While the nation’s attention is riveted on negotiations between the Administration and Congress over the final disposition of the Bush-era tax cuts, advisors to the affluent are breathing easy that one estate planning technique, the grantor retained annuity trust, has survived the legislative process intact. A word to the wise: remain on your guard.
The GRAT, a long-used strategy for transferring appreciating assets to heirs free of gift and estate taxes, is certain to face renewed Congressional scrutiny–and likely restrictions on its use–next year. Before that happens, financial professionals would do well to explore alternative wealth transfer vehicles, including life insurance, to keep clients’ estate planning objectives on track.
How it Works
With a GRAT, individuals make a gift to the trust and set terms to receive an annuity over a period of years–as if they are paying back a loan to themselves. Through these payments, the size of the gift is reduced for IRS reporting purposes.
The annuity payout is computed using the initial fair market value of the trust assets and the Internal Revenue Code Section 7520 federal discount rate. When the IRC 7520 rate drops, as it has in recent months, grantors can reimburse themselves less during the GRAT term.
In a successful “zeroed-out” GRAT, the remainder interest of the GRAT (after completion of the annuity payments) has a zero value. Any appreciation or gains on the trust assets exceeding the 7520 rate is transferred to the next generation, free of gift and estate taxes. As of December, the 7520 rate is a record low 1.8%–an easy hurdle to clear for the savvy investor.
But even if the 7520 benchmark isn’t surpassed (or worse, the trust assets decline in value) the client can opt for a redo: at the expiration of the GRAT term, the client rolls the remainder interest into a new short-term GRAT. Indeed, a common strategy among affluent individuals is to flip assets from one GRAT to the next in a cascading series of trusts, capturing appreciating value, all estate tax-free, for the benefit of heirs.
And because the assets can remain in trust for short periods (two to three years is typically elected), the GRAT carries reduced mortality risk. That’s a key benefit for older clients concerned about dying during the GRAT term, which would put the assets back into the client’s estate, subjecting them to estate tax.
The short-term GRAT is, in sum, a very good deal–and, many now argue, too good to last. As with so many other now-defunct planning techniques that were viewed as excessively beneficial to clients, the GRAT is in Congress’ cross-hairs. Several bills taken up by the House and Senate over the year past have included provisions restricting the GRAT’s use.
Proposed changes introduced this month (likely to be revisited once Congress settles on estate tax rates) would do three things: (1) extend the minimum GRAT term to 10 years; (2) require the GRAT’s remainder interest to be greater than zero, thus forcing the grantor to pay a taxable gift tax; and (3) prevent any reduction in the annuity payout during the term. The changes could also be made retroactive.
Uncle Sam would be happy to see an overhaul of the rules. As NU Washington Bureau Chief Arthur Postal reported earlier this year, the Obama administration estimates the tax law changes would raise $4.4 billion–no small sum for a federal government still knee-deep in red ink. Given the likelihood of a two-year extension of the Bush tax cuts, Congress and the Administration will have to look elsewhere, among them GRATs, to help close the federal budget deficit.
The proposed rules changes are sure to displease clients and advisors who have relied on short-term GRATs to help achieve estate planning objectives. But for producers, there is an upside: they can use life insurance to counteract the heightened mortality risk of a long-term GRAT.
Should a client die during the GRAT’s term, life insurance can provide the additional liquidity needed to meet estate tax obligations. If housed inside an irrevocable life insurance trust or ILIT, the policy’s death benefit may be paid both income tax-free and estate tax-free. Also, grantors who use all or a portion of their annuity payments to fund the policy premiums increase the trust’s gift-discounting value.
Because of these advantages, the increased use of life is likely to rise substantially subsequent of new restrictions on short-term GRATs. Ditto in respect to alternative revocable or “living” trusts that lend themselves equally well to a low interest environment; and that, like a GRAT, can transfer gains on appreciating assets to subsequent generations estate tax-free.
Among them, says Karen Yates, a partner with Withers Bergman, LLP of Greenwich, Conn., is the installment sale to a grantor trust. As with a GRAT, the installment sale technique freezes the value of assets in the owner’s estate and transfers future appreciation in the assets to the trust for descendants tax-free. The installment sale is superior to the GRAT in sheltering assets from the generation-skipping transfer (GST) tax. But the technique also entails greater valuation risk than a GRAT.
Other techniques favored in the current low interest rate environment include the intentionally defective grantor trust and, for the philanthropically inclined, the charitable lead annuity trust. Herbert Daroff, a partner at Baystate Financial Planning, Boston, Mass., says he often recommends these techniques for moving asset gains outside of the grantor’s taxable estate.
But whereas the IDGT–a technique that calls for selling devalued assets to the trust in exchange for a promissory note–freezes the value of the assets for estate planning purposes, the trust property remains subject to income tax (hence the “defective” part).
CLATs function like GRATs, providing an annuity-like income stream (in this case to a charitable beneficiary); and a remainder interest to a non-charitable beneficiary, (typically the donor, the donor’s spouse or children). However, the CLAT is irrevocable. And assets distributed from a CLAT do not have a “stepped-up” basis. So the sale of appreciated assets distributed to children or other non-charitable beneficiaries are subject to capital gains tax.
Too often, financial service professionals become unduly wedded to a particular technique, leaving their clients and practices vulnerable when changes in tax law make the technique–in this instance, the GRAT–less favorable as a planning tool. That need not happen.
Advisors can always avail themselves of other strategies and funding vehicles, including life insurance, to help achieve estate planning objectives. By working creatively and building flexibility into wealth transfer plans, advisors can insulate their clients and practices from an always-changing tax and regulatory landscape.