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.

But this new restriction is not expected to be too great a burden as presently proposed, since it is possible to construct a GRAT with a gift of $1 that would satisfy the requirement.

Second, the legislation would prevent the annuity payments to the client from decreasing year over year during the GRAT term. This second requirement is also not likely to affect many clients, as most choose to increase the annuity payments year over year in order to allow the assets more time to grow within the GRAT. The current GRAT regulations limit the annual increase to 20%.

The third requirement is more important, and would impose a minimum term of ten years on all GRATs. If enacted, this requirement would likely remove the GRAT as a possible planning technique for most elderly clients.

For clients who are expected to survive a ten-year term, however, GRATs may still be attractive. It will depend on interest rates, in particular whether the rates are increasing or decreasing. When interest rates are low (as they are now) and likely to increase, locking in a lower rate for a longer term can compound the benefits of that low rate, making it more likely that the GRAT will pass excess appreciation to the beneficiaries tax free. In the current economic environment, therefore, a ten-year minimum term should not dissuade younger clients from funding GRATs.

A ten-year minimum term would, however, make GRATs less attractive for all clients (regardless of age or health) in declining interest rate environments, when locking in a relatively higher hurdle rate for a long period of time would make less sense.

Sale To A Grantor Trust
A rival strategy to the GRAT is the sale of assets to a grantor trust. This is sometimes referred to as a sale to a defective grantor trust because the trust is treated as if it is owned by the client grantor for income tax purposes but not for estate tax purposes.

It works this way: The client sells assets to a grantor trust in exchange for a note from the trustees bearing interest at a rate that is at or above the minimum rates allowed by law. If the assets sold to the grantor trust appreciate at a rate greater than the interest rate on the note, the excess appreciation will remain in the grantor trust for the benefit of the trust beneficiaries.

This excess appreciation can be quite substantial because the applicable interest rates are extremely low-even lower than the hurdle rate for GRATs: The rates for sales to grantor trusts in November were 0.35% for short-term loans of three years or less, and 1.59% for midterm loans between three and nine years.

However, clients must carefully weigh the differences between the two strategies. While GRATs are specifically authorized by statute and regulations, there are no statutes authorizing sales to grantor trusts, which makes them more risky. Still, such sales are regularly used by estate planners, and private letter rulings offer some guidance on structuring them.

One guideline suggests that a grantor trust should have assets before the sale equal to at least 10% of the value of the assets sold to the trust. Accordingly, if there is no funded grantor trust available for the transaction, the client must make a taxable gift to the trust before the sale equal to at least 10% of the value of the assets that will be sold, using up some part or all of her $1 million lifetime gift tax exemption, or perhaps paying some gift tax. If a taxable gift is required, the sale technique may be less attractive than a GRAT (at least while zero gift GRATs remain possible).

Private letter rulings also suggest that a client may structure the note so that the grantor trust pays interest only during the term, and then makes a balloon payment of principal at the end of the term. Structuring the note in this way allows the assets more time to grow within the trust before the trust must repay the principal back to the grantor, and demonstrates one way a sale can produce better results than a GRAT: While the annuity payments under a GRAT can be back-loaded, they may not increase year over year by more than 20%.

Perhaps the most significant difference between the GRAT technique and the sale technique is the treatment of the trust assets when the client dies. With GRATs, the client's death during the term will almost certainly result in all the GRAT assets going back into the client's estate. With a sale to a grantor trust, only the value of the note will be included in the estate (the value of the note being the unpaid principal balance plus accrued interest, unless the executor can establish a lower value under certain Treasury regulations). The grantor trust assets will still pass estate-tax-free to the client's chosen beneficiaries.

All of this suggests that, for clients who may not outlive the ten-year minimum term imposed under the proposed legislation (assuming it passes in its current form), a sale to a grantor trust may be more attractive than a GRAT, especially if there is an existing, funded grantor trust that may be used for the sale.    

William A. Lowell is co-chair of the wealth management group at the law firm of Choate, Hall & Stewart LLP in Boston. Kristin T. Abati is a partner in the group. They focus their practice on complex estate and tax planning and trust administration and can be reached at wlowell@
choate.com and [email protected].