You can avoid estate and gift taxes using a Grantor Retained Interest Trust (GRIT), which is especially attractive while interest rates are at current record lows.
The estate and gift tax savings come from the assumed rate of return applied to the assets contained in the GRIT, which is currently 1.4 percent.
If you feel like taking an aggressive approach to your potential estate tax liability, and you and your investment advisers believe that you have, or can acquire, assets that will produce a significant income stream and outperform an assumed 1.4 percent annual growth, you should consider a GRIT.
A GRIT is conceptually similar to an annuity contract between a Grantor (you) and the Grantor’s selected beneficiaries, usually the Grantor’s children. The Grantor creates a trust and contributes assets to it.
When creating the GRIT, the Grantor must select a term of years during which the Grantor wants to receive cash payments from the GRIT and the amount of cash or percentage of the GRIT’s assets the Grantor wants to receive from the GRIT during each of those years.
The Grantor must also select who will receive the assets remaining in the GRIT when it terminates, usually the Grantor’s children.
Once created, the GRIT is contractually obligated to make the selected annual cash payments to the Grantor for the selected term of years. The payments must be made in cash. The Grantor’s only ownership right in the GRIT is to receive the annual cash payments, no more and no less.
When a Grantor creates the GRIT he is making a contractually binding gift of the assets remaining in the GRIT after its term has expired to the Grantor’s selected beneficiaries. The ownership right that the Grantor’s beneficiaries have in the GRIT is called a remainder interest.
Thus, there are two ownership interests in the GRIT, the Grantor’s right to the annual cash payments and his beneficiaries’ remainder interest. Because a Grantor cannot make a gift to himself, the value of the Grantor’s right to the annual cash payments is not subject to gift taxes. However, gift taxes will be assessed against the value of the remainder interest owned by the Grantor’s beneficiaries.
The Internal Revenue Service will first compute the lump sum value of the Grantor’s right to the annual cash payments by asking how much money it would take today to produce the income stream that the Grantor has retained.
The great unknown factor in coming up with that number is what future interest rates will be, or how much interest that lump sum will earn each year. The IRS solves this great unknown with an assumption based upon today’s interest rates. The IRS publishes what is known as the Section 7520 interest rates, which it applies to valuation of GRITs.
The IRS then subtracts the value of the Grantor’s right to annual cash payments from the total assets contributed by the Grantor to the GRIT.
The result is the value of the beneficiaries’ remainder interest.
Ideally the annual cash payments to the Grantor are calculated just large enough that their current lump sum value is equal to the total assets contributed by the Grantor to the GRI, which would result in no gift taxes.
However, if there is a value to the beneficiaries’ remainder interest a Grantor could use some of his $5 million gift tax exemption or his $13,000 annual exclusion to avoid any gift tax liability.
The Section 7520 rate is currently 1.4 percent. Thus, the IRS is betting that assets in the GRIT will only generate earnings of 1.4 percent per year.
The GRIT will only result in estate and gift tax savings if:
- The assets outperform an assumed 1.4 percent rate of return.
- The assets have a rate of return high enough to also meet the annual cash payments to you.
- You do not pass away during the GRIT’s term.
So, before you seriously consider a GRIT, make sure you answer “Yes” to the following:
- Do you have a larger, potentially taxable, estate?
- Do you have a desire to irrevocably pass assets to your selected beneficiaries during your lifetime?
- Do you have, or can you acquire, high-income assets that you will not need in the future?
- Can you and your investment advisorsbeata 1.4 percent annual rate of return? Can you do that while also producing enough income to meet the annual payment obligations?
Printed in Four Rivers Business Journal (Paducah Sun), February, 2012.