If you anticipate to obtain several million remaining in your estate, organize to exchange some wealth while living in a way that triggers little or no gift tax and also have your loved ones benefit from the estate tax relief. You can utilize a grantor retained annuity trust (GRAT) to do exactly that. A GRAT is an irrevocable trust set up for only particular term of years and made to move the appreciation on assets contributed to it with minimum gift-tax implications.
It's essential to understand this basic estate tax relief concept: IRS sees each asset as having two parts: the worth these days and the long term value. You possibly can split any investment into those two parts for estate tax relief and that is the aim of a GRAT.
You fund your GRAT, receive back annuity payments from it throughout its term, and what ever is left in the GRAT at the end of its period is now out of your 'estate' and will go to your designated beneficiaries (or perhaps a holding trust) gift tax free. If you pass away throughout the period, although, the funds go to your beneficiaries but remains in your 'estate' for estate and gift tax functions . The idea here is that any appreciation on the asset happens out of your estate for estate tax relief.
How do you avoid gift tax for financing the GRAT?
Everything you fund your GRAT with would appear to qualify as a gift subject to gift tax. But because the GRAT returns to you annuity payments composed of these funds plus some of their earnings over the term of the trust, the precise gift is your funding amount less the present worth of those annuity payments.
The IRS assigns an rate of interest that a trust is anticipated to earn during the time of its funding. The gift value is set equal to the initial contribution to the GRAT plus a theoretical interest gained on the principal without the annuity payments that would be made through the end of the term. So if you allocate this IRS rate to determine your annuity payments, than the net gift you have produced to your GRAT may be 'zero'- a big estate tax relief!
You deposit $1 million in your GRAT
The GRAT is to give you $50,000 yearly for 20 years
The current worth of those payments is $682,000
Thus, you have made a gift not of $1 million but of $318,000 ($1 million less $682,000)
Obviously in case your GRAT money only earned the IRS rate, you'd empty your GRAT at the end of its term leaving nothing for your receivers. Thus, you're planning on GRAT investments to grow at a considerably greater rate than the assigned IRS rate of earnings. And that is why a reduced interest rate environment - as in a recession - with the anticipated recovery during the GRAT term makes it a low or zero gift estate tax relief transfer vehicle.
Observe that since the GRAT is a grantor trust, you have to pay out income tax on all taxable trust earnings throughout its time period. But having to pay these taxes does not constitute additional gifts to the GRAT