More On Tax Planningfrom The Advisor's Professional Library
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- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
In a low interest rate environment, a grantor retained annuity trust (GRAT) can serve as a powerful estate planning tool to allow your high net worth clients to transfer assets with minimal—and in some cases zero—tax liability.
Clients with swiftly appreciating assets can transfer these assets and escape both gift and estate taxation on almost all of the appreciation using a combination GRAT-life insurance strategy in connection with the steep gift tax valuation discount available today. Despite this, the Administration has often threatened to eliminate the tax benefits that can be realized using a GRAT strategy, so the time for clients to lock in these tax savings is today.
GRATs: The Basics
Though the current low interest rate environment may present a problem in many planning scenarios, some planning vehicles actually benefit from low interest rates. One such vehicle is the GRAT, the success of which can actually thrive on low interest rates.
A GRAT is typically established in order to transfer assets while minimizing estate and gift taxes, yet allows the client to continue to receive a steady income stream in the form of annuity over the life of the trust. When a client creates a GRAT, he retains the right to fixed annual payments for the term of the trust’s life, which is either an established period of time or for the client’s life. The remaining trust assets pass to his beneficiaries at the end of the trust term.
Typically, a GRAT will be funded for a relatively short period of time, and with assets that are likely to appreciate in value over that term.
The Interest Rate Factor
The value of the taxable gift to the GRAT beneficiaries is equal to the fair market value of the property transferred into the GRAT minus the grantor’s retained interest. The grantor’s retained interest is the actuarially calculated value of the annuity stream he will retain over the GRAT’s life based on the Section 7520 rate in effect for the month in which the GRAT is created.
Because a lower Section 7520 rate will increase the present value of the grantor’s retained interest, and the current rate is locked in for the life of the GRAT, a low interest rate will reduce the taxable value of the beneficiary’s gift. For the GRAT to succeed, tax-wise, the assets placed into the trust only need to outperform that locked-in Section 7520 rate.
In some cases, a low interest rate, when combined with the set annuity payout to the grantor, can even reduce the grantor’s gift tax liability to zero.
Estate Tax Liability
The primary downside risk of a GRAT is that the grantor will outlive the established trust term, causing inclusion of all or a portion of the GRAT assets in his gross estate. While it is possible that some of the trust appreciation will escape the estate based on regulations issued in 2011, which would only include the GRAT assets that are necessary to satisfy the remaining payouts to the grantor using the Section 7520 rate in effect at the time of the grantor’s death, for high-net-worth clients, a life insurance strategy may still be necessary to offset the additional estate taxes.
The grantor may wish to form an irrevocable life insurance trust (ILIT), which will purchase a life insurance policy on the grantor’s life to protect against the risk that the grantor will not outlive the trust’s term. Because the ILIT itself will not generally be included in the grantor’s estate, those tax-free proceeds can be used to offset estate tax liability or replace any benefit to the GRAT beneficiaries that has been lost.
In the alternative, the GRAT beneficiaries themselves could purchase a life insurance policy on the grantor’s life. In this case, the grantor could fund the premiums by making annual gifts to the beneficiaries, using his per-donee annual gift tax exclusion of $14,000 (in 2013).
Though the GRAT thrives on low interest rates, clients should be aware that government proposals in recent years have frequently sought to eliminate the tax benefits of this type of trust. Because any currently existing GRATs would be grandfathered into the current treatment if any new laws are passed, the time for clients to act is now.
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