SOME INTEREST-SENSITIVE ESTATE PLANNING TECHNIQUES (WITH AN EMPHASIS ON GRATS AND QPRTS) AND A LOOK AT THE PROPOSED LEGISLATION

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1 SOME INTEREST-SENSITIVE ESTATE PLANNING TECHNIQUES (WITH AN EMPHASIS ON GRATS AND QPRTS) AND A LOOK AT THE PROPOSED LEGISLATION Lawrence P. Katzenstein Thompson Coburn LLP One U.S. Bank Plaza St. Louis, Mo (314) E- mail: lkatzenstein@thompsoncoburn.com 2012 Lawrence P. Katzenstein 1

2 SOME INTEREST-SENSITIVE ESTATE PLANNING TECHNIQUES INTRODUCTION (WITH AN EMPHASIS ON GRATS AND QPRTS) 1 Since the enactment of section 7520, which became effective on May 1, 1989, estate planning has become particularly sensitive to shifts in prevailing interest rates. Section 7520 requires that in computing the value of most actuarial interests involved in estate planning, an interest rate equivalent to one hundred twenty percent (120%) of the federal mid-term rate in effect at the time of the transaction be used to value all interests. Because some estate planning strategies are more beneficial when interest rates are high and others are more beneficial when interest rates are low, it is important that estate planners be aware of the effect of varying interest rates on various estate planning strategies. That is particularly true given the volatility in interest rates: since the adoption of section 7520, the interest rate has been as high as 11.6% in May, 1989 and as low as 1.4% for several months beginning in December, The following is a table of all section 7520 rates in effect from 1989 through March, 2012: 7520 Rates Since May 1, 1989 JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC Caution: As of the due date of this material legislation was pending to require a 10 year minimum for GRATs, at least some gift and a prohibition of decreasing annuities. 2

3 * 10* 10* 10* *Section 7520 became effective May 1, For transactions occurring in the first four months of 1989, regulations required use of a 10% interest assumption. Latest IRS Applicable Federal Rates are available from the IRS: By way of background, the computation of the section 7520 rate is not quite as straightforward as it might seem from the statute. Section 7520 provides that the 7520 rate shall be an interest rate (rounded to the nearest two-tenths of one percent) equal to 120% of the federal mid-term rate in effect under section 1274(d)(1) for the month in which the valuation date falls. One would think in reading that language that I could compute the section 7520 rate simply by multiplying the federal mid-term rate by 120%. Although that will usually give the correct answer, it won t in every case. For example, if you look at Revenue Ruling 97-24, you will see that the midterm rate for annual compounding is 6.8%. 120% of that 8.16%, but the table shows 120% of the AFR as 8.19%. Why is that? The section 7520 rate assumes annual compounding, and the federal mid-term rate prescribed by section 1274 assumes semi-annual compounding. In order to derive the section 7520 rate from the federal mid-term rate, it is necessary to multiply the federal mid-term rate by 120% and then convert it to that rate which would produce an equivalent yield for annual compounding. The final step is to round the result to the nearest twotenths of one percent. The formula to do the conversion is as follows: Assume X = midterm AFR, semiannual compounding 3

4 V = valuation rate, annual compounding, prior to rounding Then, for equivalent yield (1 v) 1.2x ) or 1.2x v 1 ) The October, 2008 federal midterm rate for semiannual compounding was 3.14%. Using the above formula, (1.2)(0.0314) v 1 ) = ( ) 2-1 =.0380 Fortunately, the Internal Revenue Service publishes the section 7520 for the following month on approximately the 20th of each month. Brief Introduction to Effect of Interest Rates on Actuarial Interests Obviously, an income interest will be worth more when interest rates are high. Similarly, remainders after an income interest will be lower. Not only is that true because the income interest is worth more, but because the value of the future interest is discounted more highly. You can think of it either way. All estate planning lawyers should know the formula for the value of a remainder interest after term of years. That formula is as follows: 1 t 1+i where i = the section 7520 rate and t equals the number of years in the term. The income interest is simply one minus the remainder interest. Note that unlike with annuity and unitrust interests, no frequency of payment adjustment is necessary to value an income interest. An income interest payable annually is worth the same actuarially as an interest stream payable quarterly, because the income beneficiary will be entitled to income earned on undistributed income so at the end of each year the distributee will not be adversely affected by a delay in payment. Annuity Interests The value of an annuity interest is the income interest divided by the section 7520 rate. If the annuity interest is paid other than annually at the end of each year, an adjustment must be made 4

