When the creator of a U.S. estate planning trust similar to a Discounted Gift Trust dies, their regular payments stop forever. The person in charge of the trust, the trustee, then takes full control of the remaining money and property. Their job is to give those assets to the people named as beneficiaries, according to the rules written in the trust document.
The central problem this type of trust solves is a direct conflict with a powerful IRS rule. This rule, found in Internal Revenue Code § 2036, says that if you give away an asset but keep the right to enjoy it or receive income from it, the IRS can pull that asset’s full value at your death back into your estate.1 This can trigger a massive and unexpected federal estate tax bill, destroying the tax-saving goal of the gift.
This strategy is more critical than ever, as the current federal estate tax exemption—the amount you can leave to heirs tax-free—is historically high at over $13 million per person.4 However, this amount is scheduled to be cut in half at the end of 2025. This change means millions of families who are not considered wealthy today could suddenly face a 40% estate tax.
Here is what you will learn to protect your family and your legacy:
- 📜 What happens the exact moment the person who created the trust (the grantor) passes away.
- 📋 The step-by-step playbook for the person left in charge (the trustee) after the grantor’s death.
- 💸 How the IRS taxes the trust if the grantor dies too soon, and how it differs if they survive.
- 👨👩👧👦 The critical differences between the two main ways to name beneficiaries and how it impacts your family’s future.
- ❌ Common, costly mistakes that can cause the entire plan to fail and how you can avoid them.
Meet the Key Players: The Grantor, The Trustee, and The Beneficiaries
To understand what happens at death, you first need to know who is involved from the beginning. Every trust has three essential roles: the Grantor, the Trustee, and the Beneficiaries.5 Think of it as a contract for managing and passing on your wealth.
The Grantor (also called the Settlor) is the person who creates and funds the trust. You are the grantor. You transfer your assets—like stocks, cash, or business interests—into the trust, permanently giving up ownership and control over the principal amount.5
The Trustees are the legal managers of the trust. You can be a trustee, but you must appoint at least one other person or a professional company to act with you.5 Their job is to follow the trust’s rules, manage the investments, make the required payments to you, and ultimately distribute the assets to your heirs after you die.8
The Beneficiaries are the people you want to inherit the assets left in the trust after your lifetime. These are typically your children, grandchildren, or other loved ones.5 Their rights to the money are determined by the type of trust structure you choose at the start.
The IRS Problem: Why You Can’t Just “Give” Money and Still Get Paid
The entire purpose of this complex trust is to get around a major tax trap set by the federal government. The IRS has a simple rule: you can’t have your cake and eat it too. If you give away an asset but continue to benefit from it, the law treats it as if you never really gave it away.
This rule is called IRC Section 2036, “Transfers with Retained Life Estate”.1 It states that if you transfer property into a trust but keep “the possession or enjoyment of, or the right to the income from, the property,” the full market value of that property at your death is included in your taxable estate.3 This can completely undo your estate planning and lead to a 40% tax bill on assets you thought were protected.
This is where a special kind of trust, known as a Grantor Retained Annuity Trust (GRAT), comes in. A GRAT is the primary U.S. legal tool used to achieve the goals of a “discounted gift.” It is specifically designed to avoid the IRC § 2036 trap by structuring your retained payments not as “income from the property” but as a fixed annuity—a series of predetermined payments that are legally a return of the capital you put in.10
Because you are receiving a fixed annuity rather than the fluctuating income the assets generate, the IRS views it differently. You haven’t retained a direct interest in the gifted property itself, only a right to a separate payment stream. This legal distinction is the key that unlocks the entire tax-saving strategy.
The “Zeroed-Out” Gift: Making a Million-Dollar Transfer with No Gift Tax
The “discounted” part of the trust’s name refers to its most powerful feature: the ability to transfer a large amount of wealth while reporting little to no taxable gift. In the U.S., this is achieved by creating what is known as a “zeroed-out” GRAT.12 This concept relies on another special IRS rule.
