The prospect of a government attack on a popular estate-planning technique, referred to as a grantor retained annuity trust, or GRAT, has been a topic of much discussion among wealth advisors and tax professionals over the past several months. President Obama drew attention to the technique in his 2011 budget proposals, and provisions targeting “short-term” and “rolling GRAT” techniques have been included as revenue offsets in legislation passed by the House. Although these anti-GRAT provisions have not survived in the Senate, a bill co-sponsored by 10 senators (relating to an extension of COBRA premium assistance) was introduced at the end of June containing provisions targeting GRATs, the most significant of which requires GRATs to have a minimum term of 10 years. So it appears that some form of this anti-GRAT legislation will eventually become law. Further, any such legislation would most likely be effective upon enactment, as provided in the prior bills.  Heres how a GRAT works and why a minimum 10-year requirement is so significant. The basic format of a GRAT can be described as follows: An individual, referred to as the “grantor,” transfers assets to a trust and retains an annuity from the trust for a term of years. To avoid a gift upon formation of the GRAT, the retained annuity is designed to equal the value of the assets transferred based upon the term of the trust and an assumed growth rate over the term set forth by the Treasury Department. This rate is fixed at the time of formation of the GRAT and is referred to as the “7520 rate.” The 7520 rate is named after the applicable provisions of the Internal Revenue Code and fluctuates monthly based on current market yields on government obligations. This rate essentially provides a “hurdle” which is necessary for the trust assets to overcome in order for the GRAT to be effective.  If the total return on trust assets outperforms the 7520 rate hurdle, the excess value passes to the next generation free of estate and gift tax. By its nature, the GRAT is a “grantor trust,” which means that the grantor remains responsible for any income taxes generated by the assets of the trust. Therefore, the assets held in the GRAT itself are not eroded by income and capital gains tax making it easier to outperform the hurdle. If asset performance remains flat or the assets decline in value, the GRAT simply unwinds and the grantor is left in the same position as if the GRAT had not been implemented.  But the GRAT technique does have its Achilles heel. If the grantor dies prior to the expiration of its term, the GRAT is unsuccessful and the assets, including any income and appreciation, remain subject to estate tax (which returns in 2011 with a $1 million exemption and 55% rate). To reduce this mortality risk, estate planners have recommended short-term GRATs, having two to four year terms, for elderly individuals or those with health concerns. In recent years, private wealth advisors have been promoting a variation of the GRAT technique referred to as the “rolling GRAT,” which is a series of consecutive short-term GRATs (generally two years each). Under this variation, death during the overall rolling GRAT period (which, by way of example, may be ten years comprised of five consecutive two-year terms) will not undermine the benefits of any of the prior two-year GRATs that have already terminated. Additionally, the rolling GRAT technique avoids the risk of market fluctuations and captures exceptional performance during any two-year period without being diluted by weaker performance during any other two-year term, since each GRAT operates independently. As noted above, the new legislation undermines the rolling GRAT technique by requiring a minimum ten-year term for any new GRAT created. Any proposed short-term GRAT should therefore be implemented as soon as possible given the current momentum of the anti-GRAT legislative proposals.  The rolling GRAT technique may have already been rendered obsolete. Since there is the strong likelihood that legislation could be passed in the near future cutting off such a plan midstream, it would not be recommended to implement such a plan now. Alternatively, depending upon the age and health of the grantor, individuals may want to consider a mid-term GRAT having a term of four to seven years. To mitigate the adverse consequences of death during the term, some form of life insurance may be an option. Additionally, there are other estate planning techniques that may be suitable under these circumstances.  Long-term GRATs remain viable and can be a powerful tool for effective wealth transfer planning, especially where interest rates are low and asset values are depressed but expected to rise. By their nature, long-term GRATs benefit more significantly from a favorable 7520 rate then their short-term GRAT counterparts. The 7520 rate has been relatively low over the past few years making long-term GRATs more attractive. Since January 2008 the 7520 rate has ranged from 4.4% to 2%, and is currently 2.6% for the month of August. Only three years ago, in August 2007, the 7520 rate was as high as 6.2%. A rolling GRAT plan may not be as effective as a long-term GRAT during a period of rising interest rates, since the hurdle rate would increase with each new two-year GRAT. Additionally, a short-term GRAT demands larger annuity payments while a long-term GRAT requires smaller payments. Where cash is unavailable and the assets in the GRAT are illiquid or difficult to transfer each year in satisfaction of the annuity payments, a short-term GRAT or rolling GRAT may not be practical.  A long-term GRAT can further leverage the benefits of a low hurdle rate by having increasing annuity payments. For example the annual payments to the grantor can be structured to increase by up to 20% each year. This would generally result in relatively low payments in the beginning thereby allowing the GRAT’s assets to grow more effectively in the earlier years without being depleted by the annual payout to the grantor.  To maximize the benefits of any estate planning technique, whether a GRAT or otherwise, one must take into account the age and health of the grantor, the value of the assets involved, current interest rates and overall tax and financial position, and consult a tax professional prior to implementing any plan.  Seth R. Kaplan is a partner in the Tax and Wealth Transfer Group of Bilzin Sumberg Baena Price & Axelrod LLP in Miami, Fla.  Prepare For The Return Of The Estate Tax  Comments are turned off for this post.
Congress seems likely to clamp down on this wealth transfer technique. Here's how you can still use GRATs.