It appears that the grantor retained annuity trust, or GRAT, is about to lose much of its flexibility. Legislation to curtail the popular estate planning tool has been on the table for some time. Just days after the Senate removed GRAT provisions from the pending small business legislation, the House plugged it into a supplemental appropriations bill that provides funding for the troop surge in Afghanistan, among other measures. Assuming the bill is passed by the Senate, the measure would apply to transfers occurring after the date President Obama signs it into law.
Understanding GRATs
GRATs offer a way to avoid gift and estate tax in transferring wealth to heirs. They’re particularly effective with assets that are expected to rapidly grow in value, yet they avoid the risk of a bad tax result if the opposite occurs. The basic idea is to place the assets in a trust that will make fixed annual payments to you for a stated period of time. (In the terminology of trusts, you are the grantor because you are the one transferring assets into the trust, and the fixed annual payments you receive are your retained annuity.) At the end of this period, the assets pass to your heirs, or to a trust established for them.
The key to this arrangement is that for gift tax purposes, you’re treated as making a gift at the time you place the assets into the GRAT, and the amount of that gift is the value of the assets minus the value of your retained annuity. With just a small dash of financial wizardry, an estate planning professional can construct a GRAT in which the retained annuity has the same value as the assets, so that the net gift is zero and you pay no gift tax when establishing the trust. If the assets increase in value as expected, a substantial amount of wealth will remain in the trust at the end of its term, despite its having made annual payments back to you, the grantor. This wealth passes to the other beneficiaries (your heirs) free of gift or estate tax.
Example: Suppose you hold an asset with a current value of $1,000,000 that you expect to grow in value to $1,500,000 in the near future. You’re looking for a way to move assets out of your estate with minimal estate or gift tax consequences. One approach, without a GRAT, is to simply give this asset to your heirs. You use your $1,000,000 gift tax exemption to avoid paying current tax on the gift, and if the asset appreciates as expected, you will have transferred an extra $500,000 in value at no gift or estate tax cost. If an unexpected setback causes the asset’s value to decline to $600,000 instead of grow to $1,000,000, however, you end up with an ugly result: you used your $1,000,000 gift tax exemption to move only $600,000 of value out of your estate.
Instead, you might consider transferring this asset to a GRAT. The terms of the trust require annual payments for a period of two years. To zero out the gift, these payments must be a little over $500,000 each (they have to take into account interest that could be earned on the initial value). If the asset grows in value as expected, the trust will terminate with roughly $500,000, which goes to your heirs free of estate and gift tax. Yet the technique won’t backfire if the asset declines in value. To meet its obligation to make annuity payments to the grantor, the trust simply returns the asset to you. The arrangement doesn’t shield you from the asset’s loss of value, of course, but it avoids an unfortunate transfer tax result. It isn’t a win-win proposition, but it’s win-breakeven, which is better than win-lose.
GRATs have their limitations, however, and one is that some or all of the value of the trust will be included in your estate if you die before the expiration of the annuity term. Partly for this reason, and partly to preserve planning flexibility, many GRATs are established for relatively short period of time (the current minimum is two years). A key provision of the pending legislation would require a minimum term of 10 years for GRATs.
Instant GRATification
The proposed restrictions on GRATs are included in President Obama’s budget proposal and seem almost certain to become law sooner or later. The House’s action in putting them into the supplemental appropriations bill creates the possibility this will happen very soon indeed. To earn congratulations from your estate planner, and gratitude from your heirs, the time to act is now.
