As the U.S. economy continues to show inconsistent signs of growth, the Federal Reserve Board has continued its policy of keeping interest rates low to help bolster it. Among other things, these unprecedented low rates have presented significant opportunities for estate planners to help their clients transfer wealth with lower-or no-taxes.
The environment has particularly favored two estate planning strategies: grantor retained annuity trusts, or GRATs, and sales of assets to grantor trusts.
The goal of both these strategies is to "freeze" the value of an asset in a client's estate and transfer its future appreciation to the next generation at a lower tax rate (or with no taxes at all).
Both strategies share the same goal, but there are significant differences between them that could make one more attractive than the other.
In addition, the world of GRATs is in flux. The House of Representatives has passed three different bills this year, all with identical language, that aim to change the future terms of GRATs. If any of them are enacted into law, GRATs could become less appealing to some wealthy clients than sales to grantor trusts.
GRATs
GRATs work this way: A client transfers assets to the GRAT in exchange for a stream of annuity payments large enough to eventually return to the client both the initial contribution plus interest at the statutory rate (or "hurdle" rate) set by Section 7520 of the Internal Revenue Code. Because the client will receive back everything she initially contributed, plus statutory interest, there is no gift.
When interest rates are low, as they are now, a GRAT is more likely to transfer wealth tax free to the client's chosen beneficiaries. This is because the GRAT assets are more likely to appreciate at a rate greater than the hurdle rate (it was 2.0% in November). When the GRAT term ends, the remainder beneficiaries get the difference between the actual appreciation rate and the hurdle rate-free of tax.
In order for the GRAT to pass assets to the beneficiaries, however, the client must survive the trust term. If she dies before the GRAT expires, it is almost certain that all the remaining GRAT property will be included back in her estate. Thus, the length of the GRAT term is very important. In the past, to hedge against the risk of death during the GRAT term, many clients have chosen shorter terms.
For older clients or clients with health problems, especially, a shorter term of two years has been preferable. A shorter term can also be attractive to young and healthy clients if the GRAT assets are expected to experience a short burst of asset appreciation.
The GRAT legislation proposed by the House, however, would make three important changes.
First, the legislation would no longer allow these trusts to "zero out." The trust, in other words, would have to produce a taxable gift to the beneficiaries. This would eat into the client's $1 million lifetime gift tax exemption, and if the exemption has already been exhausted, would require the client to pay some gift tax.