A grantor retained annuity trust (GRAT) could potentially be useful if you are exposed to the federal estate tax. Before we explain the value of these trusts, we should provide some information about the estate tax so that you can determine whether or not you are exposed.
Federal Estate Tax Parameters
Everyone does not pay the federal estate tax, because there is a relatively large credit or exclusion. The portion of the estate that exceeds the amount of this exclusion would potentially be taxable. If your assets do not exceed the amount of the credit, you would not be faced with estate tax exposure.
At the time of this writing in 2014, the estate tax exclusion stands at $5.34 million. There was a $5 million exclusion put into place for the 2011 calendar year. This has been the standard going forward, but there have been ongoing adjustments to account for inflation. You may see another inflation adjustment added next year, and the figure would be somewhat higher.
The maximum rate of the federal estate tax is 40 percent.
The gift tax is also relevant when you are talking about grantor retained annuity trusts. There is a gift tax in place that is unified with the estate tax. This prevents people from giving gifts while they are living to avoid the death tax.
The $5.34 million exclusion encompasses taxable gifts that you give during your life along with the estate that you are passing on to your heirs.
Grantor Retained Annuity Trusts
Now that we have set the stage, we can explain the value of grantor retained annuity trusts. You could reduce the taxable value of your estate by conveying appreciable assets into this type of trust. When you create the trust agreement, you name a beneficiary who would inherit any remainder that may still be in the trust at the conclusion of its term.
Because a beneficiary may be inheriting the remainder, the gift tax could be applicable. The Internal Revenue Service calculates the taxable value of the gift by adding 120 percent of the federal midterm rate to the market value of the assets that have been conveyed into the trust.
As the grantor you take annuity payments from the trust on an annual basis. The idea is to “zero out” the GRAT. To do this, you accept annuity payments equal to the entire taxable value of the trust over its term.
Theoretically, there would be nothing left at the conclusion of the term. However, if the appreciable assets outperform the anticipated interest that was applied by the IRS, there would in fact be a remainder.
The beneficiary that you name in the trust agreement would inherit this remainder, and the gift tax would not be a factor.