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.