5 to increase the value of the annuity to reflect frequency of payment. Annuity interests are very interest-sensitive: For example, using the high and low points of the section 7520 rate and assuming a $100,000 charitable remainder annuity trust with payments of 7% made quarterly at the end of each quarter, the value of the deduction for a 65-year old drops from $51, to $1,765 and of course flunks the 10% remainder value test. When interest rates are low, one particular risk with a charitable remainder annuity trust is the 5% probability of exhaustion test of Rev. Rul , C.B In the above example, the 7% annuity trust payable to a 65-year old donor would actually flunk the exhaustion test. In fact, at the February, 2009 section 7520 rate of 2.0%, a quarterly annuity of 6% paid to a 76-year old donor actually flunks the 5% test, and a 72-year old person cannot create a charitable remainder trust at all (assuming quarterly payments)! 2 How is the probability of exhaustion computed? It is actually very simple. Put the payments on a spreadsheet and assume the trust earns at the 7520 rate and pays out the annuity at the intervals required in the CRAT. (Remember to compound the interest only annually even though the trust is earning interest throughout the year.) Next, see how many years it takes to exhaust the trust and compute the probability that the beneficiary will still be alive at exhaustion by dividing the Lx value for the age at exhaustion by the Lx value for present age. If that probability of survival is more than 5%, the trust flunks the test. Obviously, if the payout is less than the section 7520 rate, you don t even have to run the test since the trust can never run out of money. However if the payout rate is the same as the interest rate it is still possible to flunk the test if the payments are made more frequently than annually. Note that this is a different test from the test required by Code section 664 for both unitrusts and annuity trusts requiring that the actuarial value of the remainder be at least 10%. It is possible to flunk the 5% test but not the 10% test or vice versa. For example, an annuity trust paying a 6% annuity in quarterly payments for the life of a 67-year old donor (I assume a 4.2% section 7520 rate) has a probability of exhaustion of 6.683% and therefore flunks the test. But because I only have one beneficiary and the beneficiary is 67 years old, the value of the remainder is actually fairly substantial: 33.5%. Conversely, a 5% annuity trust for a 5-year old cannot possibly run out of money because the payout is less than the assumed earning rate of 4.2%. However because the beneficiary is very young, the 10% test is failed. The actuarial value of the annuity, in fact, exceeds the amount of the trust contribution. Unitrust Interests Unitrusts are essentially unaffected by interest rates. In fact, if the unitrust payment is made annually and if there is no gap between the valuation date and the payment date, interest rates have no effect at all in the value of a unitrust interest. If there is any gap between the valuation date and the payment date, or if payments are made more frequently than annually, a Table F adjustment in the payout rate must be made which is slightly affected by interest rates, but the effect of interest rates will be small. Using the same example as above for the high and low points of the section 7520 rate and assuming a $100,000 unitrust with payments of 7% made quarterly at the end of each quarter, the value of the deduction for a 65-year old drops from 2 I am ignoring the fact that under section 7520 one of the two prior month interest rates could be selected because there is a charitable component. See Code section 7520(a). 5

6 $37,106 with an 11.6% interest rate to $35,541 with a 3.0% interest rate. The effect is slight compared to an annuity trust. Note that there is no interest element in the formula for a unitrust. The formula for the remainder in a term of years unitrust is: (1-p) n where p = the payout rate and n = the number of years in the term. For example, the remainder after a ten-year term for a unitrust with a 7% payout is: Common Law GRITs (1-.07) 10 = = Some history of the basic technique is useful. Prior to the enactment in 1990 of section 2702 of the Internal Revenue Code of 1986, as amended ( Code ), grantor retained income trusts ( GRITs ) were extremely popular. The basic technique involved the transfer of assets to a trust for a term of years. The grantor typically retained both an income interest in the trust and a reversion if the grantor died during the trust term. Both the actuarial value of the income interest and the retained reversion were deemed retained by the grantor, thus reducing the gift substantially. Example: Assume a 65 year old grantor who created a ten year old style GRIT and funded it with $1,000,000 at a time when the section 7520 rate was 8 percent. 3 The value of the retained income interest was The value of the retained reversion was.16140, making the total retained interest Thus, the gift was percent of the value of the property transferred. If the grantor died during the trust term, the property would still be includible in the estate under section 2036 but section 2001(b) avoided double taxation by reducing the adjusted taxable gifts by gifts includible in the gross estate. So even if the property were still only worth $1,000,000 at the end of the term, $1,000,000 would have been transferred to family members at a transfer tax cost of only $352,110. Why did Congress outlaw GRITs in 1990? The actuarial tables correctly value the income interest in a GRIT if the transferred property actually produces income equal to the section 7520 rate. The problem with GRITs was that the tables assumed a rate of return substantially higher than the trust assets were typically producing. The tables were, in the above example, assuming that 8 percent would be added to the grantor s estate each year and that the remainder would be discounted at that rate. In fact, the trusts were typically invested to produce an income stream substantially less than that. 3. This example uses IRS table 90CM mortality assumptions 6

