GRATs and What They Can Still Accomplish
Grantor retained annuity trusts (GRATs) can have non-tax purposes, but they are basically tools to help wealthy clients avoid the estate tax. The person setting up the trust keeps an annuity for a term. The trust’s assets then usually pass to a family member.
The tax measurements turn on the amount of the annuity, the term of such payments, and the Section 7520 at the time the trust is created. The monthly Section 7520 rates in 2021 began at less than 1 percent in the early months and are still considerably less than 1½ percent as we write in mid-2022 (See, e.g., the June, 2021 rate in Rev. Rul. 2021-9). The gift tax measurement starts with the fair market value of assets used to fund the trust then subtracts the retained portion, the value of the retained annuity.
The basic idea is the gift tax exemption and consequences are measured up front, and those calculations may well say nothing will be received by the other family member at termination of the trust. In tax parlance, this is the “zeroed-out GRAT.” But as (if) the trust does better than the actuarial calculations would forecast, the assets passing from the trust to the other family member may eventually do so free of gift tax or estate tax.
The annual gift tax exclusion isn’t available in this type of trust because the children are getting a future benefit , not present interests. The generation-skipping exemption isn’t available up-front upon funding the trust, so choice of beneficiary is also important here.
The annuity amounts coming back to the grantor aren’t removed from the estate, and some advisors suggest targeting these amounts to pass to the surviving spouse via the estate tax marital deduction. For income tax purposes, the trustor generally ends up taxed on the income, so the children are sheltered from additional income tax until they get assets when the trust terminates.
The tax plan contemplates that the family member getting the assets when the trust terminates will outlive the trust. As we noted, the trust also needs to do better than the actuary would calculate, which may not be too difficult in what is still a low-interest rate environment. It is important to fund such trusts with assets expected to appreciate.
What Are the Downside Aspects?
The grantor (usually the parent) can’t get at the trust assets should he/she have some unanticipated needs. Also, there are legal fees, and possibly trustee fees if the bank handles the trust. Yet, from a transfer tax standpoint, it is also a fair statement that these trusts have relatively little downside in most cases.
Their timeliness, barring legislative thwarting, is also enhanced by the prospects that the family may have better uses for transfer tax exemptions, currently scheduled to revert to reduced levels after 2025, or earlier if the Biden administration succeeds in getting the transfer tax exemptions reduced.
From an income tax standpoint, there is the issue that a successful GRAT foregoes basis step-up to fair market value at death (Section 1014). Step-up at death is another benefit that may be available less often according to some discussions of legislative changes.
The proposals associated with President Biden would eliminate step up for “gains in excess of $1 million ($2.5 million per couple when combined with existing real estate exemptions) and making sure the gains are taxed if the property is not donated to charity.” (Fact Sheet: The American Families Plan, The White House, 4/28/21; whitehouse.gov). The GRAT structure sometimes emphasizes multiple trusts with varying terms of years, so that at least some of the trusts will see termination during the grantor’s lifetime, as necessary to achieve the estate planning goal.
What Can We Expect In the GRAT’s Future?
President Obama had proposals focusing on the GRAT, and there have been other legislative proposals that didn’t become law aimed at reducing the benefit of such trusts. Senators Bernard Sanders and Sheldon Whitehouse introduced the “For the 99.5 percent Act,” on March 25, 2021.
The bill would dramatically increase gift and estate taxes. It also has provisions focused on the GRAT, including requiring a minimum ten year term, and a maximum term of the life expectancy of the annuitant plus ten years. Also, the trust’s remainder interest must not be less than the greater of 25 percent of the fair market value of trust assets or $500,000. Reportedly, such provision is not to be retroactive.
Surprisingly, from this author’s perspective, we are seeing discussion that proposed major increases in the long-term capital gains tax for high-income taxpayers will be retroactive back to April 28, 2021, when President Biden “announced” this in addressing Congress. Even if Congress enacts major capital gains increases for some, whether it would approve the capital gains tax increase with a retroactive feature is another question.
Legislation aimed at taking away the gift/estate tax benefits for GRATs may well be forthcoming but we would not expect the GRAT benefit to be repealed retroactively.