If you expect to have several million dollars of value remaining in your estate, be aware that the estate tax levy is scheduled to go WAY UP after 2012. Organize to transfer some wealth while living in a way that triggers little or no gift tax and have your loved ones enjoy the tax avoidance from your foresight. You may use a grantor retained annuity trust (GRAT) to achieve exactly that. A GRAT is a permanent trust setup for just particular period of years and made to transfer the appreciation on possessions contributed to it with little or no gift-tax implications.
You fund your GRAT, in return you obtain annuity payments from it during its term, and what ever is left in the GRAT at the end of its period is now out of your 'estate' which will go to your designated beneficiaries (or a holding trust) gift-tax free. In case you die during the term, though, the money goes to your receivers yet stays in your 'estate' for estate and gift tax purposes . The concept here is that any appreciation on the resource happens outside of your estate for estate tax avoidance (as long as you outlive the term of the GRAT).
It is important to understand this fundamental tax avoidance concept: IRS sees every resource as having two parts: the current and the potential future appreciation. You are able to split any investment into these two components for tax avoidance and that's the purpose of the GRAT. It take the future appreciation out of your estate today.
How do you avoid gift tax when funding your GRAT?
The assets that fund your GRAT would seem to qualify as a gift subject to gift tax. But since the GRAT returns to you annuity payments made up of those funds and some of their revenue over the term of the trust, the actual gift is the current value of the asset less the current value of those annuity payments. Therefore, the gift is actually quite small.
The IRS assigns an interest rate that a trust is expected to generate at the time of its funding. The gift value is set equal to the initial contribution to the GRAT along with a theoretical interest earned on the principal minus the annuity payments that would be produced through the end of the period. Therefore, if you assign this particular IRS rate to determine your annuity payments, than the net gift you've made to your GRAT can potentially be 'zero' - an enormous tax savings!
You deposit $1 million in your GRAT (could be cash or assets such as stocks, real estate, etc)
The GRAT is to give you $50,000 annually for twenty years
The present value of these payments is $682,000
So, you have made a gift not of $1 million but of $318,000 ($1 million less $682,000)
Obviously if your GRAT money only earned the IRS rate, you'd deplete your GRAT at the end of its term leaving absolutely nothing for the beneficiaries. So, you're arranging on GRAT investments to develop at a substantially greater rate than the designated IRS rate of earnings. That is why it is best to fund a GRAT with those assets you believe will appreciate the most. And that's why a reduced interest rate environment - as in a recession - with an expected recovery throughout the GRAT term tends to make it a low or zero gift tax avoidance transfer vehicle.
Observe that because the GRAT is a grantor trust, you must pay out income tax on all taxable trust earnings during its designated period. But paying these taxes doesn't represent extra gifts to the GRAT.
Although this may sound complex, this tool is used everyday and any estate planning attorney is very familiar with how you can use this tool to transfer assets at a highly reduced tax rate.
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