A grantor retained annuity trust is an irrevocable trust that could be part of your tax efficiency strategy if you are a high net worth individual who is exposed to the federal estate tax. Before we get into the details, we have to provide some background information about the estate tax so that you can determine whether or not you are exposed to the tax.
Line in the Sand
There is a line in the sand drawn between the amount that you can transfer free of the estate tax, and the amount that would be taxable as it is being transferred. This line exists in the form of the federal estate tax exclusion. During the rest of the 2016 calendar year, the precise amount of the federal estate tax exclusion is $5.45 million.
Every year the IRS has the ability to raise the exclusion to account for inflation, and there have been slight increases every year since a $5 million exclusion was installed for 2011. As a result, you can expect to see a somewhat higher figure each year, as long as the existing laws remain intact.
The estate tax was first put into place in 1916. If you were a high net worth person, and the estate tax suddenly came into being, what would you do? The logical course of action would be to give gifts to your loved ones while you were living so that the assets could be transferred tax-free, and wealthy people did go this route back then.
Tax minded legislators closed this loophole through the enactment of the federal gift tax in 1924, but it was repealed in 1926. The gift tax was reenacted in 1932, so the window of opportunity has been slammed shut since then.
The gift tax and the estate tax are unified under the tax code, so both taxes carry the same 40 percent maximum rate, and the exclusion is a unified exclusion. It applies to tax-free gift giving along with the value of your estate, so if you gave $5.45 million in tax-free gifts using your exclusion, all of your estate would be subject to the estate tax after your passing.
Grantor Retained Annuity Trusts
Now that you have the background information that you need, we can look at the value of the irrevocable trust called a grantor retained annuity trust. The strategy that you would implement to transfer assets in a tax efficient manner would be called the “zeroed out” grantor retained annuity trust strategy. This involves funding the trust with assets that you expect to appreciate considerably during the term of the trust.
When you are creating the trust declaration, you name a beneficiary who would inherit anything that may be left in the trust after it expires. If a beneficiary was to assume ownership of a remainder, this would be a taxable transfer. Because a taxable transfer could take place, the IRS determines the taxable value of the trust by adding anticipated interest. The hurdle rate is used, which is 120 percent of the federal midterm grade.
You zero out the grantor retained annuity trust by accepting annuity payments over its term that are equal to its entire taxable value. In theory, there will be nothing left to transfer to the beneficiary when the term expires.
This is the theory, but in practice, interest rates have been low for numerous years at this point. You intentionally funded the trust with highly appreciable assets. If the appreciation exceeded the amount of the hurdle rate that was applied by the IRS at the outset, a remainder would exist at the conclusion of the term. The beneficiary would ultimately take possession of this remainder in a tax-free manner.
Connecticut Estate Tax
We practice law in the state of Connecticut, and in our state, there is a state-level estate tax to contend with in addition to the federal estate tax. In fact, it is possible to be exposed to the state-level estate tax even if the value of your estate does not exceed $5.45 million. On the state level, the exclusion is just $2 million at the present time.
This is something to keep in mind. You could use an irrevocable trust of some kind to gain estate tax efficiency on the state level if you are faced with exposure. A grantor retained annuity trust is a possibility, but there are others.
Schedule a Consultation
If death taxes are a source of concern for you, we are here to help. To schedule a tax efficiency consultation, call us at 860-548-1000 or send us a message through our contact page.