As just about every estate planner knows, the financially ruinous storm clouds of 2008 did contain at least one silver lining:  an environment that made the grantor retained annuity trust (GRAT) a virtual foolproof way to pass on assets free of gift tax.

But it appears the opportunity will have been fleeting-meaning  advisors need to quickly assess their clients' wealth transfer needs before its too late to get them into a GRAT.

Perhaps paying the price for their wild popularity over the last two years, GRATs are one of the targets of the Small Business and Infrastructure Jobs Tax Act of 2010, tax legislation package wending its way through Congress.

Passed by the House in March, the legislation was before the Senate at press time. Among other things, the legislation would mandate that GRATs have a minimum term of 10 years and prohibit "zeroed-out" GRATs and require a remainder interest, thereby robbing the trusts of two of the main features that have made them so attractive to planners and their clients.

The feeling among those in estate planning circles is that the GRAT regulations will eventually be signed into law by President Obama. "There definitely has been some momentum building on this for over a year," says James H. Cundiff, a partner with McDermott Will & Emery, one of the nation's most prominent estate planning law firms, in Chicago. "With that kind of background, you get the feeling it's inevitable."

How will clients be impacted if the legislation is adopted?

Clients with a desire to pass on assets now and in the near term-namely, elderly clients-will be most affected, planners say. "Generally, it is the elderly client," says Thomas Forrest, president of Charles Schwab Bank personal trust division. "It's difficult to tell a 40-year-old to give up their money."
Clients will still have access to tax-advantaged strategies for passing on assets to children and other beneficiaries, but depending on the situation, they will end up paying more in gift taxes and be more susceptible to challenges from the IRS. Many of the people who use GRATs now, planners say, may have to turn to strategies like sales to defective grantor trusts, which have their own benefits, but at the same time are more cumbersome and prone to more IRS scrutiny.

The elimination of zeroed-out GRATs means that some gift tax will have to be paid on transferred assets, but the legislation is not clear on how this will be accomplished, according to planners.

Estate planners say the new restrictions will mean that GRATs will no longer be the surefire vehicles that they have been for clients to pass assets onto younger generations free of gift tax. This is why planners have been busy in recent months reviewing their clients' existing GRATs and creating GRATs for those clients who have been sitting on the fence. Under the current legislation, the restrictions would take affect upon signing, meaning any GRATs formed up until that time will fall under the old regulations.

"It's an excellent vehicle because there really is no downside," says Bruce J. Bettigole, a partner with Gilmore, Rees & Carlson P.C. in Wellesley Hills, Mass. "The worst that can happen is a GRAT fails and you are back where you started from. "

GRATs have been around in their present form for decades, but the reason they have become so popular-and caught the gaze of revenue starved federal legislators-was because they allowed clients to take great advantage of the low valuations that were created by the global financial collapse of 2008.

In the typical scenario, an elderly asset holder could take an undervalued asset, put it in a GRAT for a term of two or three years-a period of time where one would expect values to rise as the economy went into recovery. Under present tax law, the grantor would receive annual annuity payments during the term roughly equal to the original principal and IRS-calculated interest, or the "hurdle rate," which has been running at slightly more than 3%. At the conclusion of the term, any leftover appreciation is passed onto beneficiaries free of gift tax. This is, in effect, what is known as a "zeroed-out" GRAT.

Given the current low hurdle rates, and the great potential for appreciation in recent years, GRATs have been a boon for the wealth transfer industry, virtually assuring clients of passing millions to their heirs without paying gift tax.

Indeed, in the end, they probably worked too well, estate planners acknowledge. "The perception of most taxpayers is that only the very wealthy benefit from this strategy," says Elizabeth Schlueter, head of wealth advisory for J.P.  Morgan Private Wealth Management. "That perception makes them an easy target."

But Schlueter feels GRATs benefit a larger swath of the population than may be realized.

Anyone looking to pass wealth to their children in a tax-efficient way can potentially benefit from GRATs, she notes. The legislation, however, will limit the benefits and, as a result, limit their client suitability. "I think it would change the nature of the person who you talk to about using them," she says.
Elderly clients, for example, would have a harder time making a GRAT fit into their plans for wealth transfers because of the 10-year minimum term requirements. That's because of the mortality risk inherent in a GRAT. If the holder of a GRAT dies during the term of the trust, then all the assets of the trust goes into the person's estate and becomes subject to estate tax. Clients were able to minimize this risk by limiting GRAT terms to just a few years. A 10-year term, however, would be too much risk for many clients to accept, planners say.

In addition to mortality risk, there is also the question of whether assets will appreciate to a level over the 10-year period to make the GRAT a suitable strategy, planners say. This is an issue with clients who, for example, are using GRATs as a way to pass on a concentrated stock position, planners say.
Planners also would no longer be able to pass client wealth through the use of rolling two-year GRATs. This strategy, which funds each successive GRAT with the annuity payments of the previous GRAT, is designed to hedge against the volatility of assets such as publicly traded stocks. Front-loaded GRATs would also become a thing of the past because, under the bill, annuities may not decrease for ten years.

"The economics don't work out so well over a term of 10 years," says Linda B. Hirschon, an estate planning attorney who frequently uses the rolling GRAT strategy at Greenburg Traurig LLP in New York City.

Clients with closely held businesses, and who often place shares of those businesses in a long-term GRAT anyway, stand to be least impacted by the new legislation, according to estate planners. Given today's interest rates, such clients would probably still be good candidates for GRATs, they say.
For such clients, the priority is often to make sure the business is passed onto their children, according to Schlueter. The question of appreciation usually isn't an issue, even over 10 years, and quite often the family prefers the transition to take place over a long period so they can be groomed to take over, she says.

"For a closely held business, even with a modest rate of growth, it's still an attractive way" to pass it on to the next generation, Schlueter says.

For some clients, an alternative strategy GRATs will be sales to defective grantor trusts, which, if properly constructed, can achieve much of the same tax efficiencies of GRATs. Unlike GRATs, however, a sale to a defective grantor trust is not defined by IRS code, planner note. That means their creation is usually a more complex and time-consuming process.

Sales to defective grantor trusts do hold some advantages, Hirschon says. If a grantor dies, for example, all of the trust's assets are not transferred to the grantor's estate. But the technique is not as simple and straightforward as using a GRAT.

"The benefit of the GRAT, for now, is that it is statutory, so if you follow the regs you are not going to be challenged by the IRS," Hirschon says.

In the final analysis, planners say, the fact that GRATs will no longer be a clean, swift remedy to client wealth transfer needs means that advisors will have to get back to the business of being careful in their approach. "It becomes even more important to have a competent advisor who knows you well and really understands the goals you have for your family and successive generations," Schlueter says.