By Erin Tuggle

Summary

As noted in previous e-Alerts, the estate and gift tax laws are currently in flux. In addition, and as you probably know, Congress is attempting to raise revenue. As a result of this current environment, Congress and the administration have targeted an estate planning technique called a grantor retained annuity trust (“GRAT”) with proposed legislation that will make GRATs a less favorable estate planning technique when compared to current rules. If passed, the legislation would reduce the effectiveness of the GRAT as an estate planning tool. Therefore, if you want to take advantage of the current, more favorable rules applicable to GRATs, then you should act soon to create a GRAT prior to the effective date of the proposed legislation.

Background: What is a GRAT?

A GRAT is an irrevocable trust created by an individual (the “Grantor”) who retains an annuity payable by the trust for a certain term. At the end of that annuity term, the trust’s remaining assets pass to the beneficiaries designated by the Grantor at the creation of the GRAT. The remainder interest in the GRAT, which is a taxable gift, is valued by assuming a certain rate of return on trust assets. This rate of return, which is set by the IRS for the month the trust is created, is called the “7520 rate.”

Two things must occur for a GRAT to successfully transfer wealth to the beneficiaries chosen by the Grantor.

First, the Grantor must survive the annuity term. If the Grantor dies during this term, the GRAT’s assets are returned to the Grantor and are includible in the Grantor’s estate.

Second, the GRAT’s assets must appreciate at a rate higher than the 7520 rate in effect for the month the GRAT was created. If the 7520 rate is low, it is more likely the appreciation rate for the GRAT’s assets will exceed the 7520 rate during the GRAT’s annuity term. The 7520 rate for August 2010 is 2.6%. If GRAT property does not yield a return in excess of the 7520 rate, the GRAT will ultimately collapse and the Grantor will simply get the trust property back.

Under current law, GRATs can be structured so that the present value of the remainder interest (the taxable gift) is very low or even zero. This allows a GRAT to be created with minimal or no gift tax liability for the Grantor, making the GRAT an efficient vehicle for transferring wealth to the next generation. Further, current law does not require a minimum term for the annuity term other than to be a term of “years” (plural), so that this term may be as short as two years. A shorter annuity term reduces the risk that the Grantor will die during the annuity term, and thus increases the likelihood that the gift strategy will be successful.

EXAMPLE: This month, 50-year-old Lindsay L. gives her trust an asset worth $500,000 that appreciates at 10% a year (some do still exist), retaining a five-year annuity at a value that will generate no gift tax. The annuity amount payable every year computes to be about 21.6% of the initial trust value. After five years, Lindsay’s beneficiary gets about $145,000 tax free, and Lindsay has the cash from her annuity payments, which is approximately equal to the value of her initial investment plus a rate of return of 2.6%, which is the August 2010 7520 rate.

Recent Legislation Proposed by Congress

Earlier this year, the House of Representatives passed several bills that included modifications to the Internal Revenue Code sections governing GRATs. These bills are H.R. 4849, H.R. 5486, and H.R. 5297. All of these bills have identical provisions for the proposed changes to GRATs. None of these bills have passed the Senate but could pass at any time.

Under the proposed legislation, there are three major changes to how a GRAT can be structured. First, a GRAT will be required to have a minimum annuity term of 10 years. Second, the value of the remainder interest must be “greater than zero.” Third, annuity payments must stay the same each year during the annuity term and cannot increase in subsequent years.

The effect of the proposed legislation is to make GRATs less efficient from a gift tax perspective. Because a gift will be required at the time of creation, a Grantor will be required to use a portion of his or her lifetime gift tax exemption or, if no exemption remains, pay gift tax. In addition, the 10-year term will increase the likelihood that the Grantor will die within the annuity term or that market volatility could adversely affect the value of the GRAT asset; in each case, effectively reducing the likely success rate of GRATs, especially for Grantors who are older. Finally, the requirement that the annuity payments must stay the same each year of the annuity term affects the ability to use lower annuity payments in early years of the trust, allowing more of the trust property to stay in the trust and grow for the benefit of the ultimate beneficiary.

In addition to the legislation above, there are several Congressional bills addressing the current uncertainty of the estate and gift tax laws. Some of these bills also call for changes to GRATs similar to those described above. The effective dates for these bills are varied, and some even provide for a retroactive effective date. While the feasibility of a retroactive effective date has been much debated and appears increasingly unlikely, there is a possibility that certain rules applicable to GRATs could be retroactive, possibly back to January 2010.

Next Steps: Take Advantage of Current Rules

The proposed bills, H.R. 4849, H.R. 5486, and H.R. 5297, all provide that the effective date of such legislation would be the date the bills are signed into law by President Obama. Thus, such legislation should only apply to GRATs created after the effective date of such legislation.

If you are considering a GRAT as part of your estate plan, it would be advantageous to consider creating the GRAT prior to the effective date of the proposed legislation to take advantage of the current, more favorable rules. Any member of our Wealth Planning section can assist you with the creation of a GRAT.

For more information regarding this matter, please contact Erin Tuggle at 512.236.2065 or etuggle@jw.com or Tom Groves at 214.953.5813 or tgroves@jw.com or any member of the Jackson Walker Wealth Planning section.