Grantor-retained annuity trusts, or GRATs to those in the know on estate-tax jargon, have been planners' favorite estate planning tool for a while now (see "Get It While You Can," December 2008). But the clock is ticking on their usefulness.

What's going on? The House of Representatives passed the Small Business and Infrastructure Jobs Tax Act of 2010 on March 24 (H.R. 4849), which, if enacted, will make three changes to the GRAT technique. While these changes are less severe than a repeal, they can take a lot of the fun out of GRATs.

THREE TOUGH CHANGES

The Tax Act adds three requirements for a client's GRAT gifts to qualify for the favorable gift-tax treatment. Without this special treatment, clients would be taxed on the entire value of the assets given to a GRAT.

Here are the three requirements:

* The retained annuity interest must have a term that is not less than 10 years.

* The annuity (determined on an annual basis) may not decline during the first 10 years of the annuity term.

* The remainder interest must have a value greater than zero at the time of the transfer.

To set the foundation for this discussion, we'll start with a quick review of what a GRAT is and does. Then, we will explain each of these changes and describe how they will affect estate planning for your clients.

GRAT 101

Most advisors are likely familiar with GRATs. However, a quick overview of the technique and how it used to be used will make the explanation of the changes clearer.

Current tax rules include tough requirements for valuing certain transfers in trust of interests in property for fixed time periods (e.g., annuity interests and remainder interests). Bottom line, if your client makes a transfer to a trust to benefit a family member and retains any interest in the property transferred, the IRS will tax the entire value of the property involved (there is no reduction for the value of the interests the client retains). GRATs are one of the few exceptions to these tough rules, and the new law tightens the screws on them.

Before the proposed rule changes, a typical GRAT plan might look like the following hypothetical:

* Transfer $500,000 each to two different GRATs, each lasting for two years.

* Invest each GRAT in different volatile asset classes (this might not mean any change in the client's overall asset allocation, just a shift in the location of particular investments).

* Set up the GRATs to make high annuity payments of 50% or more to the client each year so that the present value of the gifts to the GRATs are zero for gift-tax purposes.

* If one GRAT realizes a substantial pop in value, swap in cash or Treasuries in exchange for the volatile securities, thus locking in or immunizing that gain inside the GRAT.

* Take the assets received for the annuity payments or the exchange and transfer them to new two-year GRATs and keep the plan rolling.

* Watch winning GRATs transfer huge value outside the client's estate with no gift-tax cost. Losers have no downside and are just cycled through more GRATs until they win.

How does a GRAT win? The value of the client's gift, for gift-tax purposes, is determined at the time of the initial transfer to the GRAT. If the GRAT property grows at a rate in excess of the interest rate mandated by the tax laws (the so-called Section 7520 rate), the excess appreciation passes to the remainder beneficiaries (kids, an insurance trust, etc.) without further gift-tax consequences to the grantor. Since today's interest rates are still at historic lows, it's easy for GRATs to win.

THE DETAILS

Let's see how the three new requirements will affect this process.

10-year GRATs. The retained annuity interest must now have a term not less than 10 years. This requirement substantially increases the mortality risk of using the GRAT technique. For older or infirm clients, that might eliminate GRATs entirely from their planning arsenal.

For many clients, GRATs will increasingly be paired with 10-year term-life insurance policies held in irrevocable life insurance trusts. This will be similar to the common pairing of charitable remainder trusts and life insurance inside a separate insurance trust. If the client dies before the 10-year GRAT ends, all GRAT assets are taxable in the client's estate, so the insurance can be used to pay the estate tax on those assets.