Ideally, a Grantor Retained Annuity Trust (GRAT) can provide an individual the opportunity to remove assets from his or her estate at little or no gift tax cost while shifting all future appreciation in the value of those assets, transfer tax free, to designated beneficiaries within the protective shield of a trust arrangement. While there are some economic risks inherent in the use of GRATs, their formation and operation are relatively straightforward and, unlike some wealth-shifting strategies and techniques recommended by various promoters, possess a very strong foundation supported by well-established law.
New law makes GRATs more attractive
The president recently signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. Among other aspects of the legislation, the new law increases the estate tax exemption equivalent amount from the scheduled "sunset" figure of $1 million to $5 million. It also lowers the maximum estate tax rate from 55% to 35% beginning in 2011.
While the increase in the estate tax exemption could be virtually monumental for estate-planning purposes, it somewhat pales in comparison to the provision of the law that reunifies the gift tax exemption amount with the estate tax exemption. During 2011 and 2012, individuals will be entitled to a lifetime gift exemption of $5 million (not including annual exclusion gifts). The substantial increase in the gift tax exemption will open up a variety of options that were either unavailable or unattractive prior to the change in law.
It will certainly cause planners to rethink lifetime wealth-transfer strategies. Prior to enactment of the new law, GRATs had proven to be extremely useful lifetime intergenerational wealth-transfer vehicles. Given the increased gift tax exemption and certain aspects of GRATs applicable at this particular moment in time, they may be too attractive to pass up.
Lower rate improves GRAT effectiveness
GRATs are irrevocable trust arrangements, and asset transfers made to them are irrevocable gifts. They provide annuity income to the grantor and a remainder interest to the trust beneficiaries. For transfer tax purposes, the value of the gift is determined by the fair market value of the assets transferred reduced by the actuarial value of the sum of the annuity payments retained by, and payable to, the grantor. Assuming the fair market value of the assets transferred is easily determined, the actuarial calculations refer solely to determining the value of the annuity stream. That value is effectively determined by applying a factor that takes the following into account: the grantor's age, the term of years during which the annuity is payable, the dollar amount of the annuity payable, and the applicable discount rate applied to the annuity stream as set forth under IRC Section 7520 and accompanying Treasury Regulations.
Section 7520 rates are published monthly by the IRS. It is implied that the rate reflects the IRS's expectations with respect to future appreciation of asset value as of the date the rate is published. As the rate decreases, the actuarial value of the grantor's retained interest increases, and the value of the remainder interest passed on to the trust beneficiaries decreases with respect to gift tax cost.
Consequently, execution of a GRAT results in higher wealth-transfer leverage and better economic success as the Section 7520 rate decreases and realized appreciation of the trust assets increases. What makes GRATs particularly attractive right now is a historically very low Section 7520 rate, as low as 1.8% in December. This compares with Section 7520 rates in excess of 6% as recently as 2007 and as high as 11.2% in 1989.
Planning can help avoid tax troubles
Virtually all GRATs are, by nature, grantor trusts. Accordingly, the income earned by the trust is passed through to the grantor for income tax purposes, irrespective of the amount of the annuity payment received. While possibly burdensome to the grantor, bearing the income tax burden only serves to further increase the value of the gift to the remainder beneficiaries, as their interests are not subject to reduction as a result of income tax liability.
There are some concrete ground rules concerning GRATs. First, the grantor must specify the term of years during which he or she receives the annuity. Second, the annuity must be paid at least annually. The primary risk to the arrangement is the grantor's failure to survive the specified term of the GRAT. In that event, the remainder interest may revert back to the grantor and be included in his or her taxable estate.1 Since gift tax may have been paid when the GRAT was established (or a substantial amount of the lifetime gift exemption was used), the amount of the tax paid is credited against estate tax payable. Consequently, the fundamental risk borne by the grantor is the time value of money unrealized by making the "failed" gift.
There are ways to mitigate the risk of the grantor's failure to survive the specified GRAT term. One popular technique is an irrevocable life insurance trust's (ILIT's) purchase of a term life insurance policy matching the term of years of the GRAT and paying a death benefit equal to the expected estate tax liability created by the inclusion of the GRAT assets in the grantor's estate.
GRATs work well with other planning techniques
Certainly prior to the newly enacted tax act, the typical taxpayer contemplating a GRAT generally had to be extremely stingy with his or her lifetime gift exemption. Consequently, GRATs have often been structured to minimize the amount of the gift to the trust remainder men. In order to accomplish that goal, the retained annuity generally had to be very substantial and would generally increase inversely with the number of years of the GRAT term. Short-term GRATs proliferated during the past decade and could be highly effective if the underlying assets appreciated greatly in value quickly.
But what if a client wanted to structure a GRAT term to complement other estate planning techniques? A good example would be the creation of an exit strategy for a financed life insurance policy owned by an ILIT. In many cases, clients either expect cash surrender values or death benefits to repay premium finance loans. But if policy performance doesn't provide the necessary cash value, or if the financing structure puts unexpected strain on the viability of the policy and/or its projected net death benefit, there is potential for disaster. Utilizing a GRAT, the remainder of which is payable to the ILIT, to provide cash at a specified date to repay the loan is a prudent planning strategy that could serve as an outstanding solution.
Variables aligning in favor of GRATs
The gift reportable for tax purposes is fixed, given the fair market value of the gift and the applicable annuity factor (combining term, Section 7520 rate and retained annuity). The more variable assumptions (income and growth of assets held in trust) impact the amount of the projected remainder interest.
In the charts below, note the changes in the amount of the gift made due to changes in term and the applied Section 7520 rate -- 1.8%, as it was in December, and 6.0%, reflecting a rate closer to the mean for the past 20 years.
As stand-alone lifetime intergenerational wealth-transfer vehicles, GRATs have often proven to be highly effective. The impact of the new and significantly larger gift tax exemption provides individuals the opportunity to transfer more highly valued assets to GRATs during 2011 and 2012 while generating little or no gift tax liability.
When coupled with other estate-planning techniques, GRATs can create highly effective premium finance exit vehicles, potentially decreasing the risks of such arrangements and substantially increasing the chance of success of post-mortem estate-planning techniques.
Glenn Plotkin, J.D., CFP, CLU, ChFC, CTFA, is vice president, marketing - advanced markets, for American General Life Insurance Company. He has an extensive tax and legal background in estate and business planning as well as retirement distribution planning and charitable planned giving.
1. The IRS has argued that, upon the death of the grantor prior to the completion of the term, either the GRAT corpus is includible in the estate of the grantor under IRC Section 2039 or a portion of it is includible under Section 2036. Note, however, in June 2007, the IRS issued proposed regulations stating that the portion of the GRAT assets included in the grantor's estate would be as much as is necessary to produce the retained annuity in perpetuity. Consequently, under circumstances in which a GRAT is structured so that annuity payments continue to be payable to the grantor's estate, the IRS will likely argue that Section 2033 would apply to the portion of the GRAT payable to the grantor's estate. For a long-term GRAT whose assets have appreciated substantially, however, the result may be a significant tax-free transfer of wealth even if the grantor dies during the term.
This article is for discussion purposes only. It does not provide a full discussion of the significant tax, financial or legal issues associated with the structure or implementation of a GRAT. American General Life Insurance Company, its employees, agents and/or representatives do not provide tax, legal or financial advice. No representation or warranty, express or implied, is made by AGL and its affiliates as to the completeness of the information in this article.
To ensure compliance with requirements imposed by U.S. Treasury Regulations, we inform you that any tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. There are complex legal and tax implications associated with the strategy presented herein.