The Days of Short Term GRATs May Be Limited
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.