7 The problem would be more severe from the Service s standpoint when interest rates rose, to as high as 11.6 percent in May In addition, although the actuarial value of the reversion was deemed a retained interest, thus reducing the taxable gift further, in fact the reversion would not be included in either the estate or the taxable transfer: the initial gift did not reflect the value of the retained reversion at all, even though the reversion added nothing to the grantor s estate. That value of the reversion passed at the time of termination of the GRIT with all of the other assets to the remainder beneficiaries without a further taxable transfer. The common law GRIT was too good to last for several reasons. Not only was the retained reversion deemed to be part of the retained interest, but the unrealistic assumptions regarding retained interests made the GRITs extremely attractive, even for assets not expected to appreciate. Example: Suppose in the above example that the trust were funded with $1 million of stock of a closely held corporation paying no dividends. The taxable gift on creation of the trust was $352,110. If the asset produced a dividend less than the assumed 8 percent, the retained income interest was undervalued and the value of the reversion was not taxed at all. Qualified Personal Residence Trusts The old-style GRIT lives on in several respects, including the qualified personal residence trust, which is essentially a GRIT funded with a personal residence. Unlike GRATs, qualified personal residence trusts work well even for property not expected to appreciate. Because the retained reversion is part of the retained interest for purposes of calculating the gift, even if the property declines in value, the qualified personal residence trust may be advantageous. The reason is that the actuarial value of the retained interest does not, in fact, add to the grantor s estate except in the sense that if the house were not available, other assets would have been consumed to provide housing. If a residence worth $1 million is transferred to a qualified personal residence trust, and the gift of the remainder for gift tax purposes is $500,000, at the end of the QPRT period, a valuable asset will have been transferred to family members at a gift tax cost of $500,000 even though the house may be worth, at that point, more than $1 million. But even if the house were only worth $800,000, it is still transferred at a $500,000 gift tax cost. One planning concept with qualified personal residence trusts which should be a part of every QPRT is the drop down grantor trust. At the end of the trust term, the house can pass directly to family members who can then rent the house back to the grantor at fair market value rental. (In fact, a fair market rental can even be required without causing estate inclusion problems.) But this arrangement has two disadvantages: first, if the house is sold, it will not qualify for the $250,000 ($500,000 on a joint return) exclusion because the property will not have been used by the children as their principal residence. In addition, rent payments to the children will be taxable income. A solution to both of these problems is to have the property pass not to the children, but to a trust which is a grantor trust for income tax purposes. Obviously, the grantor trust powers should be powers which would not cause the trust to be pulled back into the grantor s estate for estate tax purposes. It can also not be a power in the 7

