“Use of Short Term GRATs: Now is the Time” by Thomas D. Peebles, Jr.
The Department of the Treasury recently announced the Obama Administration’s fiscal year 2010 revenue proposals. Included within those proposals is a change in the current tax law to require a minimum term of ten (10) years for all Grantor Retained Annuity Trusts (GRATs). For this reason, and many more, those clients who expect that the value of their assets at death will exceed the current or projected estate tax exemption levels should seriously consider the implementation of a short term GRAT this year.
A GRAT is an irrevocable trust created by a Client who then transfers assets into the trust which are expected to appreciate in value. There are no restrictions on the type of assets which can be transferred to the GRAT. Marketable securities, family businesses, interests in family limited partnerships and real estate can all be included in a GRAT.
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 of the GRAT which is chosen is influenced by a number of factors, including the Client’s life expectancy, but terms of 2 to 5 years are common. The annuity is generally structured so that the value of the right to receive the annuity payments is equal to the value of the asset transferred to the GRAT. In this way, there is no “gift” and federal gift taxes can be avoided on the creation and funding of the GRAT.
During the term of the GRAT, the Client is taxed on all income earned by the trust assets, even if the income is accumulated in the trust. Structuring the GRAT in this manner assists in accomplishing the planning objective since the Client’s payment of the income taxes on the income accumulated in the trust allows the trust assets to grow income tax free for the benefit of the remainder beneficiaries, usually the Client’s children and/or grandchildren. In essence, it is an indirect “gift” to those remainder beneficiaries.
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. 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 terminates 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, even though the trust beneficiaries will own the remaining trust assets, the estate tax benefit of creating the GRAT (specifically, the tax-free transfer of the accumulated income and appreciation during the GRAT term in excess of the annuity payments) is not accomplished.
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 the new Treasury proposal is intended to assault. Imposing the requirement that a GRAT have a minimum term of ten years increases the risk of a Client’s death during the GRAT term and the resulting loss of any anticipated estate tax benefit. The Treasury’s proposal to require a minimum GRAT term of 10 years, if enacted into law, would apply to GRATs created after the date of enactment.
Clients whose families would benefit from the use of a short term GRAT (a GRAT whose term is from 2 to 5 years), now have a window of opportunity in which to implement this estate planning technique. Although changes in tax law are difficult to predict, opportunities exist today that may no longer exist in a few months. Interested Clients should take advantage of current law permitting GRATs with terms as short as two (2) years.
In addition to proposed changes in tax laws, current economic conditions compel serious consideration of the use of GRATs. For nearly a year, we have been experiencing a “perfect storm” of three economic factors which dramatically increase the odds of a favorable tax benefit through the use of GRATs: (1) historically low interest rates; (2) depressed asset values; and (3) increasing valuation discounts based on unstable markets.
For tax purposes, the IRS assumes an expected level of appreciation, called the Section 7520 rate, for any assets placed in a GRAT. The Section 7520 rate varies each month, but the rate has been at historic lows over the last several months. In discussing GRATs, the Section 7520 rate is often referred to as the “hurdle rate”.
GRATs are successful if, at the end of the trust term, the Client is still living and there are assets remaining in the trust that can be distributed to the Client’s family members. This successful result occurs if the trust assets (including accumulated income) appreciate at a greater rate than the assumed rate of growth under Section 7520. The difference between the actual accumulation in the trust and the assumed accumulation in the trust is removed from the Grantor’s taxable estate without the imposition of federal estate or gift taxes. Obviously, GRATs have a better chance of success when the Section 7520 rates are low, since the trust assets have a better chance of “beating” the hurdle rate. Consider the following example:
Client transfers $500,000 worth of assets to a GRAT. The annuity term is 3 years and, at the end of the term, any assets remaining in the trust are to be distributed to the Client’s descendants. On the date of the transfer, assume that the Section 7520 rate is 3%. In order to avoid a taxable gift upon the funding of the trust, the annuity payments to be made to the Client must approximately equal the value of the property transferred to the trust. In this instance, each year for 3 years, the Client receives an annuity payment equal to $176,766. If the trust assets actually appreciate at a rate greater than 3% (assume, for example, a growth rate of 5%), then at the end of the annuity term, there will be $81,969 remaining in the Trust to be distributed to the Client’s descendants. The $81,969 has been transferred free of federal gift taxes, has been removed from the Client’s estate for federal estate tax purposes, and the GRAT has accomplished its planning objective.
In addition to the proposed change in the tax law, there are several other factors which make this an exceptionally good time to use a GRAT. First, as noted above, the Section 7520 rate (the IRS implied interest rate) is at historic lows. The lower the IRS hurdle rate, the better chance the assets in a GRAT have of exceeding that hurdle rate. Second, the value of many assets, including marketable securities, family businesses, and real estate, are at five to ten year lows. Creating a GRAT now and transferring assets to the GRAT with low or depressed values offers tremendous opportunities, then, to allow those assets to appreciate inside the GRAT and to transfer the appreciation onto children and/or grandchildren in a tax free manner. Third, if the assets transferred to the GRAT consist of partnership interests, LLC membership interests, minority interests in closely held corporations, or fractional interests in real estate, traditionally accepted valuation principals will permit those interests to be discounted in determining their fair market value for estate and gift tax purposes. Higher discounts (for lack of marketability and minority interests) can be justified in a volatile market. In short, the convergence of economic factors and the potential for a change in the tax law make this an ideal time to consider the use of a Grantor Retained Annuity Trust. If you have further questions regarding this wealth transfer technique, please contact any member of our Estate Planning Practice Group, and we would be pleased to review with you the use of a GRAT under your specific circumstances.