The White House recently released its budget proposal for 2016, and one of the major aspects of the plan is to restrict the use and effectiveness of a common estate planning tool: grantor retained annuity trusts (GRATs). The administration has proposed limitations on the use of this estate planning technique in the past, but this is the first time that real change may be enacted in the way that people can use GRATs in their estate plan.
What is a GRAT?
A grantor retained annuity trust is an irrevocable trust that is designed to distribute assets from the trust with little to no gift tax attached. In order to properly establish a GRAT, the creator of the trust places assets into the trust that he cannot touch in exchange for receiving a small portion of those funds through annuity payments over a number of years. The distributions are kept just under the federal gift tax limit so that no federal taxes apply to the distributions.
At the end of the number of years that the GRAT is designed to run, anything that is left in the irrevocable trust is passed on to designated beneficiaries in either one lump sum or in trust. However, this only applies if the creator of the trust outlives the period of years that the GRAT is designed to run. If the creator dies before the GRAT ends, then the trust assets are considered part of the creator’s estate.
Why Restrict GRATs?
The main reason why the federal administration wants to restrict GRATs is because the tool allows for the creator of the trust and the designated beneficiaries to receive the assets in the GRAT without paying any or very little gift tax. The wealth is accumulated when the assets in the GRAT appreciate at a higher rate than the IRS rate during the month that the GRAT is created. Because the IRS rate has been at historic lows, this estate planning tool is becoming more popular than ever as a means to transfer wealth without being subject to federal tax liability.
Any appreciation of the trust funds in the first month above the IRS rate can be transferred to the creator or beneficiaries at little or no gift tax. Currently, it is one of the best options for low risk, high reward wealth transfers in estate planning unless the government passes the suggested changes to the GRAT process. The government has estimated that it is losing millions of dollars every year in federal gift tax because of the current structure and use of GRATs.
The current proposal on the table would eliminate the ability to “zero out” a GRAT where the remainder of the trust is theoretically worth nothing. The proposal would require that any remainder interest in the trust be subject to gift tax. In addition, a GRAT would be required to have a minimum term of at least ten years; however, existing GRATs would be grandfathered into the rule.