Charitable Remainder Unitrusts (CRUTs) and Grantor Retained Annuity Trusts (GRATs) are two popular types of irrevocable trusts. How do you know which one is right for you? This article explains what these trusts are and when they make sense.

Key Highlights and Takeaways

• CRUTs Defer Capital Gains Taxes: CRUTs allow their grantors to defer capital gains taxes on the sale of an appreciated asset — potentially for many years. That deferral is extremely powerful, equivalent to a large reduction in the effective capital gains tax rate.
• GRATs Avoid Gift/Estate Taxes: GRATs allow their grantors to transfer assets to their children without paying gift tax or using any lifetime gift and estate tax exemption.
• Minimizing Different Taxes: CRUTs and GRATs serve different purposes. Whether one, or both, of these strategies makes sense in any given situation will depend on the taxpayer’s objectives.

What is a CRUT?

A CRUT is an irrevocable trust that mitigates capital gains tax on the sale of appreciated assets like stock, crypto, real estate, or privately held businesses. The basic idea is that a person (the “grantor”) transfers appreciated property to a CRUT and, in return, the CRUT pays the grantor (or another beneficiary) a fixed percentage of the assets in the trust each year for either a set number of years or the beneficiary’s lifetime. If the appreciated asset is sold inside the CRUT, there won’t be any immediate federal or state capital gains tax on the sale. Instead, the capital gains tax will be paid by the beneficiary (probably the grantor) when they receive distributions from the CRUT. While the capital gains tax is eventually paid, in the meantime the grantor is able to reinvest any untaxed amount inside of the CRUT, generating returns on that entire amount. At the end of the term, anything left over in the trust passes to a charity of the grantor’s choice. The amount that passes to charity is roughly 10% of the amount that the grantor initially contributed to the CRUT, adjusted for the growth of that amount over time. In addition, the grantor gets an upfront tax deduction equal to this 10% charitable contribution. Thanks to the combination of this tax deduction and the powerful tax deferral described above, the grantor typically ends up with significantly more post-tax money than he or she would have had without the CRUT — and a charity gets money, too! That’s a win-win. (You can learn more about CRUTs here and you can estimate the potential returns here.)

CRUT Example

Imagine that Bob, a 40-year-old California resident, has a $500,000 asset with a cost basis of zero. If he contributes that asset to a standard CRUT that is designed to last for his lifetime, he’ll get annual distributions from the CRUT equal to about 7% of the value of the CRUT’s assets. So, in Year 1, he’ll get a $35,000 distribution (7% of $500,000), in Year 2 he’ll get a distribution equal to about 7% of the value of the CRUT’s assets at that time, and so on. Bob will also get an upfront tax deduction equal to 10% of the asset’s fair market value, or about $50,000. He will pay the tax on the $500,000 capital gain as the capital gain gets distributed from the CRUT, rather than all at once. In the meantime, Bob, as Trustee of the CRUT, will generate returns on the ~$175,000 that would have been taxed immediately without the CRUT. Bob will be able to squeeze much more post-tax value out of that appreciated asset by using the CRUT — perhaps more than twice as much — than he would have been able to generate without it.

Benefits of CRUTs

1. Tax Deferral: The primary advantage of a CRUT is its ability to defer capital gains taxes. By selling appreciated assets inside the trust, the grantor avoids immediate capital gains taxes when selling the asset and can reinvest and grow the assets on a pre-tax basis. The grantor doesn’t pay taxes on the sale (or any income) realized inside the trust; instead, the seller (as beneficiary) pays taxes on distributions from the trust. Over a long period of time, this can more than double the post-tax dollars the seller receives from a sale.
2. Charitable Deduction: In addition, the grantor receives a charitable deduction that is typically 10% of the value of assets contributed to the CRUT. That deduction can offset ordinary income or capital gains income.
3. Income Stream: The CRUT provides at least annual distributions for the length of the trust, which can be a set number of years or the lifetime of the beneficiary.
4. Asset Flexibility: CRUTs can be used with almost any asset ranging from public to private stocks, crypto, real estate, and collectibles.

Drawbacks of CRUTs

1. Irrevocability of Charitable Gift: Once assets are transferred into a CRUT, the grantor can’t claw back the charitable gift.
2. Illiquidity: During the term of the CRUT, the grantor is limited to annual distributions from the CRUT equal to a fixed percentage of the trust’s assets. Short of terminating the CRUT entirely, there’s not much the grantor can do to access the bulk of the principal during the CRUT term.
3. Income Variability: The income generated by a CRUT can vary depending on the performance of the trust’s investments. If the trust’s assets underperform, the income stream may be lower than expected. The flip side is that if the investments overperform, the income stream may be higher than expected. (You can use this calculator to estimate your potential returns.)

What is a GRAT?

