Using a GRAT or GRUT to shift appreciation and maintain control of the corporation

The purpose of Sec. 2702 is to determine whether a transfer after Oct. 8, 1990, of an interest in a trust to a family member is a gift and, if so, the value of the gift. A family member includes (1) the transferor’s spouse and siblings; (2) the transferor’s or spouse’s ancestors and lineal descendants; and (3) a spouse of any ancestor, lineal descendant, or sibling (Secs. 2702(e) and 2704(c)(2)). (Note that this definition of a “family member” is broader than that under the Sec. 2701 rules.)

Generally, the effect of Sec. 2702 is to value at zero the interest in a trust retained by a transferor or any applicable family members. In turn, this causes the transferred interest (the gift) to be valued at the full value of the property (Regs. Sec. 25.2702–1(b)).

Example 1. Valuing a gift of stock in trust under Sec. 2702: Shareholder A transfers stock of Y Corp., a closely held corporation, to a trust for the benefit of his son but retains a life interest in the trust income. The fair market value (FMV) of the stock is $2 million. However, without the rights to dividends from the stock during A’s lifetime, the stock is worth only $1.2 million.

Under the general rule of Sec. 2702, A is not allowed to deduct the $800,000 retained interest value ($2 million – $1.2 million) from the amount of the gift. Therefore, A is deemed to have made a $2 million gift when, in reality, the gift is only worth $1.2 million.

Although Sec. 2702 generally provides that a retained interest is assigned a value of zero, certain exceptions (called qualified interests) and exemptions apply. For transfers of stock of a closely held corporation, the primary method available to ensure that a retained interest is assigned value is to make the trust either a grantor retained annuity trust (GRAT) or a grantor retained unitrust (GRUT). (Grantor retained income trusts (GRITs) are ineffective in minimizing the gift tax consequences of most family transfers because the retained interest in a GRIT generally is assigned a zero value by Sec. 2702.) Using a GRAT or GRUT can result in the amount of the taxable gift equaling the stock’s FMV less the value of the retained annuity or unitrust interest.

Additional contingencies and requirements, other than those stated in the preceding paragraph, should be analyzed against Sec. 2702(b)’s qualified–interest rules. The Tax Court held that revocable spousal interests retained in a husband’s and wife’s respective GRATs were not qualified interests. The interests were payable if one spouse predeceased the other during the term of the trust. Therefore, these interests were contingent, not fixed and ascertainable, and failed the rule that the term extend for the life of the grantor, a specified term of years, or the shorter of those periods (Estate of Focardi, T.C. Memo. 2006–56).

Using a GRAT

A GRAT is an irrevocable trust in which the transferor or an applicable family member retains a right to receive fixed amounts, payable at least annually, for a term of years, for life, or for the shorter of the two periods. The fixed amount may be a stated dollar amount that remains constant each year or a fixed fraction or percentage of the original FMV of the property transferred to the trust. Payments based on a fixed fraction or percentage may increase each year up to 120% of the amount payable in the preceding year. The governing instrument of the trust must prohibit (1) additional contributions to the trust and (2) distributions to anyone other than the person holding the retained interest, for the life of the retained interest. The trust instrument must also contain appropriate provisions dealing with (1) situations where the initial FMV of the trust property was determined incorrectly and (2) adjustments for short tax years and the final tax year (Sec. 2702(b)(1); Regs. Sec. 25.2702–3(b)).

Example 2. Freezing the value of stock by transferring it to a GRAT: S owns all of the outstanding stock (1,000 shares) of A Inc., which is expected to have substantial growth within the next 10 years. The anticipated growth in A heightens S’s concern that her estate will incur substantial estate tax (although she is 56 years old and in excellent health). Currently, the company is valued at $8 million, and S is in a taxable estate situation without this stock.

S wants to transfer at least 40% of her stock to her two grown children who are active in A. However, she wants to transfer the stock in five to 10 years, when they have gained more maturity. S wants to keep the value of her A stock as low as possible for estate tax purposes (and to transfer more of her estate to her children) and retain voting power until her children are older.

S establishes a 10–year GRAT, naming her two children as equal remainder beneficiaries. The GRAT fits well because of the high expectations for significant future appreciation in the value of the A stock. S decides that her children will collectively own 40% of the stock of A at the end of the term, so her GRAT will be funded with 400 shares of stock. She will effectively freeze the value of the transferred stock, remain active in the company, and continue receiving current distributions from A but delay transferring the voting stock outright to her children until they have gained more maturity and business experience.

The biggest risk with the plan is that S will die before the end of the 10–year term, in which case the value of the A stock and any other assets in the GRAT will be included in her already taxable estate. In view of her age and excellent health, this is considered a risk worth taking.

