Grantor Retained Annuity Trusts (GRATs) and Intentionally Defective Grantor Trusts (IDGTs)

GRATs and IDGTs are among the most powerful estate freeze techniques available to high-net-worth clients. These strategies allow grantors to transfer future appreciation to beneficiaries while minimizing or eliminating gift and estate taxes. Understanding the mechanics, risks, and ideal applications of each technique is essential for the CFP exam.

Grantor Retained Annuity Trust (GRAT)

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

GRAT Structure and Mechanics

1. Grantor transfers assets to the irrevocable GRAT
2. Grantor receives fixed annuity for the trust term (typically 2-10 years)
3. Remainder interest passes to beneficiaries at term end
4. Taxable gift equals the present value of the remainder interest

The Section 7520 Rate

The Section 7520 rate is critical to GRAT planning. This IRS-published rate (updated monthly) is used to calculate the present value of the annuity payments and the remainder interest.

Current Section 7520 Rates:

• January 2026: 4.60%
• January 2025: 5.20%

For a GRAT to succeed, the trust assets must outperform the Section 7520 rate. Any growth above this "hurdle rate" passes to beneficiaries gift-tax free.

Example: If the Section 7520 rate is 4.60% and GRAT assets grow at 10%, the 5.40% excess appreciation transfers to beneficiaries without using any gift tax exemption.

Zeroed-Out GRAT (Walton GRAT)

A zeroed-out GRAT is structured so that the present value of the annuity payments equals the full value of the transferred assets, resulting in a remainder interest valued at approximately zero for gift tax purposes.

How It Works:

• Grantor sets annuity payment high enough that PV of payments = FMV of assets transferred
• Gift tax value of remainder interest = $0 (or nominal amount)
• No gift tax exemption used
• All appreciation above Section 7520 rate passes tax-free

This strategy was validated in Walton v. Commissioner (2000), where Audrey Walton (wife of Walmart founder Sam Walton) successfully used zeroed-out GRATs with her daughters as beneficiaries.

Rolling GRATs Strategy

A Rolling GRAT strategy involves creating a series of short-term (typically 2-year) GRATs, with each annuity payment funding a new GRAT:

Advantages:

• Reduces mortality risk: Shorter terms decrease the chance grantor dies during the term
• Captures market volatility: Takes advantage of both upswings and recoveries
• More opportunities for success: Multiple "at-bats" rather than one long-term bet
• Compounds successful transfers: Each successful GRAT's remainder funds the next generation

Example: Grantor creates 2-year GRAT annually for 10 years. If even 3-4 of the 10 GRATs "win" (outperform the 7520 rate), significant wealth transfers occur.

Best Assets for GRATs

Ideal GRAT funding assets:

• High-growth potential investments (pre-IPO stock, growth stocks)
• Appreciating real estate with low current income
• Closely held business interests expected to appreciate
• Assets with valuation discounts (minority interests, lack of marketability)

Less suitable assets:

• Stable, income-producing investments (bonds, dividend stocks)
• Assets expected to underperform the 7520 rate
• Assets requiring frequent valuation (creates administrative burden)

Critical Risk: Mortality During GRAT Term

If the grantor dies during the GRAT term, the trust assets are included in the grantor's gross estate under IRC Section 2036 (retained interest). This negates the estate tax benefits entirely.

Mitigation Strategies:

• Use shorter GRAT terms (2-3 years)
• Use rolling GRATs strategy
• Consider grantor's health and life expectancy
• Ensure grantor has adequate assets outside the GRAT

Grantor Retained Unitrust (GRUT)

A GRUT is similar to a GRAT but pays a fixed percentage of trust assets (revalued annually) rather than a fixed dollar annuity.

Key Differences from GRAT

Why GRUTs Are Less Common

• Cannot be zeroed out: Always results in a taxable gift
• Annual valuation required: Creates administrative burden and expense
• Less suitable for hard-to-value assets: Annual appraisals are costly
• No particular advantage: GRATs typically offer better planning opportunities

Qualified Personal Residence Trust (QPRT)

A QPRT is a specialized GRAT designed specifically for personal residences. The grantor transfers a home to the trust while retaining the right to live in it for a specified term.

QPRT Structure

1. Grantor transfers personal residence to irrevocable trust
2. Grantor retains right to occupy the home for the trust term
3. At term end, residence passes to beneficiaries (or trust for their benefit)
4. Taxable gift = FMV of home minus PV of retained occupancy interest

QPRT Advantages

• Freezes home value for estate tax purposes
• Significant discount on gift value due to retained interest
• Removes future appreciation from estate
• Only two personal residences allowed per taxpayer

QPRT Risks and Considerations

Primary Risks:

• Grantor dies during term: Entire home value included in estate
• Rent-back requirement: If grantor wants to continue living in home after term, must pay fair market rent to beneficiaries
• Loss of step-up in basis: Beneficiaries receive carryover basis (grantor's basis)

Section 7520 Rate Impact:

• Higher 7520 rates benefit QPRTs (greater value attributed to retained interest = smaller taxable gift)
• This is opposite of GRATs (which benefit from lower rates)

Intentionally Defective Grantor Trust (IDGT)

An IDGT is an irrevocable trust that is "defective" for income tax purposes (grantor pays the income tax) but effective for estate and gift tax purposes (assets removed from estate).

The "Defect" Explained

Intentional defects that cause grantor trust status for income tax:

• Power to substitute assets of equivalent value (swap power)
• Power to borrow without adequate security
• Spray/sprinkle power to make distributions to grantor's spouse
• Power to add charitable beneficiaries

These powers do not cause estate inclusion but trigger income tax to the grantor.

IDGT Benefits

1. Sales to IDGT avoid capital gains: Same taxpayer for income tax purposes
2. Grantor pays income tax: Trust assets grow income-tax-free (additional wealth transfer)
3. Assets removed from estate: Effective for estate/gift tax purposes
4. Interest on installment sale: Not taxable to grantor, not deductible by trust

Sale to IDGT Strategy

The most common IDGT technique involves selling appreciated assets to the trust:

Step 1: Seed Gift

• Grantor makes initial gift to fund trust (typically 10% of planned sale amount)
• Uses gift tax exemption
• Creates "equity cushion" required by IRS

Step 2: Installment Sale

• Grantor sells appreciated assets to IDGT
• IDGT gives promissory note to grantor
• Note bears interest at AFR (Applicable Federal Rate)
• No capital gains recognized (same taxpayer)

Step 3: Ongoing Payments

• IDGT makes interest and principal payments to grantor
• If assets outperform AFR, excess stays in trust (outside estate)
• Grantor pays income tax on trust income (further reduces estate)

Seed Gift Requirement

The 10% equity cushion (seed gift) is considered best practice to:

• Demonstrate the trust has independent economic substance
• Ensure the trust is not dependent solely on the sold assets to make payments
• Reduce IRS challenge risk

Example: For a $5 million sale to IDGT, grantor first gifts $500,000-$550,000 to the trust, then sells assets for $5 million promissory note.

Comparison Table: GRAT vs. GRUT vs. QPRT vs. IDGT

2026 Planning Considerations

Current Exemption Levels

With the federal estate and gift tax exemption at $15.00 million in 2026 (scheduled sunset of TCJA at end of 2025 would reduce this significantly), combining these techniques with available exemption can transfer substantial wealth.

Strategy Selection

• Client with no remaining exemption: Use zeroed-out GRAT (no exemption needed)
• Client with exemption to use: Consider IDGT sale (uses exemption for seed gift, leverages appreciation)
• Client with valuable residence: Add QPRT to strategy
• Client seeking simplicity: Single technique; complexity adds risk