Record-breaking low interest rates and depressed financial markets have created unique estate planning opportunities. Current conditions make this an opportune time to shift a substantial amount of wealth from one generation to another in a tax-efficient manner. We urge you to review and evaluate these opportunities as soon as practicable before these techniques lose their effectiveness, whether due to legislative enactments or changed economic conditions. If you are general counsel, it is important that you forward this time-sensitive information to the business owners.

2011 Transfers to Grantor Retained Annuity Trusts

Description of Technique. Current law allows taxpayers to structure a short-term (e.g., two year) Grantor Retained Annuity Trust (a “GRAT”) without paying any gift tax. A GRAT is an irrevocable trust that pays its grantor annual annuity payments over a fixed trust term. When the fair market value of the property transferred to the GRAT equals the present value of the annuity returned to the grantor based on the IRS assumed interest rate, then the grantor pays no gift tax as the GRAT has been “zeroed-out.” The grantor must survive the trust term for the GRAT to be effective, and a short two-year term minimizes the risk that the trust assets will be returned to the grantor without any tax savings due to his or her death. This ability to fully zero-out the gift for a two-year term has made GRATs very attractive. 

Historical Low Rates. Low interest rates can substantially enhance the overall effectiveness of a GRAT. The IRS assumed interest rate will be 1.4% for GRATs funded in October 2011, the lowest rate in more than 20 years: 

If the appreciation of assets held by a GRAT exceeds the IRS assumed interest rate, the trust assets remaining after payment of the annuity may be transferred to or for the benefit of descendants of the trust creator (the “grantor”) without additional gift tax consequences. The lower the IRS assumed interest rate, the greater the likelihood of having asuccessful GRAT transaction if the grantor survives.

Lock-In Low Rates for 5-10 Years. Clients may wish to lock in these historic low interest rates for a term longer than two years (such as five or 10 years), particularly for an asset with longer-term appreciation potential or a portfolio of marketable securities. Many wealth management advisers believe that the historical performance of the equity markets should far exceed 1.4% on an annual basis in the mid to long term. Although the longer trust term may increase the possibility of losing the tax benefits due to the grantor’s death during the term, it may be a reasonable risk for younger and middle-aged clients.

2011 Transfer of Closely Held Business Interests

Due to difficult business and economic conditions, the values of many closely held businesses have reached all-time lows. Combining GRATs with other planning techniques, which benefit from the historically low interest rate environment, can transfer a significant percentage of interests in a closely held business to family members at the current reduced values. The Obama administration has proposed legislation that would artificially inflate the value of interests in family controlled businesses and other entities over their independently appraised fair-market value when transferred to other family members. While it is unclear whether such legislation will be enacted, those considering the transfer of closely held businesses and other interests may wish to act as soon as practicable.

When to Act

The Obama administration has advanced various proposals to make GRATs less attractive by preventing taxpayers from structuring GRATs in this manner. The U.S. House of Representatives passed several bills last year that would restrict the use of GRATs by requiring (1) a 10-year minimum term and (2) a taxable gift upon formation, and the Obama administration continues to offer these restrictions as potential revenue raisers.

Tax advice disclosure:  Any tax advice contained in this publication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.