The House of Representatives' passage of the Small Business and Infrastructure Jobs Tax Act of 2010 may limit high-net-worth individuals' opportunities to slash their estate and gift tax bills.
Though the idea of restricting grantor retained annuity trusts, or Grats, had been discussed previously, estate planners did not give it much chance of enactment. But in both his fiscal 2010 and 2011 budgets, President Obama gave warning to affluent individuals, suggesting that Grats be limited. And though Obama did not propose repealing Grats altogether, the Small Business and Infrastructure Jobs Tax Act's enactment would significantly rein in the benefits of Grats and, in some cases, make them useless.
The Senate Finance Committee is expected to take up the bill soon, and Congress' Joint Committee on Taxation projects that tightening Grats restrictions would raise $4.45 billion over 10 years.
Grats are a trust that lets an affluent person transfer assets to a beneficiary without paying gift tax. The grantor places assets in the trust and then takes back an annuity, which consists of the asset value plus a variable interest rate. If the trust earns money above and beyond the interest rate (which has been easy with the currently low rates), heirs get the assets tax-free when the trust's term expires, usually in two to three years. If the grantor dies before the trust's term expires, the entire asset is put back into the estate and can be taxed.
Under the proposed restrictions, "Grats are going to be far less beneficial for many," said Martin Shenkman, an estate planner in Paramus, N.J.
A key term of the Grat is that a grantor must survive for the full term of the trust. With the proposed bill setting a 10-year term for Grats, grantors would be forced to pair a Grat with insurance that would kick in and pay the estate tax in case the grantor dies, Shenkman said. Without insurance, the estate would have to pay the taxes on the Grat's assets if the grantor dies early.
David Handler, a partner in Kirkland & Ellis in Chicago, said the bill's enactment would change the use of Grats.
"If you're 60 or 70, 10 years is an eternity," he said. "Grats have been used as a way to capture shorter-term gains over a two-year period. If your client is forced to use a 10-year Grat, shorter-term gains can no longer be captured. It completely changes the Grat game."
Many advisers currently suggest that their clients put a single asset class, preferably a volatile one, in a Grat. If the assets do well, "the excess gross is out of the estate," Shenkman said. "The adviser would then immunize the Grat by taking the asset in the Grat out and sitting on cash inside the Grat for the remainder of the term. If the asset doesn't appreciate enough to make it worthwhile, there's no downside" since the client can just take the assets out when the term is over, no harm done, he said.
Another change if the bill is enacted is that Grats would no longer be able to have a zero value for estate tax purposes. Currently, advisers can structure the annuity payment back to the client so that the Grat has a zero value. The bill would require that a Grat have some value. But valuation is open to interpretation.
Could the value be $1? "That's the $64 question," Shenkman said.
Many industry observers believe that, as with a charitable remainder trust, the gift's value must be at least 10% of the value of the assets transferred into the Grat. If that were the case, Grats would become useless for affluent clients, since the losses would outweigh the benefits. "The days of big-dollar Grats could be ending," Shenkman said.
For advisers and their clients, the good news is that, while the bill remains just a proposal, clients have an opportunity to set up a Grat under the current rules. "If a client is considering a Grat, they should do it sooner rather than later because it may be their last chance," Handler said.
He also suggested doing a two-year Grat, instead of five, in order to lock in that term. If Grats are restricted, Handler recommends strategies such as grantor trusts, which can be used alone or in conjunction with a Grat.
He said he thinks a greater likelihood exists for changing the law now since the Senate is likely to approve some type of estate tax legislation. "Since there will be legislation already, it's easy to tack on new rules for Grats," he said.