September 7520 Rate Remains Low

Federal interest rates for September (pdf) are still very, very low.  The Section 7520 rate remains at 3.4% for a third month in a row.  Likewise, applicable federal rates remain low -- the mid-term rate (a 3 to 9 year term) is 2.87% (annual compounding).

Individuals who want to take advantage of low interest rates and low asset values should consider using one or more of the following estate and gift tax planning vehicles:

  • a grantor retained annuity trust (a "GRAT")
  • an installment sale to a grantor trust
  • a qualified personal residence trust (a "QPRT")
  • a charitable lead annuity trust

There is talk among some estate planning commentators that we are unlikely to see legislation enacting a 10-year minimum GRAT as proposed in the Greenbook.  These commentators explain that the ten year minimum can be easily defeated by using a steeply declining GRAT.

IRS Releases Section 7520 Rate for June

In my last post, I explained how the low Section 7520 rate and depressed asset values make this a good time for some individuals to do a GRAT or re-GRAT an old GRAT.  The IRS has released the 7520 rate for June -- 2.8%.  The rate is higher than the 7520 rate for May, but is still very low.

The Time Is Right for a GRAT (or Re-GRAT)

A grantor retained annuity trust (GRAT) is a particular type of irrevocable trust -- the grantor retains an annuity for a term of years and the remaining assets pass to named beneficiaries when the term ends.  When a GRAT works, the grantor can pass assets to the next generation with little or no gift tax.  When a GRAT "fails," nothing is left in the GRAT to pass on.  The assets are returned to the grantor (or the grantor's estate), and the grantor is out the legal fees for setting up the GRAT with nothing to show for it.

Low federal interest rates and depressed asset values make this a good time for some individuals with large estates to do a GRAT or to "re-grat" an old GRAT that is failing.

From Revising Grantor-Retained Annuity Trusts in the Wall Street Journal:

Here's how a GRAT works: The grantor puts his or her assets into the trust and gets back an annuity that pays a fixed amount each year. Any assets left when the GRAT ends pass to the beneficiary -- usually the grantor's children -- tax-free.

Gift tax is paid upfront on what is known as the present value of the remainder of the trust. This is calculated by the taxpayer's attorney or accountant; a key to the formula is the hurdle rate. It is the assumed rate of return for the assets.

In fact, most GRATs are set up so that no gift tax will be owed. This is done by setting the present value of the remainder of the trust at zero, a practice known as "zeroing out" a GRAT. The person who sets up the GRAT generally takes back annuity payments equal to the value of the asset transferred to the trust, plus the 7520 rate.

As pointed out in the WSJ article, the annuity is calculated using an assumed rate of return on the assets -- the Section 7520 rate.  GRATs work when the trust assets appreciate more than the Section 7520 rate.   

A GRAT makes sense with assets that are expected to appreciate -- such as pre-IPO stock and undervalued securities.  A GRAT also makes sense now because the current Section 7520 rate -- just 2.4% -- is unusually lowTo emphasize just how low the current 7520 rate is, compare it to May 2008 (3.2%), May 2007 (5.6%), or May 2006 (5.8%).  For a GRAT that is set up this month to work, the assets in the trust will need to grow by more than 2.4%.  Even the most pessimistic among us has to admit this will be a pretty low hurdle once the market recovers.

If this is a good time to establish a new GRAT, it is a great time to fix a failing GRAT. Some existing GRATs are coming up bust because the assets in the trusts have depreciated and won't recover before the GRATs end -- especially since the 7520 rates that were in existence when the GRATs were set up are higher than the current rate.  There is just too much lost ground to make up.  This is where "regratting" comes in.  According to the WSJ article:

The process involves replacing assets in an existing GRAT, such as stock, with others, such as cash, of an equal amount. The person then takes the shares and puts them into a new GRAT. . . .

'It's an optimal time to regrat,' says Michael J. Jones, a certified public accountant and partner at Thompson Jones LLP in Monterey, Calif., who has regratted trusts for a number of his high-net-worth clients.

The assets that are moved to the new GRAT will have a chance to outperform the lower 7520 rate, so the increased value in the assets can pass tax-free to the next generation.

I believe it is important for a client to work with his or her financial advisor before making the decision to establish a GRAT.  The decision to do a GRAT should not be made in isolation, but should be part of an overall plan given the client's current situation and future goals.  Among other things, the client should work with his or her financial advisor to determine if the client has the financial security to part with the future appreciation on assets transferred to the GRAT.

Although a GRAT will make sense for some individuals with large estates, it won't make sense for everyone.  Consider the following:

  • If the grantor dies before the end of the GRAT term, some or all of the trust assets will be included in the grantor's estate for estate tax purposes.  
  • The GRAT is not effective, from a generation skipping transfer (GST) tax perspective, to transfer assets to grandchildren.  

The problem with using a GRAT to transfer wealth to grandchildren is the estate tax inclusion period (ETIP).  This means that the GST exemption is applied at the end of the GRAT term, after the assets have appreciated.  This is not the best use of the GST exemption.  There are other options to consider if someone wants to transfer assets to grandchildren.

The IRS sets the Section 7520 rate each month.  We don't know what the rates will be next month or the next.  But, for the time being, the Section 7520 rate is so low that a GRAT or re-GRAT can be a smart option.