A grantor retained annuity trust ("GRAT") is an estate planning technique that can be very effective for the right type of wealthy client. However, potential federal legislation that is now being considered may affect the tax planning benefits of GRATs. Therefore, if a you have considered establishing a GRAT, now may want to move up your timetable because short-term GRAT’s may be short lived.
What is a Short Term GRAT?
A GRAT is a trust designed to transfer future appreciation to others without incurring gift or estate tax on that growth. When a GRAT is established, the person who sets up the GRAT (the grantor) transfers property to the GRAT.
The GRAT annually pays the grantor a percentage of the initial fair market value of transferred assets for the term of the trust. The percentage is based on the federal interest rate for the month the GRAT was funded (2.8% per year for a GRAT funded in July 2010). The assets originally transferred to the trust, plus interest, are thus returned to the grantor.
Any growth in excess of the applicable annual interest rate is accumulated in the trust and, so long as the grantor is living at the end of the trust term, passes to children (or other beneficiaries) free of gift or estate tax.
Short term GRATs therefore offer the potential for transfers to the next generation without tax cost because they can be "zeroed-out" for gift tax purposes, meaning there is no taxable gift when the GRAT is established and assets are transferred to the GRAT
Generally, when GRATs are zeroed-out they are designed to last for only a short period of time, often two or three years. Proposed legislation could require a ten-year minimum term for a GRAT. Since a GRAT only “works” if the grantor survives the GRAT term, establishing a minimum ten year term will increase the mortality risk associated with GRATs. Additionally, under proposed legislation the value of the remainder must result in a taxable gift, thus forcing the grantor to use some of his or her $1,000,000 lifetime gift tax exemption when the GRAT is established and property is transferred to the GRAT.
The House of Representatives has passed this proposed legislation, and the Senate is considering it. The changes would become effective upon enactment.
What to Consider
If you want to implement a short-term GRAT that is "zeroed-out" for gift tax purposes under current law, you must establish a GRAT before the federal legislation is enacted. In addition to avoiding a current taxable gift, creating a GRAT now under the existing rules avoids the mortality risk of a longer-term GRAT.