A GRAT is a type of irrevocable trust that moves assets out of a person’s taxable estate without using that person’s lifetime gift and estate tax exemption. It’s a powerful gift and estate tax strategy. The basic idea is that a person (the “grantor”) transfers an asset to the GRAT and sets an annuity term (usually two years). A portion of the principal is returned to the grantor each year until the end of the term. The exact size of each annuity payment is based on a standardized formula, but basically the grantor is entitled to receive the full amount of the original principal amount plus interest that is based on the government’s interest rate, known as the “7520 rate.” By the end of the term, the original principal (plus some interest) has been returned to the grantor. Any remaining amount in the trust passes to the grantor’s named beneficiaries free of estate tax or gift tax. The GRAT’s magic comes from the ability to transfer wealth to beneficiaries free of tax by simply funding the trust with assets that outperform the 7520 rate. The 7520 rate is equal to roughly 120% of the yield on a 7-Year Treasury Note, so it typically comes out to somewhere in the 3%-5% range. (You can learn more about GRATs here and you can estimate the potential returns here.)

GRAT Example

Imagine that Christine is a New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If she contributes $6 million to a two-year GRAT when the 7520 rate is 4%, the GRAT will pay her approximately $6.3 million over the course of the first two years. But because the GRAT’s assets are appreciating at 9% while the 7520 rate is only 4%, there will be a remainder left over at the end of Year 2. That remainder — about $500,000 — will pass to Christine’s remainder beneficiary, perhaps a grantor trust for the benefit of her daughter. If Christine decides to set up “Rolling GRATs” — that is, GRATs where the annuity payments are used to fund new GRATs — and she keeps setting up new GRATs each year for 25 years and naming the grantor trust for her daughter as the remainder beneficiary, by Year 25 she will have transferred about $33.1 million to trusts for her daughter, saving her daughter the equivalent of about $14.5 million of tax.

GRATs funded during two-year periods where Christine’s investments performed poorly would fail, but Christine and her daughter would be no worse off than if Christine hadn’t funded the GRAT (aside from the cost of setting up the GRAT).

Benefits of GRATs

1. Estate Tax Savings: The primary advantage of a GRAT is its ability to transfer assets to a grantor’s beneficiaries free of gift tax or estate tax.
2. Ideal for Volatile Assets: Compared to other estate-tax strategies, GRATs are particularly well suited for transferring highly volatile assets. In fact, GRATs thrive on volatility. On average, a GRAT funded with highly volatile assets will generally outperform a GRAT funded with less volatile assets even if the overall percentage growth of the underlying assets is the same.
3. Downside Protection: If GRATs had a motto, it would be “Heads, you win, tails you don’t lose.” A GRAT funded with an asset that drops in value will fail to pass on assets to the beneficiaries, but that failure won’t leave the beneficiaries any worse off than they would have been if the GRAT hadn’t been created. In contrast, with other estate-tax strategies, transferring assets that later drop in value can be tax inefficient.
4. Potential Income-Tax Savings: Although GRATs don’t provide any immediate income-tax savings, they can indirectly save income tax down the line. That’s because a successful GRAT can transfer assets to other taxpayers, who may be in lower tax brackets. When those taxpayers later sell the asset, they’ll pay less tax than the grantor would have paid, due to that lower tax bracket.
5. Relative Liquidity: Compared to many other tax strategies, GRATs have little impact on a donor’s liquidity. During the term of the GRAT, a portion of the grantor’s assets are in the trust, but the grantor can always borrow from the GRAT without any tax consequences.

Drawbacks of GRATs

1. GST Inefficiency: A person cannot allocate generation-skipping transfer (”GST”) tax exemption to a GRAT during the annuity period. This makes GRATs less suited to transferring assets to grandchildren or more distant descendants than intentionally defective grantor trusts or other dynasty trusts. Still, GRATs can be a powerful estate-tax strategies alongside other, more GST-efficient strategies.
2. Irrevocability: When a grantor makes a gift to a GRAT, he or she is forfeiting the right to the excess growth above the 7520 rate. That said, if desired, a grantor can prevent too much wealth from being shifted to his or her beneficiaries by “swapping” assets out of the GRAT before the end of the term.
3. Not Ideal for Illiquid Assets: GRATs work very well when funded with liquid assets, but they are often not the best fit for gifts of illiquid assets, like real estate or privately held stock. Illiquid assets in a GRAT will need to be valued at least three different times (upon funding, upon the first anniversary of funding, and upon the second anniversary of funding). The IRS can potentially challenge each valuation. In contrast, liquid assets like public stock don’t need to be appraised at all.

Should You Set Up a CRUT or a GRAT?

CRUTs and GRATs serve different purposes. CRUTs defer capital gains taxes. GRATs transfer assets (whether appreciated or not) to the grantor’s beneficiaries without any gift tax consequences. GRATs are attractive to people who are looking to transfer assets to their beneficiaries in a tax-efficient way. GRATs don’t minimize capital gains taxes, and CRUTs don’t minimize estate taxes.

That said, if you use a GRAT to transfer an asset to a beneficiary who is in a lower tax bracket, and then the beneficiary sells the asset, the beneficiary will pay less capital gains tax than you would have paid and you’ll have transferred the asset to the beneficiary free of gift tax. But the beneficiary won’t receive the asset until at least two years after the GRAT is funded, which means that this strategy doesn’t work for people who are looking to sell assets immediately.

It is important to note that there are lots of other gift and estate tax strategies that may make more sense than a GRAT, depending on circumstances. Those strategies are worth exploring.

Conclusion

CRUTs and GRATs are both powerful tax strategies. CRUTs make sense for people looking to defer capital gains tax on the sale of an appreciated asset, while GRATs are a popular strategy for people looking to transfer assets to a child without using any lifetime gift tax exemption.

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