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George F. Bearup, J.D. Senior Legal Trust Advisor

18-Jan-22

Time To Revisit Estate Freeze Strategies- Gifts: Part One

Take-Away:  Since the 2017 Tax Act and its doubling of the applicable exemption amount to avoid transfer taxes, there has been less discussion with regard to the need to implement estate freeze strategies. That may change if the applicable exemption amount is reduced in the next couple of years and the interest rates used to value retained interests in trusts remain low. A GRAT coupled with a preferred limited partnership might be one effective freeze strategy some wealthy individuals might want to explore.

Background: Grantor retained annuity trusts, or GRATs, have been covered in the past at some length. What follows is a short, refresher of some of the benefits of a GRAT.

IRC 2702: This Tax Code punitive provision provides that when an individual makes a transfer of an interest in a trust to a family member in which such individual retains an interest in the trust, the retained interest by the transferor is valued at $0.00.  The statute provides an exception to this general rule for qualified interests. A qualified interest is structured as an irrevocable right to receive a fixed amount, payable at least annually. The right to receive an annuity is such a qualified interest. GRATs and QPRTs fall within this statutory exception to IRC 2702.

GRAT: A GRAT enables the settlor to make a gift tax-free transfer of the future appreciation (above the IRC 7520 interest rate) of a gifted assets without triggering any gift tax. A GRAT provides a mandatory stream of annuity payments back to the settlor for a selected term of years, with the remaining balance of trust assets (if any) passing usually to younger family members or to a trust for the younger family members’ benefit. The GRAT functions to shift wealth gift tax-free using the IRC 7520 interest rate to value the settlor’s retained annuity interest in the GRAT. For example, if the IRC 7520 interest rate in the month the GRAT is created and funded is 1.40%, and during the settlor’s retained annuity payment period the GRAT’s assets grow at a rate of 2.0%, at the end of the GRAT’s annuity payment period there will be assets remaining in the GRAT. Those assets then are distributed from the GRAT to the remainder beneficiaries of the GRAT (or to a continuing trust for their benefit) gift tax-free. If, by chance, the GRATs assets grow at a rate less than 1.40% during the annuity payment period, there will be no assets remaining in the GRAT at the end of the settlor’s annuity payment period. In short, a GRAT works to shift wealth gift tax-free only when the GRAT’s assets grow at a rate larger than the initial IRC 7520 rate that sets the annuity amount that the settlor will receive. This is often called beating the IRC 7520 hurdle rate.

GRAT Benefits: A short summary of the benefits of establishing a GRAT include the following:

  • Zeroed-out: The GRAT can be structured so that there is virtually no value assigned to the remainder interest at the time the GRAT is created and initially funded, hence the term zeroed-out GRAT.
  • Valuation Adjustment: Treasury Regulations provide for a valuation adjustment feature to ensure that no unanticipated additional gift will occur upon the creation and funding of the GRAT. [Treasury Regulation 25.2702-3(b)(2).] As a result, if the value of the asset that is contributed to the GRAT is increased on a gift tax audit, e.g. a closely held business interest, the amount of the annuity payment due to be paid to the settlor will automatically be recalculated so as to result in a larger annuity payment that is paid to the GRAT settlor, but will still result in the same amount of the gift made by the settlor.
  • Grantor Trust: The GRAT is classified as a grantor trust for income tax reporting purposes. [IRC 677(a)(1).] As has been reported in the past, this is often viewed as another perceived benefit of the GRAT, since the settlor’s payment of the GRAT’s income tax liability is considered a tax-free gift each year by the GRAT’s settlor to the GRAT’s remainder beneficiaries.
  • Carryover Basis: The GRAT’s remainder beneficiaries receive a carryover income basis in the GRAT’s assets at the end of the GRAT’s annuity payment period. [IRC 1015(a).]

GRAT Technical Requirements: In order to qualify for the statutory exception to IRC 2702, several technical requirements must be met by the GRAT. [Treasury Regulation 25.2702(3)(b).] Some of the key requirements include:

  • the annuity must be paid at least annually; a right of withdrawal is not a qualified annuity interest;
  • a promissory note or any type of debt instrument cannot be used by the GRAT’s trustee to satisfy the annuity payment obligation to the GRAT settlor [Treasury Regulation 25.2702-3(d)(6)((i)];
  • the annuity must be a fixed amount, but which cannot exceed 120% of the stated dollar amount of the prior year; thus, a limited escalating annuity is permissible [Treasury Regulation 25.2072-3(b)(1)(ii)(B)];
  • the excess income, above the annuity amount, can be paid to the settlor, but that excess income will not be treated as a qualified interest, and thus it will not be taken into account in valuing the settlor’s retained qualified annuity interest;
  • the annuity amount must be paid no later than 105 days following the annuity anniversary date;
  • no additional contributions can be made to the GRAT once it is funded, [Treasury Regulation 25.2702- 3(b)(5);]
  • the term of the annuity interest must be fixed and ascertainable at the creation of the GRAT, i.e. for the life of the settlor or a specified term of years, whichever is shorter; and
  • the GRAT instrument must prohibit prepayment of the settlor’s annuity interest [Treasury Regulation 25.2702-3(d)(5).]

GRAT Drawbacks: Two principal risks are associated with the use of a GRAT.

