Grantor Retained Annuity Trust
§2702 Qualified Interest

How a GRAT works

A grantor retained annuity trust (GRAT) is an irrevocable trust in which the grantor transfers assets and retains the right to receive a fixed annuity for a specified term of years. At the end of the term, the remaining trust assets pass to the remainder beneficiaries, typically the grantor’s children or a trust for their benefit.

The gift tax value of the remainder interest is the value of the transferred property minus the present value of the retained annuity, calculated using the §7520 rate (120% of the applicable federal midterm rate, published monthly by the IRS). If the trust assets appreciate faster than the §7520 rate during the term, the excess passes to the remainder beneficiaries free of gift and estate tax. If the assets underperform the §7520 rate, the annuity payments return the assets to the grantor and no transfer occurs, but nothing is lost beyond transaction costs.

The §2702 framework

Under §2702, transfers to family members in trust are valued under special rules. Retained interests are generally valued at zero unless they qualify as a “qualified interest”: a fixed annuity (GRAT) or a fixed percentage of annual trust value (GRUT). In practice, GRATs dominate because the fixed annuity is easier to administer and produces a more predictable estate freeze.

The annuity must meet the requirements of Treas. Reg. §25.2702-3(b):

• Payable at least annually
• Fixed dollar amount or fixed percentage of initial trust value
• May increase up to 20% per year over the preceding year’s amount
• Payable to the grantor (or the grantor’s estate if the grantor dies during the term)
• Cannot be satisfied with a note, other debt instrument, or option

Zeroed-out GRATs

A “zeroed-out” GRAT sets the annuity high enough that the present value of the retained annuity equals (or nearly equals) the value of the transferred property, making the taxable gift of the remainder interest approximately zero. The IRS challenged this structure, but the Tax Court upheld it in Walton v. Commissioner, 115 T.C. 589 (2000), and the IRS acquiesced.

In practice, the remainder is not exactly zero; most practitioners leave a small positive gift to avoid any argument that the transaction lacks substance. The gift is reported on Form 709 in the year of funding.

The §7520 rate

The §7520 rate is the hurdle rate for the GRAT. It determines the present value of the retained annuity and therefore the gift tax value of the remainder interest. A lower §7520 rate means a smaller remainder gift for the same annuity payment, and a lower hurdle for the trust assets to beat.

The grantor can elect the §7520 rate for the month of the transfer or either of the two preceding months (Treas. Reg. §25.7520-2(a)(2)). Rate selection is part of the planning.

Mortality risk: §2036 inclusion

If the grantor dies during the GRAT term, some or all of the trust assets are included in the grantor’s gross estate under §2036(a)(1); the retained right to annuity payments is a retained interest in the transferred property. For a qualified annuity interest, inclusion is generally limited to the amount necessary to produce the remaining annuity payments (Treas. Reg. §20.2036-1(c)(2)).

This is the primary risk of a GRAT: if the grantor does not survive the term, the estate tax savings are partially or fully lost. Managing this risk drives the choice of term length.

Rolling (cascading) GRATs

To mitigate mortality risk and capture short-term volatility, practitioners commonly use a series of short-term GRATs (typically two-year terms) rather than a single long-term GRAT. Each GRAT captures appreciation during its short window, and the annuity payments from one GRAT can fund the next.

Rolling GRATs also benefit from volatility: a single large gain in one two-year window can transfer significant wealth, even if other windows underperform. With a long-term GRAT, early gains might be offset by later losses.

Grantor trust status during the term

During the GRAT term, the trust is a grantor trust under §677(a) (the grantor is treated as the owner because the trust income may be used to satisfy the annuity obligation). This means:

• All trust income is reported on the grantor’s Form 1040
• No separate income tax is paid by the trust
• The trust files a Form 1041 as a grantor trust (reporting only, no tax computation) or uses the optional reporting method under Treas. Reg. §1.671-4(b)
• The grantor’s payment of income tax is not treated as an additional gift; it’s the grantor’s own obligation

This is a planning benefit: the trust assets grow without income tax drag, effectively allowing a larger transfer to the remainder beneficiaries.

Annuity payment administration

The annuity payment must be made on time. Under Treas. Reg. §25.2702-3(b)(4), a payment is considered timely if made within 105 days after the anniversary date. Key compliance points:

• Payments can be made in cash or in kind (using trust property at its FMV on the date of distribution)
• In-kind payments require a current appraisal for illiquid assets
• If the trust does not have sufficient cash, the trustee must distribute other assets; the annuity cannot be deferred or reduced
• Document every payment with date, amount, and FMV of any in-kind property
• Late or missed payments can disqualify the annuity interest, converting it to a non-qualified retained interest valued at zero under §2702, which would make the entire transfer a taxable gift

GRAT termination

At the end of the term:

• The remaining trust assets pass to the remainder beneficiaries (or continue in trust for their benefit, per the trust instrument)
• The trust ceases to be a grantor trust; if assets remain in a continuing trust, that trust becomes a separate taxpayer and must obtain its own EIN
• The continuing trust files its own Form 1041 as a non-grantor trust going forward
• The remainder beneficiaries take a carryover basis in the assets (the GRAT is a lifetime transfer, not a testamentary one; there is no stepped-up basis)

Gift tax reporting

The grantor reports the transfer on Form 709 in the year the GRAT is funded. The gift is the remainder interest: the value of the transferred property minus the present value of the retained annuity. For a zeroed-out GRAT, this is a small positive number. If the grantor uses any applicable exclusion amount (lifetime gift tax exemption) to offset the gift, that reduces the amount available for estate tax purposes.

What we need to open a matter

• Trust instrument: the GRAT agreement, including annuity schedule, term, and remainder provisions
• Funding documentation: what was transferred, when, and the FMV at funding
• Appraisals: qualified appraisals for any illiquid assets (closely held interests, real estate)
• §7520 rate elected: the rate used for the initial gift tax calculation
• Annuity payment history: dates, amounts, and documentation of all payments made
• Trust EIN, or we can apply (EIN application service)
• Grantor’s SSN and tax information: for grantor trust reporting during the term

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