By February the Internal Revenue Service's Code 7520 rate had fallen to 2%, its lowest point in over a decade, and by April it had risen to only 2.6%.
That historically low rate is making grantor retained annuity trusts an attractive strategy for wealthy clients looking to increase and pass on their assets to their children in a tax-efficient manner.
Advisers with wealthy clients take note: The trusts are proving a luminescent silver lining in the darkest of economic clouds.
"A GRAT is a way of giving assets to someone else at a reduced gift-tax cost," said Barbara H. Cane, an estate lawyer in Nyack, N.Y. "The idea is to squeeze as much value into giving as possible. GRATs are complicated, which is why they're only used by the high-net-worth, but they're useful tools because you're giving at a discount."
Anyone who wants to pass money to heirs can give $13,000 to each one in outright gifts each year. But if they want to pass on more to a single heir, for example, now is an ideal time to do so through a grantor retained annuity trust, observers say.
Grantors are required to receive a certain income from the trust. That income is based on interest rates, and when rates are low, trust owners can draw less income, leaving a larger core of assets as principal.
That principal and any interest on it can appreciate tax-free over the life of the trust, which is then gifted to heirs.
This would not work if the IRS 7520 rate were high.
For example, if it were 10%, the market typically would not perform well enough to cover the amount the trust holder would be forced to draw out as income, leaving nothing extra to heirs. In January 1989, for instance, the rate was 10%, and a two-year grantor retained annuity trust of $1 million would pay out $576,202 a year, leaving just $1.22 for heirs, Cane said.
"If the grantor has to pay himself more, the investments in the trust have to perform better in order to generate money for the heirs," she said. This is called the "hurdle rate."
Cane said estate planners invariably use modeling software to calculate the likely outcome of grantor retained annuity trusts. "If we didn't have access to software, no one would do it."
When the IRS 7520 rate is low, as it is now, investment returns on the principal are far more likely to exceed the income to the trust holder. A 2.6% hurdle rate may be tough to beat in today's market, but when the market comes back, it should be easy to outperform.
Since the interest or principal appreciation are not direct gifts from a wealthy grantor to a beneficiary, but rather simply interest earned by a trust that ostensibly exists to provide the wealthy parent with an income, the excess can pass on to heirs with no gift-tax liability.
At the same time, the asset is removed from the trust holder's estate, lowering estate taxes down the road.
An example of a grantor retained annuity trust in action: One of Cane's clients set up such a trust in December with $400,000. Cane set the term of the trust for five years, because she expects the market to recover in that time.
The client's goal is to give her daughter, who will graduate from college by then, a small chunk of money to help her get started in life.
According to Cane's modeling software and December's 7520 rate of 3.4%, the client will draw an annual income of $77,000, and if Cane's assumptions are correct that the market will appreciate by 10% over the next four years, the client's daughter will end up with a taxable gift of $30,000, or almost $21,351 after taxes.
Grantor retained annuity trusts tie up money for years at a time, so the first step is to figure out how much a high-net-worth client or couple needs to live on, so they will not be stuck if the market slumps.
Todd Richman, vice president and grantor retained annuity trust expert at AllianceBernstein Wealth Management in New York, calls this amount the client's "core capital," which must be calculated when forming a grantor retained annuity trust strategy.
Since the grantor will not be spending funds outside the core capital, observers say the trust is a tax-efficient way to get the excess out of an estate while the grantor is still alive.
Wealthy investors do not have to take the annuity payments themselves. They can use another kind of trust, a charitable lead trust, to pay the annuity to a charity and pass on the remaining principal to their heirs.
More common is a charitable remainder trust, which pays the client an annuity and passes on what is earned to a charity when the trust ends. One of Cane's clients, an elderly widow with no heirs, converted a massively appreciated stock paying a 2% dividend to bonds paying 5% or 6%. If she had sold the stock she bought 30 years ago outright, the capital gains would have been huge.
Cane helped the client create a charitable remainder trust. The trust could sell the stock without immediate capital gains liability and use the proceeds to buy bonds.
Though the tough economic climate is debilitating stock prices and forcing the Federal Reserve Board to keep interest rates low, grantor retained annuity and charitable remainder trusts provide advisers with a great reason to call their wealthy clients before the market picks up.