The tumultuous investing climate in recent months requires planners to help their clients reconsider their securities holdings, asset allocations and asset locations, including trusts. Trusts require careful planning during difficult market periods. Perhaps no trust is more sensitive to the effects of volatile markets than the grantor-retained annuity trust (GRAT).

These trusts are used to leverage gifts that your clients make to their children. GRATs can also afford a high degree of flexibility for investments, helping clients reach investment goals without increasing the value of their estates. This can be done while retaining a client's existing asset allocation. Now that we're in a highly volatile market, your clients can use GRATs to gain from stock upsurges and then reduce their exposure to downside volatility by substituting less volatile securities within GRATs.

Assets placed within GRATs are essentially gifted to them. These trusts run for a stated number of years. During those years your clients retain the right to receive annuity payments (retained annuity).

After the end of the GRAT's term, your client's children receive the assets left in the trust after the payment of the annuity amounts. Because GRATs are characterized as grantor trusts for income tax purposes, your client is taxed on any income earned by the trusts during its term.

A GRAT substantially discounts for tax purposes the value of your clients' gifts to their children. The annuity payments that your clients receive from these trusts return to them all of the principal they have placed within them, along with a stated rate of return on that principal, based on current interest rates. Any returns above that stated amount will inure to the benefit of the children without triggering any gift tax.

WHY NOW?

Effectively, the tax law provides that if your clients receive their invested principal and the legally mandated rate of return, no value is attributed to any investment growth beyond that rate of return. This point has several important implications.

First, the fact that GRATs repay grantors' gifts to them makes GRATs easier to sell to clients than other plans in which the clients lose access to and control over their money. Secondly, as interest rates remain historically low, this is an opportune time for clients to use GRATs because the rate of return that must be paid to the client is based on these low rates. Hence, the threshold that assets within GRATs must exceed to inure to the benefit of the client's children is also quite low.Finally, if you believe asset values are depressed and thus likely to appreciate substantially during a GRAT's term, now is an ideal time to fund GRATs with securities.

The higher the annuity percentage paid to your clients from the GRAT, the lower the value of the gift to the trust for tax purposes. Most GRATs are structured with high enough annuity payment rates to reduce the GRAT to a gift value of nearly zero. The longer the period during which the GRAT makes annuity payments to your clients, the lower the eventual value of the gift to the remainder beneficiaries (their children) for gift-tax purposes. However, if your clients don't survive the specified GRAT term, the entire principal of the GRAT is pulled back into their estates.

SHORT OR LONG?

The bottom line is that the most tax-efficient GRATs are short-term (two-year) GRATs that are designed to capture upside market volatility. With these short-term GRATs, clients can take the annuity amounts they receive each year and gift them into a new GRAT.

Have your clients set up a couple of specific asset-class GRATs—say, one funded with the emerging-markets component of their existing portfolio and another funded with their micro-caps. If there is a big upswing in one of those volatile asset classes, gains are captured outside of your client's estate. Since the principal and interest rate provided under IRS Code Section 7520 is repaid to your clients and thus included in their estate, as payments come out of existing GRATs, your clients can roll those funds into new GRATs. Hence, the industry name for this technique—rolling GRATs.

Some advisors believe that, because of the current low interest rates, the best course of action is to lock in rates with long-term GRATs. They believe that locking in low rates over the long term is better than using the short-term rolling GRAT strategy because when each new GRAT is funded in future years, the interest rate at the time will likely be higher. However, experts have demonstrated that the rolling GRAT strategy tends to be more advantageous, even if interest rates rise.