Basic Mechanism
A donor sets up a GRAT by making a donation into a trust. The trust is set up as an annuity whereby the donor receives an annual payment from the trust for a fixed period of time. At the end of the term, any remaining value in the trust is passed on to a beneficiary of the trust as a gift. Beneficiaries are generally close family members of the donor, who are prohibited from being named beneficiaries of another estate freeze technique, the grantor retained income trust. If a grantor dies before the trust period ends, the assets in the GRAT are included in the grantor’s estate by operation of I.R.C. § 2036, eliminating any potential gift tax benefit; this is the GRAT's main weakness.
The United States Internal Revenue Service has a number of regulations governing how the remaining value of the trust at the end of the term (or at the death of the donor) is taxed. When the GRAT is first set up, a “gift value” of the GRAT is calculated. The gift value is set equal to the initial contribution to the GRAT plus a theoretical interest earned on the principal minus the annuity payments that would be made through the end of the term. The theoretical rate of interest is determined by IRS regulations. The rate is set equal to 120% of the federal mid-term rate during the month that the GRAT is established.
To realize a tax benefit, the sum of the scheduled annuity payments of a GRAT is set to be about equal to the principal plus theoretical interest. Thus, for tax purposes, the initially calculated gift value is zero, since what will be paid back to the donor in annuity payments is anticipated to be about equal to what the donor invested, plus interest. If a GRAT is funded with highly volatile assets, however, it is possible that the actual interest earned on the assets will be substantially higher than the IRS theoretical interest. Thus at the end of the term, the value remaining in the GRAT may still be large, even though the initial IRS calculation suggests that it should have been zero. This remaining value is then passed on to the beneficiary without incurring a gift tax.
Read more about this topic: Grantor Retained Annuity Trust
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