|March 13, 2014|
Previously published on March 12, 2014
A recent article in Bloomberg estimates that certain estate planning techniques such as the grantor retained annuity trust (GRAT) has cost the US federal government over US$100 billion since the year 2000. The proof of these tax savings is calculated based upon filings which are made with the US Securities and Exchange Commissions (SEC). As an example, the Bloomberg article highlights casino magnate Sheldon Adelson who has given at least US $7.9 billion to his heirs by using a series of GRATs using calculations based on SEC filings, all of which will save him and his estate roughly US $2.8 billion in US tax.
The Bloomberg article also discusses the popularity of the GRAT by detailing other individuals who have used GRATs, such as Facebook founder Mark Zuckerberg and Goldman Sachs CEO Lloyd Blankfein. Although GRATs created by billionaires illustrate pronounced tax savings and make for interesting headlines in newspapers, the GRAT is a very common and effective estate planning technique for regular US citizens seeking to reduce their US federal estate and gift tax.
At a very basic level, a GRAT provides an alternate means to transfer property to selected beneficiaries with minimal US federal gift tax owed, and results in substantial tax savings. With the US federal estate and gift tax currently taxed at a rate of 40%, the tax savings can be tremendous.
A GRAT is created when an individual transfers assets into an irrevocable trust but retains the right to fixed payments for a fixed term of years (‘annuity payments’). When the fixed term of years ends, the assets in the trust are held for the benefit of the selected remainder beneficiaries to the exclusion of transferor.
The remainder interest is a completed gift for US federal gift tax purposes, so the value of the remainder interest will reduce the transferor’s lifetime exemption amount, which is currently US $5.34 million. Under current law, however, the GRAT can be set up so that the actuarial value of the remainder interest is close or equal to zero (‘a zeroed-out GRAT’). Under a zeroed-out GRAT, the annuity is structured so that the present value of the annuity payments is equal to the value of the assets which were transferred to the trust plus a required rate of growth. The required rate of growth is determined by prescribed interest rates, which are currently at historic lows - a lower rate is better. A zeroed-out GRAT provides substantial benefit because the transferor should not be required to reduce his or her US federal gift tax lifetime exemption amount. The benefit is that all income and appreciation in excess of the annuity accumulates for the benefit of the remainder beneficiaries.
Another benefit provided by a GRAT is that the transferor pays US federal income tax on the trust income and gains. This is because a GRAT is a grantor trust for US federal income tax purposes. This allows the transferor to effectively make additional tax-free gifts to the GRAT, which enhances the shifting of family wealth to the remainder beneficiaries.
One negative aspect of the GRAT is that in the unlikely event that the transferor passes away during the term of the GRAT, the entire value of the trust property would be included in his or her estate for US federal estate tax purposes. This risk can be minimised through the use of a short term GRAT or multiple short term GRATs. If the individual does not outlive the GRAT term, he is in most respects no worse off than he would have been before creating the GRAT from a US federal gift and estate tax perspective.
Some US politicians have voiced a genuine concern over income and economic inequality in society, which has resulted in new proposed laws designed to increase US taxes. Since Barack Obama became President in 2009, some US lawmakers have put forward proposals to limit the effectiveness of various estate planning techniques, including the GRAT. For instance, recent proposals include (i) creating a minimum term for GRATs, (ii) prohibiting zeroed-out GRATs, (iii) limiting the grantor’s ability to pay US federal income tax on income generated from GRAT assets, and (iv) limiting the length of time a GRAT and other trusts can exist without the trust or beneficiaries paying US federal estate, gift, or generation-skipping transfer tax.
With the current interest rates at historic lows, and current proposals from US politicians trending towards reducing the effectiveness of the GRAT, if you want to take advantage of the GRAT planning, you should consider doing so immediately.