A Last Bite at the GRAT Apple?

The House of Representatives has passed, and now the Senate is considering, a bill that would dramatically curtail shorter-term and zeroed-out GRATs

As soon as the end of May, Congress may adopt a bill, effective immediately, that would dramatically curtail taxpayers from creating shorter-term, zeroed-out grantor retained annuity trusts (GRATs).

On March 24, 2010, the House of Representatives passed the Small Business and Infrastructure Jobs Tax Act of 2010. Among its revenue offsets are proposals to substantially alter the rules for creating and funding GRATs. The Congressional Budget Office estimates that the bill’s GRAT provisions could generate about $4 billion in additional tax revenue over 10 years.

Specifically, the bill would require that:

(1) GRATs have a minimum 10-year term.

(2) Annuity payments not decline during the first 10 years of the trust.

(3) A GRAT’s design at inception envisions a remainder (thus effectively eliminating the zeroed-out GRAT).

That means now is the time to consider – and act quickly – if creating such GRATs might serve your needs or if you have an existing GRAT strategy that could benefit from adjustments.

Acting now is particularly important for individuals who are concerned about outliving a 10-year GRAT term and therefore might benefit from shorter-term GRATs. Estate-planning professionals should discuss the following with their clients:

* New GRATs - A GRAT can be an excellent tool for individuals with enough wealth to gift now. It offers them the potential of passing to beneficiaries trust assets as well as any income and/or appreciation on the trust’s assets – all free of gift and estate taxes. It’s important that advisors help clients determine how much they might need to ensure future financial security and, therefore, how much they might have available for gifting.

* Outperforming GRATs - Much also can be done now for a GRAT that already has substantially outperformed its hurdle rate (the Section 7520 rate). Consider “immunizing” such a GRAT’s gain against potential future underperformance by exercising the power of substitution with existing low volatility non-GRAT assets, borrowing against existing non-GRAT assets to create sufficient amounts of low volatility liquidity or hedging.

* Underperforming GRATs - Similar strategies are available to immunize a GRAT that has substantially underperformed. The goal here is to cut your losses in the existing GRAT and move the assets you think might appreciate to a fresh GRAT.

Our research* has shown that, historically, three critical factors impact a GRAT’s success: the Section 7520 rate; the total return on investments; and what, precisely, the grantor is trying to accomplish.

Shorter-term GRATs are attractive not only because they minimize mortality risk, but also because they reduce commitment to the strategy. For example: with a two-year GRAT, the grantor receives an annuity payment in Year 1 and the GRAT terminates with a second annuity payment in Year 2.

Additionally, two- and three-year GRATs are attractive because assets received back from them can be rolled into new short-term GRATs in a serial manner. The beauty of the math of short-term rolling GRATs is that grantors don’t lose even if one of the short-term GRATs underperforms; but grantors can benefit substantially when one short-term GRAT succeeds. If shorter-term GRATs are no longer an option, grantors will have to consider carefully the optimal terms for their next, all important GRAT.

Importantly: J.P. Morgan proprietary research* suggests that medium-term GRATs may be optimal under the current economic conditions. Our simulations suggest that GRATs with six- and seven-year terms may outperform shorter- and longer-term GRATs: Using historical data from January 1962 through September 2009, for example, our simulations suggest that, in a median case, seven-year GRATs funded with the Ibbotson Small Cap Stock Index would have transferred about 160 percent more wealth than a two-year GRAT and about 14 percent more than a 10-year GRAT.

All this suggests it may be quite detrimental if Congress eliminates GRATs that are shorter than 10 years.

What’s Happening on the Hill

The Senate has taken up the bill and observers on Capitol Hill report that it might adopt the legislation before Memorial Day. However, some Senators have talked about folding these GRAT provisions into estate tax reform when (and if) Congress addresses that issue.

Even if Congress doesn’t clamp down immediately, GRATs are likely to remain on the endangered strategies list. As long as the federal budget remains tight, lawmakers could target GRATs as a politically attractive way to keep more money on the tax rolls.

Consider acting now to ensure that you can take full advantage of the GRAT, a strategy that has served many clients for decades.


*Past performance is not indicative of future results. It is not possible to invest in an index. Research is performed using hypothetical assumptions which may or may not reflect actual market conditions and is presented for discussion purposes only.

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