GRAT Strategy Can Yield Tax Savings

On the surface it seems like there should be no obstacles standing between you and people that you would like to give gifts to. Unfortunately, the tax code says otherwise. There is a federal gift tax with a rate of 35% that is connected with the estate tax.

While there is currently a lifetime $5 million gift tax exclusion, your available estate tax exclusion will also be reduced by the amount of any gifts that you give under this exclusion. (These are gifts over and beyond the $13,000 per person you can give each year under the annual exclusion.)  So, for example, if you gave $5 million in tax-free gifts and used up your gift tax exclusion, your whole estate would be subject to the estate tax.

As a result, people who have assets in excess of the unified estate and gift tax exclusion amount have to seek tax-efficient ways to pass on their assets. One strategy is the zeroed out GRAT or Grantor Retained Annuity Trust.  Here is how it works:

An individual (the “grantor”) funds the trust and names a beneficiary who becomes owner of any remainder left in the trust after a period of time. When you create the trust, you schedule annuity payments that you will be receiving throughout the trust term. The assets you use to fund the trust are considered a gift by the IRS, and the IRS calculates the amount of income or appreciation it thinks the assets will generate by using 120% of the federal midterm rate.

Of course the value of the gift you give to your beneficiary is going to be reduced by your retained interest, so you “zero out” the GRAT by taking annuity payments equal to the entire estimated value of the trust, or the original gifted amount plus the appreciation the IRS calculates you will receive. But if the assets in the trust appreciate beyond the original IRS estimate, this extra value will remain in the trust after its term has ended. This remainder will become the property of your beneficiary and no gift tax will be due.

With the current low federal rates, a GRAT may be an attractive strategy if you have assets you expect to appreciate substantially over time.