New Bill Threatens Short-Term Grantor Retained Annuity Trusts (GRATs)

Mike Yates – Tax Services

Chaos continues to reign with respect to the future fate of the Federal estate, gift and generation-skipping transfer (“GST”) taxes. If Congress does not act this year, the Federal estate and GST taxes will be resurrected at pre-2001 levels, which will allow for a $1 million exemption and will impose a maximum tax rate of 55%. If Congress does act, it is unknown what form the resurrected taxes will take.

As we wait to learn the fate of these taxes, Washington is pressing on with further estate tax reforms. In March of 2010, the House passed H.R. 4849, the Small Business and Infrastructure Jobs Tax Act of 2010 (H.R. 4849). If approved by the Senate, among its provisions are some that would reduce the effectiveness of one popular planning technique: the short-term Grantor Retained Annuity Trust, or GRAT.

What Is a GRAT?

The GRAT is a very valuable tool in estate planning. GRATs allow taxpayers to structure a transfer of assets to another individual in such a way that substantial gift taxes may be avoided.

A GRAT is an irrevocable trust in which the grantor retains an annuity interest and transfers a remainder interest to another person or trust (such as for the grantor’s children). The retained annuity is paid with any cash on hand or, if there is no cash, with in-kind distributions of trust assets. At the end of the term, the remaining trust assets pass to the beneficiaries.

Generally, GRATs are structured to produce a nominal taxable gift. This is known as a “zeroed out” GRAT. The annuity is set so that its present value is roughly equal to the fair market value of the property transferred to the GRAT. There is virtually no gift tax cost associated with creating a zeroed out GRAT.

A GRAT can be funded with any type of property, such as an interest in a closely held business or venture fund, hedge fund, private equity fund, or even marketable securities. The most important consideration in deciding which assets to transfer to a GRAT is whether the assets are likely to appreciate during the GRAT term at a rate that exceeds the Internal Revenue Service (IRS) hurdle rate—an interest rate published by the IRS every month (in June 2010, the hurdle rate is 3.2%). If the trust’s assets appreciate at a rate greater than the hurdle rate, the excess appreciation will pass to the beneficiaries free of any transfer tax. Therefore, any asset that you think will grow more than 3.2% a year may be a good candidate for funding a GRAT.

Other factors to consider in selecting the assets to be transferred to the GRAT are whether they have a low valuation or represent a minority interest (which may qualify the assets for valuation discounts based on lack of marketability or lack of control).

If the grantor dies during the GRAT term, a significant portion of the GRAT assets (possibly all of the GRAT assets) is included in the grantor’s estate for estate tax purposes. This generally would eliminate the benefit of using a GRAT. As a result, taxpayers have created short-term GRATs to reduce the mortality risk and to maximize the opportunity to isolate and transfer rapidly appreciating assets.

Proposed Bill Reduces Effectiveness of GRATs

H.R. 4849 requires that the value of the remainder interest (upon which gift tax is measured) must be greater than zero, although it is not clear whether a remainder with a nominal value would continue to be sufficient. It also would require that the annuity not decrease during the first ten (10) years of the GRAT term. The minimum 10-year term makes it more difficult for taxpayers to use the GRAT for short-term planning.

According to the bill’s effective date language, the proposal applies to transfers made after the date of enactment. So, if enacted, there may be a short window of time in which GRATs may be established under the more favorable current laws.

Contact Frank, Rimerman + Co. LLP

If you are considering creating a short-term GRAT, or if you are contemplating gifts or sales of assets that lend themselves to valuation discounts, you should do so as soon as possible. If any of the proposed changes are enacted, these estate planning tools may become less effective. The tax advisors at Frank, Rimerman + Co. LLP are available to assist you. For more information or if you have other questions, contact Mike Yates at [email protected].

Any tax advice in this communication is not intended or written by Frank, Rimerman + Co. LLP to be used, and cannot be used, by a client or any other person or entity for the purpose of (i) avoiding penalties that may be imposed on any taxpayer or (ii) promoting, marketing, or recommending to another party any matters addressed herein. With this communication, Frank, Rimerman + Co. LLP is not rendering any specific advice to the reader.