by David M. Cordell, Ph.D., CFA, CFP®, CLU, and Thomas P. Langdon, J.D., CFP®, CFA
David M. Cordell, Ph.D., CFA, CFP®, CLU, is director of finance programs at the University of Texas at Dallas.
Thomas P. Langdon, J.D., CFP®, CFA, is professor of business law at Roger Williams University in Bristol, Rhode Island.
As science fiction author Isaac Asimov once proclaimed, “The only constant is change, continuing change, inevitable change, that is the dominant factor in society today. No sensible decision can be made any longer without taking into account not only the world as it is, but the world as it will be.” Financial advisers, particularly those who recommend tax planning techniques to clients, need to pay special attention to this advice. A case in point: proposed regulatory changes in grantor retained annuity trusts give a new reason to consider life insurance.
Grantor Retained Annuity Trusts
A technique used by estate planners to prevent future appreciation on property from being subject to estate tax is the grantor retained annuity trust (GRAT). When a GRAT is created, a taxpayer transfers property to a trust that will return a specified amount to the taxpayer each year during the trust term. Upon termination, any assets that are left in the GRAT are transferred to a third party (the remainder beneficiary). If properly structured, using a GRAT can result in the transfer of future appreciation on the trust assets to the remainder beneficiary with little or no transfer tax consequences. The transfer tax savings result from the valuation approach specified in I.R.C. Sec. 2704, which sets the value of the gift equal to the value of the property that is transferred to the GRAT minus the present value of the payments made to the taxpayer over the GRAT’s term.
GRATs have become increasingly popular in recent years, in large part due to the declining interest rate environment—as interest rates decline, so does the gift tax on the transfer. The primary risk a taxpayer faces when creating a GRAT is mortality risk—the possibility that he or she will not survive the term of the trust. If the taxpayer dies before the trust does, the assets in the trust are subject to estate tax in the taxpayer’s estate. To limit potential exposure to estate taxation, taxpayers frequently use short-term (two-year) GRATs to minimize mortality risk. While declining gift taxes and short-term GRATs provide clients with a reason to celebrate, a cash-strapped president and Congress looking for spending money have had reason to mourn … until now.
What Lies Ahead in the GRAT Beyond?
In his fiscal year 2011 budget (page 126), President Obama proposed changes to the rules governing GRATs, and they were included in the Small Business and Infrastructure Jobs Act of 2010 passed by the U.S. House of Representatives March 25. The changes include: (1) a minimum 10-year term for GRATs, (2) a requirement that annuity payments made by the GRAT may not be reduced from year to year during the first 10 years, and (3) a requirement that the taxable gift resulting from the creation of a GRAT be greater than zero. The committee report of the House Ways and Means Committee stated that these provisions were “designed to introduce additional downside risk to the use of GRATs.”
Of course, the joy of putting obstacles in the path of tax planners was not the ultimate objective of this legislation. The Congressional Budget Office estimated that this change would add $800 million to congressional coffers in its first five years, and $4.45 billion over a 10-year period.
By requiring a GRAT to have a minimum term of 10 years, Congress increased the mortality risk associated with using this estate planning technique. Everyone has a greater probability of dying over a 10-year period than over a shorter one, such as two years. With the increased probability of death comes an increased risk that the appreciation in the asset that was transferred to the GRAT will be subject to the estate tax when the taxpayer dies, which can disrupt the smooth transition of wealth from the taxpayer to his or her intended beneficiaries. Obviously, this change reduces the benefit of a GRAT.
Upon first reading, the third requirement imposed by the legislation—that the taxable gift upon creation of the GRAT be greater than zero—also appears to be of concern, but the legislation does not provide any guidance on how much greater than zero the taxable gift has to be. Even if a 10-year term is required, it is possible to structure a GRAT so that the gift tax value is $1, thereby allowing the taxpayer to efficiently transfer growth and appreciation on the property, provided, of course, that he or she survives the term of the GRAT.
