Now that the House of Representatives has passed the Small Business and Infrastructure Jobs Tax Act of 2010, high-net-worth individuals will have fewer opportunities to slash their estate and gift tax bills when they pass down their wealth.

Although the idea of restricting grantor retained annuity trusts, or GRATs, had been tossed around previously, estate planners didn’t think it would become a reality.

But President Obama has given affluent individuals a reality check. In both his fiscal 2010 and 2011 budget proposals he suggested limiting GRATs. Although Obama did not mention repealing GRATs altogether, if the Small Business and Infrastructure Jobs Tax Act of 2010 is enacted the changes will significantly reign in the benefit of GRATs, and in some cases, make them useless for clients. The Senate Finance Committee is expected to take up the bill next week.

Martin Shenkman, an estate planner in Paramus, N.J., said that the administration is “so desperate for revenue” that it will have to pass the bill. Congress’ Joint Committee on Taxation expects that tightening the restrictions on GRATs will raise $4.45 billion over 10 years.

GRATs are a trust that allows an affluent individual to transfer assets to a beneficiary without paying a gift tax. A grantor places assets into the trust and then takes back an annuity, which consists of the asset value plus a variable interest rate. If the trust earns money above and beyond the interest rate (which has been easy with such low interest rates), the heirs receive the assets tax-free when the term of the trust ends, which is usually two to three years. If the grantor dies before the trust’s term limit is up, the entire asset is put back into the estate and can be taxed.

So, what will the new restrictions mean for your clients?

“GRATs are going to be far less beneficial for many,” Shenkman said.

One of the key terms of the GRAT is that a grantor needs to survive the full term of the trust. With the proposed bill calling for a ten year term on GRATs, clients will be forced to pair a GRAT with insurance that will kick in and pay the estate tax in case the client dies, Shenkman said. If there is no insurance, all the assets in the GRAT return back to the estate and are taxable when the grantor passes away.

David Handler, a partner at Kirkland and Ellis in Chicago, said if the bill becomes law it will change the use of the GRAT as we know it.

“If you’re 60 or 70 ten years is an eternity,” he said. “GRATs have been used as a way to capture shorter term gains over a two year period. If your client is forced to use a ten year GRAT, shorter term gains can no longer be captured. It completely changes the GRAT game.”

Currently, many advisors suggest their clients put a single asset class, preferably a volatile asset class, in a GRAT.  If the assets do well “the excess gross is out of the estate,” Shenkman said. “The advisor would then immunize the GRAT by taking the asset in the GRAT out and sitting on cash inside the GRAT for the remainder of the term. If the asset doesn’t appreciate enough to make it worthwhile there’s no downside,” since the client can just take their assets out when the term is over, no harm done, he said.

Another change that will take place if the bill is enacted is that a GRAT will no longer be able to have a zero value for estate tax purposes. Currently, advisors can structure the annuity payment back to the client so the GRAT has a zero value. The new proposal says that the GRAT has to have some value. But what that value is, is open for interpretation.

Could the value be $1? “That’s the $64 question,” Shenkman said.

Many industry observers believe that like a charitable remainder trust, the value of the gift will need to be at least 10% of the value of the assets transferred to the GRAT. If that is the case it would be useless for an affluent client to use a GRAT since the losses outweigh the benefits. “The days of big dollar GRATs could be ending,” Shenkman said.

The good news is that the bill still hasn’t passed into law giving clients the opportunity to rush to set up a GRAT under the current rules. “If a client is considering a GRAT they should do it sooner rather than later because it may be their last chance,” Handler warned.

He also suggested doing a longer GRAT- two years instead of five-in order to lock in that term. If GRAT restrictions are put in place, Handler has other strategies he recommends clients’ use, such as grantor trusts, which can be used alone or in conjunction with a GRAT.  

Although reigning in GRATs has been discussed for a long time, Handler said he thinks there’s a greater likelihood for a change in law now since there is a significant likelihood that the Senate will pass some type of estate tax legislation. “Since there will be legislation already, it’s easy to tack on new rules for GRATs,” he said.

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