  • Mortality Risk: If the settlor dies during the GRAT’s annuity payment period, then a portion (possibly all) of the trust’s assets needed to pay the annuity for the balance of the annuity payment period will be included in the settlor’s estate. The amount that will be included in the settlor’s estate will be calculated based upon a formula that calculates the amount of principal required to generate the remaining annual annuity payments without reducing or invading principal, based upon the IRC 7520 interest rate that exists at the date of the settlor’s death. Often this risk is mitigated with the use of short-term GRATs, like two to three years of the annuity payment duration. The goal with the use of a short-term GRAT is to have the settlor survive the short duration of the GRAT so that no assets are included in the settlor’s taxable estate; this reduces the potential mortality risk by increasing the chance that the settlor will survive the term of each GRAT. It also leads to what is commonly referred to a rolling or cascading GRATs, where the annuity payment received by the settlor from the GRAT is then used to fund a second, or rolling The corollary benefit of a short-term GRAT is that it allows for an opportunity to ‘lock-in’ the upside of a volatile market, increasing the likelihood of beating the IRC 7520 interest rate hurdle.
  • Estate Tax Inclusion Period (ETIP): The other main drawback to the use of a grantor retained annuity trust (GRAT) to shift wealth gift tax-free to a younger generation member or a dynasty-type trust is the estate tax inclusion period, or ETIP. The estate tax exclusion period provides that a generation skipping transfer tax (GST) exemption cannot be allocated to a GRAT if the assets would otherwise be included in the settlor estate under IRC 2036 if he/she died during the annuity payment period. [IRC 2632(c)(4).] If the settlor dies during the annuity term, a portion of the GRAT assets will be included in his/her estate. [IRC 2036(a)(1).] Consequently, the ETIP rule precludes the settlor from allocating his/her GST exemption to the GRAT until the end of the ETIP period, i.e. it can be assigned only at the end of the annuity payment period. Because of this limitation, there is little if any ability to leverage the settlor’s GST exemption with a GRAT. Allocation of the settlor’s GST exemption at the end of the annuity payment period then has to be made based upon the then values of the GRAT’s assets, and thus it would be an inefficient use of the settlor’s GST exemption.

Preferred Partnership GRAT: While the use of short-term GRAT is the best way to address the mortality risk associated with a GRAT, the ETIP risk poses a bit more of a challenge. One way to address the ETIP  drawback is what is called the preferred partnership GRAT. The GRAT must comply with the restrictions of IRC 2702, reviewed above. The preferred partnership must comply with the restrictions of IRC 2701 (which will be covered in the next missive to follow.) This strategy provides a way to obtain the statutory certainty of a GRAT while at the same time shifting appreciation of the GRAT’s assets into a GST-exempt trust. It may even address the amount of potential estate tax inclusion if the settlor dies during the GRAT’s term.

  • Example:  Dan, creates and funds a preferred partnership with what are hoped to be appreciating assets. Initially, Dan owns both the common, or growth, partnership interests and also the preferred, or frozen, partnership interests. Dan then gifts the preferred partnership interests to a long-term zeroed-out GRAT, i.e. no gift tax is paid by Dan with regard to the GRAT’s remainder interest. Accordingly no gift tax is paid by Dan when he funds his GRAT. Dan also creates a GST-exempt dynasty Dan makes taxable gifts of his common partnership interests to the GST-exempt dynasty trust using both his lifetime basic exclusion amount and also his GST exemption; Dan elects to allocate and report his GST exemption to this dynasty trust. Dan’s GRAT is structured so that the preferred partnership payments, i.e. the coupon payments, made annually, will be sufficient to satisfy the annuity payment obligation to Dan from the GRAT. The GST-exempt dynasty trust that owns the common partnership interests will receive all the growth above the preferred partnership interest coupon payable to the GRAT. At the end of the GRAT’s annuity payment period, if Dan is living, the GRAT remainder will be distributed to its remainder beneficiaries. However, the preferred partnership interest in Dan’s GRAT will have been frozen to the amount of the liquidation preference and the partnership coupon, which is the goal since the GRAT’s remainder interest is GST non-exempt due to the ETIP rule. Any appreciation of the GRAT’s assets above the preferred partnership coupon obligation, will exist in the common partnership interest that is held by the GST-exempt dynasty trust. An even more significant benefit of this strategy is the limitation on the mortality risk that is typically associated with a GRAT. If Dan dies during the GRAT’s annuity payment period, the estate tax inclusion amount will be limited to the frozen preferred partnership interest that Dan gifted to the GRAT. However, because the common partnership growth interest was never held by the GRAT, instead it accrued to the GST-exempt dynasty trust by way of Dan’s lifetime gift, Dan’s death during the annuity payment period becomes irrelevant with respect to the appreciated common partnership interests that are held by the GST-exempt dynasty trust.

Conclusion: GRATs are sometimes referred to as a soft freeze strategy, since the IRC 7520 interest rate will add some value to the settlor’s taxable estate in the form of the annuity payments that are required to be made to the GRAT’s settlor. That said,  a GRAT is a safe strategy since it is expressly endorsed in IRC 2702 and its Regulations. When the GRAT is coupled with the preferred partnership and a companion dynasty trust, the major drawbacks to the GRAT, i.e. the mortality risk and the ETIP deferral of the settlor’s GST exemption, can be mitigated to some degree.

It is important to remember that President Biden suggested that there are some perceived abuses associated with GRATs that might be curtailed through legislative changes, including: (i) a minimum annuity term of 10 years, eliminating the use of short-term GRATs; (ii) a maximum annuity term of the annuitant-settlor’s life plus 10 years; and (iii) the GRAT’s remainder interest would have to have a minimum value of the greater of 25% of the value of the contributed assets or $500,000, effectively eliminating any zeroed out GRATs. While those proposals did not (so far anyway) make their way into the most recent legislative proposal, we probably have not seen the end of the proposals to curb the effective use of GRATs.