GReAT NEWS!
February 2001
Recent developments have made Grantor Retained Annuity Trusts (GRATs) an even more attractive wealth transfer device. Unless you believe that the estate tax is going away -- soon and for good - you'd be wise to consider "GRATting" now any property with significant appreciation potential.
As you may know, a GRAT returns to the donor the original principal, plus interest at the IRS assumed interest rate (currently 6.2%). This means generally that, to the extent the GRAT assets grow faster than the 6.2% assumed rate, all excess appreciation will pass to the next generation.
When GRATs were first sanctioned by the Internal Revenue Code 10 years ago it was thought that it was possible to "zero out" a GRAT. That is, the value of the annuity retained by the donor would equal the value of the assets transferred to the GRAT. But the IRS quickly took the position that the value of the retained interest had to be reduced by the actuarial value of the payments that would be made to a donor’s estate if the donor died during the GRAT term. Thus, the difference between the value of the GRAT assets and the now-reduced value of the retained annuity became a taxable gift. The older the donor the larger the chance the donor would die during the GRAT term and the larger the gift. Similarly, the longer the GRAT term, the larger the gift.
One way around the IRS attack on "zeroing out" was to introduce the spouse as a secondary annuitant. Because two lives were involved, the actuarial value of the payments made after both deaths would be extremely small even for the elderly. So this two-life approach quickly became the preferred way to almost "zero out" the gift under a GRAT.
The IRS did not like the two-life approach and said so in private letter rulings. But it was not until this past July that the IRS won the debate in the Cook case. In Cook, the Tax Court held that the second life should be ignored in determining the value of the gift. Bad news and not entirely unexpected.
All was not lost. In late December, in Walton, the Tax Court took up the question of whether a GRAT annuity payable to the donor or the donor's estate should be reduced in value for the actuarial value payable to the estate. The answer was a resounding NO. This means that it, indeed, is possible to zero out a GRAT. And the zero gift can be achieved regardless of the age of the donor!
What does this all mean?
- Any GRATs in the pipeline that have not been completed should be converted BEFORE SIGNING from two-life GRATs to one-life with any annuity payments due after the donor's death made payable to the donor's estate. This is the only way to avoid the clutches of Cook and to qualify for the benefits of Walton.
- "Zeroing-out" a la Walton means that, other than transaction costs, GRATs are now riskless. If the GRAT assets beat the IRS hurdle rate, wealth is transferred without any gift tax; if the GRAT assets fail to beat that rate, all the trust assets are returned to the donor. Pre-Walton, insufficient appreciation meant that any gift tax paid or exemption allocated was wasted. For older donors because the gift could be large, this was a real risk. Now, older donors can consider GRATs without concern about a failed gift. And because older donors are the least likely to be benefitted by estate tax relief, they should act now.
- Consider a so-called "ramp-up" GRAT. That's the GRAT that pays an increasingly larger annuity each year. The increase can be up to 20% per year. The benefit of this approach -- especially if the GRAT will be making any of the annuity payments in-kind -- is that it allows more of the assets to stay in the trust longer. That way if the assets take off in value, more will be in the trust to generate returns. While the ramp-up GRAT always has been available, pre-Walton the gift tax cost of this approach was more expensive. That's because backloading the payments also subjected them to the greater actuarial risk that the donor would die before the end of the GRAT term. Post-Walton the risk of donor death is no longer part of the equation.
Besides Walton, the timing appears right for GRATs. Interest rates have declined and the GRAT hurdle rate may drop in March 2001. Many stocks and other assets have taken a hit recently. Catching these assets on the rebound in a GRAT is an attractive strategy, especially when there is no gift tax cost to the gamble.
