“House Passes GRAT Restrictions” by Thomas D. Peebles, Jr.

The House of Representative on June 15, 2010 passed H.R. 5486, the Small Business Jobs Tax Relief Act of 2010. Included within this bill are new restrictions which will limit estate planning opportunities with the use of Grantor Retained Annuity Trusts (GRATs). Clients interested in this wealth transfer planning technique should consider acting soon, before H.R. 5486 is passed by the Senate and signed into law by President Obama.
First, some background. A GRAT is an irrevocable trust created by a Client who then transfers assets into the trust which are expected to appreciate in value. Under the terms of the irrevocable trust, the Client retains the right to receive annuity payments from the GRAT for a fixed number of years (the “term”). The term chosen is influenced by a number of factors, including the Client’s life expectancy and the volatility of the asset transferred. GRAT terms of 2 to 5 years are common.
The annuity paid from the GRAT to the Client is generally structured so that the value of the right to receive the annuity payments is equal to the value of the assets transferred to the trust. When the annuity is structured in this way, the GRAT is often referred to as being “zeroed-out” because the remainder interest is valued at zero for gift tax purposes. Thus, the payment of federal gift taxes, or the use of the gift tax exemption, can be avoided.
When the GRAT term expires, the annuity payments to the Client cease and the assets which remain in the GRAT, if any, are transferred to (or held in further trust for) the remainder beneficiaries, generally the Client’s children or grandchildren. All accumulated income and asset growth in the trust which is in excess of the amount required to make the annuity payments to the Client accrues for the benefit of, and is eventually distributed to, the next-generation family members. As a result, when the trust term expires, it is possible to transfer substantial assets to family members free from any federal estate or gift taxes.
A GRAT will be successful, however, only if the Client survives the GRAT term. If the Client dies while the annuity payments are still required to be made, the trust assets (or at least the portion needed to produce the retained annuity) are included in the Client’s estate for estate tax purposes. In this event, the estate tax benefit of creating the GRAT is not accomplished.
H.R. 5486 would impose the following three restrictions on the use of GRATs, such restrictions effective upon the enactment of the bill into law:

• First, the GRAT must have a term of not less than ten (10) years.
• Second, the annuity payments may not decline during the first ten (10) years of the GRAT.
• Third, the remainder interest must have a value greater than zero at the time of transfer.

The use of short term GRATs (in which the annuity is paid for a term of as little as 2 years) obviously minimizes the risk of the Client’s death during the term. It is this technique that H.R. 5486 is intended to assault. Imposing the requirement that a GRAT have a minimum term of 10 years increases the risk of a Client’s death during the GRAT term and the resulting loss of any anticipated estate tax benefit. In addition, the requirement of a minimum term of 10 years runs the risk that significant short term appreciation in the trust assets will be cancelled out by a return in the long term to more normal values. The requirement that the annuity payments may not decline during the first 10 years of the GRAT removes the option of “front-loading” the annuity payments to achieve the same results as a short-term GRAT.
By requiring that the remainder interest must have a value greater than zero at the time of transfer, HR 5486 eliminates the use of “zeroed-out” GRATs and requires the Client to pay some federal gift tax or use some portion of the Client’s gift tax exemption when the GRAT is funded. If the assets in a GRAT fail to appreciate as expected and no assets remain to be transferred to the next-generation family members at the termination of the annuity term, the result will be that the Client paid unnecessary gift taxes or unnecessarily used up a portion of the Client’s gift tax exemption.
The GRAT restrictions contained inHR 5486 are intended to raise revenues by eliminating the use of short-term zeroed-out GRATs. Although it is impossible to know if the Senate will agree to those GRAT restrictions, prudence would suggest that now is the time to consider the use of this planning tool. If you have any questions regarding this wealth transfer technique, or any other estate planning issues, please contact any member of our Estate Planning Practice Group.