8 grantor to substitute assets under Internal Revenue Code section 675(4) as this would violate the requirement in the Regulations that the trust prohibit buy-backs of the residence although a power to reacquire held by a non-spouse third party is permitted. 4 If the trust is a grantor trust, not only will the rent payments not be taxable income because they are in effect payments to the grantor, but in addition the house will be considered owned by the grantor for income tax purposes and therefore qualify for the section 121 exclusion of gain on the sale of a principal residence. One of the more controversial aspects of planning with QPRTs is the fact that Regulation Section (c)(9) requires the governing instrument to prohibit the trust from selling or transferring the residence, directly or indirectly, to the grantor or related parties. The regulations even go so far as to prohibit a sale back to the grantor at any time after the QPRT term if the trust is then grantor trust, i.e., a sale from a drop down trust. The purpose of such a buy back might be to pass the house through the grantor s estate so it can acquire a new basis, to provide security to the grantor or other worthy tax or non-tax reasons. In announcing the proposed regulations (Internal Revenue Bulletin ), the Service described the retention of the right to buy the house back as bait and switch, stating that Congress intended the personal residence trust exception to the general rules of Chapter 14 to enable transferors to pass the family home to younger members of the family. However, in the author s opinion, this statement misapprehends the purpose of the personal residence exception. These rules were developed very much in parallel to the Tax Reform Act of 1969 rules applicable to split interest transfers to charity. In the Tax Reform Act of 1969, Congress excepted transfers of remainder interests in personal residences to charities from the general rules (Code section 170(f)(3)(B)(i)) because, according to the Committee reports, the abuse which Congress was intending to prevent was simply not possible with a retained interest in a personal residence. Remember the purpose of the rules: transferors were transferring property to remainder trusts and retaining fiduciary accounting income. The income interest was valued using a prescribed interest rate, but in fact the trust was being invested in ways which made valuation of the interest inaccurate. Such manipulation of investments is not possible with possession of a life estate in a personal residence. Use of a residence is equivalent to an income stream. Why were houses excepted from the regular GRAT rules? Probably for the same reason the 1969 Act excepted residences from the parallel charitable split interest rules see Code section 170(f)(3)(B)(i): as noted in the Committee reports, the abuse potential (investing the assets in a way that makes a monkey of the tables) is not present with a house. That is why not permitting buybacks from the QPRT or a dropdown grantor trust makes no sense. It is the author s belief that the buy back prohibition in the regulations is invalid. (But we still have to comply with it!) The GRIT is Not Dead Not only are QPRTs essentially GRITs funded with a personal residence, but common law, pre Revenue Reconciliation Act of 1990 type GRITs may still be done for persons who are not family members within the meaning of section 2701(e)(2). That section is incorporated by reference in section 2702 and defines family members (to whom the special valuation rules of 4 Whether a third party can reacquire trust assets within the meaning of Code section 675(4) has been put to rest by Rev. Proc

9 section 2702 apply) as including with respect to any transferor only transfers to a spouse, a lineal descendant of the transferor or the transferor s spouse and spouses of any such descendant. Therefore, old style common law GRITs can still be done for nieces and nephews and more distant family members. But unlike a GRAT, a GRIT cannot be zeroed out. On the other hand, they can work well, as noted above, even if the asset doesn t appreciate, or doesn t depreciate too much. GRIT Calculations It is easiest to understand the mathematics of the common law GRIT by realizing that the gift is essentially the present value of the remainderman s future interest times the probability that the grantor will survive the term. Let us analyze these two separately. The present value of the remainderman s future interest i.e., the value of the right to receive an amount in the future discounted by an interest rate to reflect the time value of money can be determined by the following formula: 1 t 1+i where i = the section 7520 rate and t equals the number of years in the term. 1. For example, the value of the right to receive $1 in ten years, assuming an 8 percent interest rate is: = divided by 1.08 taken to the tenth power equals But in a GRIT calculation, the remainderman will receive the GRIT assets only if the grantor survives the term, so we need to further discount this remainder by the probability that the grantor will survive the term. The mortality assumptions underlying all the actuarial calculations rely on a table showing the number of persons living at every age from 0 to 110, starting with a cohort of 100,000 people. If I know that there are 1,000 people alive at one age, and 500 people alive at a later age, I know that the probability of survival from the first age to the second age is 500 divided by 1000 or 50 percent. The probability that a 65 year old will live to age 75 is, therefore, divided by 82224, or times equals.36369, which is the gift. As the age of the grantor increases, the gift decreases as there is an ever increasing chance that the grantor will not survive the term. The value of the reversion rises faster than the value of the retained income stream falls. Note that this is a far simpler way to calculate the value of the remainder following a common law GRIT with reversion (or the gift in a QPRT) than the method usually shown in the literature. Articles frequently suggest using commutation tables to calculate first the value of an income interest for a term of years or until 9

