People who are exposed to the federal estate tax have to position their assets in a tax efficient manner. In 2016, the amount that you can transfer before the estate tax would be applied is $5.45 million.
There is also a gift tax, and it is unified with the estate tax. This exclusion is a unified exclusion; it applies to your estate, but it also applies to large lifetime gifts.
Irrevocable trusts of various kinds are used for estate tax efficiency purposes. As you can clearly see from the name of the trust, you cannot revoke or dissolve this type of trust once you establish it. In legal terms, you are surrendering incidents of ownership. As a result, assets that have been conveyed into irrevocable trusts are no longer part of your estate from a tax perspective.
Let’s look at a couple of the irrevocable trusts that can provide estate tax efficiency.
Qualified Personal Residence Trusts
Since your home is probably one of your most valuable assets, if you could reduce its taxable value, you would be making headway. A qualified personal residence trust could potentially fill the bill.
To implement this strategy, you fund the trust with your home, and you name a beneficiary. The beneficiary would assume ownership of the home after the term of the trust expires. The trust term is called the retained income period.
You do not have to worry about an immediate disruption of your living environment. As the grantor of the trust, you decide on the duration of the retained income period. During this interim, you can continue to live in the home as usual, rent-free.
When you fund the trust with the home, you are removing the value of the home from your estate for tax purposes. However, the beneficiary is eventually going to assume ownership of the home, so you are giving a taxable gift to the beneficiary.
This is the bad news; the good news is that the value of the taxable gift will be far less than the actual fair market value of the home.
The taxable value of the gift is reduced because of the retained income period. Let’s say that you set a retained income period of 15 years. Suppose you told a neutral buyer that you wanted to sell the home, but the buyer could not assume ownership for 15 years.
No one would pay full market value under those circumstances. The IRS uses this rationale when the taxable value of the gift is being determined.
After the expiration of the retained income period, the beneficiary assumes ownership of the home, and the transfer tax consequences are minimized.
Zeroed Out GRAT
The zeroed out grantor retained annuity trust (GRAT) strategy can be effective if you have assets in your possession that are probably going to appreciate considerably into the foreseeable future.
To implement this strategy, you convey the appreciable assets into the GRAT. In the trust declaration, you name a beneficiary who would assume ownership of any remainder that is left in the trust after the expiration of the term.
A taxable gift may be going to the beneficiary, so the IRS adds anticipated interest accrual to the value of the trust. The hurdle rate is used; this is equal to 120 percent of the federal midterm rate.
You set the duration of the trust term when you create the trust. Throughout the term, you accept annuity payments on an annual basis. The idea is to “zero out” the GRAT, so you take annuity payments that are equal to the entire taxable value of the trust.
Since you funded the trust with highly appreciable assets, they may outperform the anticipated interest that was applied by the Internal Revenue Service. If this does in fact take place, there will be a remainder left in the trust, even though you zeroed out the taxable value.
If there is a remainder left in the trust, the beneficiary would assume ownership of the assets, and there would be no further tax consequences.
One thing that you have to remember when you are creating a grantor retained annuity trust is the fact that the strategy falls apart if you pass away before the trust term expires. If this was to take place, all or part of the assets in the grantor retained annuity trust would once again become part of your taxable estate. As a result, you should be conservative when you are setting the duration of the term.
Attend a Free Seminar
We have looked at two irrevocable trusts in this blog post, but there are many different tools in the estate planning toolkit. If you would like to learn about them, attend one of our seminars. These sessions are free to attend, and you can visit our seminar schedule page to get all the details..