Valuing the gift of a remainder interest in a GRAT

The annuity (retained) interest is valued under Sec. 7520 (Sec. 2702(a)(2)(B); Regs. Secs. 25.2702–1(b) and 25.2702–2(b)(2)). The interest rate to use is 120% of the federal midterm rate for the month in which the gift is made, compounded annually and rounded to the nearest two–tenths of 1% (Sec. 7520(a)(2)). The federal midterm interest rate is published by the IRS in the monthly revenue ruling that lists the applicable federal rates for the month.

The gift value of the remainder interest is determined by subtracting the value of the annuity interest from the total value of the property transferred (Regs. Sec. 25.2702–1(b)). At the conclusion of the term or life interest, the trust property is distributed to the designated beneficiaries (usually the younger generation).

Generally, the lower the Sec. 7520 rate, the smaller the value of the remainder interest (i.e., the gift) subject to gift tax when the trust is funded. And, to the extent that the assets placed in the trust outperform the Sec. 7520 rate, assets are transferred tax–free to the taxpayer’s beneficiary.

Planning tip: GRATs continue to be worthwhile techniques for shifting wealth at a reduced gift tax cost. However, the increased basic exclusion amount ($15 million for 2026 (or higher for married couples electing to pass the first–to–die’s unused exclusion to the surviving spouse)) may reduce the interest in GRATs. Nevertheless, using GRATs may be beneficial for state death tax purposes.

Example 3. Valuing the gift of stock transferred to a GRAT: Assume the same facts as in Example 2. S establishes a GRAT in which she retained a 10–year $112,000 annuity interest. The terms of the GRAT state that S’s estate is entitled to receive the required periodic trust payments if S dies during the trust term. Therefore, S or her estate will receive a fixed amount of $112,000 annually for 10 years. The source for the $112,000 distribution will be A. Any amount distributed by A to the GRAT in excess of $112,000 will be retained by the GRAT and invested. At the end of the trust term, the stock, along with any accumulated investment, will be distributed to her children.

S’s retained annuity interest is valued by multiplying the $112,000 annual annuity amount by a factor based on (1) the term (the number of years) of the GRAT; (2) the interest rate in effect the month the stock is transferred to the GRAT; and (3) the timing of the annual payment (e.g., whether paid to S on a monthly, semiannual, or annual basis).

The value of S’s taxable gift equals the FMV of the stock transferred to the GRAT, less the value of her retained interest. After considering a valuation discount for the minority interest position of the stock to be placed in the GRAT, which an appraiser determines to be 30%, the FMV of the 40% of A stock that S wishes to give to the GRAT is determined to be $2,240,000 ($8,000,000 × 40% × 70%). Assume the calculations show the value of S’s retained annuity interest is $945,706. Therefore, S made a taxable gift of $1,294,294 (with no annual exclusion allowed because the gifts are future interests).

Assuming the FMV of the stock given grows to $6 million in 10 years, when the term of the GRAT ends, even after $112,000 per year has been distributed to S, her children will receive stock valued at $6 million at a minimal tax cost. This is because neither estate tax nor gift tax is incurred at the termination of the GRAT. When the GRAT terminates, S will have no further interest in the A stock that was once held by the GRAT.

The following are several observations regarding the amount of the annual annuity:

• The annual annuity payment amount to be selected can be based on what would be a comfortable level for A to distribute in the future, balanced by the desired level of taxable gift to be reported. A larger annual annuity will lower the value of the remainder interest subject to gift tax; a smaller annual annuity will increase the amount subject to gift tax.
• The amount of the gift to be reported will also vary, based on the length of the term of the GRAT. A term longer than 10 years will decrease the amount of the gift, while a shorter term will increase it. But as previously noted, the longer the term, the greater the likelihood that S will die during the term, negating the GRAT’s estate-freezing benefit.
• Congress allowed exceptions to the restrictive rules of Sec. 2702 for an annuity trust or a unitrust, on the theory that the annual payout to the holder of the retained interest would essentially negate or offset growth in the value of the asset contributed to the trust. If, however, the taxpayer is fortunate enough to select assets whose growth exceeds the payout amount, the taxpayer may achieve substantial savings. Because S believes that the growth in the value of the A stock transferred to the trust will exceed $112,000 annually, her plan has the potential for real tax savings.
• Funding the GRAT with A stock does not dictate or restrict the amount or level of distributions that A can or must make. The annual distribution requirement is an obligation of the GRAT, not the corporation. If distributions exceed $112,000 in a year on the stock held by the GRAT, the excess is retained by the GRAT and reinvested. If the amount to be distributed on the stock held by the GRAT is less than $112,000 in a given year, the GRAT can still satisfy the distribution requirement by using previously accumulated income or by invading the GRAT’s principal.

Using a GRUT

A GRUT is an irrevocable trust in which the transferor or an applicable family member retains a right to receive amounts payable at least annually that are a fixed percentage of the annual FMV of the trust’s assets. The payments must be for a term of years, for life, or for the shorter of the two periods. The governing instrument of a GRUT must contain provisions similar to those discussed for GRATs, except there are no restrictions on additional contributions to a GRUT (Sec. 2702(b)(2); Regs. Secs. 25.2702–3(c) and (d)).

