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Financial Planning > Trusts and Estates > Trust Planning

A Wealth Transfer Strategy to Consider Now

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A little over three months ago, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act of 2010. The act significantly increases the amount an individual may gift during his or her lifetime without incurring transfer tax liability. Prior to 2011, an individual could make lifetime gifts totaling $1 million before paying out-of-pocket gift tax. Now, thanks to the new law, the amount has increased to gifts totaling $5 million.

The $5 million exemption for lifetime gifts came as a pleasant surprise, but wealth managers must realize that this opportunity may be for a limited time only. The provisions set forth in the new law are due to expire at the end of 2012, which would send the lifetime gift exemption, absent any future legislation, back to the $1 million per individual.

When the law was first passed, I had anticipated that 2011 would begin with a heightened focus on making lifetime gifts. The uncertainty over the status of the estate and gift tax following 2010 had past, and taxpayers had been given an unprecedented $5 million gift tax exemption. It was time to start transferring some significant wealth. But what I have experienced has been the opposite of what I had expected.

A Sure Thing, for a Short Time

Perhaps many wealth managers are still coming to grips with the new law and about what it may mean for their wealthiest clients. And, yes, there is some uncertainty again because the new law has an expiration date. But we know this much for certain: we have a law on the books that we should take advantage of now—through lifetime transfers—while we can.

Knowing that we have a great opportunity today to help clients make tax-efficient gifts, let’s review one of the transfer strategies that wealth managers can employ to maximize the effectiveness of their clients’ plans.

Grantor-Retained Annuity Trusts (GRAT)

A GRAT has been a very valuable wealth transfer strategy for some time, but it may not be available in its current form for long. There has been plenty of discussion over the past few years regarding legislation to significantly reduce a GRAT’s appeal—and likely effectiveness—by imposing a 10-year minimum term for the trust. Many had expected such a restriction to be included in the recently-passed act. Because that did not happen, GRATs remain an excellent wealth transfer strategy to consider today.

  1. To implement a GRAT, the client, as the grantor, transfers property with the potential for significant appreciation to the irrevocable trust.
  2. The grantor retains a percentage interest in the trust in the form of an annual annuity payment for a specified term of years.
  3. Upon completion of the trust term, the assets remaining in the GRAT pass to the trust beneficiaries (commonly, the grantor’s children outright or in trust) free of estate tax.
  4. But there is one caveat. If the grantor happens to pass away prior to the completion of the GRAT, the trust assets are pulled back into the grantor’s estate.

The true benefit of the GRAT is in the possible leverage that a client may enjoy from a gift tax perspective. When the grantor funds the GRAT, he or she is making a taxable gift; however, the amount of the gift is reduced because of the value of the grantor’s retained interest in the trust.

The value of the gift is also influenced by the Applicable Federal Rate (AFR) or §7520 Rate at the time the trust is funded.

A Low Applicable Federal Rate is Desirable

The AFR is the rate used to calculate the present value of the remainder interest to pass to the trust beneficiaries upon completion of the trust term. As of March 2011, the AFR is 3%, which is important, because the lower the AFR upon creating the GRAT, the lower the taxable gift. Historically, the AFR has averaged between 6% and 8%. We remain in a low-AFR environment, which adds to the appeal of funding a GRAT.

The low AFR certainly creates a favorable environment for a GRAT; however, think back to the possible legislation that I had mentioned regarding the imposition of a minimum trust term. It has me more concerned than a potential rise in the AFR. Currently, a GRAT can be drafted with a term as short as one year, but that flexibility will disappear if new legislation imposes a 10-year minimum term.

Some popular GRAT strategies focus on creating a short-term GRAT, where the grantor retains a 100% interest in the GRAT property so that there is effectively no gift made when the assets are transferred to the trust. Assuming the assets appreciate over the GRAT term at a rate in excess of the AFR, the appreciation above the AFR is passed along to the beneficiaries free of gift and estate tax. The short-term of the GRAT helps hedge against a reduced life expectancy while helping to maximize the amount to pass free of transfer taxes.

There’s No Time Like the Present To Fund a GRAT

As noted above, right now, there is no minimum term imposed on GRAT design. In addition, we can make large tax-free gifts because of the $5 million lifetime gift tax exemption. Taken together, these factors present an environment where a wealth manager can diversify the design of a client’s GRAT strategy. In fact, many client scenarios can find added benefit in a plan with multiple GRATs that contain various retained interests and terms of years.

Whether or not GRAT diversification is appropriate for your client depends upon the client’s situation, but we are in a period where consideration should be made to how your clients can best take advantage of the opportunities we have right now. You never know when those opportunities may disappear.