Amid pressure to close the yawning federal budget gap, congress is mulling over several bills that would significantly narrow the advantages of using grantor-retained annuity trusts to avoid estate and gift taxes.

A GRAT is a popular estate planning device under which a grantor transfers property to a trust and retains the right to an annuity stream for a fixed number of years.

At the expiration of the annuity term, any property remaining in the GRAT passes to designated beneficiaries free of tax, notes Doug Siegler, a tax partner at Sutherland, Asbill and Brennan, Washington, D.C.

If the grantor dies during the term of the GRAT, then the property remaining in the GRAT is included in the grantor’s estate for tax purposes, he explained.

Under current law, the duration of the annuity term and the size of the annuity payments can be set to virtually eliminate any gift tax at the time the GRAT is created, Siegler said.

The House in March passed H.R. 4849, the Small Business and Infrastructure Jobs Tax Act of 2010, which would extend small business tax benefits that expired last December.

To finance the tax credits, the House included three new requirements for a valid GRAT: a minimum term of 10 years, no reduction in the required annuity during the first 10 years of the GRAT, and a remainder interest at inception greater than zero.

The Obama administration estimates changing the rules would raise $4.4 billion in revenue over 10 years. That bill was referred to the Senate Finance Committee.

Rep. Sander Levin, D-Mich., chairman of the House Ways and Means Committee, is pushing for prompt House action, possibly this week, on H.R. 5486, the Small Business Jobs Tax Relief Act of 2010, which contains a similar provision.

It is unclear when the Senate will act on the provision that would change the rules for GRATs, said Sarah Spear, director of policy and public affairs at the Association for Advanced Life Underwriting. One reason for the delay is that the Senate still appears to lack consensus on legislation restoring the estate tax, she said.

Some Senate members want the revenues created by changes to the GRAT requirements to be used to increase the threshold of the estate tax and reduce the maximum tax rate on the estate tax, she said.

Currently, there is no estate tax. But current law mandates returning the estate tax to a $1 million per-person exemption and a 55% maximum tax rate in 2011.

The House legislation would increase the threshold to $3.5 million and the maximum tax rate to 45%, the rules that were in effect in 2009.

But the cost of such a proposal is $260 billion over 10 years. And Sen. Blanche Lincoln, D-Ark., and Sen. Jon Kyl, R-Ariz., are seeking to raise the threshold to $5 million and reduce the maximum tax rate to 35%, which would cost an additional $84 billion over 10 years.

At the moment, there is an impasse on the issue.

The provisions in the Levin bills would significantly scale back the benefits GRATs can provide, says Siegler of Sutherland, Asbill.

“GRATs can be a highly efficient way to transfer property via a gift that has the potential to appreciate quickly in value,” he said.

Taxpayers commonly structure GRATs with a short duration–usually two or three years–and set the annuity rate high enough to reduce the value of the gift to near zero, Siegler said.

Short-term GRATs reduce both the risk of the grantor dying during the term of the GRAT and the possibility of a substantial decrease in the value of the GRAT assets, thereby leaving little or nothing to pass to the children at the end of the annuity term.

The proposed tax change would both increase the gift tax of a GRAT, by requiring the GRAT to have some minimum remainder value at inception, and introduce greater mortality and investment risk, by extending the minimum period to 10 years.

The longer required term raises the risk the grantor would die during the term of the GRAT, which would eliminate the expected transfer-tax benefit, Siegler said.

In addition, the longer required term “opens up the possibility that the value of the property in the GRAT will experience one or more material decreases during the GRAT term, thereby reducing or eliminating the value of the property remaining at the end of the term,” he said.