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What's great about GRATs? Here's a look at how and why estate planners use grantor retained annuity trusts and what impact a new treasury department proposal might have on GRATs.

Given the uncertainty of the estate tax applicable exclusion amount--currently at $2 million this year and next, $3.5 million in 2009, unlimited in 2010, and $1 million in 2011 and thereafter--practitioners must use flexible planning techniques. One such technique is the grantor retained annuity trust ("GRAT'), which has grown in popularity due in large part to its ability to minimize gift taxes.

Recently, the treasury department issued proposed regulations that offer guidance for trust and estate practitioners on GRATs. here's a primer on the use of GRATs as a flexible wealth transfer technique and an assessment of the likely impact of the proposed regs.

Overview of the technique

The basic objective of a GRAT is to shift from the grantor to the remainder beneficiaries the appreciation generated by the contributed property during the GRAT term. This can be accomplished for little to no gift tax cost when the GRAT is structured to return to the grantor all of the contributed property (plus a stated rate of return) during the term. This technique is called "zeroing out" the GRAT.

Here's an easy example to illustrate both the benefits and risks of a GRAT. The grantor creates a two-year term GRAT by contributing a race horse worth $1 million dollars. The terms of the GRAT provide that the grantor is to receive two payments of $500,000 in year one and year two, plus the required stated rate of return on the property contributed at 6 percent. Shortly after creation, the horse runs in and wins the Kentucky Derby--a purse of (we'll say for hypothetical purposes) $100 million dollars.

At the end of year one and two, the GRAT makes annuity payments to the grantor of $500,000 (resulting in all of the value contributed) plus the stated rate of return (assume $60,000 per year). At the end of the term, the balance remaining in the GRAT ($98.8 million) passes to the remainder beneficiaries pursuant to the terms of the GRAT. Note, if the horse doesn't win (or at least show in) the Kentucky Derby, the GRAT will not generate the stated rate of return and the technique will fail.

Another (more common) example would be contributing pre-IPO stock to a GRAT. If the IPO occurs as planned, there could be significant appreciation. If the IPO was delayed, all the stock might be returned in kind to meet the annuity payments, and there would likely not be enough appreciation to surpass the stated rate of return (also referred to as the hurdle rate).

Additionally, if some portion or all of the stock was distributed back to the grantor in the form of in-kind annuity payments, the appreciation will be in the hands of the grantor when and if the IPO does mature. Thus, the key to a successful GRAT technique is to contribute property that has a high likelihood of appreciation at the right time.

Advantages and disadvantages of GRATs

The obvious benefit of using a GRAT is that if an appreciating asset is contributed, wealth can be transferred with little to no gift tax cost if the GRAT is zeroed out.

One drawback is that this is a gifting technique (even if no gift tax liability is generated) and the remainder beneficiaries receive the grantor's carryover basis--which means that if the property is sold by the remainder beneficiaries in the GRAT, capital gains will be generated on the appreciated property. A second drawback is that GST exemption cannot be easily applied, so the technique is not typically used for generation-skipping objectives.

A final drawback, which is the subject of the new rule, is that if the grantor does not survive the GRAT term, the full value of the GRAT apparently will be included in the grantor's estate. The proposed regulations aim to clarify this survival and estate-inclusion rule.

Proposed regulations

The proposed regulations provide that only the portion of the GRAT necessary to satisfy the remaining annuity payment (after death) will be included in the decedent's estate. Thus, if the annuity payment is $10,000 and the stated rate of return is 6 percent, property necessary to satisfy the remaining annuity payment would be $166,666.

While this rule may have a positive impact on some GRATs by consuming less than all of the property included in the decedent's estate, this development is probably not helpful for a zeroed out GRAT. The reason: to zero out the GRAT, the grantor must increase the annuity payment. The greater the annuity amount, the less value left in the trust and the lesser the value of the gift.

Applying the proposed regulations to a zeroed-out GRAT, it becomes apparent that it will take a significant portion of the GRAT property to produce a high annuity based on the stated rate of return. Expressed another way, the amount includable in the decedent's estate to produce the annuity payment will likely be the balance (if not more) of the GRAT. Thus, the proposed regulations do not offer much relief from the old rule that the entire GRAT is includible if the grantor dies during the term.

Note, however, that while the proposed regulations may not help with zeroed out GRATs, they certainly do not diminish the value of previous GRAT planning.

David A. Berek <> of Credit Suisse Securities (USA) LLC is chair of the ISBA Trusts and Estates Section Council.
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Title Annotation:grantor retained annuity trusts
Author:Berek, David A.
Publication:Illinois Bar Journal
Date:Aug 1, 2007
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