It’s a tale as old as time. ... The estate planner who (mistakenly) thinks that there won’t be a mad rush before Dec. 31 this year. Now that tax returns on extension have been filed, estate planners can consider an interesting option for the fourth quarter of 2023: the 2-year grantor retained annuity trust (GRAT), which can help clients who have unused generation-skipping transfer (GST) tax exemption. But they’ll have to act before the hidden Dec. 31, 2023 deadline.
A Difficult Conversation
A new client walks into your office seeking praise for his DIY wealth transfer planning that he believes has created a long-term financial legacy for his family and that “used his bonus tax exemption before he lost it.” We’ve all known of this bonus since 2017, although we might not refer to it as such. Under the 2017 Tax Cuts and Jobs Act (the Act), the U.S. gift, estate and generation-skipping transfer (GST) tax exemption amounts were doubled, but only for a limited time. The increased portion of the transfer tax exemptions provided for under that Act (the bonus) will no longer be available if, as scheduled, those exemptions are cut in half on Jan. 1, 2026. In anticipation of this loss, the client had gifted his interests in a closely held entity directly to his children, and by using most of his then available U.S. gift tax exclusion, the client had used his bonus gift exclusion before he lost it.
After listening to the client boast about how smart he is for transferring assets out of his estate, you take a deep breath and reluctantly tell him you have some bad news. ... Because the gifts were to his children outright (as opposed to trusts for the benefit of the children and future generations), the transfers didn’t use any of his separate GST tax exemption; therefore, those entity interests could be subject to estate tax on the deaths of his children. This is hardly the lasting financial legacy the client had envisioned. To make matters worse, the client isn’t in a financial position to permanently part with another sizable gift (and pay gift tax) simply to make use of his available bonus GST tax exemption.
The client’s smile has vanished and been replaced with a look of horror. Thankfully, he has come to the right advisor, as you have an interesting option to help him make use of his unused GST tax exemption so that it doesn’t go to waste, and he truly creates the lasting financial legacy he intended. But time is of the essence—he has only until the end of 2023 to act.
Implement a 2-Year GRAT
An approach to your client’s unused GST tax exemption conundrum is to transfer property that’s expected to appreciate significantly in value to a 2-year GRAT, which is “nearly zeroed-out.” When creating a nearly zeroed-out GRAT, the annuity payments will be structured so that your client will use very little of his gift tax exemption on transferring assets to the trust. This is possible because the actuarial value of the retained annuity stream that your client will receive from the GRAT (determined using the Internal Revenue Code Section 7520 rate) is nearly equal to the value of the property he’ll transfer to the trust, which results in a very small actuarial remainder. That is, your client will be making a very small taxable gift to the GRAT remainder beneficiaries. To the extent the GRAT’s annual rate of return is greater than the IRC Section 7520 rate, the GRAT will have assets left over after making its final annuity payment.
While GRATs can be leveraged to transfer wealth using a small amount of gift tax exemption, your client won’t be able to allocate his GST tax exemption to the initial contribution of assets to the GRAT due to the estate tax inclusion period (ETIP) rules (Internal Revenue Code Section 2642(f)). Under IRC Section 2642(f), no GST tax exemption may be allocated to transferred property that would be includible in the gross estate of the transferor (under any section other than IRC Section 2035) if the transferor were to die immediately after the transfer until the end of the ETIP. The ETIP is the period beginning on the date the property is transferred and ending on the earliest of: (1) the date when the property would no longer be includible in the transferor’s gross estate; (2) the date on which there would be a generation-skipping transfer with respect to the property; or (3) the date of the transferor’s death (Section 2642(f)(3)). GST tax exemption can’t be allocated during a GRAT’s term because if your client were to die during the term of the trust, the GRAT’s assets would be includible in his estate. If your client survives the GRAT term, any property remaining in the trust after the last annuity payment is made will pass to the remainder beneficiaries. If the remainder beneficiaries are all skip persons (for example, grandchildren or a trust for the benefit of skip persons), then GST tax will be owed unless GST tax exemption is allocated to the transfer. Your client can affirmatively allocate GST tax exemption to the transfer under Section 2632(a), or your client can rely on the GST automatic allocation rules under Section 2632(c)(1), which apply to transfers to GST trusts. The amount of GST tax exemption that must be allocated to the remainder interest will be equal to the fair market value of the interest on the GRAT’s termination date (that is, the end of the ETIP). So if the GRAT remainder is significant, your client will be able to successfully allocate his remaining GST tax exemption to the transfer of the remainder without incurring gift tax from making a large taxable gift.
Example
The following example will illustrate the benefits of this strategy – assume the following:
- Your client transfers a $25 million interest in a closely held business to a 2-year nearly zeroed-out GRAT, and the discounted value of that interest is $17.5 million (that is, a 30% discount)
- The Section 7520 rate is 5%
- The annuity payment will escalate 20% in Year 2
- The total annual appreciation of the business interest is 31.5%
- An irrevocable trust for the benefit of your client’s children and future generations is the remainder beneficiary
- Your client has $12.92 million of GST tax exemption and $860,000 of gift tax exemption
- Your client survives the term of the GRAT
Under this example, your client will have made no taxable gift on transferring the business interest to the GRAT. The GRAT would pay your client $8.58 million in Year 1 and $10.29 million in Year 2. After the second annuity payment is made, the remainder of $12.42 million left in the GRAT will pass to an irrevocable trust that qualifies as a GST trust under Section 2632(c). Because your client survived the ETIP period, he may allocate $12.42 million of his $12.92 million GST tax exemption to the remainder interest, which results in a tax-efficient use of your client’s GST tax exemption, including the bonus amount portion.
There’s one problem. As noted above, the increased GST tax exemption is scheduled to be cut in half by operation of law on Jan. 1, 2026. This means that your client must establish and fund a 2-year GRAT on or before Dec. 31, 2023 to attempt to use his bonus GST tax exemption. Any 2-year GRAT created after this date will terminate on or after Jan. 1, 2026, and your client will lose the ability to allocate his bonus GST tax exemption to the GRAT remainder.
Look for Other Affected Clients
As the new client leaves your office with his 2-year GRAT in place, you crack open your existing client files. While the new client presented an extreme case of a discrepancy between available gift tax and available GST tax exemptions, even your well-informed clients may find themselves with unused GST tax exemption that exceeds their unused gift tax exclusion. This imbalance typically results from periodic moments of generosity that (despite exceeding their annual gift tax exclusion amounts) go unthought of as a taxable event. These transfers include the generous wedding gift to a sibling, the purchase of a car for a child and other one-off occurrences that have whittled down the client’s available gift tax exclusion without similarly reducing the client’s GST tax exemption.
While not every client will see the need to eliminate this discrepancy and use all of their bonus GST tax exemption before the end of 2025 (and some clients may have another means to use such bonus through the late allocation of GST tax exemption to certain non-exempt trusts), estate planners should be taking note of clients who have such discrepancies and preparing themselves for a busy fourth quarter focused on creating and funding 2-year GRATs before Dec. 31, 2023, for those clients who want to resolve their excess GST tax exemption by using this strategy.