United States

Section 7520 rate drops for March, dip or blip, we'll take it

Opportunity knocks with a surprising downtick in a key interest rate

INSIGHT ARTICLE  | 

The IRS announced in Rev. Rul. 2017-7 that the section 7520 rate for March 2017 will drop to 2.4 percent from February’s rate of 2.6 percent. After the recent run-up in rates over the past few months, even this slight drop in the section 7520 rate is welcome news for those who would like to do wealth transfer planning without triggering gift tax. In this alert, we will take a look at how grantor retained annuity trusts (GRATs) work and why they enjoy such popularity in a gift tax-averse environment.

The GRAT is a form of deferred gift designed to ‘freeze’ the value of an appreciating asset in an individual’s estate and transfer a portion of that appreciation to the next generation. GRATs work best for assets that are expected to appreciate, generate cash flow and can be discounted for gift tax purposes.

How the GRAT works

An individual (the grantor) transfers an asset (let’s assume stock in a closely-held company) to an irrevocable trust. The grantor reserves an income stream (annuity) from the trust for a term of years. The annuity is calibrated to return to the grantor the value of the stock plus interest at the section 7520 rate in effect for the month in which the GRAT is established. Thus, the lower that rate, the lower the annuity will be and the easier for the GRAT to transfer wealth.

The GRAT pays the annuity from distributions from the company or with shares of stock, as needed. If the grantor survives the GRAT term, then upon its expiration, his or her interest ceases and the asset remains in the trust for the benefit of the next generation or is distributed to them outright, free of gift and estate tax.

Key tax aspects of the GRAT

The grantor will make a taxable gift upon funding the GRAT equal to the difference between the fair market value of the transferred asset and the actuarial value of the annuity interest retained. The value of the gift can be zeroed-out, meaning that the value of the asset transferred and the annuity retained can be equal. As noted above, the actuarial value of the annuity is determined by reference to the section 7520 rate in effect for the month in which the GRAT is established. Therefore, the lower that rate, the lower will be the annuity needed to zero-out the GRAT.

If the grantor survives the term of the GRAT, the assets in the trust are not included in his or her estate for estate tax purposes. Of course, this introduces an element of risk in the GRAT, which can have a bearing on the profile of the individual for whom the GRAT might be appropriate.

The GRAT is a grantor trust for income tax purposes, so trust income is taxed to the grantor but accrues for the benefit of the remaindermen. Under current law, the grantor’s payment of the income taxes attributable to the GRAT are not considered gifts or additional contributions to the trust. What’s more, transactions between the grantor and the trust have no income tax implications.

The GRAT is not the first choice for generation-skipping planning because the grantor cannot allocate generation-skipping until the end of the grantor’s retained term because the transfer is subject to the estate tax inclusion period.

Benefits and advantages of the GRAT in the current environment

GRATs have at least three significant advantages in today’s climate. First, in light of potential repeal of the estate tax, individuals are well-advised to avoid triggering gift tax on a transfer, as that gift tax could be a ‘down payment’ on an estate tax that could be repealed. The structural design of the GRAT even lends some assurance to this result. Even if the IRS succeeds in challenging the valuation of the asset transferred to the GRAT, the trust automatically adjusts the annuity so that the taxable gift is virtually unchanged, a major benefit for risk averse taxpayers. Second, even if the estate tax is not repealed, by minimizing the up-front gift on the transfer, the GRAT preserves exemption for the grantor to use at death so that the exempted amount of property can pass to the next generation without estate tax and, if applicable, with a stepped-up income tax basis. Finally, the technique has codified operative guidance and the blessing of the IRS.

Risks and disadvantages of the GRAT

Any discussion of the risks of the GRAT has to start with the mortality risk we noted earlier, i.e., if the grantor does not survive the GRAT term, the trust property is included in his or her estate. But there are other risks as well. Though necessary to make the GRAT as tax efficient as possible, grantor trust status can become a burden to a grantor who may need cash beyond the annuity to pay the tax. There is a loss of stepped-up basis in the transferred asset at the grantor’s death, though there is some ancillary planning that can be done with a so-called ‘substitution power’ that can help address that issue. If the annuity must be paid with stock that was discounted upon contribution to the trust, then that stock must be discounted when used to pay the annuity. Repeated valuations can be expensive and administratively burdensome. There has also been some potential legislative risk to the GRAT from time to time, e.g., the Obama administration’s proposal for a minimum 10-year term.

Key design considerations

While section 2702 and regulations thereunder somewhat dictate the broad outlines of GRAT design, there are many variables for discussion. For example, the length of the GRAT term will likely be influenced by the individual’s age and health, the pattern of anticipated growth of and cash flow from the asset, and other factors. The annuity can be level or can (start lower and) increase by 20 percent per year, with the latter often preferred because it allows an appreciating asset to remain in the trust longer, thereby increasing the opportunity for more wealth transfer. Choice of trustee is another consideration. Grantors often ask if they can be the trustee of the GRAT for control reasons. The answer is usually, “Yes, but we have to be very careful that your powers as trustee don’t cause the trust’s assets to be included in your estate after the GRAT term.” Finally, the grantor has to choose whether the trust should distribute the assets remaining after the GRAT term outright to the children or, as many grantors prefer, remain in trust for the traditional benefits of those vehicles. What’s more, the succeeding trust can be a grantor trust so that the grantor can continue to pay the income tax on behalf of the trust, thereby reducing his or her estate without making taxable gifts. One planning nuance of interest to many grantors is to have the GRAT distribute its remainder to their irrevocable life insurance trusts, thereby providing additional funding to those trusts without gift tax cost.

GRAT example

Individual transfers closely-held stock to a GRAT with a five-year term and a 20 percent  increasing annuity. The transfer is made in March 2017 when the section 7520 rate is 2.4 percent. The stock has a $10 million value, discounted to $6.5 million for gift tax purposes. It appreciates at 5 percent per year and yields 5 percent cash. At the end of the GRAT term, the remainder passing to the individual’s children (or remaining in trust for their benefit) will be approximately $4.94 million. Just for sake of comparison, at February’s rate of 2.6 percent, the remainder would be approximately $4.84 million, with the difference being attributable to the slightly higher annuity required at the slightly higher section 7520 rate.

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