10 the prior death of the grantor, and then the reversion in a separate calculation, and adding the two together to calculate the total retained interest which, if subtracted from one, equals the gift. Doing this requires the use of commutation tables from Publication 1457 as follows: Estate of O Reilly Nx factor for age Minus Nx factor for age divided by the Dx factor for age 65: = / = Convert this annuity factor into an income factor by multiplying it by the interest rate. The income factor is therefore Calculate the reversion as follows: Mx factor for age minus Mx factor for age divided by the Dx factor for age 65: = / = The total of the income and reversion interest is or and this subtracted from one equals the gift of In establishing common law GRITs, (i.e., GRITs for persons who are not family members within the meaning of Section 2702 nieces and nephews, for example) consideration must be given to Estate of O Reilly, 973 F.2d 1403 (8th Cir. 1992), rev g 95 T.C The Internal Revenue Service never fully conceded that the actuarial tables could be used to value assets producing income far less than the table assumptions and Estate of O Reilly marks the high water mark of the Service s success in pushing this issue. The Tax Court had ruled that as a matter of administrative convenience, the tables must be used to value these interests. No asset produces exactly the rate of return under the tables. Are we to have a separate set of tables for each asset? The Tax Court said no. This was consistent with other Tax Court rulings regarding the use of actuarial tables, including the Shapiro case discussed infra. Deviations from the tables undermine the uniformity and ease of administrability of valuing assets. The Eighth Circuit reversed, holding that the Service s tables could not be used to value the grantor s retained 10

11 interest in the GRIT because the closely held stock held in the GRIT was paying a dividend far less than the 10 percent interest rate then assumed by the table. Do we have a different result under Treasury Regulations ( Regulations ) for section 7520? The Regulations provide that the tables may not be used to value unproductive property, but are less clear on the subject of underproductive property (see Reg. 520, (b)(2)(v) Example 1). In may very well be that underproductive property, by inference, will still be valued using the tables. Since section 7520 requires use of the tables except where the regulations specifically provide otherwise, and since they do not provide otherwise with respect to underproductive (as opposed to unproductive property) it is the author s opinion that O Reilly is no longer good law. Chapter 14 GRATS By now it should be obvious why Congress changed these rules. The combination of income interests which were being undervalued and reversions which were not subject to transfer tax at all caused Congress to change the rules so that the retained annuity interest in a trust would have some relationship to what was actually being retained and would have no relationship to how the trust assets were actually invested. There are two ways to do this: either the grantor can be required to keep a retained annuity interest, or the grantor can be required to keep a retained fixed percent of the trust as revalued annually (a unitrust interest). It will be readily apparent that if I retain the right to receive a fixed dollar amount annuity each year, I have no economic incentive to invest the trust one way or the other. Regardless of how the trust is invested, I will be receiving the same dollars each year and a proper valuation can be made of the right to receive the fixed dollar amount. The same is true with a unitrust interest. If I receive a fixed percent of the trust revalued annually, it becomes irrelevant whether the trust is being invested in high income, low appreciation assets, or in low income, high appreciation assets, as a unitrust interest is ownership of a piece of everything. Because interest rates are essentially irrelevant in valuing a unitrust interest, actual investment performance will not matter and my retained unitrust interest will have been correctly valued. So this is what was done in Chapter 14. Section 2702 provides that for purposes of determining whether the transfer of an interest in trust to or for the benefit of a member of the transferor s family is a gift (and the value of the gift), the value of any interest retained by the transferor is valued at zero unless the retained interest is a qualified interest (i.e., unitrust or annuity), or the transfer consists of a transfer in trust of a personal residence. If the interest is not a qualified interest, for tax purposes it is valued at zero and nothing is deemed to have been kept for gift tax purposes. A reversion, for this reason, is not a qualified retained interest and will not be deemed part of the retained interest except in the case of a personal residence GRIT. It is important to remember that these rules are rules only for gift tax purposes. If, for example, I create a GRAT and retain a reversion, the trust will be a grantor trust under section 673 if the value of the reversion exceeds 5 percent as of the inception of the trust. The reversion 11

