Press Room: Tax Release

June 01, 2010

Estate Planners Alert: Proposed Legislative Limitations on GRATs

While pending legislation may soon eliminate short-term GRATs, there are a number of other estate planning tools that can be even more effective at shifting future appreciation.

Why All is Not Lost

To aid family wealth transfer, many estate planners use a very simple, but effective, planning tool called the Grantor Retained Annuity Trust, or GRAT.  A GRAT allows a taxpayer to place a highly appreciating asset in a trust and receive back a fixed rate of return in the form of an annuity payment over a number of years. Structured correctly, the present value of the stream of annuity payments equals the value of the asset placed in the GRAT. If the asset’s rate of appreciation exceeds the grantor’s required rate of return, then any excess appreciation shifts to the remainder beneficiaries, typically children. This is known as a “zeroed-out GRAT.”

With the zeroed-out function, there should be no gift tax exposure to the grantor. A GRAT, however, does have some limitations. If the grantor dies during the GRAT period, the value of the annuity payments is included in the grantor’s estate. Also, a grantor cannot use a GRAT to shift wealth to his/her grandchildren or later generations. Lastly, a GRAT’s effectiveness can be limited by the volatility of the asset’s value.

To mitigate these limitations, estate planners often structure GRATs for a two year term. The two year period lessens the risk that the grantor will die during the GRAT term. Also, by using a two year term, a grantor can continuously “roll over” the annuity payment he/she receives into a new GRAT. Utilizing the roll over technique helps to “smooth out” the short term volatility of an asset. As long as the asset appreciated over the long term in excess of the required rate of return, the grantor would shift additional wealth to the next generation without triggering gift tax.

Earlier this year, the House of Representatives passed a bill that would substantially limit the benefits of GRATs. The bill would eliminate the ability to “zero-out” a GRAT and increase the GRAT term to a minimum of 10 years. As a result, grantors would have a taxable gift upon formation. The 10 year minimum term would increase estate tax exposure as well as inhibit the grantor from smoothing out the short term volatility of the asset.

While the proposed GRAT legislation would limit the effectiveness of GRATs from an estate planning perspective, the reality is that other planning techniques are available that accomplish many of the same goals as GRATs - shifting future appreciation. In addition, many of these techniques accomplish what a GRAT cannot, such as shifting wealth to grandchildren or other future descendants.

In light of the potential legislation becoming law, if you have been considering a GRAT, now is the time to take action before the estate planning benefits are severely curtailed. Keep in mind that a GRAT is not the perfect or only planning technique and a number of estate planning options are available to you to accomplish your objectives.

With this and other tax law changes on the horizon, we hope to get the chance to speak with you in the near future. If you have any questions, please contact us at your earliest convenience.