GRAT IT WHILE YOU STILL CAN

We previously posted on planning strategies that work really well in this current low interest rate environment.  In that post, we discussed the grantor retained annuity trust (“GRAT”).  In summation, a GRAT pays an annuity to the grantor for a specified term of years (the “retained interest”) with the balance at the end of the term passing to designated beneficiaries (the “remainder interest”).  The present value of the remainder interest is a gift, while the retained interest is not.  The GRAT produces a tax benefit only if the assets produce a total return in excess of the statutory rate of return (known as the 7520 rate).  This is why the GRAT is attractive when the 7520 rate is very low.  And the GRAT has little downside when the retained annuity is calculated to “zero out” the gift, which is when the grantor retains an annuity equal to the value of the entire trust and is not considered to have made a gift.  In that case, if the GRAT assets do not outperform the 7520 rate, the grantor takes back all the transferred property and ends up in the same position as if the GRAT were not done in the first place (except for transaction costs).

Typically, GRATs are short-term (often 2 years) to capture market volatility and improve the chances the grantor will survive the term.  Oftentimes, multiple GRATs will be created and each will hold a single investment, such as stock in one company.  But long-term GRATs, including those with diversified assets, can produce tremendous results as well, especially in this time of low interest rates.  Now is the time to be GRATful because the 7520 rate is near a historic low, and creating and funding a GRAT now will lock in this rate for the full GRAT term regardless of the future of our transfer tax laws.  The following chart shows the difference between a standard GRAT and a “zero out” GRAT, each with a 15 year retained term funded in April 2013 with $5,000,000 by a 60 year old grantor who survives the retained term, and the assets are assumed to generate 3% annual income and 5% annual growth:

It should be noted that to achieve the most out of a GRAT, the grantor must survive the retained term since the assets of the GRAT will be included in the grantor’s gross estate if the grantor dies before expiration of the retained term.  However, Treasury released final regulations under Code § 2036 in November 2011 which provide that the amount to be included in the grantor’s gross estate for estate tax purposes is only that portion of the GRAT assets necessary to generate sufficient income to satisfy the retained annuity using the 7520 rate in effect at the time of the decedent’s death.  Thus, if the assets of the GRAT appreciate in excess of the 7520 rate, some of this appreciation may still escape estate taxation even if the grantor dies during the term.  In addition, the deceased grantor will realize a benefit as well if the 7520 rate is higher at date of death than date of funding because a higher rate at death will result in a lower amount of principal necessary to produce the decedent’s retained income interest.  The risk of estate tax inclusion can be offset by the GRAT beneficiaries purchasing life insurance on the grantor which could be funded by the grantor making gifts to such beneficiaries using grantor’s annual exclusion from gift and generation-skipping transfer (GST) tax (currently $14,000 of annual gifts to each beneficiary is exempt).

GRATs are not good vehicles to leverage use of the GST Exemption since the grantor’s GST Exemption may not be allocated to the GRAT assets until expiration of the retained term.  If GST Exemption is allocated at such time, it must be allocated based upon the value of the GRAT assets at expiration of the retained term.  Thus, it may be better to gift to a GST Trust for your grandchildren which is not subject to this special rule and then utilize the GRAT for transfers to your children or non-GST trusts.

Finally, President Obama is in favor of legislation which will curtail the use of GRATs by requiring: (i) a minimum retained term of ten (10) years; (ii) a maximum term of life expectancy of the annuitant plus ten (10) years; and (iii) a remainder interest (gift) value greater than zero at the time of creation.  If this new legislation passes, it would only apply to GRATs created after the enactment date.  So now is the time to create and fund a “zero out” GRAT or a standard GRAT.