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Proposed Law will Radically Change GRAT’s

Given the current combination of low interest rates and undervaluation of assets, there continues to be an excellent opportunity for many individuals to use GRATs (Grantor Retained Annuity Trusts) to achieve wealth-transfer and estate-tax savings. However, this opportunity may be closing quickly given the pending legislation regarding longer GRAT terms and potential gift-tax consequences of structuring a GRAT.

What is a GRAT?

A GRAT is a popular, statutorily defined, wealth-transfer strategy whereby a grantor transfers property to an irrevocable trust. In exchange for this transfer, the grantor receives annuity payments over a predetermined time period (GRAT term). The value of the annuity to be received by the grantor is based on an IRS-published interest rate (the Section 7520 rate, often called the “hurdle” rate). The beneficiary receives any assets left in the trust gift tax free after the payment of the annuity to the grantor.

The benefit of a GRAT is that to the extent the assets contributed to the trust appreciate at a rate in excess of the hurdle rate, the assets will be excluded from the grantor’s estate and will pass free of gift tax to the beneficiaries of the trust (typically the children of the grantor).   An additional benefit is that, because the grantor can be required to pay the income tax on the earnings of the GRAT, the amount of assets available to the beneficiaries is increased.

For example, assume an individual contributes $10 million to a GRAT in July 2010 with a three-year term and earns 10% per year on these assets. In this scenario, at the end of the three-year period the individual would have transferred over $1.65 million to the beneficiaries, gift tax and estate tax free.  Per IRS tables and using the July 2010 Section 7520 rate of 2.8%, the annual annuity rate the GRAT must pay to the grantor is calculated to be $3,521,746 to obtain a gift tax value of zero.  

GRATs are especially effective when the individual has assets that are expected to appreciate rapidly in a short period (perhaps due to the sale of a company or IPO). If the rate of return increased from 10% to 30% in the above example, the individual would have transferred over $7.9 million to the trust beneficiaries, estate and gift tax free (chart below).

 

 

A further benefit of the GRAT is the ability to discount the assets transferred to the trusts. This is very common if the assets transferred to the GRAT are shares of a family-owned business or units of a real estate partnership. The value used in determining the GRAT annuity payment may be valued at less than the true “enterprise value” due to lack of marketability and lack of control discounts available. In the above example, assuming a 20% discount on the $10 million, the amount going to the remainder beneficiaries in year three is approximately $10.7 million (with total annuity payments of approximately $8.5 million to the grantor).

There is very little downside risk to a GRAT. The risks are if the property fails to appreciate above the hurdle rate or if the grantor dies during the term of the GRAT, the property will revert back to the grantor.  Because of these risks it is very common to create GRATs with a term of one to three years to help mitigate the risk of the grantor’s death occurring during the trust terms.  Also, the ability to exceed the hurdle rate is easier over the short term compared to a longer period. Shorter periods thus make it easier for the assets remaining inside the GRAT at the end of the term to be transferred to the trust beneficiaries.

Potential Legislative Changes

On March 24, 2010, the House passed Bill 4849 (Small Business and Infrastructure Jobs Tax Act). One of the revenue-raising provisions of this bill would require that a GRAT have a minimum term of 10 years, instead of the more common shorter periods. The longer term would increase the chance that the grantor dies during the term of the GRAT and that the assets won't appreciate above the hurdle rate, thus resulting in the assets being included in the estate of the deceased grantor.

In addition to the minimum term of 10 years, the House bill also would prevent “zeroed-out GRATs.” A zeroed-out GRAT is structured to have a zero value for gift-tax purposes (as illustrated above).  By eliminating these GRATs there would be a gift-tax component for GRATs established after the enactment of the bill, thus making GRATs less attractive in the future.  Therefore GRAT’s created before the bill becomes enacted can be formed by the existing, more favorable rules. 

The current House bill was referred to the Senate Finance Committee, where it currently sits for their review. Even if this bill does not pass the Senate, once a revenue-raising provision is identified it often appears in later bills to keep the bill revenue neutral.

The current interest rate and legislative environment provide an excellent opportunity to use a GRAT as part of an overall wealth-transfer strategy; however, this window may be closing quickly. If you have any questions or would like to discuss using the GRAT as part of your estate-planning strategy, please contact Brian Carter at 312.980.2994, Michael Calahan at 312.980.2996 or your Blackman Kallick representative.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.