September 7520 Rate Remains Low

Posted on September 4, 2009 by Karen Meckstroth

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.

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Estate Tax Change Is Around the Corner: A Recap of the Current Proposals

Posted on June 15, 2009 by Karen Meckstroth

With 2010 nearing, we should see Congress act in the next few months to pass new estate tax legislation.  What changes can we expect to see?

Here is a recap of where we are:

Federal Estate Tax Exemption and Rates: 

  • Congress's concurrent budget resolution for fiscal year 2010 is based on the assumption that the federal estate tax exemption will be frozen at $3.5 million with a 45% tax rate. 
  • Members of Congress have introduced a number of House and Senate bills, ranging from repeal of the estate tax to Rep. McDermott (D-WA)'s "Sensible Estate Tax Act of 2009" (H.R. 2023), which calls for a $2 million exemption with new graduated rates of 45%, 50% and 55%. 
  • The Treasury Department's "Greenbook," (pdf) which explains the Obama Administration's fiscal year 2010 revenue proposals, states on p. 125 of the Appendix:  "Estate and gift taxes are assumed to be extended at parameters in effect for calendar year 2009 (a top rate of 45 percent and an exemption amount of $3.5 million)."
  • I believe that the most likely outcome is a $3.5 million exemption at a 45% rate -- but we will have to wait and see what legislation Congress actually passes.

Portability:

  • Members of the House and Senate have introduced bills (H.R. 2023 and S. 722) calling for portability -- i.e., the transfer of a deceased spouse's unused unified credit to the surviving spouse
  • The Greenbook does not mention portability
  • Policymakers have discussed portability for years -- will Congress makes portability a reality?  It's hard to predict what will happen. 

Other Greenbook Proposals

The Greenbook contains three proposed changes to the estate and gift tax laws starting on page 119:

  • Require Consistency in Value for Transfer and Income Tax Purposes
  • Modify Rules on Valuation Discounts
  • Require Minimum Term for Grantor Retained Annuity Trusts (GRATs)

Ronald D. Aucutt discusses these proposals in Capital Letter No. 17 published on the ACTEC website.  The article provides in-depth analysis of the proposals, and I recommend reading it in its entirety.  Below, I have excerpted parts of Aucutt's discussion:

Require Consistency in Value for Transfer and Income Tax Purposes:

. . . this proposal would require the income tax basis of property received from a decedent or donor to be equal to the estate tax value or the donor’s basis.  

The proposal would be effective as of the date of enactment.

Modify Rules on Valuation Discounts:

The proposal is to create a category of "disregarded restrictions" that would have to be ignored when valuing an interest in a family-controlled entity (such as an interest in a family limited partnership) transferred by one family member to another.  It would apply to transfers after the date of enactment, but would not apply to restrictions created on or before October 8, 1990.  Aucutt comments:

. . . . Using section 2704(b) as a framework, the proposal would create a more durable category of “disregarded restrictions.”  Disregarded restrictions would “include” restrictions on liquidation of an interest that are measured against standards prescribed in Treasury regulations, not against default state law.  Thus, no change in state law would affect the reach of the statute.  In addition, the Greenbook is careful to cast its references in terms of all “entities,” not just corporations or partnerships.

Although the Greenbook does not say so, it is possible that that the “disregarded restrictions” in view, which “include” certain limitations on liquidation (the current scope of section 2704(b)(2)(A)), may also include other restrictions, such as restrictions on management, distributions, access to information, and transferability. . . .

Disregarded restrictions would also include limitations on a transferee’s ability to be admitted as a full partner or other holder of an equity interest, thus apparently overriding any disposition to value a transferred interest as an “assignee” interest.  Treasury would be empowered by regulations to ignore the ownership of certain interests by charities, treating those interests as held by the family. . . .  

 Require Minimum Term for Grantor Retained Annuity Trusts (GRATs):

"Zeroed-out" GRATs survive under the proposals.  Instead, the proposals target short-term and rolling GRATs.  The proposals require GRATs to have a minimum term of ten years.  The 10-year term increases the probability that the grantor will die during the GRAT term -- in other words, it increases the risk that some or all of the GRAT assets will be included in the grantor's gross estate.  The proposal would apply to GRATs created after the date of enactment.  Aucutt comments:

After reciting the history of section 2702 and the use of GRATs, the Greenbook notes that “[t]axpayers have become more adept at maximizing the benefit of this technique, often by minimizing the term of the GRAT (thus reducing the risk of the grantor’s death during the term), in many cases to 2 years, and by retaining annuity interests significant enough to reduce the gift tax value of the remainder interest to zero or to a number small enough to generate only a minimal gift tax liability.”

While rumors have occasionally been heard of congressional plans to limit the attractiveness of GRATs by imposing a minimum gift tax value for the remainder (such as 10%), the Greenbook instead proposes to increase the mortality risk of GRATs by requiring a minimum ten-year term.

The Greenbook proposals are proposals, not law.  But the proposals identify substantive changes in tax legislation that we could see in the next few months.  Again, we will have to wait and see.

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IRS Releases Section 7520 Rate for June

Posted on May 20, 2009 by Karen Meckstroth

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.

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

Posted on May 7, 2009 by Karen Meckstroth

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 low.  To 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.

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