Non-grantor trusts 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

• Two Powerful Estate Tax Strategies: Non-grantor trusts and GRATs both save estate tax, but they’re used in different circumstances.
• Non-Grantor Trusts Avoid Both State Income Tax and Estate Tax: A non-grantor trust can be a valuable tool for taxpayers in high-tax states who are looking to transfer wealth to future generations, as non-grantor trusts can avoid not only future estate tax but also state income tax.
• GRATs Efficiently Transfer Volatile Assets: GRATs are ideal for people with volatile, liquid assets who are looking to transfer assets to their children.

What is a Non-Grantor Trust?

A non-grantor trust is a type of irrevocable trust that is treated as a separate taxpayer for income-tax purposes. By setting one up in a no-tax state, taxpayers can avoid state income tax. Properly structured non-grantor trusts also help families avoid estate tax, since assets gifted to them (and any appreciation after the date of the gift) will be outside the grantor’s estate for estate-tax purposes.

Typically, a person (the “grantor”) creates a non-grantor for the benefit of one or more loved ones — such as children, grandchildren, or siblings. The grantor funds the trust using a portion of his or her lifetime gift and estate tax exemption. Once an asset is in the trust, that asset is outside the grantor’s estate and will never be subject to gift tax, estate tax, or generation-skipping transfer tax as long as it remains in the trust. Any resulting appreciation will also be outside the grantor’s estate. (You can learn more about non-grantor trusts here.)

Non-Grantor Trust Example

Imagine that Jim 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 Jim sets up a non-grantor trust and then contributes a $6 million asset to it, he will use up $6 million of his lifetime gift tax exemption, but the asset will be able to grow outside of his taxable estate. After 25 years, the non-grantor trust’s assets will be worth about $33.5 million! And if Jim dies in Year 25, he will have saved his heirs about $15.2 million of tax between state capital gains taxes and estate taxes relative to the counterfactual where he hadn’t funded the non-grantor trust.

Benefits of Non-Grantor Trusts

1. Estate Tax Savings: Non-grantor trusts use a grantor’s lifetime gift tax exemption to efficiently shift assets out of the grantor’s estate for estate-tax purposes. However, non-grantor trusts are a bit less estate-tax efficient than IDGTs.
2. State Income Tax Savings. In California, the top marginal state income-tax rate is 13.3%. In New York City, the top rate is 14.776%. In South Dakota, the top marginal state income-tax rate is 0%. Setting up a non-grantor trust in a state like South Dakota, and then putting investments that generate lots of investment income inside of that trust, can save a grantor’s family a lot of income tax over time.
3. Asset Protection: A non-grantor trust, as a separate legal person, is generally not subject to liability for actions taken by a trust’s grantor or beneficiary. So the grantor’s or beneficiary’s creditors won’t be able to access the trust’s assets even if they win a lawsuit against the grantor or beneficiary. In addition to protecting assets from lawsuits, non-grantor trusts can help shield inherited assets from a divorcing spouse.
4. QSBS Stacking. For founders or early startup employees who have QSBS-eligible stock, perhaps the biggest benefit of non-grantor trusts is the additional QSBS exclusion they receive. Non-grantor trusts are eligible for their own $10 million QSBS exclusions — a single QSBS-stacking non-grantor trust can save a family millions of dollars of capital gains tax.
5. Various Federal Deductions. Non-grantor trusts get their own federal deductions and exemptions such as the $10,000 state and local income tax deduction, excess business loss deductions, mortgage interest tax deductions, Section 199A small business tax deductions, and more. Collectively, these tax benefits can be quite significant.
6. Ideal for Illiquid Assets: Non-grantor trusts work well whether funded with liquid or illiquid assets.
7. GST Efficiency: A person can allocate generation-skipping transfer (”GST”) tax exemption to a non-grantor trust when the trust is first funded. As a result, the non-grantor trust is a popular form of dynasty trust.

Drawbacks of Non-Grantor Trusts

1. Illiquidity: When the grantor makes a gift to a non-grantor trust, he or she loses access to the assets in the trust. Unlike with IDGTs or some other trust types, with a non-grantor trust, the grantor cannot “swap” or borrow assets without income-tax consequences.
2. Irrevocability: When a grantor makes a gift to a non-grantor trust, the gift is irrevocable.
3. Spouse Cannot Be Beneficiary: Generally the grantor’s spouse cannot be the beneficiary of a non-grantor trust.
4. Potentially Higher Federal Tax Brackets: Non-grantor trusts are taxed at the highest federal tax bracket on annual income above a few thousand dollars. If the grantor is not a high-bracket taxpayer, gifting assets to a non-grantor trust may actually increase the effective federal tax rate paid on any income generated by assets inside the trust.
5. No Direct Control: The grantor cannot act as trustee of the non-grantor trust, though he or she can remove and replace the trustee at any time.

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).

Note that in this example the GRATs transfer slightly less wealth than the non-grantor trust described above. But that’s not always the case. If the assumed returns had been higher or more volatile, the GRAT could have easily outperformed.

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 grantor’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.
6. Direct Control: The grantor can act as trustee of the GRAT during the GRAT term, which means he or she retains direct control over the trust’s assets and how they are invested.

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 non-grantor trusts, intentionally defective grantor trusts, or other dynasty trusts. Still, GRATs can be a powerful estate-tax strategy 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 Non-Grantor Trust or a GRAT?

Non-grantor trusts and GRATs both save estate tax, but they’re used in different circumstances.

Non-grantor trusts can save state income tax, which is a big deal for people in high-tax states like New York or California. You’ll often see people in high-tax states with $10 million to $25 million of assets setting up non-grantor trusts. These people tend to be more focused on state income tax than on estate tax. Non-grantor trusts are also desirable for people with QSBS stock, since they can claim their own $10 million QSBS exclusions.

GRATs are ideal for people with volatile assets that are easy to value, like individual stocks or crypto, who are looking to transfer assets to their children. GRATs are particularly useful for people who have limited unused lifetime gift tax exemption, since GRATs don’t require lifetime gift tax exemption in order to work.

It is important to note that there are lots of other gift and estate tax strategies that may make more sense than a GRAT or a non-grantor trusts , depending on circumstances. Those strategies are also worth exploring. Moreover, non-grantor trusts and GRATs are not mutually exclusive; some people set up both.

Conclusion

Non-grantor trusts and GRATs are both powerful tax strategies. Non-grantor trusts make sense for people looking to transfer less volatile assets. GRATs make sense for people with volatile assets who are looking to transfer assets to a trust without using any lifetime gift tax exemption.

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