Making Good Use of GRATs in 2010

With the scheduled reinstatement of the Federal estate tax less than 4 months away, many taxpayers are taking advantage of the current low-interest-rate environment to use estate freezing techniques.  Estate freezing strategies are designed to limit future estate tax value of an asset to its current value (“freeze” the value) and allow future growth to pass to the taxpayer’s beneficiaries free of gift or estate tax.

Estate freezing techniques are usually used to supplement and enhance a solid gifting strategy.  Although there is no estate tax in 2010, there is still a gift tax of 35 percent.  Taxpayers are allowed to make annual exclusion gifts of up to $13,000 per done (doubled to $26,000 for married couples) without incurring gift tax.  But gifts in excess of the annual exclusion will chip away at the taxpayer’s $1 million lifetime exclusion.

Grantor-retained annuity trusts (GRATs) are popular estate freezing techniques.  GRATs are irrevocable trusts in which the grantor retains an interest that is a “qualified” interest under the Internal Revenue Code.  The grantor transfers property into the trust, which provides that the grantor will receive a fixed annuity on at least an annual basis for a number of years.  At the end of the trust term, whatever is left in the trust after the annuity has been fully paid will go to the remainder beneficiaries.  The “gift” is the theoretical value of the remainder, which is calculated using a statutory interest rate known as the 7520 rate.

GRATs are appealing in a low-interest rate environment because the 7520 rate is correspondingly low.  The value of the grantor’s retained interest is “frozen” at the value of the contribution plus the 7520 rate.  If the assets in the trust out-perform the 7520 interest rate (2.4 percent for September), the excess will be transferred to the remainder beneficiaries free of gift tax when the trust term ends.

The most aggressive GRAT strategy—and one which may soon be limited—is the “zeroed-out” GRAT.  By manipulating the amount of the retained annuity and the term of the trust, it is possible to set the GRAT up so that the value of the retained interest is technically worth nothing.  If the assets outperform the 7520 rate, all of the assets remaining in the trust at termination will pass to the remainder beneficiaries free of gift or estate tax. If the asset does not out-perform the 7520 rate, the assets are simply returned to the grantor at the end of the trust term and the grantor is in no worse position than if the trust had not been established.  Because zeroed-out GRATs have little downside and can yield big tax savings, they have become increasingly popular in recent years.

Many fear that we may be nearing the end of the era of the GRAT as an estate-planning tool.  President Obama’s 2011 budget projects almost $3 billion in savings from restricting the use of GRATs, and the Joint Committee on Taxation believes that restrictions on GRATs could raise almost $4.5 billion over 10 years.

In the current political environment, some believe that Democrats will curb the use of GRATs in order to raise revenue for other tax breaks or for spending.  And we have seen recent proposals to do just that.  For example, the Small Business Tax Relief Act of 2010 proposed by Rep. Sander M. Levin (D-MI) on July 30, 2010, would require 10-year minimum term for GRATs (compared with the current 2-year term).  Since all of the GRATs assets are included in the grantor’s estate if he or she dies within the term, extending the term from 2 to 10 years would make it much more likely that the full value of the GRAT will be subject to estate tax.  This increased “mortality risk” could curb the use of GRATs for gift tax savings.  Other bills have proposed to limit the use of zeroed-out GRATs.

If the proposals to curb the use of GRATs are ultimately successful, changes would probably not be effective until the date the proposals are signed into law.  Many taxpayers are seizing the current opportunity to take advantage of the low 7520 rate and establish GRATs before the law changes.  Others are shifting assets from existing GRATs into new ones with lower interest rates.  Those who are concerned with the reinstatement of the estate tax in 2011 should consider incorporating GRATs into their estate planning strategy.