In Low Interest Rate Environment Grantor Retained Annuity Trusts Remain Attractive
The May interest rates that the Federal government requires taxpayers to use when engaging in various gifting transactions were recently released. One of the rates, the section 7520 rate, has been set at 1.8% which is quite low. To put the rate in perspective, in March 2010, the section 7520 rate was 3.2%.
A low section 7520 rate is particularly favorable for clients interested in creating a Grantor Retained Annuity Trust (“GRAT”). A GRAT is an irrevocable trust that an individual (the “Grantor”) creates and funds with assets that are expected to appreciate over time. The Grantor retains the right to receive an annuity from the GRAT which is computed by applying the section 7520 rate to the value of the assets transferred to the GRAT.
A GRAT can be structured so as not to result in a taxable gift or require the use of any portion of the Grantor’s Federal exemption (a “zeroed-out GRAT”). If the contributed property appreciates or produces income that outpaces the section 7520 rate, that growth or appreciation remains in the GRAT. If the Grantor survives the GRAT term, the assets remaining in the GRAT pass to the beneficiaries named in the trust agreement free of gift tax. If the income or growth is less than the section 7520 rate, the annuity payments to the Grantor will exhaust the GRAT assets and nothing will pass to the remainder beneficiaries; however, the Grantor is in no worse financial position. Thus, there is a clear advantage to using the lowest section 7520 rate possible when calculating the Grantor’s annuity.
Example 1: The Grantor creates a three-year zeroed-out GRAT at a time when the section 7520 rate is 3.6% and transfers $2,000,000 of assets to the GRAT. Each year an annuity payment of $715,231 must be made to the Grantor. If the assets produce income at 5% and also appreciate by 5%, then approximately $300,000 of assets would remain in the GRAT at the end of the term. This amount would pass to the Grantor’s children with no gift being made and no portion of the Grantor’s Federal exemption being used.
Example 2: Assume the same facts as Example 1, except the Grantor creates the GRAT in May 2016 when the section 7520 rate is 1.8%. The annual annuity would be $690,798 and at the end of the term, approximately $381,778 would pass to the Grantor’s children (an increase of $81,778 from the amount passing in Example 1).
Example 3: Assume the same facts as Example 2, except that the Grantor is confident that the assets will generate more growth over the long term, so the Grantor extends the GRAT term from 3 years to five years. This means that the annuity payment that must be paid to the Grantor each year would be $421,860, significantly less than in Example 2. Correspondingly, more assets would be left in the GRAT to appreciate and produce growth. At the end of the term, approximately $657,443 would pass to the Grantor’s children (an increase of $275,665 from the amount passing in Example 2).
As you can see, a GRAT can be a very useful estate planning technique for those assets that you believe will appreciate in the future at a rate greater than the current section 7520 rate of 1.8%. Even if the assets do not appreciate as anticipated, you would be in no worse a position than if you had not created the GRAT because there was no gift or use of your Federal exemption.
A popular use of GRATs is to create a series of short-term GRATs (“rolling GRATS”)” under which you re-contribute the annual annuity payments to a new short-term GRAT. The benefits of rolling GRATs are three-fold: first, the potential for positive investment returns in the GRAT is maximized and the risk of negative economic performance is reduced; second, the risk of estate tax inclusion due to the death of the Grantor prior to the expiration of the term is reduced; and third, the remainderman will have earlier access to the appreciation in the GRAT. A potential downside to rolling GRATs is the risk of an increase in the section 7520 rate, which would reduce the overall effectiveness of the future GRATs.
There are a number of reasons to create a GRAT now. First, the current section 7520 rate is very low; just this past February it was 2.2%. Given the expected rise in interest rates and future inflation, the section 7520 rate will most likely increase in the future. Second, the President’s budget proposal has taken aim at GRATs and would greatly reduce their usefulness by mandating a minimum term of ten years (eliminating the benefit of rolling GRATs) and an actuarial remainder of at least 25% of the value of the assets contributed to the GRAT (eliminating the use of zeroed-out GRATs). A long term GRAT of ten years or more is generally less desirable for two reasons: (1) such a long term subjects the GRAT assets to exposure to more economic fluctuations (negative returns offset positive returns reducing the overall rate of return of the GRAT) and (2) if the Grantor dies during the term, the GRAT assets will be includible in the Grantor’s taxable estate.
If you would like to discuss whether the creation of a GRAT to take advantage of currently low 7520 rate is an appropriate estate planning technique for you, please contact any of the attorneys in our Tax or Trusts and Estates Groups.