# GRAT (Grantor Retained Annuity Trust): How It Works, With the California Rules

> How a GRAT works: § 2702, the 5.6% § 7520 hurdle, zeroed-out and rolling GRATs, Walton and Badgley, death during the term, and what changes in California.

Source: https://ridleylawoffices.com/grantor-retained-annuity-trust-grat/

By Eric Ridley, attorney, Ridley Law. Updated October 2026.

**Who this page is for:** California families with estates above $15 million single or $30 million married, in the $15 million to $100 million band and the $100 million and up band, who own something likely to grow fast. Think founder stock before a sale, a concentrated public position, or an operating company on the way up. Below those amounts there’s no federal estate tax to save, and a GRAT mostly costs you the step-up in basis. For the wider picture, see [high-net-worth estate planning in California](https://ridleylawoffices.com/high-net-worth-estate-planning-california/) and [ultra-high-net-worth estate planning](https://ridleylawoffices.com/ultra-high-net-worth-estate-planning-california/).

**Short answer –**A GRAT (grantor retained annuity trust) is an irrevocable trust you fund with an asset. You take back a fixed annuity for a set number of years, and whatever is left at the end goes to your family. The IRS values your gift as the asset minus the annuity, using the § 7520 rate, which is 5.6% for October 2026, so a high enough annuity leaves a gift close to zero. Growth above 5.6% passes to your family free of gift and estate tax. If the asset earns less, the family gets nothing and you’ve lost only the cost of setting it up. If you die before the term ends, the trust comes back into your estate, so the term has to be one you’ll outlive.

**5.6%**

Section 7520 rate for October 2026, the hurdle a GRAT has to beat (Rev. Rul. 2026-19)

**120%**

Most an annuity payment can rise over the prior year’s (Treas. Reg. § 25.2702-3(b)(1)(ii))

**105 days**

Deadline to pay an annuity after the anniversary date (Treas. Reg. § 25.2702-3(b)(4))

**2 years**

GRAT term upheld in Walton v. Commissioner, 115 T.C. 589 (2000)

## What a GRAT does with an asset that’s about to grow

A GRAT lets you hand an asset’s future growth to your children while the gift tax is figured on a much smaller number. You put the asset into the trust, and the trust pays you a fixed annuity for a term of years. What’s left after the last payment goes to your children or a trust for them. Your taxable gift is the value of what you put in, minus the value of the annuity you kept, and the annuity is valued at the § 7520 rate (IRC § 2702; 5.6% for October 2026, Rev. Rul. 2026-19). Set the annuity high enough and the gift is close to zero. Because a zeroed-out GRAT uses almost none of your $15,000,000 federal exclusion (Rev. Proc. 2025-32), it suits people who’ve already used much of theirs.

Take a hypothetical $10 million, 2-year zeroed-out GRAT funded in October 2026. It pays you $5,423,813 a year and passes nothing if the asset grows 5.6% or less. At 8% growth about $382,000 passes to the family, and at 20% about $2.47 million does.

| Annual growth | Annuity paid to you each year | Left for the family after 2 years |
| --- | --- | --- |
| 0% | $5,423,813 | $0 (annuity uses it all) |
| 4% | $5,423,813 | $0 (annuity uses it all) |
| 5.6% (the hurdle) | $5,423,813 | $0 (annuity uses it all) |
| 8% | $5,423,813 | $382,468 |
| 12% | $5,423,813 | $1,045,516 |
| 20% | $5,423,813 | $2,467,611 |
| 30% | $5,423,813 | $4,425,230 |

Below 5.6%, the annuity pays the asset back to you and the GRAT ends. What you lose is the cost of the documents and the appraisal. Above it, everything over 5.6% goes to the family with no gift tax and no estate tax, where the top federal estate tax rate is 40% (IRC § 2001(c)). That small downside is why GRATs suit volatile assets. A loss can’t come back to hurt you, because the annuity is fixed, and a gain above 5.6% passes. So a concentrated position belongs in its own GRAT. In a diversified portfolio, gains and losses offset.

A GRAT moves only the growth above the IRS’s assumed rate out of your estate, and the asset’s current value stays in. For how it compares with a sale to a grantor trust, a SLAT, or an outright gift, see the [estate tax strategy matrix](https://ridleylawoffices.com/estate-planning-strategies-compared/).

