There are two standard trusts that can be used aggressively to nearly eliminate estate and gift taxes…
While getting substantial amounts of property out of your estate:
The grantor retained income trust and the charitable lead trust.
These strategies are ideal for rapidly appreciating property, such as stocks in a bull market.
The strategies are known as the “near-zero GRAT” (grantor retained annuity trust) and the “zeroed-out CLAT” (charitable lead annuity trust).
The grantor retained annuity trust is referred to as “near-zero” because IRS regulations don’t allow the elimination of gift taxes on the GRAT, while it is possible to eliminate the taxes with the charitable lead annuity trust.
Here’s an example of how a zeroed-out charitable lead annuity trust can work.
Let’s say that Mr. Max Profits transfers $1,000,000 to a CLAT for the benefit of his son, Hi.
The trust will pay a charity a substantial amount annually for six years.
Hi will inherit the remainder interest after six years. What’s the benefit?
The IRS requires the use of current market interest rates to compute the present value of the trust for gift tax purposes.
Max used the current interest rate to estimate the payout to the charity that will result in zero gift taxes and a maximum charitable contribution deduction.
Then the charitable lead annuity trust (CLAT) is invested in assets that Max hopes will earn a higher return than the IRS interest rate.
If it does, then Hi receives tax-free the amount by which the trust’s investments exceed the IRS’s interest rate.
For example, if the IRS rate is 5.4% and the trust earns 10%… then roughly $231,950 will remain in the trust at the end of six years.
Hi will pocket it free of gift taxes.
Max has made a substantial gift to charity, received a tax deduction for it, and still managed to leave a significant additional amount to Hi at zero tax cost.
If Max planned to benefit the charity anyway, he hasn’t lost anything if the charitable lead annuity trust’s investments don’t exceed the IRS’s interest rate.
You can get a similar result with a grantor retained annuity trust (GRAT) that will pay you income for a few years — then leave the remainder for your children.
The IRS won’t let you get the gift tax down to zero, but you can get it down to a very small percentage of the amount put in the trust.
Usually a near-zero GRAT is designed to last only two to four years.
The near-zero GRAT is funded with assets that the creator expects will appreciate rapidly, such as growth stocks, especially stock in a company owned by the creator.
The major difference is that the income from a grantor retained annuity trust is paid to the creator instead of the charity.
What Is the Benefit of a Near-zero GRAT?
Again, a meaningful amount of property is out of your estate and in the hands of your heirs at a very low tax cost.
But with a grantor retained annuity trust, very large annual distributions are made to you for a few years.
That money is back in your estate.
Some GRAT creators use the income to make charitable contributions.
Or the grantor retained annuity trust can be used to buy life insurance, after paying income taxes on the distributions.
These are aggressive strategies.
They work well… when they’re done carefully.
Be sure such plans are set up by an experienced estate planner and that you know all the potential consequences of a strategy.
Also, there are frequent proposals by the IRS and Congress to eliminate them, and we’ll dive into those in future issues of Retirement Watch Weekly.