Published in the NH Bar News, January 16, 2009 (http://www.nhbar.org/publications/display-news-issue.asp?id=4908)
Estate planners are constantly looking for ways to assist their clients with transferring wealth from senior generations to junior generations with little or no gift tax consequence. In addition to the standard methods of annual gifting, Grantor Retained Annuity Trusts (“GRATs”) have become increasingly attractive to clients looking for ways to maximize their gifting opportunities.
A GRAT is an irrevocable trust established by the grantor (senior generation) for the benefit of a beneficiary(ies) (the junior generation). Pursuant to the terms of the trust, the grantor retains an income interest for a term of years. The income interest will be equal to the Internal Revenue Service (“IRS”) Section 7520 rate in effect as of the date of funding. This rate is often referred to as the “hurdle rate.” Upon termination of the trust, to the extent trust assets have appreciated at a rate greater than the hurdle rate, such assets will pass to the remainder beneficiaries free from federal gift tax.
To make this more concrete, consider the following example. Father (grantor) establishes a GRAT for a two year term and names Son as beneficiary. The prevailing hurdle rate at the time of the GRAT funding is 5%. At the end of year one, Father receives his annual income payment from the trust. Again, at the end of year two, Father takes the second annuity payment. At that point, the trust terminates and Son receives any remaining assets in the GRAT. The idea here is that if the assets placed in the GRAT can appreciate at a rate higher than the threshold rate (5 percent in this example), then all excess appreciation will inure to the benefit of Son without gift tax consequence to Father.
In fact, the benefits can be even greater than indicated above because the Treasury Regulations allow the grantor to increase the annuity payment by 20 percent each year. This means that annuity payments will be smaller in early years, leaving more assets in the trust to grow.
The rub here is that in order for the GRAT to accomplish its objective, the assets in the trust must grow at a rate in excess of the hurdle rate. The hurdle rate is tied directly to the Applicable Federal Rate and changes on a monthly basis as established by the IRS. The Section 7520 rate went into effect on May 1, 1989 at 11.6 percent. In the nearly 20 years since its inception, the 7520 rate has fluctuated depending on the prevailing Applicable Federal Rate. The average 7520 rate for 2008 was 3.8 percent.
In December 2008 the IRS announced that it would drop the 7520 rate from 3.4 percent to 2.4 percent for January 2009. This rate is the lowest it has been since the inception of the 7520 rate in May 1989. Because the threshold rate has dropped so dramatically, GRATs have increasingly become a useful estate-planning tool. As such, if a grantor were to establish a GRAT in January 2009, any appreciation in the trust assets over 2.4 percent would pass free of federal gift tax to the remainder beneficiaries. Since 2.4 percent is a relatively low threshold, even in today’s market, clients are becoming more interested in this estate planning vehicle.
For the client who does not need to live on the annual annuity payment, one might consider establishing a series of “rolling” GRATs. With a rolling GRAT, the grantor establishes the initial GRAT for a term of years (assume 2 years). At the end of year 1, when the Grantor receives his first annuity payment, he then takes that payment and funds a second GRAT. When the first GRAT terminates at the end of year 2, the grantor takes his second annuity payment and funds a third GRAT. This can go on as long as the grantor desires. One advantage of rolling GRATs is that if an investment loses money or the growth of trust assets fails to surpass the 7520 rate, the grantor can start over with another GRAT. A series of rolling GRATs will continue to transfer assets free of gift tax to the beneficiaries so long as the asset growth exceeds the 7520 rate.
Given the historically low Section 7520 rate (currently 2.4 percent), an extraordinary planning opportunity exists for those clients who are looking for additional ways to transfer assets to their children with no gift tax consequence. So long as the trust assets grow at a rate exceeding the 7520 rate, use of GRATs can have exceptional outcomes on wealth transfer with no gift tax consequence.
Craig Standish is an attorney in the Trust and Estate Department at McLane, Graf, Raulerson & Middleton, P.A. He can be reached at craig.standish@mclane.com. The McLane Law Firm is the largest full-service law firm in the State of New Hampshire, with offices in Concord, Manchester and Portsmouth, as well as Woburn, Massachusetts.