## The rate the asset has to beat

The 5.6% is the number the asset has to beat, and it comes from a formula you can check yourself. The § 7520 rate is 120% of the federal mid-term rate for the month of the transfer, rounded to the nearest two-tenths of a percent (IRC § 7520(a)(2)). For October 2026, 120% of the mid-term rate is 5.54%, which rounds to 5.6% (IRS, Section 7520 interest rates, and Rev. Rul. 2026-19).

You can confirm the rate before you fund. The IRS publishes each month’s rates in a revenue ruling. Table 1 lists the short-, mid- and long-term applicable federal rates, and Table 5 gives the § 7520 rate. The IRS’s Section 7520 page shows the same number in a running table with two columns, the unrounded 120% figure and the rounded rate you use.

The month you fund fixes your hurdle, and you can’t borrow a lower month’s rate. You use the rate for the month you fund the GRAT. Section 7520(a) lets a taxpayer pick either of the two prior months’ rates only when a charitable deduction is allowed for part of the transfer, so a family GRAT doesn’t get that choice. The rate also moves. It was 4.6% in January 2026 and 5.6% in October (IRS). A higher rate means a higher annuity and a higher hurdle, so the asset has to do more before anything reaches the family.

## What the trust document has to say

Whether the zero holds depends on the document, because the statute values your retained annuity at zero unless it qualifies. When you put property in a trust for family members and keep an interest, § 2702(a)(2)(A) values what you kept at zero unless it’s a “qualified interest.” An annuity of fixed amounts paid at least once a year qualifies (§ 2702(b)(1)), and § 2702(a)(2)(B) values it under § 7520. A zeroed-out GRAT sets the annuity so its § 7520 value nearly equals what you put in, leaving a taxable gift close to $0. If the annuity fails to qualify, the retained interest is worth zero and the whole transfer is a gift.

You fund the trust once. The document has to prohibit additional contributions (Treas. Reg. § 25.2702-3(b)(5)), so each new asset or new year usually means a new GRAT.

How the annuity is stated and paid decides whether it qualifies. It is a stated dollar amount or a fixed percentage of the trust’s starting value “as finally determined for federal tax purposes,” paid at least once a year (Treas. Reg. § 25.2702-3(b)(1)(ii)). Each year’s payment can be up to 120% of the prior year’s, and a payment that jumps by more than that fails as a qualified interest to the extent of the excess (Example 2). If you state the annuity as a percentage, the trust must adjust payments if the IRS later changes the starting value (Treas. Reg. § 25.2702-3(b)(2)). A payment keyed to the anniversary date is due within 105 days after it (Treas. Reg. § 25.2702-3(b)(4)).

Nobody else can be paid during the term, and you can’t be paid with an IOU. The document must bar distributions to anyone other than you (Treas. Reg. § 25.2702-3(d)(3)), must bar prepaying your interest (§ 25.2702-3(d)(5)), and must bar the trustee from paying you with a note (§ 25.2702-3(d)(6)). A note doesn’t count as payment of the annuity (§ 25.2702-3(b)(1)(i)), so a trustee who pays you with an IOU has missed the payment.

When the term ends, whatever the trust holds after the last payment goes to the remainder beneficiaries, outright or in a continuing trust. If the assets earned less than the § 7520 rate, the annuity used them up and nothing passes.

You also pay the income tax along the way, which helps the trust. A GRAT is drafted as a grantor trust, so its income is taxed to you (IRC § 671). Every dollar of tax you pay on trust income is a dollar the trust keeps. See the [grantor trust](https://ridleylawoffices.com/estate-planning-glossary-california/grantor-trust/) definition.

## How the zeroed-out structure won in the Tax Court

The Tax Court approved the zeroed-out structure in Walton v. Commissioner, 115 T.C. 589 (2000). Audrey Walton put about $100 million of Wal-Mart stock into each of two 2-year GRATs in 1993. Each paid her 49.35% of the starting value in year one and 59.22% in year two (the second payment is 120% of the first). If she died during the term, the rest of the payments went to her estate. She reported gifts of zero. The IRS said the payments to her estate were a separate contingent interest that didn’t qualify, which would have made each gift about $3.8 million. The court held the annuity was a single interest for a fixed 2-year term, payable to her or her estate, and that the regulation example the IRS relied on was “an unreasonable interpretation and an invalid extension of section 2702.” That left only a small gift, which the court sent back for computation. Walton herself had conceded $6,195.10 per trust.

