Summary:
What if you could save $2 million dollars in future taxes without losing control of the business, upsetting your investors, or really harming yourself financially. What if the future tax savings was even more?
If it is of interest, keep reading and we will outline the benefits of the Grantor Retained Annuity Trust, a little-known strategy in the estate planning/high net worth world.
Key Takeaways:
- Minimize future potential estate tax by reducing your estate while retaining ownership of your company.
- Flexible structures, but typically set up for the benefit of your children.
- We’ve utilized this strategy with entrepreneurs of all kinds from early Google employees to AvidExchange to less well-known entrepreneurs.
- It’s a complex concept but very simple to execute. So prepare to go into the weeds of estate tax planning as we tackle the basics, and a little more.
Entrepreneur Challenges:
Entrepreneurs face many hardships and must wear multiple hats inside the business.
For startup founders, you raise capital to fund the growth. You are involved in sales, marketing, legal and HR. You have to work with the team to take customer feedback and constructively use it to grow the company. You navigate payroll, hiring, regulations, and a host of other things thrown at you. The list is endless in the things that must be overcome to grow the business.
Business growth is there to support current and future clients. Without growth, it’s harder to invest into the business to provide better service, technology, products and other enhancements.
The growth is there to provide opportunities for the current and future team. Company growth gives employees the opportunity to grow professionally.
Growth also rewards investors with returns and the potential to put future capital to work in your successful business.
But it’s also there to support the entrepreneur, the founder. But typically, the list of those who benefit from the company falls in the order we just highlighted. Because you, the founder, have to wait so long to see the full suite of benefits of the company’s growth, you leave opportunities to maximize the growth out of the picture.
Opportunities for Entrepreneurs (and investors in high growth companies):
There are, however, many opportunities for the business to help the entrepreneur and other members of his/her team.
One such opportunity is utilizing the provisions of the tax code – we’ve written in the past about Qualified Small Business Stock (QSBS) which allows a great exclusion for capital gains of certain businesses. But that’s not the only benefit for you. Congress intentionally sets up provisions of the tax code to promote certain behavior – sometimes by accident. And sometimes crafty professionals are the ones who figure out how to utilize the accident to benefit individual taxpayers. Fortunately, for entrepreneurs there are several provisions in the tax code you can utilize for yourself, family, and employees (and investors).
One such provision in the tax code particularly useful to the entrepreneur is the Grantor Retained Annuity Trust – otherwise known as the GRAT.
A GRAT is a great tool for individuals who own an asset expected to quickly appreciate in value, like an entrepreneur/founder of a fast growth company. A GRAT is successful when the assets contributed appreciate faster than the IRS Section 7520 rate, which is currently 4.6%. The trust can be set up for the individual to receive their original contribution back by the end of the selected term, and direct who (typically children or other family members) receives the appreciation value remaining in the trust. This allows the individual to transfer assets to the next generation gift and estate tax free gift and estate tax free to the next generation.
Founder Concerns:
Founders can be understandably cautious with their stock. They have investors, potentially new vesting periods and other issues to navigate. But make no mistake, the GRAT is a commonly used vehicle in the venture backed world. The key provision or terminology is ‘grantor retained’. The grantor is you and the fact that you ‘retain’ the asset AND the control over the asset via a trust means you have NOT given up control. This has been tested over the years and I have yet to talk with a VC who hasn’t allowed the founder or early team members to utilize it.
The Problem:
Let’s take a quick look at an example of how a single GRAT may work. Assume a company raises $2 million at a $10 million pre-money valuation – or a $12 million post money valuation. The investors likely believe this can be a $100 – $150 million business in the next 5-10 years. If we take the long road, a year over year growth rate of about 28% for 10 years would get us to $140M – assuming no additional capital raised, dilution, etc.
