If your estate is subject to the estate tax gaining estate tax efficiency is going to be one of your primary objectives. It would be logical to think that you can simply give gifts to your heirs who would otherwise be inheriting these resources while you are still alive in an effort to avoid the estate tax. The IRS has a strategy to discourage this however in the form of the gift tax.
There is a lifetime gift tax exemption of $5 million, but it is unified with the estate tax exclusion so between your estate and the gifts that you may give the total exemption available to you is $5 million. For this reason using the lifetime exemption to give gifts really doesn’t provide you with any estate tax efficiency because your available estate tax exclusion will be reduced by the amount of these gifts.
Courses of action do exist that enable significant asset transfers free of the gift tax, and one of these is the “zeroed out” GRAT (grantor retained annuity trust) strategy. As you would with any trust you fund it and you name a beneficiary, and you as the grantor receive annual annuity payments from the trust.
The key to this strategy is to initially fund the trust with assets that you would expect to appreciate considerably. The trust is subject to the gift tax and anticipated appreciation is accounted for by the IRS by applying 120% of the federal midterm rate that was in place during the month the trust was created. But the way that the strategy works is that you arrange for your combined annual annuity payments to be equal to the entire value of the trust as determined by the IRS. Since you are retaining all of the interest in the trust you would have no gift tax liability.
But, if the assets placed in the trust appreciate beyond the initial IRS valuation there would be a remainder, and this remainder would be passed on to your beneficiary with no gift tax being applicable.