Each month, the IRS publishes an official interest rate called the Section 7520 rate.14 This rate represents the government’s assumed rate of return on investments. When you create a GRAT, this rate is used to calculate the total present value of the annuity payments you will receive back over the trust’s term.16
If you structure the trust so that the calculated value of your retained annuity payments is equal to the value of the assets you initially put in, the taxable value of the gift to your beneficiaries is considered to be zero.12 You report the transfer on IRS Form 709 (U.S. Gift Tax Return), but it uses up little or none of your lifetime gift tax exemption.17 This allows you to move significant, high-growth assets out of your estate without paying an upfront gift tax.
The Clock Stops: Immediate Consequences of the Grantor’s Death
The death of the grantor is the most critical moment in the life of the trust. At that exact moment, two things happen that define the outcome for your estate and your beneficiaries.
First, your right to receive annuity payments stops immediately and permanently.19 Because your right to these payments was legally defined as lasting only for your lifetime, its value becomes zero at the moment of your death. As a result, the value of this income stream is not an asset that gets included in your taxable estate.21
Second, the trustees’ primary responsibility shifts entirely. While you were alive, their main duty was to ensure you received your contractually required annuity payments. Upon your death, their sole legal and fiduciary duty is now to the beneficiaries named in the trust.5 The remaining trust fund is now held exclusively for them.
The Successor Trustee’s Checklist: From Paperwork to Payout
When the grantor dies, the successor trustee must spring into action. They have a formal, step-by-step job to do to legally wind up the trust and distribute the assets. This process requires careful attention to detail and adherence to strict legal duties.8
Here is the essential playbook for any trustee administering a trust after the grantor’s death:
- Obtain Official Death Certificates: The trustee will need multiple certified copies of the death certificate to provide to financial institutions, government agencies, and for tax filings.
- Notify All Relevant Parties: The trustee must formally notify the bank or brokerage firm holding the trust’s assets. They must also notify all named beneficiaries that the grantor has passed away and that they are now managing the trust.
- Locate and Review the Trust Document: The trustee must find the original trust agreement and read it carefully to understand the rules, the beneficiaries’ identities, and the instructions for distribution.
- Inventory and Value All Trust Assets: The trustee must create a detailed list of every asset in the trust and get a formal “date of death” valuation for each one. This is crucial for tax filings and ensuring fair distribution.8
- Coordinate with the Estate’s Executor: The trust is separate from the grantor’s will, which is managed by an executor. The trustee must work with the executor to file the final estate tax return (Form 706), as information about the trust may need to be included.
- Pay All Final Debts and Taxes: The trustee is responsible for paying any outstanding expenses of the trust and filing a final income tax return for the trust if necessary.8
- Distribute the Assets to Beneficiaries: Once all debts and taxes are paid, the trustee’s final job is to distribute the remaining assets to the beneficiaries as instructed in the trust document. This may involve transferring property titles, writing checks, or assigning investment accounts.8
Beating the Clock: The High-Stakes Gamble of the GRAT Term
The single greatest risk of a GRAT is the mortality risk—the chance that the grantor will not outlive the trust’s term.4 The entire tax-saving benefit hinges on the grantor surviving until the last annuity payment is made. The outcome is binary: success or failure.
If the grantor dies before the trust term ends, the strategy fails. Under IRC § 2036, because the grantor was still receiving payments from the trust at death, the IRS pulls a significant portion, if not all, of the trust’s assets back into the grantor’s taxable estate.26 The assets are valued at their full market price on the date of death, meaning all the appreciation you tried to move is now subject to the 40% estate tax.
If the grantor survives the trust term, the strategy succeeds. The moment the final annuity payment is made, the trust terminates its connection to the grantor. Any and all assets remaining in the trust pass to the beneficiaries completely free of any additional gift or estate tax.10 This is how millions of dollars in asset growth can be transferred to the next generation entirely tax-free.
Real-World Scenarios: Success, Failure, and Unexpected Turns
How these rules play out can vary dramatically. Here are three common scenarios that illustrate the potential outcomes of a GRAT strategy.
