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Low Rate Creates an Ideal Opportunity for Grantor Retained Annuity Trusts

May 31, 2012

The Internal Revenue Service (the “IRS”) recently announced that the Section 7520 Rate (the interest rate used by the IRS to determine the present value of term interests, life interests, annuities and remainder interests) will be 1.2% for transfers made in June and July. This is a historic low for the Section 7520 Rate and provides an excellent opportunity to consider a grantor retained annuity trust (a “GRAT”).

A GRAT is an irrevocable trust that pays its grantor annual annuity payments over a fixed term of years. A GRAT is appealing to those persons who have already consumed their exemption amount, wish to preserve a portion of their exemption amount, or wish to “freeze” the value of their current estate. Under current law, a GRAT can be structured with a short term (e.g., two years), which substantially reduces the mortality risk that the trust assets will be returned to the person creating the GRAT (its grantor) if he or she fails to survive the trust’s term. In addition, a GRAT currently can be formed with no taxable gift (i.e., “zeroed-out”) if the fair market value of the property transferred to the GRAT equals the present value of the annuity returned to the grantor based upon the applicable IRS assumed interest rate.

In the event the grantor dies prior to the expiration of the GRAT term, the trust property is includible in the grantor's estate. However, the grantor's estate is in no worse a position than if the GRAT was not created because there was no gift tax payable upon creation of the GRAT. The same is true if the GRAT assets do not produce the expected income and/or growth; all of the GRAT property may need to be paid out to the grantor in the form of the annuity.

The historic low interest rate substantially enhances the overall effectiveness of a GRAT. If the GRAT assets outperform the Section 7250 Rate (1.2%), the GRAT will have assets remaining after paying the annuity to the grantor, and those assets will pass transfer tax-free to the grantor’s family at the end of the trust term.

The following example illustrates the benefits of a GRAT:

Example 1: The grantor transfers $1,000,000 of assets to a GRAT having a five-year term and earns a 6% annual return on the assets contributed to the GRAT. At the end of the five-year term, approximately $169,890 would pass tax-free to the grantor’s family. If the term of the GRAT were increased to ten years instead of five years, the projected remainder would increase to approximately $384,220. As noted above, there would be no gift made upon the creation of the GRAT, because the annuity payments that must be made back to the grantor are sufficiently high so that actuarially they will equal the initial value of the trust property.

The following example illustrates the benefits of the current low Section 7520 Rate when compared to an increased Section 7520 Rate:

Example 2: Assume the same facts as in Example 1 (the grantor transfers $1,000,000 of assets to a GRAT having a five-year term and earns a 6% annual return on the assets contributed to the GRAT), however, increase the Section 7520 rate from 1.2% to 3%. At the end of the five-year term, approximately $107,340 would pass tax-free to the grantor’s family; if the term of the GRAT were increased to ten years instead of five years, the projected remainder would increase to approximately $245,660. As you can see, the current low Section 7520 Rate results in a significant increase in the amount that may pass tax-free to the grantor’s family.

With interest rates at historic lows, now is an excellent opportunity to consider a GRAT.

Please contact your estate planning attorney at Wolff & Samson PC (see below) if you have questions or would like more information regarding GRATs.

Tax, Trusts and Estates Department at Wolff & Samson PC:

David L. Schlossberg
Member of the Firm
Phone (973) 530-2010
dschlossberg@wolffsamson.com

Sean M. Aylward
Member of the Firm
Phone (973) 530-2105
saylward@wolffsamson.com

Roxanna E. Hammett
Member of the Firm
Phone (973) 530-2039
rhammett@wolffsamson.com

Carl B. Levy
Of Counsel
Phone (973) 530-2035
clevy@wolffsamson.com

Christopher DeFilippis
Associate
Phone (973) 530-2046
cdefilippis@wolffsamson.com

Farah N. Ansari
Associate
Phone (973) 530-2044
fansari@wolffsamson.com