The regulation now reads Walton’s way, so the GRAT document should pay the remaining annuity to your estate if you die early, for the original term and no longer. Example 5 of Treas. Reg. § 25.2702-3(e) says that A’s right, and A’s estate’s right, to payments for a 10-year term “in all events” is a qualified interest for 10 years. Example 6 adds that a right of the estate to keep collecting past the fixed term doesn’t qualify. Both examples describe a unitrust, but Walton called the unitrust-annuity distinction one “without a substantive difference.”

## If you die during the term, the trust comes back into your estate

The GRAT document should pay the remaining annuity to your estate if you die early, for the original term and no longer (Walton; Treas. Reg. § 25.2702-3(e), Examples 5 and 6), but that doesn’t keep the assets out of your estate. IRC § 2036(a)(1) pulls back into your estate the amount of trust principal needed to pay your annuity out of income alone at the § 7520 rate in effect at death, up to the whole trust (Treas. Reg. § 20.2036-1(c)(2)).

The formula is the annuity divided by the § 7520 rate, adjusted for payment timing. On a short, zeroed-out GRAT that number is almost always bigger than the trust. In the 2-year example above, assume you died while the death-month rate was still 5.6%. Then $5,423,813 divided by 5.6% is about $96.9 million. The trust holds far less than that, so all of it comes back in, and you end up roughly where you’d have been without the GRAT, less what it cost.

A grantor who dies near the end of a long term loses the whole benefit, and Badgley v. United States, 957 F.3d 969 (9th Cir. 2020), is the controlling appellate case for Californians. Patricia Yoder put her half interest in a southern California family partnership, worth $2,418,075, into a 15-year GRAT paying her $302,259 a year. It was not zeroed out. She paid $180,606 of gift tax. She died in November 2012, shortly before the term ended. The Ninth Circuit held the annuity was retained enjoyment of the property under § 2036(a)(1) and the date-of-death value of the GRAT belonged in her estate. The court treated her attack on the regulation’s formula as waived and didn’t rule on whether the formula itself is valid.

Pick a term you’re likely to outlive. For an older grantor that usually means short GRATs, rolled, and a grantor in poor health shouldn’t take on a long term at all.

## Rolling short GRATs so one bad year costs only one trust

A rolling GRAT program uses a series of short GRATs, usually 2 years, and puts each annuity payment into a new GRAT as soon as it’s paid. One bad year ends only one GRAT, while good years pass to the family.

On a sequence that averages slightly under the hurdle, a rolling program passes far more than one long GRAT. The chart below uses one hypothetical return sequence that swings up and down and compounds to about 5.55% a year, slightly under the 5.6% hurdle. One 10-year GRAT nets the gains against the losses and passes about $195,000. The rolling program captures each good year in its own trust.

| Year | Return | Remainder passing to family | Annuities paid back to you | What happens to those annuities |
| --- | --- | --- | --- | --- |
| 1 | +30% | $0 | $5,423,813 | New 2-year GRAT funded with $5,423,813 |
| 2 | -20% | $637,136 | $8,365,588 | New 2-year GRAT funded with $8,365,588 |
| 3 | +25% | $0 | $6,283,933 | New 2-year GRAT funded with $6,283,933 |
| 4 | -10% | $790,343 | $7,945,627 | New 2-year GRAT funded with $7,945,627 |
| 5 | +20% | $0 | $7,006,262 | New 2-year GRAT funded with $7,006,262 |
| 6 | -15% | $131,854 | $8,109,625 | New 2-year GRAT funded with $8,109,625 |
| 7 | +30% | $0 | $7,200,343 | New 2-year GRAT funded with $7,200,343 |
| 8 | -5% | $1,438,294 | $8,303,841 | New 2-year GRAT funded with $8,303,841 |
| 9 | +12% | $0 | $7,791,042 | Kept by you (ladder stops) |
| 10 | +4% | $484,464 | $4,503,848 | Kept by you (ladder stops) |

A long-term GRAT still makes sense when you expect rates to rise and you’ll outlive the term. It fixes the funding month’s § 7520 rate for the whole term, which helps if rates rise, and there’s only one document. Its weakness is mortality. The longer the term, the more likely you die during it, and Badgley shows what that costs. A rolling program resets the rate each time it funds a new GRAT, so rising rates raise each new hurdle. It also needs a trustee and a CPA who will make every payment on time for years, because a payment that is late, made with a note, or skipped puts the qualified interest at risk.

## Funding a GRAT with company stock or other hard-to-value assets

How the asset is valued on the funding date decides whether the annuity holds. Hard-to-value assets need a current, qualified appraisal on the funding date. State the annuity as a percentage of the value “as finally determined for federal tax purposes” with the adjustment clause the regulation requires (Treas. Reg. § 25.2702-3(b)(2)). If the IRS raises the value, the annuity rises with it and the gift stays small.