Scenario 1: The Perfect Plan (Success)
John funds a 5-year GRAT with $2 million of tech stock when the Section 7520 rate is 3%. The stock grows at 12% per year. John survives the 5-year term.
| Event | Financial Outcome |
| GRAT Creation | John transfers $2M of stock into a “zeroed-out” GRAT. He reports the gift on Form 709 but uses none of his lifetime gift exemption. |
| During the Term | John receives his required annuity payments each year. The stock inside the trust grows much faster than the 3% hurdle rate. |
| End of Term | John has received back his full $2M plus the 3% assumed return. The remaining growth, valued at over $750,000, passes to his children with zero estate or gift tax. |
Scenario 2: The Tragic Failure (Death During Term)
Mary funds a 10-year GRAT with $5 million of real estate. The Section 7520 rate is 4%. Mary unexpectedly passes away in year 8 of the trust term.
| Event | Financial Outcome |
| GRAT Creation | Mary transfers $5M of property into a “zeroed-out” GRAT, using no gift tax exemption. |
| During the Term | Mary receives her annuity payments for 7 years. The property appreciates significantly. |
| Grantor’s Death | Because Mary died during the term, IRC § 2036 is triggered. The entire date-of-death value of the property, now worth $8 million, is pulled back into her taxable estate. Her estate now faces a potential $3.2 million estate tax bill on that property. |
Scenario 3: The Underperformer (Assets Don’t Grow)
David funds a 3-year GRAT with $1 million of stock in a volatile market. The Section 7520 rate is 5%. The stock performs poorly and only returns 2% per year. David survives the term.
| Event | Financial Outcome |
| GRAT Creation | David transfers $1M of stock into a “zeroed-out” GRAT. |
| During the Term | The stock’s growth is not enough to cover the annuity payments. The trustee has to sell shares each year to pay David. |
| End of Term | David has received all his money back through the annuity payments. Because the assets did not outperform the 5% hurdle rate, there is nothing left in the trust for the beneficiaries. The strategy failed to transfer wealth, but there is no negative tax consequence; it’s as if it was never created (aside from legal fees).29 |
Fixed vs. Flexible: Choosing the Right Beneficiary Structure
When you create the trust, you must decide how your beneficiaries will inherit the assets. There are two main structures, each with significant trade-offs between certainty and flexibility.31
An Absolute Trust (often called a Bare Trust) is the most straightforward. You name specific beneficiaries and their exact shares from the start. This decision is permanent and cannot be changed.33
A Discretionary Trust provides maximum flexibility. Instead of naming specific people, you name a class of beneficiaries (e.g., “my children and grandchildren”). You give your trustee the discretion to decide who receives money, how much they get, and when they get it, based on their needs at the time.32
| Feature | Absolute (Bare) Trust | Discretionary Trust |
|—|—|
| Beneficiaries | Named and fixed from the start. Cannot be changed. | A group of potential beneficiaries is named (e.g., “descendants”). |
| Flexibility | None. Your decisions are locked in forever. | High. The trustee can adapt to future family changes, like new grandchildren or a child’s financial hardship. |
| Trustee’s Role at Death | Purely administrative. The trustee’s only job is to transfer the assets to the named people. | Requires judgment. The trustee must decide how to best distribute the funds according to your wishes and the family’s needs. |
| Potential for Disputes | Low. Everyone knows exactly what they are getting. | Higher. Beneficiaries may disagree with the trustee’s decisions, which can lead to family conflict.35 |
Cautionary Tales: 5 Critical Mistakes That Can Wreck Your Trust
These trusts are powerful, but they are also complex and unforgiving. A single mistake in setup or administration can cause the entire strategy to fail, leading to devastating tax consequences.
