To understand what a GRAT is and why you may want to use one, you have to digest some information about the federal estate tax. This levy can have a very significant impact on your legacy, because it carries a draconian 40 percent maximum rate.
There is a federal estate tax credit or exclusion that allows you to transfer a certain amount before this death levy would become applicable. At the time of this writing in 2020, it is $11.58 million. Each year, there are adjustments to account for inflation, so you will probably see a somewhat higher figure when the new year rolls around.
The estate tax is not a factor when you are transferring assets to your spouse, because there is an unlimited marital deduction. One caveat to this statement would be that your spouse must be an American citizen to take advantage of this spousal exemption.
There is a solution if you are married to a citizen from another country in the form of a qualified domestic trust, but we will look at that device in a different blog post.
On the subject of spouses and the estate tax, the exclusion has been portable since 2011. In this context, the term “portability” refers to the ability of a surviving spouse to use the exclusion that was allotted to his or her deceased partner. Using the figures that are in place this year, a survivor would have a total exclusion of $23.16 million.
You may consider gift giving as a way to get around the estate tax, and this was possible shortly after the tax was enacted in 1916. However, there has been a federal gift tax in place since 1932, so this loophole was closed a very long time ago. The $11.58 million credit is a unified exclusion that applies to lifetime gifts and the value of your estate.
If you are exposed to the estate tax, you have to take steps to facilitate asset transfers in a tax efficient manner. You can do this through the utilization of the zeroed-out grantor retained annuity trust (GRAT) strategy.
The way that it works is you fund the trust and name a beneficiary. You arrange to receive annuity payments from the trust for a prescribed period of time. Anticipated interest is applied by the Internal Revenue Service using the 7520 rate, which is just .6 percent at the time of this writing.
To implement this strategy, you “zero out” the grantor retained annuity trust by accepting combined payments that are equal to the entire value of the trust, including the anticipated appreciation. In theory, there would be nothing left for the beneficiary if the trust is really zeroed out.
However, if the assets that have been conveyed into the trust outperform the 7520 rate, there will in fact be a remainder left in the trust, and it can be quite significant. This remainder would be transferred to the beneficiary free of taxation, and this is why the grantor retained annuity trust can be a very effective estate tax efficiency tool.
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