No one likes to pay taxes. This is especially true for wealthy individuals, who already pay the vast majority of the taxes collected. Gift and estate taxes are especially reviled, as they are essentially a second tax on assets already taxed when earned. There are many methods employed by the wealthy to avoid these taxes. Of the techniques currently in use, one of the best is the Grantor Retained Annuity Trust (GRAT).

The concept of the trust is fairly simple. The grantor (person funding the trust) places assets into the trust. The trust then invests these assets for the benefit of a beneficiary (or beneficiaries). The wrinkle here is that the grantor receives an annuity (annual payment) from the trust in exchange for the assets placed therein. If structured correctly, this arrangement either reduces or completely eliminates any gift tax, while effectively transferring the remainder assets.

The mechanics of the transfer are rooted in a tax concept called Applicable Federal Rate (AFR). What this means is that the present value of an annuity (what the annuity is worth today) for gift tax purposes, is calculated by applying a specific interest rate determined by the federal government. When interest rates are low, as they are currently, the AFR is low. For example, a grantor can place $1,000,000 into a GRAT. In exchange, the grantor will receive a two year annuity with a 2% interest rate. This annuity results in payments of $520,000 and $510,000 after years one and two respectively. Owing to the low AFR, this annuity has a present value of approximately $1,000,000. The gift to the trust is now effectively $0, as the grantor is receiving an annuity of equal value to the gift. If the assets in the trust earn just 5%, $46,500 will be transferred tax free to the beneficiary after just two years.