Here are five of the most common and costly errors to avoid:
- Choosing a Term That’s Too Long. The biggest risk is failing to outlive the trust term. While a longer term might seem to allow for more asset growth, it dramatically increases the mortality risk. It is often better to use a series of shorter, “rolling” GRATs to minimize the chance of dying mid-term.24
- Funding with the Wrong Assets. GRATs work best with assets that have high growth potential, like pre-IPO stock or a concentrated position in a growth company. Funding a GRAT with slow-growing assets like bonds or cash is unlikely to beat the IRS hurdle rate, making the strategy pointless.24
- Ignoring Trust Administration. A trust is not a “set it and forget it” vehicle. The trustee must make the annuity payments on time and correctly every year. Failure to follow the trust’s terms, like in the cautionary tale of an ILIT where required “Crummey letters” were never sent, can give the IRS an argument to invalidate the trust.37
- Creating an “Implied Understanding” with the Trustee. This is a subtle but deadly mistake. If you continue to use or benefit from the trust assets outside of your fixed annuity (e.g., living in a house you put in a GRAT without paying fair market rent), the IRS can argue there was an “implied understanding” that you never truly gave up enjoyment of the property. This is a direct trigger for IRC § 2036, which would pull the entire trust back into your estate.1
- Putting All Your Eggs in One Basket. If you have multiple high-growth assets, it is almost always better to fund several separate GRATs rather than one large one. This isolates risk. If one asset underperforms, it won’t drag down the successful growth of the others, maximizing the total wealth you can transfer tax-free.36
At a Glance: The Pros and Cons of a GRAT Strategy
| Pros | Cons |
| ✅ Massive Tax Savings: Can transfer millions in asset growth to heirs completely free of estate and gift tax. | ❌ Mortality Risk: The entire strategy fails if the grantor does not survive the trust term, potentially triggering huge estate taxes. |
| ✅ Uses No Gift Tax Exemption: A “zeroed-out” structure allows you to preserve your lifetime gift tax exemption for other planning. | ❌ Performance Risk: Assets must grow faster than the IRS Section 7520 rate for the trust to be successful. If they don’t, the effort is wasted. |
| ✅ Provides an Income Stream: The grantor receives fixed annuity payments for the entire term, providing a predictable cash flow. | ❌ Irrevocable and Inflexible: Once created, the trust terms cannot be changed. The grantor gives up all access to the principal. |
| ✅ “Heads I Win, Tails I Tie”: If the assets underperform, they are simply returned to the grantor via the annuity. There is no negative tax outcome, only the loss of legal and administrative fees. | ❌ Complexity and Cost: GRATs are complex legal instruments that require expert legal and tax advice to set up and administer correctly, which involves fees. |
| ✅ Removes Future Appreciation: Freezes the value of an asset for estate tax purposes, ensuring all future growth happens outside of your taxable estate. | ❌ Not for Generation-Skipping: GRATs are not efficient tools for transferring wealth directly to grandchildren due to rules around the Generation-Skipping Transfer (GST) tax.38 |
Frequently Asked Questions (FAQs)
1. Do my annuity payments stop when I die?
Yes. Your right to receive payments ends immediately upon your death. The value of your payment stream becomes zero and is not part of your taxable estate.19
2. Can my beneficiaries get the money right away after I die?
No. If you die during the trust term, the assets are pulled back into your estate for tax purposes. If you survive the term, the trustee distributes the assets after your final annuity payment is made.39
3. What happens if I die during the trust’s term?
The trust fails its tax-saving purpose. The IRS will include a large portion or all of the trust’s assets in your estate, where they will be subject to the 40% federal estate tax.26
4. Can I change the beneficiaries later?
Only if you use a Discretionary Trust. This gives your trustee flexibility to choose from a group of beneficiaries. If you use an Absolute (Bare) Trust, the beneficiaries are fixed and can never be changed.33
5. Can I stop or change my annuity payments?
No. The payment amount and schedule are fixed when the trust is created and cannot be altered. This rigidity is a legal requirement for the trust to work for tax purposes.33
6. What happens if the investments perform poorly?
If the assets don’t grow faster than the IRS interest rate, they will all be returned to you through your annuity payments. Your beneficiaries will receive nothing, but there is no negative tax consequence.29
7. Is the tax saving guaranteed?
No. The entire strategy depends on two key factors: you must survive the trust’s term, and the assets inside the trust must grow faster than the IRS’s Section 7520 rate.
8. Can I be the only trustee?
No. While you can serve as a co-trustee to manage the investments, you must appoint at least one other independent trustee to act alongside you to ensure the trust is administered properly.5
9. Do my beneficiaries pay income tax on the money they receive?
It depends. When the assets are distributed, they may receive a “carryover basis,” meaning they could owe capital gains tax if they sell the asset later. The rules are complex and require professional tax advice.
10. Can I put my house in this type of trust?
Yes, but it may not be the best asset. These trusts work best for assets expected to appreciate significantly. A different tool, called a Qualified Personal Residence Trust (QPRT), is often better suited for a primary residence.