Chris from San Diego asks: “I am holding assets that I expect to appreciate significantly in the coming years. How can I transfer them to my heirs without estate and gift taxes?”
Chris, thank you for the question and reaching out. This is one of the most common questions I have recieved over my decades of practicing international tax law.
If you’re investing in assets that you expect to increase in value, and you plan to hold those assets for a number of years – not buy and sell, but hold – you might consider setting up a Grantor Retained Annuity Trust, or GRAT.
A Grantor Retained Annuity Trust is used by long-term investors to protect appreciating property and family businesses from gift and estate taxes. Here’s how a GRAT works and how to use it to eliminate gift and estate taxes…
When you transfer assets to a revocable trust, you will typically pay gift tax on the transfer. If you hold those assets in your estate (no trust) and transfer them upon your death, you’ll pay estate tax on the transfer. Either way, Uncle Sam wants his cut of your wealth… at least if you’re in the top 5% with an estate worth $5.49 million or more in 2017.
The Grantor Retained Annuity Trust allows you to gamble that your assets will appreciate at a rate faster than the IRS’s published rate. If you’re buying cryptocurrency, pre-IPO stocks, foreign real estate, Initial Coin Offerings, or anything else that you expect to appreciate quickly and consistently, consider forming a GRAT.
More specifically, a GRAT is a bet that your assets will appreciate at a rate higher than 120% of the Applicable Federal Midterm Rate. The Midterm rate is a rate of interest published each month on the IRS website.
The Midterm rate has been at 2.4% and 2.6% during 2017. So, if you expect your assets to appreciate more than 2.6% over the next several years, and you wish to leave those assets to your heirs, you will benefit from a GRAT.
Here’s how a Grantor Retained Annuity Trust works:
When you transfer assets into a GRAT, you (the settlor) receive a guaranteed annuity over a certain number of years. That annuity is meant to return to you 100% of the assets contributed to the trust, plus a profit (the interest rate) over the life of the trust.
Because the assets and the profits are being returned to you, no gift tax is payable when you fund the trust.
If your assets appreciate at a rate lower than or equal to 120% of the Midterm rate, all of the assets of the trust will have been distributed to you with nothing left for your heirs.
If your assets appreciate at a rate higher than 120% of the Midterm rate, that difference will pass to your heirs with zero gift or estate tax payable.
So, you’re gambling that your cryptocurrency and IPO / ICO portfolio will do better than 2.6% (the highest rate in 2017 – click here for historic rates) over the term of the trust. Assuming you plan to hold and transfer the assets to your heirs, the downside of this bet is minimal. If you lose, you’re out the legal fees… no penalties or extra taxes apply.
The same is true if you die while the GRAT is in place. The assets in the trust are returned to your estate and pass to your heirs. The only loss is legal fees to set up and maintain the trust.
You might also transfer shares in a family business into a GRAT. This fixes the value of those shares at their current value, plus the interest rate. Transferring family shares into the GRAT allows the trust to “buy” the business from the settlor over the years, rather than upon his or her death.
For example, you transfer shares from your family business into a 10-year GRAT. Those shares are valued at $1 million and the interest rate over those 10 years is 2.5%. Your intent is that your heirs will take over the business at your passing.
In this case, the GRAT will pay the settlor $25,000 in interest, plus 1/10th of the value of the stock per year, for a total of $100,000 + $25,000 = $125,000 for 10 years. At the end of those 10 years, the stock is free and clear of estate taxes and will be transferred to the heirs on the passing of the settlor.
So, if you’re buying and holding appreciating property, or wish to protect a family business from estate tax, I suggest you consider a Grantor Retained Annuity Trust. For more information, you can reach me at (412) 749-0500 or click here to view my website.