As is true within many legal specialties, the field of estate planning has more than its share of jargon and an alphabet soup of acronyms that are used to describe wordy legal terms, and one of these is the GRAT. These initials stand for “grantor retained annuity trust,” and the utilization of this financial instrument can provide a number of different benefits, especially when the Federal Midterm Rate is low.
The way that a grantor retained annuity trust works is that you place assets into the trust, and this would ideally be property that is subject to significant appreciation such as interests you may hold in a business, stocks and other securities, and real property. You name a beneficiary to the trust, and this would be the the heir to whom you would like to bequeath anything that may be left in the trust after its term has expired. You as the donor receive annuity payments from the trust, and these would typically be monthly, quarterly, or annual payments for a term that you state when you set up the trust agreement.
The estate planning purpose of the grantor retained annuity trust is to pass along the appreciation of these assets to your heirs without incurring gift or estate tax responsibility, and this is done through what is called a zeroed-out GRAT. When you fund the trust the transaction is considered to be a gift by the IRS that is subject to the gift tax. The gift value will be computed using the value of the assets placed into the trust plus the anticipated interest that these assets will earn over the course of the agreement.
The IRS revises the Federal Midterm Rate monthly, and the 120% Federal Midterm Rate will be used for the month that you created the trust. The zeroed-out strategy involves setting the total annuity payments out of the trust to be about equal to the original value of the gift plus the anticipated interest. When you do this the the gift value is zero and no gift tax is due. If the assets in the trust appreciate at a rate that is greater than the 120% Federal Midterm Rate used to calculate your gift tax liability, that remainder will be transferred to your beneficiary at the end of the trust term and no gift tax will have been paid.