Fiduciary Trust International

Tucked quietly into the “Small Business and Infrastructure Jobs Tax Act of 2010” (H.R. 4849), which was passed by the House of Representatives on March 24, 2010, are important changes to the rules governing grantor retained annuity trusts (“GRATs”).  The bill was referred to the Senate Finance Committee on March 26, 2010 and is not yet the law of the land.  However, it may soon be time to say “goodnight” to “zeroed-out” or “Walton” GRATs and “hello” to longer terms.   

Basic Rules of a GRAT

GRATs are powerful tools for transferring rapidly appreciating assets to one’s family members at little or no gift tax cost while still retaining an income stream from those assets for a specified term.   

An individual creates a GRAT by transferring assets to an irrevocable trust for a specified term of years or for the shorter of a fixed term or the grantor’s lifetime.  The grantor retains the right to receive an annuity from the trust during the specified period.  The annuity may either be a fixed dollar amount or a fixed percentage of the initial fair market value of the assets transferred to the trust.  The annuity is payable to the grantor regardless of how the trust performs and to the extent that income is insufficient, the annuity will be paid from principal.  At the end of the GRAT term, the remaining assets of the trust pass to the designated beneficiaries, usually the grantor’s family.  

Under ordinary gift tax rules, if an individual makes a gift to a trust and retains an income stream from the transferred property, only the value of the remainder interest (i.e. the right to receive assets following the expiration of the grantor’s interest) is deemed a gift for gift tax purposes.  The remainder interest is valued using a discount rate (commonly referred to as the “section 7520” or “hurdle” rate) in effect for the month that the transfer is made.  The hurdle rate for March and April 2010 is 3.2%  

Special rules apply when the remainder beneficiary is a member of the grantor’s family.  In that case, the value of the grantor’s retained interest is deemed to be zero, thereby resulting in a taxable gift of the entire value of the transferred property.  

However, if the grantor’s retained interest in the transferred property is a “qualified annuity interest” as defined in section 2702 of the Internal Revenue Code and the related Treasury Regulations, the ordinary rules apply and the value of the remainder interest is equal to the value of the transferred property less the present value of the grantor’s retained interest.  

In order for the grantor’s retained interest to be deemed a “qualified annuity interest”:

• The grantor must have the right to receive payments of a fixed amount or a fixed percentage of the trust assets no less than annually;
• The governing instrument must prohibit distributions from the trust to anyone other than the grantor;
• The trust agreement must clearly specify the trust term;
• Commutation (or prepayment) of the annuity interest must be prohibited by trust agreement;
•  Additional contributions must be prohibited by the trust agreement;
• The trust agreement must contain provisions to address incorrect valuation of trust assets and to provide for the adjustment of the annuity amount in a short taxable year and the last year of the trust; 
• Payment of the annuity interest with a note or other debt instrument must be prohibited by the trust agreement: and
• The trust must function exclusively as a GRAT from the first day of the trust’s existence.
  

If all of these requirements are satisfied, the value of the remainder beneficiaries’ interest is calculated as the value of the property transferred to the trust less the present value of the grantor’s retained interest using the hurdle rate in effect for the month the transfer was made.

Walton GRATs

GRATs have been around for quite some time but they became particularly attractive for many donors following the Tax Court’s decision in Walton v. Commissioner,  115 T.C. 589 (2000).  There, the Tax Court held that the value of the grantor’s retained interest could include the entire value of the annuity provided that the annuity was payable to the grantor during the term or to the grantor’s estate if the grantor died within the term.  With the issuance of Notice 2003-72, the Internal Revenue Service acquiesced in the Tax Court’s decision and the “zeroed-out” GRAT boom was born.

With a Walton or zeroed-out GRAT, the grantor’s annuity interest is calculated as that percentage of the transferred property necessary to create a remainder of zero.  In other words, the present value of the annuity payments over the GRAT term will equal or nearly equal the value of the assets contributed.  Thus, there is little or no taxable gift to the grantor’s family members.  If the assets used to fund the GRAT appreciate at a rate which exceeds the hurdle rate in effect at the time the transfer was made, all of the excess appreciation passes to the remainder beneficiaries free from tax. 