12 is valued at zero for gift tax purposes only. Remember also that the estate tax rules and the gift tax rules do not perfectly dovetail. If I create a trust paying income to me for life, with a remainder to my child, I have made a gift of 100 percent of the trust assets for gift tax purposes because the retained income interest is not a qualified interest. However, the trust will be entirely included in my estate under section (Section 2001(b) of the Code prevents double taxation of the same property: The amount of taxable gifts is reduced by any property included in my estate.) An Economic Analysis of the GRAT Let us next look at the mathematics of creating GRATs. In order to do that, we must first look at how an annuity is valued as a mathematical matter. As noted above, the value of a remainder after a term of years is calculated by the following formula: 1 t 1+i where i = the section 7520 rate and t equals the number of years in the term. Formula For Valuing Annuity Let us assume in these examples an 8 percent section 7520 rate. The right to receive one dollar after a ten year term is 1 divided by 1.08 taken to the tenth power, or The value of the term interest is, obviously, one minus the remainder, or To determine the value of an annuity interest i.e., the value of the right to receive one dollar per year for a ten year term at a section 7520 rate of 8 percent we divide the term income interest by the interest rate. An annuity is valued this way: income interest rate divided by.08 is This is the value, at 8 percent, of an annuity of one dollar payable for a 10-year term. Therefore, the value of the right to receive $10,000 a year for ten years assuming a section 7520 rate of 8 percent is 10,000 x or $67,101. If I were to contribute $100,000 to a trust and retain the right to receive an annuity of $10,000 per year for ten years, the value of my gift would be the amount contributed, less the retained annuity interest or $100,000 less $67,101 or $32,899. Do GRATs Really Make Sense From a Mathematical Standpoint? GRATs are sometimes touted as a way of making tax free gifts to family members because the annuity can be set so high that the gift is nothing, or essentially nothing. (We are assuming for the moment that mortality need not be taken into account. More on this later.) 12

13 Let us assume for the moment that a GRAT really can be structured so that there is no up front gift, and look at how the GRAT would actually perform in practice. Let us fund a ten year GRAT with one million dollars. We know that the value of an annuity of one dollar paid for a 10-year term (at an 8 percent section 7520 rate) is $ How much of an annuity, therefore, do we have to pay to have the retained interest exactly equal the amount in the trust? Or to put it another way, what number multiplied by will equal $1,000,000? x = $1,000,000 Therefore, x equals one million divided by or $149,029. The following spreadsheet shows that if the trust is invested at 8 percent and pays out an annuity of $149,029, with the payment of the final annuity in year ten, the trust would be exhausted. Year Opening Assumed Annuity Ending Balance Growth Balance 1 $1,000,000 $80,000 ($149,029) $930,971 2 $930,971 $74,478 ($149,029) $856,419 3 $856,419 $68,513 ($149,029) $775,903 4 $775,903 $62,072 ($149,029) $688,945 5 $688,945 $55,116 ($149,029) $595,032 6 $595,032 $47,603 ($149,029) $493,605 7 $493,605 $39,488 ($149,029) $384,063 8 $384,063 $30,725 ($149,029) $265,759 9 $265,759 $21,261 ($149,029) $137, $137,990 $11,039 ($149,029) $0 If, however, the trust earns 10 percent, at the end of 10 years, the trust will have $218,596 remaining, which will pass to the beneficiaries free of all transfer tax. Year Opening Assumed Annuity Ending Balance Growth Balance 1 $1,000,000 $100,000 ($149,029) $950,971 2 $950,971 $95,097 ($149,029) $897,038 3 $897,038 $89,704 ($149,029) $837,712 4 $837,712 $83,771 ($149,029) $772,454 5 $772,454 $77,245 ($149,029) $700,670 6 $700,670 $70,067 ($149,029) $621,708 7 $621,708 $62,171 ($149,029) $534,849 8 $534,849 $53,485 ($149,029) $439,304 9 $439,304 $43,930 ($149,029) $334, $334,205 $33,421 ($149,029) $218,596 Note two key things: 13

14 What we are succeeding in removing from the grantor s estate is growth in excess of the section 7520 rate and that is all we are doing, and in a zero out GRAT, all of the value of the underlying property is being added back to the estate where it will continue to grow and eventually be subject to estate tax. (In most cases there will not be sufficient cash or other property to avoid payment of the annuity in kind. Because the trust is structured as a grantor trust, there is of course no gain when the annuity is satisfied with appreciated property.) With a GRAT the original underlying property will still be subject to tax. The GRAT Myth It is often stated that the GRAT produces leverage: for use of a small amount of unified credit, substantial assets can be moved from the grantor s estate. One article gives the following example, assuming a 7 percent section 7520 rate: Example: A grantor transfers property with a value of $1,000,000 to a two year GRAT providing for an annuity payment of $442,478 to the grantor. At the end of the two year period, the trust is to distribute the remaining trust property to the grantor s descendants. The value of the annuity is $800,000 ($442,478 times ). The gift is therefore $200,000. Assume the trust actually earns 10 percent, 3 percent higher than the section 7520 rate. At the end of the two year period, the beneficiaries would receive $280,796 as follows: Year Opening Assumed Annuity Ending Balance Growth Balance 1 $1,000,000 $100,000 ($442,478) $657,522 2 $ 657,522 $ 65,752 ($442,478) $280,796 The author then compares this transfer to an outright transfer of $200,000, which will also be a $200,000 gift. At the same assumed 10 percent interest rate, the outright gift of $200,000 would be worth only $242,000 at the end of two years, the original $200,000 plus a 10 percent annual return. So, many people conclude, the GRAT produces leverage: for $200,000 of taxable transfer I get more to the beneficiaries with the GRAT than with the outright gift. It is this author s opinion that this is a myth and that the so called leverage is illusory because it does not take into account the fact that with an outright gift, all of the future income and appreciation is removed from the grantor s estate. Or to put it another way, with the GRAT we remove from the estate appreciation in excess of the section 7520 rate. The transfer tax cost of establishing a zeroed out GRAT is zero. With an outright gift, all future appreciation is removed from the estate with no transfer tax cost as to that appreciation. The underlying property will be subject to gift tax, but in the GRAT that is true as well because it will all be 14

