A common estate minimization technique had been to use Grantor Retained Annuity Trusts (GRATs) to shift value outside a taxpayer’s estate. The most common GRAT approach was the use of short-term “rolling” or “cascading” GRATs intended to capture upside market volatility. The mathematical superiority of short-term rolling GRATs over long-term rolling GRATs has been documented in a host of studies and journals. Congress was well aware of the no-downside nature of GRATs, and that very wealthy taxpayers structure GRATs to minimize their gift and estate tax burdens. There were a number of proposals to restrict GRATs. The House of Representatives, for example, had passed the Small Business and Infrastructure Jobs Tax Act of 2010 on March 24th (H.R. 4849) that would have made very negative changes to the GRAT technique, including requiring a 10-year minimum term and a current (albeit minimal) taxable gift. Although most advisers had expected the technique to be severely restricted, the TRA did not address the technique and post-TRA GRATs remain a viable estate tax minimization technique. Wealthier taxpayers should continue to evaluate the use of GRATs. Moderately wealthy taxpayers, (e.g., perhaps $4 to $5 million+) may be able to use the technique to limit the upside growth of their estates to minimize the likelihood of exceeding the $5 million estate exclusion threshold.
Although the tax proposals to eliminate GRATs were not enacted, they might be back in the future. Considering the political volatility, that the law in 2013 reverts back to a $1 million exclusion and a 55 percent rate, perhaps taxpayers should lock in GRATs now.
How does the GRAT technique work? Current tax rules include tough rules for valuing certain transfers in trust of interests in property for fixed time periods (e.g., annuity interests and remainder interests). Bottom line, if a taxpayer makes a transfer to a trust to benefit a family member and retains any interest in the property transferred, the IRS will tax as a gift the entire value of the property involved (i.e., there is no reduction for the value of the interests the client retains). GRATs are one of the exceptions to these tough rules.
A typical GRAT plan might look like the following:
Transfer $1 million to each of four different GRATs each lasting for two years.
Each GRAT will be invested with a single and different volatile asset class. This might not mean any change in the client’s overall asset allocation strategy, rather a shift in the location of particular investments. All this should be reflected in the client’s and each trust’s investment policy statement (IPS).
The GRATs are set up to make high 50 percent+ annuity payments to the taxpayer/grantor each year, so that the present values of the gifts to the GRATs are zero (or almost zero) for gift tax purposes.
If one GRAT realizes a substantial increase in value, the grantor will exchange nonvolatile assets such as cash or Treasuries for the volatile securities, thus locking in or immunizing that gain inside the GRAT. This is the very power (of substitution) that is used to assure grantor trust income tax status for the GRAT.
The taxpayer/grantor takes the assets received for the annuity payments or the exchange and transfer them to new two-year GRATs and keep the plan rolling, hence the name of the plan “rolling GRATs”.
The end result, is that winning GRATs (i.e., GRATs that have combined income and appreciation above the Code Section 7520 rate) transfers huge value outside the taxpayer/grantor’s estate with no gift tax cost. Losers have no downside; the trust assets are simply returned to the grantor in annuity payments and are cycled through more GRATs until they produce extraordinary gains above the imputed tax law interest rate under Code Section 7520.
How does a GRAT win? The value of the client’s gift for gift tax purposes is determined at the time of the initial transfer to the GRAT. If the GRAT property grows at a rate in excess of an interest rate mandated by the tax laws (the so called, “Section 7520” rate), the excess appreciation passes to the remainder beneficiaries (for example, an insurance trust to provide a payoff strategy for a split-dollar arrangement, or to another grantor or defective trust to continue the income tax burn for the grantor) without further gift tax consequences to the grantor. Because today’s interest rates are still at historic lows, the bar that GRATs have to exceed to be successful is also very low by historical standards.
Some of these applications might change in light of the $5 million gift exclusion enacted by the TRA. Taxpayers may simply choose to gift dollars to an insurance trust, and use up some of their new large gift tax exclusion, rather than use the rolling GRATs paying into their insurance trusts. However, this does not negate the benefits of GRATs.
Should only ultra high net worth taxpayers consider GRATs? With a $5 million gift and estate exclusion and portability, will this planning be limited only to ultra high net worth clients? Perhaps not. If 2013 holds the specter of a reduced estate tax exemption and a higher rate, perhaps other clients should consider pursuing GRATs while they remain advantageous. GRATs continue to offer the possibility of transferring large values out of the estate without using up any of the client’s estate tax exclusion amount. An impediment for many clients with estates that would appear to be below the new estate tax thresholds will be the costs of GRATs. So who might the best candidates for GRATs be, other than ultra high net worth clients? Perhaps wealthy clients, who have already implemented GRATs, so that the complexity and cost barriers to consummating additional GRATs are low.
Example: A taxpayer with a combined net worth of $8 million implemented several two-year GRATs in November 2010. While $8 million can readily avoid estate tax with a $5 million exclusion enhanced by portability, the client understands that GRATs, and the cost of funding more GRATs with nearly identical terms and using the same investment manager, is quite modest. Such a taxpayer might opt to continue funding new GRATs, and to roll or cascade the existing GRATs into new GRATs when the payments come due. For the relatively modest cost involved, it provides a safeguard against asset growth or 2013 law changes pushing them into a taxable estate situation.
The typical rolling GRAT strategy might make sense for some clients to minimize state estate tax even if there is no federal tax likely.
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