A grantor retained annuity trust (GRAT) is an estate planning technique used to transfer wealth to the next generation with little or no gift tax consequence. Essentially, the Grantor transfers an asset that is likely to experience significant appreciation to a GRAT in return for annuity payments during the GRAT term. The annuity payments are computed using the initial fair market value of the assets and the Internal Revenue Code Section 7520 rate, the required rate for calculating a “qualified interest” under the Code. For a successful zeroed-out GRAT, the remainder interest has a zero value and the appreciation over the Section 7520 rate is effectively transferred to the next generation free of gift and estate taxes. Recently the Section 7520 rate has been historically low (within 2% to 3% from January to June of 2009 and currently 3.2% in November 2009), which has resulted in GRATs being an appealing planning opportunity.

 

The term of a GRAT is determined by the age of the Grantor and the type of asset being transferred. However, the preferred approach may be to keep the GRAT term short, two years being the shortest term. There are two primary reasons why a short-term GRAT is desirable. First, if the Grantor dies during the term of the GRAT, the trust assets required to produce the annuity payment, based on the Section 7520 rate at the time of the Grantor’s death, are includible in the Grantor’s gross estate for estate tax purposes. Thus, the benefits of a GRAT can be significantly reduced or completely lost as a result of the premature death of the Grantor. Secondly, short-term GRATs enable a Grantor to capture appreciation and pass it to the next generation at the end of the GRAT term without such appreciation being minimized by a subsequent period of depreciation. This last concept is accomplished through what is known as “Rolling” or “Cascading” GRATs, which utilize a series of short-term GRATs instead of one long term GRAT to leverage volatility.

 

Given the significant benefits of short-term GRATs and the loss of tax revenue that naturally flows from these benefits, the Obama Administration has targeted short-term GRATs in its “General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals.” Released on May 11, 2009, one of the Treasury’s proposals requires that a GRAT have a term of not less than ten years. The proposal addresses only the GRAT term and not the often controversial concept of creating a zeroed-out GRAT. This change, which would apply to trusts created after the date of enactment, would have the greatest effect on a Rolling GRAT strategy and Grantors with a life expectancy close to ten years.   

 

If a client has been contemplating a short-term GRAT, it would be prudent to create the GRAT now and avoid the potential effect of the Treasury proposal in the future. However, a GRAT’s usefulness will not totally be lost with the new Treasury proposal. For the younger clients, the increased risk associated with outliving a ten-year term is not as significant. Additionally, instead of transferring volatile assets to a series of short-term GRATs, Grantors may still effectively transfer assets that are projected to produce consistent appreciation over time. Finally, according to the Treasury proposal, a GRAT may still be zeroed-out and, thus, continues to be attractive for clients who have previously utilized most, or all, of their lifetime gift tax exemption.

 

While short-term GRATs may become a thing of the past, GRATs will continue to be a unique estate planning technique to pass wealth to the next generation.