In pursuit of tax revenues, Congress and President Obama have set their sights on Grantor Retained Annuity Trusts or "GRATs." A GRAT is an irrevocable trust designed to allow the donor to transfer assets into the trust and retain the right to receive back an annuity for a term of years, enabling the donor to receive an annual payment for a fixed period equal to the value of the assets contributed plus interest at a rate set by the IRS each month.

At the end of the GRAT term, any remaining value in the trust (i.e., the appreciation and return on the assets exceeding the IRS rate during the GRAT term) will pass to the remainder beneficiaries of the GRAT free of transfer taxes. However, if the donor dies before the end of the GRAT term, some or all of the GRAT assets will be included in the donor's estate for estate tax purposes.

The primary tax benefit-the tax-free transfer of the GRAT remainder interest after the trust term ends-is derived from the fact that the initial gift value of the remainder interest upon the formation of the GRAT was designed to be zero because the total annuity payments to the donor were expected to equal the amount originally contributed, plus interest, thus resulting in no taxable gift. After the financial collapse of 2008, when valuations plummeted across the board, many donors chose to fund GRATs with highly volatile assets which were expected to increase over a short period of time, resulting in the excess principal that could pass to beneficiaries transfer-tax free.

In President Obama's fiscal 2010 and 2011 budget proposals, he has suggested extending the minimum GRAT term to ten years with the expectation of raising $4.45 billion in incremental tax revenues over that time period. Today, most GRATs are structured with no more than two to three year terms to hedge against the possibility of the donor dying during the term. The ten-year restriction is designed to prevent such strategies.

On June 15 and June 17, the House of Representatives passed H.R. 5486, the Small Business Jobs Tax Relief Act, and H.R. 5297, the Small Business Lending Fund Act, respectively.  Both bills are being considered by the Senate as bill H.R. 5297. The new law would: (1) require a ten-year minimum GRAT term, (2) require the remainder interest to have a value "greater than zero," effectively precluding "zeroed-out" GRATs; and (3) prohibit annuity payments from being front-loaded for the first ten-year term. The bill could still be changed before final adoption. If GRAT terms are extended to a ten-year minimum, the donor may need to consider adding an insurance policy to his or her estate plan to hedge the increased mortality risk.

Impact On Investment Portfolios
Advisors need to consider how the changes in the tax code will affect investment portfolios. Potential considerations include the following:

Cash Investments: Tax-exempt money market funds will become increasingly more attractive relative to government and prime money market funds. Risk aside, investors in the highest tax bracket would benefit by investing in tax-exempt money markets on an after-tax basis if the yield were at least 56.6% (1- [tax rate]) of the equivalent taxable money market fund.

Fixed Income: For high-quality fixed income, where little capital appreciation is expected and returns are driven almost exclusively by income, the same rule as for cash investments would apply. For fixed-income investments with expected capital gains, such as high-yield bonds, the tax bite as a percentage will be less, given their capital gains potential, and that may make them suitable for diversification and after-tax return contribution for taxable investors at times when they trade for less than par value.

Multi-Strategy Hedge Funds: Funds employing arbitrage trades where a significant portion of returns are either short-term capital gains or income will be among the most heavily impacted by higher taxes. There are funds in this space that may be more efficient, such as those employing distressed-debt strategies or event-driven strategies, where a more significant portion of returns may be long-term capital gains. Despite the lower tax-efficiency, the diversification value of these strategies may still justify their use.

Equity: Managers with a high level of tax awareness-holding investments until they reach long-term status, holding dividend paying companies long enough to ensure their "qualified" status and regularly harvesting losses (particularly short-term)-will add value to a portfolio. Tax-managed index strategies will become even more attractive on an after-tax basis. This begs the consideration of whether active management should be utilized at all in asset classes where a manager's ability to outperform an index is challenged and the magnitude of outperformance on a pre-tax basis for the most successful of managers is minimal. Exchange-traded funds minimize distributions and are generally considered very tax-efficient.