How a GRAT Can Transfer Wealth While Reducing Massachusetts Estate Taxes

Why GRATs Are a Strategic Option for High-Net-Worth Families in Massachusetts

A Grantor Retained Annuity Trust (GRAT) is an estate planning tool that allows individuals to transfer wealth to heirs while minimizing gift and estate taxes. It is especially effective for individuals who expect significant asset appreciation, such as stocks, real estate, or businesses. By using a GRAT, the grantor retains an income stream from the trust for a set period, after which the remaining assets pass to beneficiaries with minimal tax liability.

Understanding Estate Taxes

Estate taxes are taxes paid on the value of a person's assets when they pass away, applied to anything over a specific exemption amount. As of 2025, the federal estate tax exemption is $13.99 million per individual ($27.98 million for married couples). However, key provisions from the Tax Cuts and Jobs Act (TCJA) of 2017 are set to expire on December 31, 2025. After that, the exemption is expected to decrease to $7 million per individual ($14 million per married couple). As these exemptions decrease, more estates will be subject to estate taxes than before.

Many states impose their own estate taxes, and the exemptions vary depending on where you live. For example, in Massachusetts, if your estate is valued over $2 million and is left to a non-spouse beneficiary (such as children, a life partner, nieces, or nephews), the state will charge an estate tax. The tax rate ranges from 7.2% to 16% and applies only to the value of your estate that exceeds $2 million.

What is a GRAT?

A GRAT is an irrevocable trust where the grantor transfers assets into the trust but retains the right to receive annual annuity payments for a specified period (usually 2-10 years). After the annuity term, any remaining assets pass to the beneficiaries, often children or grandchildren, free of gift tax.

How a GRAT Works

Creation and Funding: The grantor establishes the GRAT and funds it with assets like stocks or real estate.
Annuity Payments: The grantor receives fixed annuity payments based on the initial asset value and the IRS Section 7520 rate. Payments are typically for 2-10 years.
Transfer of Remainder Interest: Once the annuity period ends, the remaining assets are transferred to the beneficiaries. The value of the gift to the beneficiaries is determined by the present value of the remainder interest, which is usually significantly lower than the initial asset value, thereby reducing gift tax liability.
Tax Benefits: If assets appreciate at a rate higher than the IRS Section 7520 rate, the appreciation passes to beneficiaries tax-free.

The Mechanics of a GRAT

To understand how a GRAT works, it's important to explore how the annuity payments are calculated and how the value of the remainder interest is determined.

Annuity Calculation: The annuity payments for a GRAT are based on a fixed percentage of the initial value of the assets placed in the trust. The IRS’s monthly Section 7520 rate is used to determine the present value of these payments. This ensures that the total value of the annuity stream equals the initial value of the assets, minus the remainder interest. In the calculation below, “r” represents the Section 7520 rate, and “n” represents the number of years.

Present Value of Remainder Interest: The remainder interest is the current value of the assets that will remain in the trust at the end of the annuity term and pass to the beneficiaries. It is calculated using IRS tables and the Section 7520 rate, which reflects the time value of money and the GRAT term length. A lower Section 7520 rate reduces the present value of the remainder interest, thereby lowering the grantor’s gift tax liability. In some cases, annuity payments are structured so that the present value of the annuity matches the transferred asset value, resulting in a zero remainder interest for gift tax purposes. More details can be found in the "Zeroed-Out GRAT Strategy" section below.

Tax Implications: The gift tax liability is based on the value of the remainder interest when the GRAT is set up. If the assets grow in value during the GRAT term, that growth is transferred to the beneficiaries without triggering any extra gift or estate taxes.

Benefits of a GRAT

Gift and Estate Tax Minimization: GRATs allow assets to be transferred with reduced gift tax liability, especially if the assets appreciate at a higher rate than the Section 7520 rate.
Retained Income: The grantor continues to receive an income stream from the trust.
Asset Flexibility: GRATs can hold a variety of assets, including stocks, real estate, and businesses, which may appreciate over time.

Zeroed-Out GRAT Strategy

A Zeroed-Out GRAT strategy aims to minimize or eliminate gift tax liability by setting the annuity payments so that the value of the remainder interest is as low as possible, ideally zero. This is effective when the assets are appreciated more than the IRS Section 7520 rate.

For example, let's assume the grantor contributes stock worth $1,000,000 to a 2-year GRAT, where they will receive annuity payments for two years, with any remaining assets passing to their children. Based on a Section 7520 rate of 5%, the annuity payment required to “zero out” the gift is 53.8% of the initial contribution, or $537,633 annually. The annuity can be paid in cash or by distributing the appropriate amount of stock, valued on the date the annuity is paid.

Let’s then say that the stock in the GRAT appreciates by 10% each year for two years. After one year, the value of the stock in the trust increases to $1,100,000 (reflecting a 10% gain). The Trustee then distributes $537,633 to the grantor, leaving a remaining balance of $562,367 in the trust. Over the next year, the assets continue to grow at a rate of 10%, bringing the total value of the trust to $618,604 at the end of the second year (the termination date of the GRAT).

At this point, the Trustee distributes:

An annuity payment of $537,633 to the grantor.
The remaining balance of $80,971 is distributed to the grantor's children, free of gift tax.
In total, the grantor receives distributions valued at $1,075,266, while the children receive $80,971.

Potential Risks and Considerations

Mortality Risk: If the grantor dies during the GRAT term, the remaining assets may be included in their estate, potentially negating tax benefits.
IRS Scrutiny: GRATs, particularly those with short terms and low annuity payments, may attract IRS scrutiny.
No Step-Up in Basis: Beneficiaries do not receive a step-up in basis, meaning they may pay capital gains tax on any appreciation when selling the assets.

Conclusion

A GRAT is an effective tool for transferring wealth to heirs while minimizing taxes. By retaining annuity payments and transferring the remainder interest, the grantor can pass on appreciated assets with minimal tax consequences. However, it's important to consider potential risks, such as mortality risk and IRS scrutiny. Consulting with legal and financial advisors is essential to ensure the GRAT is properly structured and aligns with the grantor’s estate planning goals.

If you’d like an opinion on whether this strategy is right for you, we encourage you to reach out to our office.