Beating the Odds

There are two keys to a successful GRAT:  (1) the trust property must appreciate at a rate that exceeds the hurdle rate in effect at the time the trust was established and (2) the grantor must survive the trust term.  With interest rates still near historical lows, GRATs present an attractive planning opportunity for individuals with high-yield or rapidly appreciating assets.  

For example, assume a 65 year old grantor were to transfer assets with a fair market value of $1,000,000 to a two year GRAT in March 2010.  In order to zero-out the remainder amount, the annuity payment is set at 53.265%.  Using the applicable hurdle rate of 3.2%, the value of the grantor’s retained interest is $999,999.93.  The value of the remainder interest (i.e. the taxable gift) is $0.07.  If the assets transferred to the GRAT grow at a 7% rate, $42,311.40 will pass to the remainder beneficiaries at the end of the two year term.  If the grantor dies within the two year term, the trust property reverts to the grantor’s estate.

The choice of property used to fund the GRAT is critical to the success of the transaction.  In the example above, a 7% interest rate was selected as a moderate rate of return.  If, however, the property used to fund the trust is expected to appreciate dramatically in value, such as pre-IPO stock, the tax-free gift to the remainder beneficiaries may be even more significant.   

To further increase the odds that a GRAT will be successful, the grantor may choose to structure a series of shorter GRATs (often with 2- or 3-year trust terms) rather than one long-term GRAT so as to minimize the risk that the grantor will die during the trust term.  An additional benefit to establishing a series of shorter-term GRATs is capitalizing on market volatility - some GRATs may fail but others are likely to succeed.

On the other hand, if the value of the trust property does not appreciate at a rate which exceeds the hurdle used in the initial calculations or if the grantor does not survive the trust term, the GRAT has “failed.”  However, a failed GRAT has no consequence other than the costs of creation of the trust, so it is a low-risk transaction.

New legislation proposes to change the rules

Since Walton, short term, zeroed-out GRATs have been viewed as particularly attractive wealth transfer vehicles.  In fact, in some cases, the results seemed almost too good to be true.  Ten years later, it seems that Congress is determined to put the brakes on aggressive planning with GRATs.  

The bill provides that the remainder interest in a GRAT must have a value greater than zero.  In other words, a GRAT must trigger a taxable gift.  The grantor may, as with other taxable gifts, choose to apply a portion of his or her lifetime gift tax exemption (currently $1,000,000) to the gift so that no actual tax need be paid unless the grantor has previously exhausted his or her lifetime gift tax exemption.   

Notably, the bill does not impose a minimum remainder interest requirement on GRATs.  Thus, assuming the bill (in its present state) becomes law, it may still be possible to create a GRAT with a nominal remainder interest as in the example above.  However, a final version of the bill or subsequent regulations may provide more explicit requirements and a minimum remainder interest requirement should not be ruled out.  If Congress does choose to impose a minimum remainder interest requirement, then it will be “night-night” for the Walton GRAT.

The bill also imposes a minimum 10 year term on GRATs.  A longer term increases the risk that the grantor will die during the term of the GRAT, thereby increasing the mortality risk and the possibility that transfer tax savings will be lost.  This may have serious implications for older donors who, in prior years, may have hedged their bets by creating a series of shorter-term GRATs rather than establishing a single longer-term GRAT.  

Act now to take advantage of current rules

The bill passed the House with a vote of 246-178 but it still must be approved by the Senate and signed into law by President Obama.  While we do not have a crystal ball, it seems likely that, if passed by the Senate, the bill will become law as these proposed GRAT restrictions were first introduced as a part of the administration’s 2010 budget proposal back in May 2009.

Suffice it to say, the bill appears to be on the fast-track - it was only introduced in the House on March 16, 2010, was passed by the House just eight days later and was referred to the Senate on March 25, 2010.  Therefore, now may be the time to act if you or your clients are contemplating entering into a GRAT.

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