There are various different strategies that can be implemented to mitigate gift and estate tax exposure. In this post we will look at the value of the grantor retained annuity trust as a tax efficiency tool, but we should explain the federal transfer tax parameters first.
Unified Gift and Estate Tax Exclusion
The federal estate tax credit or exclusion is the amount that can be transferred free of the death tax. We are getting near the end of the 2014 calendar year, but for the rest of this year, the estate tax exclusion is $5.34 million. Every year there are inflation adjustments, and the adjustment for 2015 will be $90,000, so that will bring the exclusion up to $5.43 million.
In addition to the estate tax, there is also a federal gift tax. It is unified with the estate tax, and as a result, the exclusion is a unified lifetime exclusion. The exclusion encompasses lifetime gifting along with the value of your estate. If you are exposed, you are looking at a top rate of 40 percent.
Grantor Retain Annuity Trusts
Now that we have set the stage, we can get into the zeroed out grantor retained annuity trust (GRAT) strategy.
The idea is to fund the trust with assets that you would expect to appreciate considerably over time. You as the grantor of the trust will accept annuity payments throughout the term. When you create the trust declaration, you name a beneficiary who would assume ownership of anything that may remain in the trust after the expiration of its term.
You are removing the value of the assets that you convey into the trust from your estate when you fund the vehicle. That’s good, but you may be giving a gift to the beneficiary. That’s bad, because the gift tax would be applicable.
The Internal Revenue Service applies anticipated interest for transfer tax purposes using 120 percent of the federal midterm rate. This is called the hurdle rate, and rates have been low for quite a few years.
You want to zero out the grantor retained annuity trust, so you accept annuity payments throughout the trust term that equal the entire value of the trust as it has been calculated by the IRS. This is “zeroing out” the GRAT, because there should be nothing left according to the Internal Revenue Service.
However, you intentionally funded the trust with assets that were highly appreciable. If the assets outperform the hurdle rate, the value of the trust will not be zero after the expiration of the term. There will be something left, and the remainder would be transferred to the beneficiary free of the gift tax.
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If you would like to learn more about grantor retained annuity trusts and other tax efficiency vehicles, please contact our office.