Future of Popular Estate-Planning Tool May Hinge on Election

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By Allyson Versprille

May 27 — The outcome of the presidential and congressional elections this November could impact the use of one of the most popular and powerful tools for transferring wealth to descendants, while at the same time bypassing estate and gift taxes.

The technique, called a grantor-retained annuity trust (GRAT), has been successfully used by several of the wealthiest people in America, including Facebook Inc. Chief Executive Officer Mark Zuckerberg; Lloyd Blankfein, CEO of Goldman Sachs Group Inc.; and Las Vegas Sands Corp. CEO Sheldon Adelson, who has given at least $7.9 billion to his heirs while legally avoiding about $2.8 billion in gift taxes since 2010 (243 DTR G-2, 12/18/13).

Using a GRAT, the assets that are expected to appreciate are transferred to the trust for a retained annuity plus interest to the grantor over the duration of arrangement. When the trust expires, any remaining assets left after the annuity is paid out are transferred tax-free to the beneficiaries.

For transfer tax valuation purposes, the amount of the taxable gift is the fair market value of the property transferred minus the value of the grantor’s retained annuity interest.

The Obama administration has been advocating for modifying the transfer tax rules for GRATs in its annual budget proposals since 2010. Earlier proposals called for requiring a minimum term for GRATs, but the most recent 2016 and 2017 proposals have included additional modifications.

“Whether those proposals see the light of day really depends on the presidential election and the outcome of the congressional election,” said Mark Watson, a partner at Weaver LLP, an accounting firm based in Fort Worth, Texas.

If Democratic front-runner Hillary Clinton wins, it is anticipated that many of her policies will be in line with the current regime. Such is the case when it comes to the estate tax. Like the Obama administration, Clinton has expressed a desire to restore the parameters that were in place in 2009. That would reduce the tax exemption threshold for estates to $3.5 million—$7 million for a married couple—with no adjustment for future inflation and would increase the top tax rate from 40 percent today to 45 percent.

Watson said he expects that in a Clinton administration it would be reasonable to presume there would be a push for proposals limiting GRATs, similar to what has been recommended over the past six years. However, the ultimate success of those proposals would be determined by the congressional race, he told Bloomberg BNA in a May 24 interview.

Importance of Congressional Results

“Unless we get a Democratic-controlled Congress, I don’t think you’ll see those changes actually get through,” Watson said.

Winning back the Senate is an attainable goal for Democrats, who would need to gain four or five seats (depending on which party wins the presidency because a vice president breaks a tie). Twenty-four of the 34 seats up in 2016 are currently held by Republicans, and seven of the seats are in states that voted for Obama twice. Winning the House of Representatives, where Democrats would need to pick up 30 seats, is harder to imagine.

On the flip side, Watson said in a situation where presumptive Republican presidential nominee Donald Trump wins the election, the proposals on GRATs would likely disappear. Trump's tax plan involves repealing the estate tax, which is more in line with removing restrictions on GRATs, Watson said.

‘The Right Price Tag.'

Ron Aucutt, a partner with McGuireWoods LLP, said he doesn't necessarily view the current administration proposal on GRATs as being partisan-driven, though he did say it is more likely that the proposals would continue to exist in a Clinton administration as opposed to a Trump one.

Even with a divided government, which the president faces today, proposals limiting GRATs could be enacted, he said in a phone interview May 25.

“It’s easy to say that because the president is a Democrat and Congress is controlled by Republicans that those proposals don’t make any difference, but that’s not always true,” Aucutt said.

He compared the GRAT proposals to the basis consistency proposals that were written into the Surface Transportation and Veterans Health Care Choice Improvement Act (Pub. L. No. 114-41), which was signed into law last July. Among other measures, the act requires consistent basis reporting between a decedent's estate and a person acquiring property from the decedent (148 DTR G-3, 8/3/15).

Last summer, when the Ways and Means Committee picked up those proposals on consistency of basis, “nobody thought that those rules had a chance,” Aucutt said. However, “when Congress was trying to raise the money to extend the highway trust fund for three months, this apparently was sitting on the shelf with exactly the right price tag to fill that gap,” so they pulled it off the shelf and stuck it in the legislation, he said.

“Everybody—even Treasury and the IRS, even though they had proposed the idea in the first place—were very surprised to see it enacted,” Aucutt said.

“The same thing could happen to any of those proposals” in the administration's budget, he said. And the GRAT proposals, in particular, have been relatively noncontroversial on both sides of the aisle, he added.

The proposals could be especially attractive because of their associated price tag. The administration estimates that the changes would raise $19.15 billion in additional tax revenue over a 10-year period.

2017 Proposal

The Obama administration's budget proposal on GRATs is focused on short-term grantor-retained annuity trusts where the grantor would attempt to transfer a large amount of wealth to the next generation in a very short period of time—as little as two years.

The 2017 proposal would require that a GRAT have a minimum term of 10 years and a maximum term of life expectancy of the annuitant plus 10 years. This requirement would “impose some downside risk in the use of a GRAT” because if the grantor dies during the trust term, the assets needed to produce the retained annuity are returned to the grantor's gross estate for tax purposes, according to the budget plan.

