Some attorneys are working feverishly to get clients’ assets into a specialized trust before proposed federal legislation eliminates the provisions that have made it so popular as a means of significantly reducing taxes. The most attractive features of the grantor retained annuity trust (GRAT) would be undone under terms of the Small Business and Infrastructure Jobs Tax Act that was approved by the U.S. House of Representatives in March; similar legislation is now being studied by the Senate Finance Committee. “It’s anybody’s guess what could happen to it,” says Ron Aucutt, partner and head of the Private Wealth Services Group at McGuireWoods LLP. “If (clients) have a GRAT in the works, they should not wait but do it now, because there’s a likelihood that Congress will make the GRAT less useful by this legislation.”
Estate planners have used GRATS since the early 1990s as a way for the affluent to pass along appreciated assets to their children or other beneficiaries while paying little or no gift taxes. The grantor places the assets in the trust for a period of time and is entitled to annual annuity payments; at the end of the term of the trust, the beneficiaries receive the principal. When the trust is first formed, the value of the gift to the beneficiaries is determined by subtracting the present value of the annuity payments from the principal; a discount rate is supplied each month by the IRS to do the calculation.
The trick is to fund the trust with assets that will appreciate at a greater rate than the official discount (not too difficult these days; the rate for June is 3.2 percent.) By engineering the term of the annuity on the short side -- say, two or three years -- and by boosting the annual payouts of the annuity, the trust can “zero out” and result in no gift tax due even when the principal appreciates by a sizable amount. Aucutt says many families structure GRATs so that a sizable annuity payment in the first year can be used as the principal for a new GRAT. Assets of equivalent value also can be swapped in the trust, he adds; property that may have peaked in appreciation can replace something else whose prospects still have momentum.
One important catch: if the grantor dies during the term of the trust, the principal is included in the grantor’s estate for estate tax purposes. That’s a key reason for keeping the term of the trust relatively brief, says Michael Halloran, a wealth management advisor for Northwestern Mutual in Jacksonville, Fla. “I would say the majority of people are probably doing zeroed-out GRATS,” he says. “You don’t do it on a 90-year-old. When the attorney is drafting the documents, it’s their job to ask the client, ‘How’s your health?’ If the guy says, ‘I need a heart transplant in 6 months,’ you don’t do a 10-year GRAT.”
Therein lies the problem with the proposed legislation in Congress. The House bill would require minimum terms of 10 years for GRATs, as well as mandating that the remainder interest in the trust must be greater than zero. Annuity payments must not decrease during the first 10 years of the trust’s term. These provisions effectively end the GRAT’s ability to completely offset gift tax liability. The provisions were included in the small business bill as a way of raising revenue to offset the costs of other parts of the bill; the Congressional Budget Office estimates it would raise about $4.5 billion over 10 years.
Aside from the greater mortality risk posed by the new rules, it could become more difficult to decide what sort of assets belongs in a 10-year GRAT. “You’ve got your crystal ball out,” Halloran says. “I’m not going to put a common stock in there that’s publicly traded. Over a 10-year period, you don’t know what administration is coming in. Are they going to change the rules, and is a stock that’s doing well now going to tank?” But a longer GRAT term doesn’t necessarily mean it won’t work, he adds. Depending on the type of market it’s in, real estate may offer some good appreciation prospects. And shares of a closely-held business may also work well in a 10-year GRAT if the owners are planning to hold a public offering and have good reason to believe the company will prosper, Halloran says. “It’s all timing.”
Another factor that may keep GRATs around despite possible changes in the law is the relatively low discount rates from the IRS. Locking in a rate in the 3 percent range may still provide an attractive return with principal appreciation over 10 years, Aucutt says. (In February 2009, it was down to 2 percent.) Estate planners will still need to talk with clients about their preferences, and also their thoughts about how much time they think they still have in this world to benefit from the arrangement.
“Usually we’re talking with people who are healthy enough where [death] is not a serious and immediate concern, recognizing, though, that there are no guarantees ever for anybody. But these clients already are talking about estate planning, so they’ve already come to deal with the fact that they’re going to be talking about their death and what happens after,” he says. “If they’re talking to me, they’ve already committed themselves to talking about that subject. It doesn’t mean they like it, but they’ve chosen to face up to it for the overall good of their families.”