15 added to the estate through annuity payments, as seen in the above illustrations. What the two year GRAT analysis above fails to take into account is that we are returning substantial amounts to the estate, which we have not taken into consideration. Another way, therefore, of examining this gift is to calculate the tax benefits after inclusion in the estate of two year s worth of annuity payments. Example: Let s look at the above example again. If I make an outright transfer of $1,000,000, I have, after two years, put $1,210,000 in my beneficiaries hands for the transfer tax cost on $1,000,000. Case 1: A $1,000,000 outright gift puts $1,210,000 in the beneficiaries hands for a total taxable transfer of $1,000,000. Year Opening Assumed Ending Balance Growth Balance 1 $1,000,000 $100,000 $1,100,000 2 $1,100,000 $110,000 $1,210,000 Case 2: My $1,000,000 GRAT ($200,000 gift) puts annual payments of $442,478 in my estate which after 2 years will be worth $929,204. Year Opening Assumed Annuity Ending Balance Growth Balance 1 $0 $0 $442,478 $442,478 2 $442,478 $44,248 $442,478 $929,204 With the GRAT, after two years $280,000 will have passed to my beneficiaries, but I will have also put back in my estate two years of annuity payments of $442,478 plus 10 percent return, or $929,204, which will itself be subject to estate tax. We simply must look at the tax cost of putting the annuity back in the estate. So with the GRAT, what passes to the beneficiaries is $280,796 + $929,204 or $1,210,000 for a transfer tax cost on $200,000 + $929,204 or $1,129,204. This compares unfavorably with the outright gift, which passed the same $1,210,000 to the beneficiaries for tax on a transfer of $1,000,000. The reason should be obvious. With an outright gift, all future income and appreciation on the transferred property are removed from the estate. In the case of a GRAT, only income and appreciation in excess of the section 7520 rate is out of the estate. Far greater leverage can be obtained by making gifts large enough to remove the gift tax from the tax base because of the tax exclusive nature of the gift tax, a subject beyond the scope of this paper. The above analysis WILL however make the GRAT superior if we focus only on the size of the taxable gift. For example if the client is willing to pay gift tax of a certain amount each year, but no more, the GRAT may be the superior vehicle based on the 15