The proposals would also require that the remainder interest in the GRAT at the time the interest is created have a minimum value equal to the greater of 25 percent of the value of the assets contributed to the GRAT or $500,000—but not exceeding the value of the contributed assets.

Aucutt said it would end, or at least seriously limit, the usefulness of GRATs if the gift had to be at least 25 percent of the initial value.

“One of the things that makes GRATs attractive is that there’s no downside,” Aucutt said. However, if a person puts $10 million into a GRAT and the gift has to be $2.5 million—using up that much of the grantor's lifetime exemption—and then the GRAT fails, that's terrible for the taxpayer, he said.

Currently, under grantor-retained annuity trusts, individuals have the option to use significantly less of their gift tax exemption. This new requirement would make it much more likely that gift taxes would be triggered.

In addition, the administration proposal would prohibit any decrease in the annuity paid to the grantor during the GRAT term, and would prevent the grantor from engaging in a tax-free exchange of any asset held in the trust.

Election Bump

Watson said he hasn't seen any sort of rush from individuals wanting to set up grantor-retained annuity trusts based solely on the president's proposals, but that could change following the November election.

“If Hillary Clinton gets elected as president you might then start to see a rush to set up these transactions.”

Aucutt said he would expect to see “a bit of an uptick” in November, but he doesn't envision a huge surge or rush to establish GRATs.

Fed Rate Moves a Factor

Outside of the recent budget proposals, rising interest rates could also impact the usefulness of GRATs in the long term.

“In a lower interest rate environment, the property transferred to the GRAT doesn’t have to appreciate as much as it would in a higher interest rate environment for the GRAT to be a successful vehicle” for transferring wealth to remainder beneficiaries, said James Hogan, managing director at Andersen Tax LLC in a May 23 interview.

In a grantor-retained annuity trust, if the assets in the trust produce a return in excess of the tax code Section 7520 rate, the increase in value above the rate is passed to the beneficiaries. The Internal Revenue Service defines the Section 7520 interest rate as 120 percent of the applicable federal midterm rate, compounded annually. The rate for June is 1.8 percent.

The Federal Reserve has indicated it is strongly considering raising its benchmark interest rate at the next meeting in June, which would affect rates across the board, including the Section 7520 rate.

As a general rule, as interest rates increase the ability to effectively execute a successful GRAT decreases because the hurdle—the Section 7520 rate—that the investments need to exceed is greater, said Jordon Rosen, a director and shareholder at Belfint, Lyons & Shuman P.A. .

He said one 25 basis-point increase—which is the increase anticipated in June—will most likely not affect the strategy for using GRATs in the near future. “But over time when interest rates go maybe from where they are today to 2 to 3 percent and maybe higher to 4 percent, eventually that will diminish the effectiveness of the GRAT as we know it today,” he said.

Aucutt noted that typically a rate spike will be known on the 20th of the month prior to when the new rate would be put into effect. This creates a 10-day buffer where individuals who have been considering setting up a GRAT can make that final decision and avoid being impacted by the higher interest rate.

Time for GRATs Is Now

All things considered—uncertainty regarding future proposals and the potential for interest rate increases—experts across the board said the best time to set up a grantor-retained annuity trust is today.

The current environment is also beneficial for GRATs because certain asset classes that are expected to appreciate rapidly in the future are artificially depressed, said Jeff Chadwick, an associate at Winstead PC.

Watson said oil and gas assets are a good example.

“Oil and gas properties have been beat way down because of declining oil prices, but the expectation is that those properties are going to appreciate in the future again and probably at a rapid pace. So that would be an ideal asset to put into a grantor-retained annuity trust,” he said.

Alternative Transfer Methods

Experts noted that there are alternatives to using grantor-retained annuity trusts for transferring wealth.

Sales to grantor trusts, also known as “intentionally defective grantor trusts,” would be one technique that would become more popular if Congress enacts changes to the GRAT rules, Watson said.

The tool is used to freeze the value of certain assets for estate tax purposes, but not for income tax purposes. The trust is created with an intentional flaw where the grantor continues to pay income taxes, but the value of the asset is removed from the person's taxable estate.

In higher interest rate environments, alternatives that individuals could consider are charitable remainder trusts (CRTs) and qualified personal residence trusts, Rosen said. Low interest rates limit the tax benefits available from CRTs.

“The reason that a higher interest rate environment works here is that the calculation for the amount of the charitable deduction is based on current interest rates, the age of the taxpayer and some other factors that are worked into an IRS schedule,” he said. Higher rates increase the charitable deduction available to the donor when the trust is set up.

Higher rates also favor qualified personal residence trusts. Such trusts allow taxpayers to contribute either their principal residence or secondary residence into a trust, and based on current interest rates, they would retain the right to live in the home for the rest of their lives, he said.

A higher interest rate “greatly reduces the amount of lifetime gift exclusion that they have to use up,” Rosen said.

Chadwick said what might occur—if legislation was passed or interest rates increased to the point where GRATs became less attractive—is more people will start giving away property or making outright gifts, as opposed to trying to use a freeze technique or make a wealth shift through a GRAT.

To contact the reporter on this story: Allyson Versprille in Washington at aversprille@bna.com

To contact the editor responsible for this story: Brett Ferguson at bferguson@bna.com