First, What is Crypto?
Cryptocurrencies like Bitcoin and Ethereum are a new way to invest your money. In the simplest form, cryptocurrencies are digital money. Cryptocurrencies are digital assets that use computers to secure their transactions. When you invest in cryptocurrencies, you are essentially buying units of digital currency. These units can be stored in a digital wallet, which is like a bank account.
Because they exist only in the digital world, crypto assets are not subject to the same government or financial institution control that banks have to abide by (for now, anyway). The government doesn’t even consider crypto to be “money”. Instead, they consider it to be “property” (See Internal Revenue Service Notice 2014-2). Much like owning stock – you invest in it, and the value can go up and down.
What is a GRAT?
The acronym “GRAT” stands for Grantor Retained Annuity Trust. A GRAT is an irrevocable trust where the trust creator (called the “grantor”) transfers assets to a trust, in exchange for a fixed payment, or annuity, for a specific term of years. Because the trust makes fixed payments back to the grantor, which can be used as income by the grantor, the gift tax on the transfer can be avoided, without using any of the grantor’s gift tax exemptions. The trust term can be as short as two years and typically range between 2 and 5 years. Although the term is typically measured by a fixed number of years, it may also be measured by the grantor’s life. The end result is that you can remove the transferred asset from your taxable estate, and the growth in value of the asset is estate and gift tax-free! It works great for cryptocurrency because of the fast rate that crypto can grow in value.
How does a GRAT help protect Cryptocurrency like Bitcoin?
The short answer is that the GRAT allows you to pass your cryptocurrency on to your beneficiaries completely free of the estate tax, gift tax, and capital gains tax. If the value of your crypto holdings grows, that gain is considered a “capital gain” according to the IRS. Then, when the crypto is sold or traded, that capital gain is taxable, and a huge chunk of the gain can be eaten up in the tax - right now the capital gains tax rates are as high as 20%! At the same time, if the crypto is in your name, the growth of the asset is part of your taxable estate. So not only can you be hit with capital gains taxes, but your beneficiaries get stuck with estate taxes as well!
The federal government has a high limit for estate and gift taxes, for now anyway, (it’s $12,060,000, but is set to come back down) and only affects the very wealthy. But here in Massachusetts, once your total estate exceeds $1 Million, including your home value and life insurance death benefits, estate taxes will be assessed and must be paid by your beneficiaries. Because the home value and life insurance death benefits count toward that $1 Million thresholds, it’s very easy to go over. It’s your children and other beneficiaries that get stuck with this tax, and it comes out of the assets you intended to leave them as an inheritance. Meanwhile, with the right planning, the estate, gift, and capital gains taxes can be avoided!
A GRAT can also help you to avoid using up your gift tax exemption on a volatile asset that could go down in value. For example, if you give $200,000 worth of Bitcoin or Etherium to your child, you’ve used up $200K of your lifetime gift tax exemption. And if that $200K in bitcoin drops in value to $100K, you’ve still used up $200K of your exemption, and you can’t get it back! Meanwhile, with a GRAT, you arent using ANY of your gift tax exemptions when you transfer the bitcoin to the GRAT. So, if it does go down in value, none of your lifetime exemption is wasted. But if it goes up in value, at least in the amount of the IRS’s minimum rate (called IRS “7520 Rate”, named for its section of the tax code, which changes monthly but sits a little over 2% in May 2022) that growth is capital gains tax-free!
What are the logistics of a GRAT?
The goal is simple – remove the value of the asset from your taxable estate and allow the growth of the crypto to be capital gains-free. We do that by creating the trust and putting the crypto assets into that trust. The creator of the trust is called the “Grantor” and the trust pays the Grantor back an income stream while holding on to the appreciation in crypto value. Because the income stream is equal to the value of the cryptocurrency put into the GRAT, there is no gift tax on the transfer to the trust.
If the value of the crypto goes down, the trust basically cancels itself out, and the Grantor is no worse off when it comes to taxes. The lifetime gift tax exemption wasn’t wasted, and the tax situation is the same as it was without the GRAT.
But if the value goes up, at least in the amount of the “7520 rate”, that gain in value is free of the estate, gift, and capital gains taxes. The assets are then passed to your children or other named beneficiaries. It’s an amazing loophole that can save you and your beneficiaries thousands!
There are some other logistical factors that your estate planning lawyer can go over with you, regarding the actual transfer of the funds into the trust.
Future Use of GRATs
There’s always a downside, right? First, there’s a cost to setting up a GRAT. It’s an expert-level trust, so expected to pay a premium to your estate planning lawyer to set it up. However, the return on investment is typically many times the set-up costs. The other downside is that IRS is realizing the lost tax revenue with GRATs, and may try to limit their use in the future. That’s why it’s important to act now before the rules change. The current administration is proposing that GRATs must last a minimum of ten years and that transfers to the GRAT are a “gift” for gift tax purposes (Read more about this in this article from Forbes). These changes may not come to pass, but if they do, the effect would make GRATs less desirable and less tax-advantageous. Trusts made before the rules change should be exempt from the new rule.
GRATs and crypto work so well together that this strategy is a no-brainer when trying to plan ahead and limit taxes. We expect more regulation of crypto in the future, which is why now is a great time to put these strategies to work for you.