Let’s assume we have two co-founders and together they own 60% of the company. At the end of 10 years, their shares are valued approximately $42 million each. That’s a very good outcome. The downside to having all this wealth is it creates an estate tax problem for you and your heirs. As a result, you are going to spend countless hours with attorneys working to reduce the estate tax through complex LLCs, Trusts and other instruments.
A GRAT (or likely a series of GRATS) allows you to plan and reduce some of the estate tax ahead of time.
The current estate tax exemption amount – or what you can pass to heirs estate tax free – is about $13 million per person, $26 million per couple. Anything above that gets taxed at 40% – at the Federal level (few states have an estate tax anymore). However, in 2026, the current exemption expires and your exemption will be closer to $7 million per person or $14 million per couple.
Congress has a bit of a spending problem which continues to create more deficits and larger debts. One way to close that gap is by increasing taxes. Some in Congress have even proposed lowering the estate tax exemption amount back to $2 million per person – and $4 million per couple. It’s unlikely to happen but not completely out of question.
So as you can see our two entrepreneurs have a current estate tax problem – which can easily become a much bigger problem.
The Solution:
Contribute company shares to a Grantor Retained Annuity Trust for a period of years (must be at least 2 years). Since the trust owns the shares, it receives any pro-rata distributions made by the company. Each year the trust pays you back a portion of your contribution (shares) plus a little interest in the form of an annuity. Any assets remaining in the GRAT at the end of the term or years passes to the beneficiary you choose and you can dictate when and under what conditions they can access it. But you are the grantor (the person who established and funded the Trust) and have certain powers as such.
What’s the Catch:
Grantors must outlive the term of the GRAT or all assets revert back into their estate.
GRATs are most effective in low interest rate environments when the hurdle is low for appreciation of the contributed assets. When interest rates are high, there is the risk that the GRAT “fails” because the assets transferred into the GRAT grow at a rate lower than the section 7520 rate. If that is the case, since you still receive your initial contribution back, your only loss is the cost to set up the trust.
Example:
The entrepreneur puts $500,000 of his/her company stock into a 10-year GRAT in January 2023. The 7520 rate – the minimum rate you can loan money to an entity like this – is 4.6% and the business grows at 28% so the trust makes 24% per year. At the end of year 10, the Trust has a value of $5.9 million.
The GRAT must repay the principal ($500,000) plus the interest (approximately $230,000) back to the founder. The founder gets back approximately $730,000 (principal plus interest) and the Trust gets to keep approximately $5.1 million – free from any future estate taxes.
You wouldn’t do a 10-year GRAT for a number of reasons but you could set up a series of ‘rolling GRATs’ to accomplish a similar outcome.
But we’ve frozen part of your estate and allowed the appreciation to grow outside of the business. And there are all kinds of ‘fun and interesting’ ways to do this and determine beneficiaries and future beneficiaries. The goal was to take something that is out of your control – future estate taxes – and put it back within your control.
If one of our co-founders did the transaction and the other one didn’t, then the estate tax equation for each would look like this. As you will see, this simple solution increases the amount of money left to heirs by $2 million and correspondingly reduces your estate tax by a similar amount. All done perfectly legal and while allowing your investors to know you are taking care of yourself but maintain control of the stock/voting rights.
Founder #1
| Founder | GRAT | |
| Net Worth | $37 Million | $5,100,000 |
| Estate Tax Exemption (Couple in 2033 – 10 years from now) | $15 Million | No Estate tax due as it was moved outside of the estate |
| Estate Exposed to Estate Tax | $22 Million | |
| Estate Tax (@40%) | $8,800,000 | $0 |
| Net Estate | $13,200,000 | $5,100,000 |
| Total left to heirs | $18,300,000 |
Founder #2
| Founder | GRAT | |
| Net Worth | $42 Million | $) |
| Estate Tax Exemption (Couple in 2033 – 10 years from now) | $15 Million | |
| Estate Exposed to Estate Tax | $27 Million | |
| Estate Tax (@40%) | $10,800,000 | $0 |
| Net Estate | $16,200,000 | $ |
| $16,200,000 |