New legislation working its way through Congress could put a halt to a popular estate-planning technique. The crackdown limits the ability to avoid gift tax on transfers to a grantor annuity trust (GRAT). In particular, the proposed legislation no longer allows taxpayers to "zero out" a GRAT.
Strategy: When appropriate, set up a GRAT now. If Congress approves the new tax bill, it's likely the changes will take effect on the date of enactment.
Furthermore, the current economic conditions are favorable for GRATs.
Here's the whole story: With a GRAT, you (the "grantor") generally transfer a business interest to an irrevocable trust while retaining the right to receive fixed annuity payments for a term of years. At the end of the term, the remaining assets are distributed to the beneficiaries, usually the grantor’s children. Therefore, the assets are removed from your taxable estate.
When the GRAT is created, you're treated as having made a taxable gift equal to the present value of assets minus the value of the retained annuity. The present value is based on the prevailing Section 7520 interest rate. This rate, adjusted monthly, reflects interest rate changes. The lower the interest rate when the GRAT is set up, the lower the value of the remainder interest.
Currently, the rates are on the low side, encouraging transfers to GRATs. For instance, the rate for May 2010 was 3.4%. As recently as August 2007, the rate was 6.2%.
Note: If the grantor dies before the end of the trust term, the assets are included in his or her taxable estate. Typically, the GRAT will be set up to last a short period of time. With a short-GRAT term, the grantor has a better
Tax objective: Zero out the GRAT
It's important to minimize the value of the remainder interest under a GRAT. Reason: The value of the remainder does not qualify for the gift-tax exclusion ($13,000 for 2010). However, annuity payments for a GRAT can be structured so that there are no assets left in the trust at the end of the term.
This is accomplished based on the assumed Section 7520 rate. By “zeroing out” the GRAT, the grantor owes no gift tax at the funding.
Example: You establish a nine-year GRAT when the Section 7520 rate is only 3.4%. Then you name your daughter as the remainder beneficiary. Because you don't want to incur any gift tax, you need to retain an annuity of $654,201. At the assumed interest rate of 3.4%, the annuity will completely deplete the GRAT at the end of nine years.
However, assume that you fund the trust with $5 million of undervalued assets that grow by 8% a year instead of 3.4%. After nine years, $1,825,000 will pass gift-tax-free to your daughter.
Change in the works: Under the Small Business and Infrastructure Jobs Tax Act of 2010 (H.R. 5849), a GRAT would be required to last for a minimum of 10 years. What's more, the new legislation doesn't permit the value of the remainder interest to be reduced to zero. Thus, any transfer to a GRAT would constitute a taxable gift.
Under the current estate and gift tax rules, an individual may use his or her estate tax exemption to shelter the transfer from tax. But this would erode the future estate tax shelter for the individual. The estate tax exemption is scheduled to revert to just $1 million in 2011. (There is no federal estate tax in 2010 as the law stands now.)
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