We are living in unprecedented times in many ways right now. While we hope for a return to something closer to “normal” in the coming months, the current unprecedentedly low interest rates have opened a unique window for some sophisticated estate and tax planning. We don’t know when interest rates will return to more “normal” levels, but we do know that the low rate environment makes it the perfect time to consider certain wealth transfer techniques. Today’s low interest rates provide a great opportunity to transfer wealth without incurring gift or estate taxes by using an irrevocable trust known as a Grantor Retained Annuity Trust (“GRAT”).
So how does a GRAT work? A person wishing to make gift and estate tax-free transfers establishes a GRAT and transfers assets into it that are expected to appreciate. This can be closely held business assets, real estate, or even marketable securities. Assets with the highest amount of expected appreciation will provide the greatest gift and estate tax savings.
The person can choose the term of years which the GRAT will last. During the selected term, the GRAT will repay the person an amount equal to the assets initially transferred into the GRAT, plus an IRS mandated annual rate of return (0.6% for June 2020). In essence, this is like a loan of the property to the GRAT, with the “lender” getting the principal back over the term plus the amount of IRS mandated “interest.” The objective is for the assets to appreciate during the term of the GRAT at a higher rate than the IRS required rate of return. The wider the gap between the mandated 0.6% and the actual rate of appreciation of the assets, the more is transferred free of tax.
Since the IRS mandated rate of return for GRATs created this month is only 0.6%, it is not hard to envision an asset appreciating at a higher rate, even in light of the current market volatility. All the “excess” appreciation over the 0.6% is a tax-free gift to the beneficiaries of the GRAT (very often, family members).
For a simple example, assuming a growth rate of 8%, a $1,000,000 five-year GRAT would return to the donor approximately $1,018,081 and transfer approximately $274,793 tax free, with a tax savings of up to approximately $107,079. If the person dies during the term of the GRAT, the tax benefits are lost, but the person is left in exactly the same position as if the GRAT had never been established. That is, even if the person dies, they are no worse off for having done the planning.