Timing around a sale matters most. In Chief Counsel Advice 202152018 (2021), a founder created a 2-year GRAT three days after receiving buyout offers and funded it at a value taken from an appraisal roughly seven months old. The eventual tender price was nearly three times that value. IRS counsel concluded the annuity, keyed to the stale value, was “less than 34 cents on the dollar” of what it should have been and that the founder did not keep a qualified annuity interest. Under § 2702(a)(2)(A) that values the retained annuity at zero, so the entire transfer becomes a gift. Chief Counsel Advice isn’t precedent and can’t be cited as such, but it tells you how an examiner will read the file. A founder shouldn’t fund a GRAT with company stock after buyout offers arrive, using last year’s appraisal, and founders should also see [QSBS and California](https://ridleylawoffices.com/qsbs-section-1202-california/).

## Using a swap power to protect a gain or buy back basis

A swap power lets you adjust a GRAT after it’s funded. A GRAT can give the grantor a power to take back trust assets by substituting other property of equal value, held in a nonfiduciary capacity. That power is one of the ways the trust becomes a grantor trust (IRC § 675(4)(C)). The IRS has ruled that this power, by itself, won’t pull the trust into your estate under §§ 2036 or 2038, as long as the trustee must confirm the values are equal and the power can’t shift benefits among beneficiaries (Rev. Rul. 2008-22). A swap at a value the trustee never checked is where it fails.

After a big run-up, you can swap the volatile asset out for cash or bonds of equal value, which keeps the gain inside the GRAT so a crash before the term ends can’t erase it. Late in life, you can swap high-basis assets into the trust and take the low-basis ones back into your own name, so they get a step-up at your death. Assets left in a grantor trust outside your estate don’t get one (Rev. Rul. 2023-2), as covered in [step-up in basis for irrevocable trusts](https://ridleylawoffices.com/irrevocable-trust-step-up-in-basis-california/).

## Why GRATs and generation-skipping don’t mix

A GRAT remainder for grandchildren rarely works. You can’t allocate GST exemption to a GRAT until the estate tax inclusion period ends, which is the end of the annuity term (IRC § 2642(f) and Treas. Reg. § 26.2632-1(c)). While you’d be taxed on the GRAT if you died under § 2036, the trust is in an “ETIP,” and any allocation of GST exemption only takes effect when that period closes (Treas. Reg. § 26.2632-1(c)(1)(ii)). By then the remainder holds all the growth, so the exemption you’d need is measured at its highest value. So a GRAT remainder is better left to children, or to a trust for children that isn’t meant to be GST-exempt. If grandchildren and a long-lived trust are the goal, a sale to a grantor trust usually fits better, because the seed gift can carry GST exemption from day one. See [the intentionally defective grantor trust (IDGT) page](https://ridleylawoffices.com/intentionally-defective-grantor-trust-idgt/) and [generation-skipping trusts in California](https://ridleylawoffices.com/generation-skipping-trust-california/).

## Where California changes the decision

The GRAT’s estate tax benefit is all federal, because California adds no gift or estate tax to the math. California’s estate tax equals the federal credit for state death taxes (R&TC § 13302), and that credit was repealed (IRC § 2011, repealed by Pub. L. 113-295). See [California estate tax in 2026](https://ridleylawoffices.com/california-estate-tax-planning-2026/).

California does tax the trust’s income during the term, and you pay it, which helps the trust. California applies the federal trust income tax rules of subchapter J, grantor trust rules included, unless its own code says otherwise (R&TC § 17731). Trust income and gains land on your return at rates up to 13.3% (the 12.3% bracket plus the 1% tax on income over $1 million under R&TC § 17043), and California has no lower rate for capital gains (FTB). That tax bill is part of the benefit, since the trust keeps what you pay.

If the asset is community property, both spouses are involved before anything goes in. A spouse can’t give away community personal property without the other’s written consent (Fam. Code § 1100(b)). One approach is for each spouse to fund a GRAT with his or her own half. Another is to first convert the asset to separate property, which takes an express written transmutation (Fam. Code § 852). See [transmutation agreements](https://ridleylawoffices.com/transmutation-agreements-trust-california/).

