There are various different types of trusts that can be used to transfer assets at a tax discount. One of them is the grantor retained annuity trust. Before we get into the details, we should explain the estate tax parameters so that you can evaluate your position.
On the federal level, the estate tax carries a 40 percent maximum rate. As long as the people involved are American citizens, unlimited tax-free transfers between spouses are allowed. This is because of the existence of the unlimited marital deduction.
Due to a relatively recent Supreme Court ruling that resulted in federal recognition of same-sex marriages, the unlimited marital deduction is afforded to any and all legally married couples.
The amount that you can transfer to anyone other than your spouse before the estate tax would kick in is called the federal estate tax exemption or exclusion. For the remainder of 2016, the exclusion is $5.45 million. There can be annual adjustments to account for inflation, so the figure tends to rise slightly year-by-year.
If the value of your estate exceeds the amount of this exclusion, you may naturally consider lifetime gift giving to avoid the estate tax. Unfortunately, there is a gift tax that is in place to stop people from taking this route. The $5.45 million exclusion that we have during the current calendar year applies to large gifts that you give while you are living, along with the value of the estate that will be distributed among your heirs after you pass away.
To boil down the implications, if you gave $5.45 million in tax-free gifts this year using your transfer tax exclusion, there would be nothing left to apply to your estate. The entirety of your estate could be subject to the estate tax and its 40 percent maximum rate.
There are a number of states in the union that have state-level estate taxes to contend with as well. Fortunately, here in Florida where we practice law, there is no state-level estate tax. However, many people move to Florida from states like New York, Connecticut and New Jersey after they retire. These states do have state-level estate taxes, and the taxes could come into play if you still own valuable property in these states, even if you are technically a Florida resident.
The Zeroed-Out GRAT Strategy
Now that you understand the lay of the land, we can look at the value of the grantor retained annuity trust for estate tax efficiency purposes. To implement this technique, you intentionally fund the trust with highly appreciable assets. You receive annuity payments from the trust throughout its term, and you name a beneficiary who would assume any remainder that is left in the trust after the term expires.
When you fund the trust, you are removing those highly appreciable assets from your estate for estate tax purposes, but the beneficiary may be receiving a gift. Since a gift may be given, the gift tax is applicable. The IRS determines the taxable value of the potential gift by adding anticipated interest. The hurdle rate is applied; this is equal to 120 percent of the federal midterm rate.
The idea here is to “zero out” the grantor retained annuity trust. You do the math and arrange for the total of your annuity payments to equal the entire taxable value of the trust after the hurdle rate has been applied.
At the outset, you endeavored to fund the trust with assets that you expect to appreciate considerably. Since federal interest rates are low, the assets in the trust may well outperform the hurdle rate. If this plays out, assets will still remain in the trust after the expiration of its term, even though you took the entire taxable value of the trust in annuity payments. The gift tax would not be applied on the transfer of this remainder to the beneficiary.
Attend a Free Estate Planning Seminar
We have looked at one specialized topic in this blog post, but you may have questions about other estate planning topics. If you would like to gain a broad understanding of the process in a very efficient manner, we are offering an opportunity that may be right up your alley.
During the coming months, we will be holding a number of different estate planning seminars. These informational sessions are absolutely free to attend, and we try to accommodate every schedule. They are held throughout different locations in southwest Florida, so you should find a time and a location that works for you.
To obtain more details and registration information, visit this page: Free Estate Planning Seminars.