AGrantor Retained Annuity Trust is a popular estate-planning tool used by business owners for wealth preservation. When utilized properly, a GRAT can assist in transferring wealth on a nearly tax-free basis.
New IRS proposed regulations, however, could significantly alter this form of trust.
“The proposed regulations impose tough valuation standards that work indirectly to undermine the transfer tax benefits that certain grantor trusts have traditionally been able to provide,” says Mouris Behboud, principal-attorney at law for Gumbiner Savett Inc.
Smart Business spoke with Behboud about GRATs, the benefits they provide and what effects the IRS regulations are likely to have.
What is a Grantor Retained Annuity Trust?
A Grantor Retained Annuity Trust is an irrevocable trust that pays an annuity to its grantor for a specified period of time. At the end of the term of the GRAT, the remainder passes to the grantor’s descendants or other beneficiaries. If the rate of return on the GRAT assets exceeds the applicable Internal Revenue Code Section 7520, wealth passes to the remainder beneficiaries upon termination of the grantor’s annuity interest with the grantor having made a small or no taxable gift. The use of GRAT has become one of the most powerful estate-planning techniques since the enactment of IRC Section 2702 in 1990.
What type of benefits does this technique provide as an estate-planning tool?
A properly formed GRAT achieves the possible transfer of wealth on a tax-free or nearly tax-free basis. It is an excellent technique when the trust assets are likely to appreciate substantially and rapidly. For example, the owner of a closely held business who plans to sell his business may consider using a GRAT. The value of the business interest contributed to the trust is reduced using valuation discounts for lack of control and marketability. When the business is sold within the term of the GRAT, the trust receives the proceeds of the sale, which may be substantially higher. In effect, the GRAT has provided for a significant transfer of wealth to the business owner’s descendants or the remainder beneficiaries.
Another popular form of GRAT is a zeroed-out GRAT, also known as a Walton GRAT, which is created without generating a taxable gift. Simply put, this involves dividing the original principle amount by the rate of the appropriate factor for the corresponding term of years and Section 7520 in order to compute an annual payment that results in an annuity having a present value equal to the original trust principle.
When forming a GRAT, what considerations should be taken into account?
One of the critical considerations in forming a GRAT that practitioners usually face is the length of the term of the GRAT. The benefits of using a short-term GRAT are twofold. First, a short-term GRAT minimizes the possibility that a year or two of poor performance of the GRAT assets will adversely impact the overall effectiveness of the GRAT. A series of short-term GRATs funded with volatile securities perform better than a single long-term GRAT. In turn, the remainder beneficiaries receive significantly higher value using a series of short-term GRATs.
The second advantage of using a short-term GRAT is the reduced exposure to the risk that the grantor will die during the term.
On the other hand, when funding annuity payments is likely to be a problem because of insufficient cash flow, a long-term GRAT may provide a good solution. An additional advantage of using a longer-term GRAT is in a low interest rate environment when one can lock in the low interest rate applicable at the beginning of the term.
How do the new IRS-proposed regulations affect this form of the trust?
On June 7, 2007, the IRS published proposed regulations to IRC Section 2036 and 2039 regarding the inclusion of GRAT assets in the estate of the grantor when the grantor does not survive the term of the trust. These new proposed regulations appear to be part of the IRS’s larger strategy to curtail the use of grantor trusts and other similar techniques used as vehicles for minimizing transfer tax liability.
Under the proposed regulations, the amount includible for estate tax purposes is not based on the present value of the future stream of annuity payments. Rather, it is the amount of trust corpus that is necessary to yield the annuity payment based on the IRC Section 7520 rate in effect at the date of death or alternate valuation date.
In light of these proposed regulations, how important are timing issues?
These proposed regulations are especially not favorable for short-term GRATs. Since a short-term GRAT has a high annual annuity payment intended to zero-out the taxable gift, the result of the formula under the proposed regulations can significantly exceed the total value of the assets in the GRAT. This problem is magnified if the GRAT assets significantly outperform the IRC Section 7520 rate. IRC Section 7520 provides valuation tables for annuity, any interest for life or a term of years and remainder or reversionary interests.
MOURIS BEHBOUD is principal-attorney at law for Gumbiner Savett Inc. Reach him at firstname.lastname@example.org or (310) 828-9798.