A Grantor Retained Annuity Trust (usually referred to as a “GRAT”) is a trust agreement in which a donor (usually referred to as the “Grantor” or the “Settlor”) transfers assets to a trust. In exchange, the trust must make annual annuity payments back to the Grantor. These annual annuity payments consist of a portion of the principal along with interest. The interest rate for the annuity payments is set by the government based generally on the cost of money. The annuity payments are made each year during the term (or lifetime) of the GRAT.
The assets held by the GRAT will accrue interest. The interest can be thought of as consisting of two parts. First, there is the small portion that reflects interest earned based on the applicable federal rate (“AFR interest”). That portion, along with part of the principal, must be returned to the Grantor. The second part of interest is the actual market interest. So long as actual interest exceeds the AFR interest, there will be funds left in the GRAT at the conclusion of the GRAT term.
The funds remaining in the GRAT at the conclusion of the term are owned by the GRAT — or, more to the point, by the beneficiaries of the GRAT. In other words, the Grantor has transferred assets to her heirs without suffering any transfer tax burdens.