By Deborah L. Jacobs
For several years, financial advisors have been warning their clients that Congress might curtail some popular estate planning tools. The House of Representatives took a giant step in that direction on March 24 when it passed H.R. 4849-a bill that would eliminate the low-risk grantor retained annuity trust or GRAT.
Assuming the Senate follows suit, it will still be possible to use these trusts, but they will become much less attractive as a tool for shifting wealth to future generations. Before that happens, there is a window of opportunity to tap into the huge gift-tax savings now associated with a GRAT.
This device allows someone to put assets into an irrevocable trust and retain the right to receive distributions back over the trust term. The annuity is equal to the value of what's been contributed plus interest at a rate set each month by the Treasury called the Section 7520 rate (named after the section of the Internal Revenue Code that applies). For April, this rate is 3.2%.
If the value of the trust assets increases by more than the hurdle rate, the GRAT will be economically successful. In that case, the excess appreciation will go to family members (the remainder beneficiaries) or to trusts for their benefit when the GRAT term ends. If the appreciation never occurs, the trust can satisfy its payout obligations by returning more of the assets to the grantor-the person who created the trust.
The anti-GRAT provisions recently adopted by the House were included as a revenue raiser in the Small Business and Infrastructure Jobs Tax Act of 2010, which includes tax breaks for small business, among other things. They would radically change the playing field for GRATs set up after the law is enacted.
For the moment, it is possible to form what's called a zeroed-out GRAT, in which the remainder is theoretically worth nothing so that there is no taxable gift. Although the estate tax was repealed for one year at the end of 2009, there's still a gift tax (currently at a 35% rate) if you give away more than $1 million in cash or other assets during life. A zeroed-out GRAT enables clients to use their $1 million lifetime gift tax exemption for other transfers. Plus, there's no exemption wasted if the asset does not perform as hoped.
In its March 19 report on H.R. 4849, the House Committee on Ways and Means stated, "such uses of GRATs for gift tax avoidance are inappropriate." Without requiring a specific value for the remainder interest, the bill indicates that it must be "greater than zero."
More drastically the House bill requires GRATs to have a term of at least ten years, compared with the current two-year minimum. This greatly accentuates what is called the "mortality risk" of a GRAT: If the grantor dies during the trust term, all or part of the trust assets will be included in her estate for estate tax purposes. Clients would no longer be able to use short-term GRATs to minimize that risk. This provision of the bill alone would raise an estimated $4.5 billion in ten years, according to a March 18 report by Citizens for Tax Justice, a lobbying group that describes its mission as "requiring the wealthy to pay their fair share."
Another drawback is that the bill limits the ability to structure the payout to reflect a client's expectations about investment performance. For the first ten years of the trust term, it would no longer be possible to provide for a higher initial payment, and lower ones in subsequent years. In the past, this strategy might have been used when clients expected a big capital gain in year number one, for example.
Since the law would apply only to GRATs put in place after it is passed, clients who are concerned about estate tax once the tax springs back in 2011 (or sooner if Congress restores it retroactively), should act swiftly. In particular, a GRAT may appeal to people who have a liquidity event, such as a sale, on the horizon, or expect depreciated assets to recover during the trust term.
For now, there are many possible variations on the theme. You can engineer both the GRAT term and the annuity for maximum economic benefit. And you can hedge the mortality and investment risks using a series of short-term GRATs created over a certain period of time-say, five GRATS, each with a two-year term and holding a different investment.
This is also a great time to review existing GRATs. Let's say asset values have declined, so that a GRAT now in place is unsuccessful, but the client believes that the asset will bounce back. In that case, there may be a benefit to moving the volatile asset out of an existing GRAT and putting it into a new one at the lower rate, essentially giving the client a fresh start. That can be done by exchanging the property either for cash or for another asset of equal value. Alternatively, the asset can be bought from the GRAT using a promissory note.
With Congress on Easter recess until April 12, there's a pause in the action and time to reflect on the potentially larger significance of H.R. 4849. This may well be a sign that we are in for creeping estate tax reform, rather than a single piece of legislation. It may also be the first step toward whittling away at some really great tax deals for high net worth clients. We may soon look back on the past decade as the golden era of wealth transfer.
Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide (DJWorking Unlimited, 2009). To learn more, visit www.estateplanningsmarts.com. Copyright © 2010 Deborah L. Jacobs