to tap it, then utilizing a GRAT could shelter a significant amount of wealth from estate tax. It is important to emphasize here that the GRAT does not make the original asset value free of estate tax. That value plus the interest paid by the GRAT to the grantor, is always considered part of the estate. The GRAT only removes the appreciation in excess of the threshold interest rate on the asset from the estate.

Light: But it is not uncommon for individuals to transfer shares in a private company to a GRAT and for that company to subsequently have a liquidity event —for example, an initial public offering or an acquisition. Then the value of the shares increases by many multiples, essentially dwarfing the value of the original shares.

Gagne: Any gains on the assets in the GRAT are realized, meaning that investments held by the trust are sold at a profit, then this gain will be subject to income tax, in particular capital gains tax. The “grantor” part of the GRAT acronym has several implications, including that the income tax from the assets in the GRAT will be reported on the tax return of the grantor, who is the person who set up the GRAT and who owned the assets that went into it.

While the GRAT results in estate-tax-free treatment of the appreciation of the assets, it does not result in income-tax-free treatment. Conversely, while withdrawals from a Roth IRA enjoy income tax-free treatment, the account is not free of estate tax.

Light: Why would anyone sell the appreciated assets in the GRAT and subject themselves to potentially millions of dollars of capital gains tax?

Gagne: In the case of a private company going public, where the assets in the trust significantly increase in value, it would create a major concentrated asset as part of the investor’s overall net worth. Prudent financial planning in most cases suggests diversifying the investment as soon as possible, even at the cost of paying capital gains taxes. That’s not just because the pop could be temporary, but because any single company, especially a new and still relatively small company, is subject to all sorts of idiosyncratic risks that investors may not be compensated for.