The cost of using a GRAT on community property is the double step-up. Community property included in the first spouse’s estate gets a new basis for both halves (IRC § 1014(b)(6)). Assets that pass out through a GRAT keep your old basis instead. On a low-basis asset in a family under the exemption, that trade usually isn’t worth it. See [community property step-up](https://ridleylawoffices.com/community-property-step-up-vs-separate-property-california/).

Real estate in a GRAT raises a Prop 13 question when the term ends. Moving real property into a trust isn’t a change in ownership while you’re the present beneficiary (R&TC § 62(d)). When the term ends and the property passes to your children, it can be one (R&TC § 60), and the parent-child exclusion now reaches only a family home or family farm (R&TC § 63.2). Entity interests carry their own triggers under R&TC § 64(c) and (d). See the [Prop 19 parent-child exclusion](https://ridleylawoffices.com/prop-19-parent-child-exclusion-california/).

A remainder that stays in trust can become a California taxpayer. Once the GRAT ends and the remainder stays in trust as a non-grantor trust, California can tax its income if a trustee or a noncontingent beneficiary lives here (R&TC § 17742).

## Working with Ridley Law

I work alongside your CPA and, where the matter calls for it, co-counsel. Work at this level is built for each family and quoted in writing before any drafting starts.

The first call is free and runs 30 minutes, by phone or Zoom. [Book my 30-minute call](https://ridley.click/eric-30) or call 805-244-5291. To see your exposure first, run the [estate tax calculator](https://ridleylawoffices.com/estate-tax-calculator/).

## Frequently asked questions

### What does GRAT stand for?

Grantor retained annuity trust, so “GRAT trust” says trust twice. You are the grantor, you retain an annuity, and the trust holds the asset. The rules are in IRC § 2702 and Treas. Reg. § 25.2702-3.

### What is a GRAT in simple terms?

You put an asset in a trust and take its value back, plus IRS-set interest, as annuity payments over a few years. Any growth above that interest rate stays in the trust for your children, free of gift and estate tax.

### How long should a GRAT term be?

Walton approved a 2-year term. Longer terms fix the rate for longer but raise the chance you die during the term and lose the benefit under § 2036.

### What happens to a GRAT if the asset goes down?

The annuity pays the remaining assets back to you and the family gets nothing. You’ve lost the cost of setting it up and you have used almost no exemption.

### Is a GRAT better than a sale to an IDGT?

A GRAT uses almost no exemption, and if the asset lags it ends with nothing lost but costs. A sale to a grantor trust needs a seed gift but has a lower hurdle (the 5.22% long-term AFR in October 2026 against 5.6%) and works for grandchildren. The [IDGT page](https://ridleylawoffices.com/intentionally-defective-grantor-trust-idgt/) compares them.

### Do GRAT assets get a step-up in basis?

Not if the GRAT works. Assets that pass to the family keep your basis (Rev. Rul. 2023-2). A swap power lets you buy low-basis assets back before death.

### Does California tax a GRAT?

California has no gift or estate tax, but you pay California income tax on the GRAT’s income during the term because it is a grantor trust (R&TC § 17731).

This page is general information about California and federal law as of its update date. It isn’t legal, tax, or investment advice for your situation, and reading it doesn’t create an attorney-client relationship. All examples are hypothetical.

**Related reading:** [sale to an intentionally defective grantor trust](https://ridleylawoffices.com/intentionally-defective-grantor-trust-idgt/); [estate tax strategies compared](https://ridleylawoffices.com/estate-planning-strategies-compared/); [estate planning strategies that backfire](https://ridleylawoffices.com/estate-planning-strategies-that-backfire/); [QPRTs](https://ridleylawoffices.com/qprt-california-2026/); [SLATs](https://ridleylawoffices.com/slat-trust-2026-california/); [gift tax in 2026](https://ridleylawoffices.com/gift-tax-2026-california/); [trust tax rates](https://ridleylawoffices.com/trust-tax-rates-2026/).

Sources

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- [Franchise Tax Board, 2025 California tax rate schedules](https://www.ftb.ca.gov/forms/2025/2025-540-tax-rate-schedules.pdf) (2025, accessed 2026-10-09)
- [Franchise Tax Board, Capital gains and losses](https://www.ftb.ca.gov/file/personal/income-types/capital-gains-and-losses.html) (accessed 2026-10-09)

**Related reading:** [a GRAT before a founder’s exit](https://ridleylawoffices.com/estate-planning-examples-by-net-worth/), [Grantor Retained Annuity Trust](https://ridleylawoffices.com/estate-planning-glossary-california/grantor-retained-annuity-trust/).