Grantor Retained Annuity Trusts (GRATs) are among the
most popular and powerful estate planning strategies. But they may
soon lose some of their power. Legislation to restrict the use of GRATs
has been passed by the House of Representatives in two separate bills,
most recently on June 15, 2010 in the Small Business Jobs Tax Relief
Act of 2010. The legislation includes a requirement that a GRAT have a
minimum term of ten years. It also prohibits the annual annuity payment
from decreasing during the first ten years of the term and requires
that the remainder interest have a value greater than zero. The changes
are expected to raise $5.3 billion of tax revenue over ten years.
What is a GRAT?
A GRAT is created by a grantor transferring assets to an
irrevocable trust for the benefit of family members, while retaining
an annuity interest in the trust for a term of years. Under the rules
of 2702 of the Internal Revenue Code, the IRS allows the value of the
grantor’s retained annuity to be based on the applicable §7520 interest
rate. If the GRAT property produces income and appreciation in excess
of that rate, the excess return—which may have significant value—is
transferred to family members free of estate and gift tax. If the
grantor dies during the term of the GRAT, however, all or a portion of
the property must be included in the grantor's estate. That makes it
important to select a term of years that the grantor is likely to
survive. It is often advantageous to create a series of short-term
GRATs, usually for terms of two years. Such short-term GRATs reduce
the risk that the grantor will die before the end of the retained term
and help to avoid having unanticipated losses in one year off-set gains
in other years.
Benefits of a GRAT
To understand the benefit of a GRAT, assume that a
65-year-old parent transfers 100 shares of family business common stock
worth $2,000 to a GRAT for the benefit of his children. Under a
two-year GRAT, the parent could be paid an annuity each year equal to
$1,042, an amount based on the two-year term and the current §7520 rate
(2.8%). The annuity can be paid in shares of company stock. If the
value of the company doubled during the first year, the annuity would
be paid in shares valued at $40 per share, requiring only 26 shares to
fund the payment. If the value increased to $50 per share by the end of
year two, the second annuity payment would require only 21 shares of
stock, leaving the GRAT with a remainder interest of 53 shares of stock
that could be transferred to children free of estate and gift tax.
Using a rolling GRAT strategy, the shares received in payment of the
annuity could be immediately transferred to a new two-year GRAT.
What might change?
If the current legislation becomes law, the GRAT would
have a ten-year minimum term and significantly reduced annuity
payments. This would increase the risk that the parent might die during
the term and that the remainder interest could be substantially
reduced or eliminated if the value of the company fluctuated or
decreased in future years. There would also be a taxable gift on
creation of the GRAT, which would likely require use of a portion of
the grantor’s applicable exclusion for lifetime gifts.
Even if these changes become law, the GRAT will remain a
valuable estate planning tool. But, if a client is already a good
candidate for this strategy, it may be wise to accelerate the creation
and funding of the GRAT before the new limitations apply.
version of this article appeared in the Massachusetts Society of
Certified Professional Accountants "Friday@Five" weekly newsletter on
July 1, 2010.