As we go to press, the transfer tax arena remains in a muddle, characterized by continuing uncertainty. The confusion extends not only to future tax rates and exemption amounts, but also to the present. Will the estate and generation-skipping transfer taxes remain suspended for all of 2010, or will there be, as the Administration has proposed, a reinstatement of prior law, with a permanent $3.5 million exemption and 45% maximum rate? Moving to the gift tax, how sure can we be that the current 35% rate will remain in place through December 31? Whatever the outcome, one thing is certain: Congress will continue to look for more revenue. To this end, legislation is already pending to limit two well-established wealth transfer strategies, the grantor retained annuity trust and the family limited partnership.
To GRAT or Not to GRAT? — Grantor Retained Annuity Trusts
Grantor retained annuity trusts (GRATs) are low-hanging fruit for the current Congress in its ever-more-desperate search for revenue. The House Ways and Means Committee estimates that imposing three simple restrictions on GRATs would raise more than $5 billion over 10 years. And as of early August, legislation to do just that had been introduced into Congress no fewer than seven times within a seven-month timeframe. As proposed, this legislation would be effective no earlier than the date it is signed into law.
Significantly, the GRAT is a creature of statute, expressly permitted under Section 2702 of the Internal Revenue Code. Thanks to their tax-favored status, GRATs became very popular with sophisticated estate planners and their clients, particularly in the current low interest rate environment, where they work exceptionally well. Indeed, it is the success of GRATs as a wealth transfer strategy that is leading Congress to seek to limit them.
Under current law, a GRAT allows the donor to transfer substantial wealth to the next generation with minimal or no gift tax cost. The mechanics are simple: Assets are transferred to a trust, from which the grantor receives large annual annuity payments, typically for a two-year term. At the end of the term, whatever remains (the “remainder”) is transferred, either outright or in trust, to designated beneficiaries, typically children.
As noted above, the key to the current popularity of GRATs is the current low interest rate environment. As of August, the federally set interest rate used to value a remainder interest for gift tax purposes (the Section 7520 rate) was a very low 2.6% — and was not expected to rise substantially in the near future. At these current low interest rates, GRATs can be structured so that the value of the remainder interest, for gift tax purposes, is close to zero. Because the gift tax is based on the value of the remainder interest, minimal gift tax is due on the transfer. Moreover, if, during the trust term, the assets used to fund the GRAT appreciate at a rate greater than the current Section 7520 rate, substantial value can be transferred to the remaindermen at no additional gift tax cost.
There is a wrinkle in the GRAT strategy, however. If the grantor dies before the GRAT terminates, part or all of its value will be included in his or her gross estate. The longer the term of the GRAT, the greater this mortality risk. The proposed GRAT limitation language pending in Congress would increase mortality risk by requiring that every GRAT have a minimum term of at least 10 years. It also would require the GRAT remainder interest to have a value greater than zero at the time of funding and would bar decreasing GRAT payments during the first 10 years of the GRAT term.
Over the years, planners have devised vehicles, such as sales to defective grantor trusts, which in certain circumstances may achieve some of the same objectives as a GRAT. Unlike GRATs, however, these strategies are not expressly permitted by the Internal Revenue Code. As a result, the rules governing their use are not as clear, creating a kind of transaction risk not present with a GRAT.
As we go to press, there is still a window of opportunity for those considering a short-term GRAT. Although legislation has been proposed, it is generally proposed to be effective only for GRATs funded after such legislation is signed into law. (And one version of the proposed legislation would be effective only for GRATs funded after 2010.) Clients considering a GRAT should consult now with their estate planning attorneys to see whether this vehicle makes sense for them.
For years, family limited partnerships have provided a vehicle for pooled investment management, facilitating the preservation of legacy assets as well as the financial education of the entire family. And, although transfers of partnership interests are taxable gifts, the gift tax consequences of those transfers are favorable under current law, which takes such factors as lack of control and restrictions on transfer into account when computing fair market value of a partnership unit.
Complex legislation currently pending in Congress would change the landscape considerably by severely limiting the use of such valuation discounts. As proposed, the change in law would be effective for transfers of partnership interests completed after the legislation is signed into law. This suggests that clients holding existing partnership interests may want to talk with their estate planners now about making substantial transfers while favorable gift tax treatment is still available.
With so much in flux, is the wisest strategy to stand still until Congress makes up its mind? The answer depends on your individual situation — and your appetite for risk. For further updates on pending legislation, visit us at northerntrust.com/wealth.