When the value of your estate exceeds the estate tax exclusion amount your estate planning objective is to rearrange your assets to create space and bring the value of your estate under that exclusion. Giving gifts is one way of doing this, but of course the IRS is well aware of this so there is the gift tax to contend with. However, there are financial instruments that can be used to facilitate tax-free gift giving when they are successfully implemented, and one of these is the grantor retained annuity trust or GRAT.
The objective of the grantor retained annuity trust is to pass along the appreciation of volatile assets, so when you create the trust you fund it with things like stocks and other securities, business interests, and real property. You name a beneficiary and set a term during which you as the grantor or donor will receive annuity payments from the trust. This term can be as long as you want it to be but the assets in the trust will go back into your estate if you die before the term expires so you have to keep this in mind.
The strategy we are presenting here is the “zeroed out” GRAT. The funding of the trust constitutes a taxable gift, but the IRS sets the value of this gift using the Federal Midterm Rate that is in effect during the month that the trust was created. This taxable value will be reduced by your retained interest in the trust, so if you “zero it out,” i.e. take payments out of it throughout the term that, when combined, are equal to the original taxable value, you owe no gift tax. At the end of the term, if the assets appreciated beyond that original taxable value your beneficiary assumes ownership of this remainder tax-free.