As of early July, the Small Business and Infrastructure Jobs Act of 2010 passed by the House has not yet been passed by the Senate, but proposals to change the GRAT rules are alive and well there. On June 24, Senator Bernie Sanders (I–Vermont), and three Democratic senators proposed estate tax legislation (retroactive to January 1, 2010) that included, among other changes to current law, a 10-year minimum term provision for GRATs. Whether the Senate acts on this new estate tax proposal or follows its year and a half precedent of ignoring the issue remains to be seen. One thing, however, seems certain—if estate tax legislation is brought to the floor, the 10-year minimum term requirement for GRATs will be discussed, if not adopted, by the Senate.
Given the new proposal by Senator Sanders and his colleagues, the effective date of changes to the GRAT rules (if adopted) is now uncertain. Under the House bill, the effective date for the legislation would be the date the president signs the bill. Senator Sanders and his colleagues seem to prefer retroactive application of the law to pick up some lost revenue that resulted from the temporary repeal of the estate tax under EGTRRA 2001. While some commentators, relying on the Small Business and Infrastructure Jobs Act passed by the House, have suggested that “now is the time to GRAT,” following that advice may result in unintended consequences if the Senate version is adopted.
To paraphrase another fiction writer, Dr. Seuss, the question for planners is, “Would you, could you, do a GRAT?” The Obama administration and the congressional sponsors of the GRAT rule changes hope you will respond appropriately, “I would not, could not, do a GRAT. I do not like them, Uncle Sam.” Failing to use a GRAT when appropriate, given the needs and objectives of a client, however, plays right into Uncle Sam’s hand. Giving assets away and triggering a gift tax on the full value of the property, or, worse yet, keeping the property and transferring both the property and the appreciation to the intended beneficiaries at death and subject to an estate tax, lines Uncle Sam’s pockets at the expense of your clients’ heirs. Even if the proposals to change the GRAT rules are adopted in their current form, GRATs should still be considered whenever a client wishes to transfer growth on an asset to younger family members while retaining the principal value for the taxpayer.
A GRAT Use of Life Insurance
As noted earlier, the primary change in the GRAT proposal is the new 10-year minimum term requirement, designed to “introduce additional downside risk to the use of GRATs,” to discourage planners and taxpayers from using them, and thereby to raise $4.45 billion in new tax revenue over the next 10 years. The 10-year minimum term increases the mortality risk for the taxpayer by increasing the likelihood that he or she will die during the term of the trust, thereby subjecting the value of the trust to estate taxation. To seasoned planners, this increased risk should not pose a planning obstacle. The solution is merely a variation on what planners have been doing for years in other contexts—if Uncle Sam wants to increase our exposure to mortality risk in the planning process, we can hedge that risk perfectly with life insurance.
Upon setting up a GRAT, a taxpayer could purchase a 10-year term policy (or, if multiple GRATs will be used over time, a permanent life insurance policy) that will cover estate tax costs if the taxpayer dies before the GRAT dies. To ensure that Congress cannot tax the life insurance in addition to the GRAT assets, the policy should be held outside of the taxpayer’s estate. This criterion can be easily accomplished by using an irrevocable life insurance trust, or by having the policy owned by the ultimate beneficiaries of the estate; thus, any shrinkage in the estate caused by the inclusion of the GRAT is replaced by the receipt of the death benefit from the life insurance.
When choosing the appropriate death benefit on the policy, keep in mind that it is not the current value of the assets transferred to the GRAT that matters, but rather the appreciated value of those assets that may be brought back into the estate if the taxpayer does not survive the GRAT term. If the taxpayer outlives the GRAT, not only has the appreciation on the asset been transferred on a gift and estate tax free basis, so has the death benefit on the life insurance.
As with most aspects of life, change in financial planning is constant, and planners must be ever-diligent to the complex cat-and-mouse game that we play with elected representatives and faceless bureaucrats in Washington. This truism is especially so in the area of estate planning because of its legal complexity and the deep pockets it protects. While we may not know with certainty what the future holds, to make sensible recommendations to clients we have to look beyond the world as it is and anticipate what it will be.
