Popular Estate Planning Techniques Under Attack

11/1/2016 | Articles & Alerts

Not surprisingly, the 2015 proposed budget aims to restrict popular estate planning techniques:

The grantor retained annuity trust or GRAT. This device allows someone to put assets into an irrevocable trust and retain the right to receive distributions back over the trust term. The annuity is equal to the value of what’s been contributed plus interest at a rate set each month by the Treasury called the Section 7520 rate.

If the value of the trust assets increases by more than the hurdle rate, the GRAT will be economically successful. In that case, the excess appreciation will go to family members (the remainder beneficiaries) or to trusts for their benefit when the GRAT term ends.

For the moment, it is possible to form what’s called a zeroed-out GRAT, in which the remainder is theoretically worth nothing so that there is no taxable gift. The President’s proposal would require that the remainder interest have a value greater than zero at the time the interest is created and would also require that a GRAT have a minimum term of 10 years, compared with the current two-year minimum. These requirements would apply to only to new GRATS, so existing ones would be grandfathered.

This greatly accentuates what is called the “mortality risk” of a GRAT: If the grantor dies during the trust term, all or part of the trust assets will be included in his estate for estate tax purposes.

Dynasty trusts. Some states allow trusts to continue in perpetuity (or for a very long time) and pass wealth through multiple generations without incurring estate, gift or generation-skipping transfer taxes. The President’s proposal would do away with dynasty trusts, limiting the generation-skipping transfer tax exemption to 90 years.

Grantor trusts. This is not a single variety of trust, but a set of characteristics that can be incorporated into various types of popular trusts. The term refers to the fact that the person who creates the trust, known as the grantor, retains certain rights or powers. As a result, the trust is not treated as a separate entity for income tax purposes and the grantor, rather than the trust or its beneficiaries, must pay tax on trust earnings.

A 2004 Revenue Ruling made it clear that paying the tax is not considered a gift to the trust beneficiaries. Yet this tax, on income that the grantor probably never receives, shrinks his estate. At the same time, assets can appreciate inside the trust without being depleted by ordinary income or capital gains taxes.

Until now, another attractive feature of these irrevocable trusts is that assets placed in the trust are removed from the senior family member’s estate. From an estate and gift tax perspective, the transfer is treated as a completed gift. The value of the assets is frozen at the time of the transfer.

The proposed budget would include these trusts as a taxable part of the grantor’s estate. And distributions from the trust to beneficiaries during the grantor’s life would be subject to gift tax.