On March 25, 2010, the House of Representatives passed the “Small Business and Infrastructure Jobs Tax Act of 2010” (H.R. 4849). Section 307 of this bill would impose restrictions on the use of a grantor retained annuity trust (GRAT), including a requirement that a GRAT have a minimum term of ten years. This is adapted from a recommendation in the Obama Administration’s budget proposals for fiscal 2011 (page 126) and is included as a revenue raiser to help offset some of the tax cuts in the bill. It is estimated to raise approximately $800 million over the first five years and $4.45 billion over ten years. The GRAT provision is the only transfer tax provision in the House bill.
The Use of GRATs in Estate Planning
A GRAT is often a useful and tax-efficient technique for transferring to children property that the transferor expects to appreciate in value. In taking advantage of this technique, the transferor (the “grantor” of the trust) creates an irrevocable trust, places property into the trust as a gift, and retains the right to a fixed payment each year until the GRAT term ends. Often the payments are described as percentages of the initial fair market value of the property transferred to the GRAT, and often those payments increase each year in order to reduce the amount of the taxable gift and to keep the largest amount of the appreciating assets in the GRAT as long as possible. The maximum increase allowed each year is 20 percent. After the GRAT term ends, the remainder interest typically passes to the transferor’s children or continues in trust for the transferor’s children. (A GRAT is not as effective as other techniques for passing property to generations younger than the transferor’s children and typically is not used for generation-skipping transfers because of possible adverse generation-skipping transfer tax consequences.)
The initial transfer to the GRAT is treated as a taxable gift of the remainder interest, equal to the current value of the property placed in the GRAT minus the calculated present value of the annuity payments retained by the transferor. That present value is calculated with reference to the term of the GRAT, the amount of the payments, and a discount or “hurdle” rate derived from market interest rates and published monthly by the Internal Revenue Service. Usually the term and payments are selected so that the transfer produces a small taxable gift.
An Example of the Mathematics of a GRAT
For example, for this month and next month, the published discount (hurdle) rate (often called the “7520 rate,” after the section of the Internal Revenue Code that sets forth the applicable valuation rules) is 3.2 percent. If someone places property with a value of $1,000 into a two-year GRAT and retains annuity payments of 47.7 percent at the end of the first year and 57.24 percent (a 20 percent increase) at the end of the second year, the calculated taxable gift is only 35 cents. If the property grows in value at an even annual rate of exactly 3.2 percent, which is what the valuation rules assume, the $1,000 will grow to $1,032 the first year, and the $477 annuity payment will leave a balance of $555. Then the $555 will grow to $572.76 the second year, and the $572.40 annuity payment will leave a balance of 36 cents to pass to the transferor’s children (which corresponds to the initial taxable gift of only 35 cents).
While no one would go to this trouble to give their children 36 cents, the GRAT can work powerfully when the property outperforms the published discount rate. For example, if the $1,000 asset grows at an annual rate of 10 percent rather than 3.2 percent, it will grow to $1,100 the first year, and the $477 annuity payment will leave a balance of $623, which will grow to $685.30 the second year, and the $572.40 annuity payment will leave a balance of $112.90 for the transferor’s children. That is $112.90 in the children’s hands that was treated as a taxable gift of 35 cents. Add some zeros and make it an initial transfer of $1,000,000, and the children receive $112,900 from a taxable gift of approximately $350. That leverage can be increased still further by using a more refined percentage for the first-year annuity payment, such as 47.716 percent, which produces $112,532 for the children with a taxable gift of less than $16. If the property increases in value by 20 percent per year, the children will receive approximately $295,000, and the taxable gift will still be less than $16. Not only are these very good upside results, the taxable gift of only $16 means that the downside – for example, if the property declines in value or grows at less than 3.2 percent – is very small. That is a distinct advantage of using a GRAT.
Significance of the House Action
Offsetting somewhat the benefits of a GRAT is the fact that the transferor must survive the GRAT term for those benefits to be realized. In general, if the transferor dies during the GRAT term, the amount that passes to the transferor’s children will be subject to estate tax. This is the main reason that most GRATs have a very short term, often just two years, although in recent years there has been more use of longer-term GRATs to lock in relatively low interest rates or values.
The principal change to the GRAT rules included in the House-passed bill would require a GRAT to have a term of at least ten years. This would increase the likelihood that the GRAT will “fail” and be subject to estate tax upon the transferor’s death. The House Ways and Means Committee Report (page 55) explicitly states that this change is “designed to introduce additional downside risk to the use of GRATs.”
The House bill would make two other changes to the GRAT rules, requiring that the annuity payment not be reduced from one year to the next during the first ten years and requiring that the taxable gift of the remainder interest at the time of the transfer have “a value greater than zero.’’ These rules would not particularly change the design of GRATs, but they would discourage improvisations that might otherwise reduce the effect of the mandatory ten-year term.
All in all, the restrictions included in the House bill would still permit the achievement of significant upside benefits from the use of GRATs, while limiting the downside risks. Such legislation would indeed increase the likelihood of the downside event of the transferor’s death during the GRAT term. Nevertheless, as long as the gift tax value at the time of the initial transfer is required only to be “greater than zero” and not any prescribed minimum amount, the downside from the use of the GRAT in that case would still be only the nominal taxable gift, which typically would use only a nominal amount of the transferor’s gift tax exemption.
Prospects for the House-Passed Bill
The House vote on the small business bill was partisan. Only four Republicans voted for it and only seven Democrats voted against it. It goes to the Senate now, where, as we have recently seen, it is hard to pass partisan legislation that often requires 60 votes to be considered. Many give the small business bill little chance in its current form. But the Senate Finance Committee could change the bill to give it more bipartisan appeal, or the Senate leadership could package the bill with other measures that make it harder to ignore. It is also possible that while the small business bill is pending the GRAT provision will be used as a revenue offset in other legislation, including legislation to provide clarity and stability for the estate tax itself.
Effective Date and Recommended Action
The GRAT legislation contained in the small business bill, like the earlier recommendation in the Administration’s budget proposals, states that it will take effect when the President signs it into law. There is no known inclination to change that effective date at this time, but that does not guarantee that the effective date will not be changed. For example, the Senate Finance Committee could report out the bill and change the effective date to the date of its report, allowing no time to react. In any event, if the Senate passes this bill, which is viewed by the Administration and congressional leadership as an important economic initiative, the President might sign it very quickly. Even if the Senate makes changes to the House-passed bill, the House might promptly approve the changes and send the bill to the White House.
While such developments are difficult to predict, the fact remains that this action in the House takes a theoretical proposal to limit GRATs one significant step closer to enactment into law.
GRATs are not for everyone, and there is probably no reason why this pending legislation should encourage someone to create a GRAT who would not otherwise do so. However, for those for whom a GRAT at this time makes sense or those who have a pattern of creating GRATs from time to time, it may now be important to consider acting sooner rather than later to finalize the creating and funding of a GRAT or GRATs. Moreover, even if such restrictions on GRATs become law, there are other planning opportunities available for those for whom age or health suggest a greater likelihood of dying during a ten-year term.
The lawyers of the McGuireWoods Private Wealth Services Group are available to help with questions about GRATs and other estate planning techniques.
For more background on GRATs, see the article “Overview of Grantor Retained Annuity Trusts (GRATs)” by Dennis I. Belcher and the technical outline “Grantor Retained Annuity Trusts (GRATs) and Sales to Grantor Trusts” by Ronald D. Aucutt.
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