If you anticipate to obtain several million remaining in your estate, organize to transfer some wealth while living in a way that triggers little or no gift tax and have your family enjoy the tax savings. You may use a grantor retained annuity trust (GRAT) to do just that. A GRAT is actually an permanent trust set up for just particular term of years and made to transfer the appreciation on possessions contributed to it with minimum gift-tax implications.
It's essential to understand this basic tax saving idea: IRS sees each asset as having two parts: the value these days and also the long term value. You are able to split any investment into those two components for tax savings and that's the purpose of a GRAT.
You fund your GRAT, receive back annuity payments from it throughout its period, and whatever is left in the GRAT at the end of its term is now out of your 'estate' and will go to your assigned receivers (or a holding trust) gift tax free. If you pass away during the term, although, the money go to your receivers but remains in your 'estate' for estate and gift tax functions . The idea here is that any appreciation on the asset occurs from your estate for estate tax savings.
How do you avoid gift tax for funding the GRAT?
Everything you fund your GRAT with would seem to qualify as a gift subject to gift tax. However since the GRAT returns to you annuity payments made up of those funds and some of their earnings over the term of the trust, the actual gift is your funding amount less the current worth of those annuity payments.
The IRS assigns an interest rate that a trust is expected 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 earned on the principal without the annuity payments that would be made through the end of the term. So in the event you allocate this IRS rate to find out your annuity payments, than the net gift you've made to your GRAT can be 'zero' - an enormous tax savings!
You deposit $1 million in your GRAT
The GRAT is to give you $50,000 annually for twenty years
The present value of those payments is $682,000
Thus, you've produced a gift not of $1 million but of $318,000 ($1 million less $682,000)
Obviously if your GRAT funds only gained the IRS rate, you'd deplete your GRAT at the end of its term leaving nothing for the beneficiaries. Thus, you're arranging on GRAT investments to grow at a substantially greater rate compared to the designated IRS rate of earnings. And that's why a low rate of interest environment - as in a economic downturn - with the expected recovery during the GRAT term makes it a low or zero gift tax savings transfer vehicle.
Note that since the GRAT is a grantor trust, you must pay income tax on all taxable trust earnings throughout its term. But having to pay these taxes doesn't constitute extra gifts to the GRAT
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