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Advisors, Use This Wealth Transfer Strategy While You Can

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Earlier this year, the White House released a general explanation of the Obama Administration’s proposed fiscal year 2013 budget. While not legislation, the explanation offered a glimpse of what may be on the horizon, including several interesting changes related to the estate, gift and generation-skipping transfer (GST) tax. In this article, I will focus on two provisions that would forever change a very popular wealth transfer planning strategy: “zeroed-out” grantor-retained annuity trusts (GRATs). 

The provisions call for new restrictions on GRATs — specifically, that any GRAT must have a minimum term of 10 years and that the present value of the remainder interest must be greater than zero upon creation of the trust. If adopted as legislation in 2013, these provisions would effectively put an end to the use of zeroed-out GRATs, which allow clients to make significant wealth transfers to family members without incurring gift tax liability. 

How GRAT strategies work

When the grantor transfers an asset to a GRAT, he or she retains an interest in the trust in the form of an annuity payment, which is distributed to the grantor over the trust term. At the end of the term, the assets remaining in the trust pass to the remainder beneficiaries.

What makes this such an effective wealth transfer strategy? First, although the initial transfer to fund the GRAT is a taxable gift, the amount of the transfer that is taxable is reduced by the annuity interest retained by the grantor. Therefore, the larger the annuity payment retained by the grantor, the lower the taxable gift upon creation of the GRAT. In addition, any appreciation of the GRAT asset during the term of the trust above the applicable federal rate (AFR) upon creation will pass to the trust beneficiaries without an additional tax impact. 

With a zeroed-out GRAT, the grantor retains a whole (or close to whole) interest in the property transferred to fund the trust. By optimizing the annuity payouts, the entire interest transferred to the trust is returned to the grantor over the GRAT term. Optimizing the annuity payments essentially zeroes out the remainder interest, resulting in minimal or no gift tax on the initial transfer. And remember, appreciation of the GRAT asset above the AFR during the trust term passes to the GRAT beneficiaries free of any transfer taxes. 

Carpe GRAT

If you have clients with assets that are expected to appreciate in a short period of time and for whom efficient wealth transfer is a priority, consider implementing a GRAT today. With the current lifetime gift tax exemption at a historic high of $5.12 million, a top gift tax rate of 35% and a historically low AFR of 1.20%, it only makes sense to explore the wealth transfer benefits a GRAT can provide. 

While it’s difficult to say what will change in 2013, initial indications suggest that GRATs may lose their revered status among wealth transfer strategies. Wealth managers would do well to take advantage of this opportunity now, while current law provides the utmost flexibility.

For more on estate tax changes, see:

4 Ways to Deal With Estate Tax Uncertainty

Estate Planning: Focus on the Legacy, Not the Tax Bill

AALU Panel: Action on the Estate Tax is Likely in 2013


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