Warning: According to the regulations, when a GRAT or GRUT term is the shorter of a period of years or the transferor’s life, the valuation is based on both the trust term and the grantor’s life expectancy, whichever is shorter (Regs. Sec. 25.2702–3(e), Examples (1) and (5)). Therefore, the actuarial value of the annuity interest is reduced to reflect the probability that the grantor will die during the term of the trust (increasing the value of the gift). However, this valuation under the regulations is no longer considered correct if the grantor’s estate is entitled to receive the required periodic trust payments at the transferor’s death during the trust term (Walton, 115 T.C. 589 (2000); Notice 2003–72). The Tax Court’s ruling means that qualified interests in a GRAT can be valued using a straight term of years, and the remainder interests (the taxable gifts) can be reduced to zero.

At the end of the GRUT’s term or life interest, the trust assets are distributed to the designated beneficiaries. As with a GRAT, the annuity interest in a GRUT is valued according to the Sec. 7520 valuation rules, and the value of the remainder interest (the gift) is determined by subtracting the value of the annuity interest from the total value of the property transferred to the trust (Regs. Secs. 25.2702–1(b) and 25.2702–2(b)(2)).

Regs. Sec. 25.2702–3, which applies to both GRATs and GRUTs, explains the rules for determining whether a retained interest is a qualified interest under Sec. 2702. These regulations clarify that a trust using a note or other debt instrument, an option, or a similar financial arrangement to satisfy the annual payment obligation does not meet the requirements of Sec. 2702(b) (Regs. Sec. 25.2702–3(d)(6)). However, notes or other debt instruments obtained from an unrelated party to make the required payment are permitted (although the step–transaction doctrine will be applied).

Choosing between a GRAT or a GRUT to transfer stock

The choice between a GRAT or a GRUT depends in part on the client’s tax saving objectives (current versus future savings) and on whether the underlying assets are expected to appreciate. In the typical case in which amounts to be distributed to the retained interest holder are less than the assumed rate under Sec. 7520 (١٢٠% of the federal midterm rate), a GRUT will produce a smaller gift tax liability than a GRAT. (The GRUT is revalued annually. Because income in excess of distributions will increase subsequent revaluations, the annual distributions from a GRUT (which are a fixed percentage of the revalued assets) are assumed to increase in future years. However, with a GRAT, distributions are constant.) Finally, GRUTs allow additional gifts to be made after initially establishing it, while GRATs do not.

Example 4. Choosing between a GRAT or a GRUT to transfer stock: Assume the same facts as in Example 3. A GRAT provides distributions of a fixed amount each year, while distributions from a GRUT are based on a set percentage of the (fluctuating) value of the assets transferred to the GRUT. This value must be determined annually (Sec. 2702(b)(2)).

This basic difference suggests three distinct disadvantages of a GRUT toS:

1. Because the annual payout is based on a value that changes annually, a degree of certainty is lost.
2. The need to value the A stock on an ongoing basis could be expensive because its closely held nature would require an annual appraisal (with accompanying professional fees).
3. If S is correct on the growth potential, she does not want the annual payout to be based on the increasing value of A. Using that measure for payout means more paid out to her each year and ultimately more value retained in her estate on which to pay estate taxes.

Also, S does not anticipate making later gifts to the trust. Therefore, it appears that the GRAT structure is the best strategy for S.

For either type of trust to be effective, the retained interest holder must survive the term of the retained interest. If the holder does survive, the GRAT may ultimately produce a greater estate tax benefit, assuming the assets in the trust appreciate and the estate tax is in effect in the year of death. With a GRUT, appreciating assets cause the trust distributions to increase, and, consequently, the estate of the retained interest holder will also increase. With a GRAT, the distributions are constant even if the assets increase.

The IRS will not issue letter rulings or determination letters on whether the assets in a grantor trust receive a Sec. 1014 basis adjustment at the death of the deemed owner of the trust for income tax purposes when those assets are not includible in the gross estate of that owner (Rev. Proc. 2026–3, §5.01(7)). Practitioners have speculated that this no–rule guidance may be the result of an overly aggressive use of intentionally defective grantor trusts as an estate planning tool. An intentionally defective trust is an irrevocable trust designed to secure certain tax benefits by taking advantage of the fact that the grantor trust income tax rules differ from the estate tax inclusion rules. Due to these differences, a trust may be drafted in a way that the grantor is treated as the owner of the trust for income tax purposes, but the trust property is not includible in the grantor’s gross estate for estate tax purposes. As a result, the grantor is able to keep future appreciation on the assets transferred into the trust from being included in the grantor’s estate.

Contributor

Shannon Christensen, J.D., MBT, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org. This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s C Corporations topic. Published by Thomson Reuters, Frisco, Texas, 2026 (800-431-9025; tax.thomsonreuters.com).