Estate Planning in the Age of Obama

Estate planners should take note that the Obama administration’s 2014 budget plan, released Wednesday, was expected to take aim at some of their most effective planning tools.

Though the American Taxpayer Relief Act (ATRA) provided some certainty in the tax code, much remains in the political battle over government spending and revenue generation. Many of these estate planning tools have survived past budget battles, but today’s generous estate tax exemption makes them a much more likely target in the days and years ahead. Here is what you need to know to keep your clients’ planning strategies on the right page.

Grantor Retained Annuity Trusts

A Grantor Retained Annuity Trust (GRAT) allows a client to transfer assets into a trust from which it retains an income interest that is received as an annuity payment. The trust assets are then distributed to the beneficiaries at the end of the trust term. Typically, a GRAT is set up for a relatively short term—sometimes as little as two or three years—and funded with assets that are likely to appreciate in value more quickly than the IRS-imposed interest rate applicable at the time.

This allows the client to minimize transfer taxes while passing wealth to beneficiaries. Gift tax is determined at the inception of the trust term, and any appreciated value is passed to the beneficiaries without further tax liability if the client is still alive at the end of the trust term.

Now, as in the past, this tax-savings technique has attracted the attention of the government, which is now proposing to require a minimum trust term of 10 years. This increases the possibility that the grantor will die during the trust term, which would require that the trust assets be included in his or her estate for estate tax purposes.

The administration proposal would also eliminate the possibility that the GRAT could be “zeroed out”—essentially requiring that some gift tax be paid when the trust is created.

Intentionally Defective Grantor Trusts

The intentionally defective grantor trust (IDGT) is a grantor trust that is not treated as a separate entity for income tax purposes, but can serve to exclude the value of its assets from the client’s taxable estate. Because the client continues to pay the income taxes on the appreciated value of the trust assets (rather than the trust itself paying those taxes), more value can be transferred to beneficiaries outside of the client’s estate.

President Obama’s proposal would require that gift tax be paid upon any distribution from the IDGT and that any value remaining in the IDGT at the grantor’s death be included in the estate for estate tax purposes. Since the primary purpose of the IDGT is to maximize the transfer of wealth to a client’s beneficiaries while reducing the taxable estate, these proposals would largely eliminate the purpose of an IDGT strategy.