16 above analysis. But it should be clear by now that focusing only on the taxable gift rather than what we are removing from the donor s estate is misleading. Let s look at another more extreme example with respect to GRATs versus outright gifts. Let us assume an estate in a 45 percent bracket, in which we have exhausted our gift tax exemption and all we have left after prior gifts is $1,450,000. Case 1: I give away $1,000,000 and use my last $450,000 to pay the gift tax on the gift. If the gifted property can earn 10 percent, at the end of ten years it will be worth $2,593,742. Case 2: I put the entire $1,450,000 in a ten year zeroed out GRAT (assuming I could do that) which will pay an annuity, assuming a 7 percent section 7520 rate, of $206,447. At the end of ten years, there will be $470,693 left in the trust passing to my beneficiary. In addition, I would have paid back to my estate an annual annuity of $206,447 which if invested at the same 10 percent rate, will be worth at the end of ten years $3,290,233. The estate tax at a 45 percent marginal rate would be $1,480,605, making the amount left to pass from my estate at my death $1,809,628. The total amount passing to my heirs, therefore, is $2,280,321. This is less than the $2,593,742 they would have had if I would have simply given them the money outright. 5 To the extent the annuity can be paid back in cash or assets other than the underlying appreciating property, the damage occasioned by having the underlying highly appreciating property returned to the estate can be reduced. Why do people do GRATs, therefore? The reasons GRATs are so popular are simple, and the reasons make perfectly good sense. The reasons GRATs are popular are that: 1. Not all assets go up in value, some go down. If I make an outright gift and the property goes down in value, I have wasted unified credit. If I make a gift to a GRAT and the property goes down, the trust may be exhausted, but I will be no worse off then if I had not done the GRAT, except to the extent of any small taxable gift (see discussion of zeroing out below). If the assets go up in value, I am a winner, and if the assets go down in value, I am not a loser. This is superior to the treatment of outright gifts. 2. Most clients are unwilling to pay gift tax. Despite the fact that we can show how the tax exclusive nature of the gift tax makes payment of gift tax superior to payment of estate tax, many clients simply are unwilling or unable to pay gift tax during lifetime. For them, the zeroed out GRAT is the giving vehicle of choice, and as seen below if the amount of gift tax the donor is willing to pay is the engine driving the amount of the transfer, the GRAT may very well make sense. But it is important to understand that the donor willing to transfer all assets outright 5. I have ignored for this example the tax benefit of removing gift tax from the tax base if the donor survives the gift by three years. 16

17 in excess of what he or she needs for support will do better with an outright gift than with a GRAT. Avoiding loss of step up where death occurs within three years The point is sometimes made that the GRAT avoids against the risk of premature death: with an outright gift, if the grantor dies within three years of the gift, not only is nothing accomplished because the gift is brought back into the estate by section 2035, but the transferred assets have lost the stepped up in basis we would have had had no gift been made. Is it possible to devise a way in which the gifted property would be includible in the grantor s estate if the grantor died within three years? This is tricky to accomplish because many of the ways that pull the property back into the grantor s estate also prevent the transfer from being a completed gift for gift tax purposes. How about providing that during the first three years of the trust, the grantor retains a power of appointment, exercisable only with the consent of the primary beneficiary of the trust, over an amount of the trust equal to the original taxable gift? Regulation section (c) provides that a gift is incomplete if and to the extent that a reserved power gives the grantor the power to name new beneficiaries or change the interests of the beneficiaries as between themselves unless the power is a fiduciary power limited by a fixed or ascertainable standard. However, Regulation section (e) provides that a transferor is considered as having such a power if it is exercisable by him in conjunction with any person not having a substantial adverse interest in the disposition of the transferred property or in the income therefrom. Although the Regulation does not state the opposite it can only mean that if the power is exercisable only in conjunction with a person having a substantial adverse interest in the disposition of the transferred property or in the income therefrom, the gift is complete for gift tax purposes. The Regulations under section 2038, on the other hand, provide that a decedent s power to alter, amend, revoke or terminate a trust will cause inclusion in the estate unless the power is exercisable by the decedent only in conjunction with all parties having an interest, (vested or contingent) in the transferred property, and if the power adds nothing to the rights of the parties under local law (Underlining added.) This should cause the property to be includible in the grantor s estate even though the transfer is complete for gift tax purposes. (Section 2001(b) will of course prevent double taxation by removing the amount includible under section 2038 from adjusted taxable gifts.) This technique should not start a new three year period running at expiration of the original three year period, because section 2038 and section 2035 deal only with relinquishments or transfers of rights, not lapses, unlike the provisions of section From the standpoint of getting the gift tax out, section 2035 simply includes gift tax on gifts within 3 years of death. Is there any theory under which the Service could extend this three-year period? There does not appear to be. If a power is retained only over the specific dollar amount of the original gift, will that bring back only the amount of the gift or will the Service argue for a fractional inclusion? It is hard to see this as being abusive: we are only putting the grantor back where he would have been 17

18 had no gift been made. The trust could also include provisions allowing distribution of cash out to the beneficiaries, or appreciation in excess of the original value. Understanding Zeroing Out What makes GRATs attractive is the fact that they can be structured so that there is little or no up front gift. The Regulations at one time took the position that the value of the retained annuity interest is not the actuarial value of the right to receive an annuity for a term (as in the above illustrations), but rather the right to receive income for a term or until the prior death of the grantor. Now repealed example 5 of Regulation section (e) provided that this was the case even if the annuity was, pursuant to the governing instrument, payable to the estate of the grantor for the remainder of the term if the grantor died before the end of the term. This would always reduce the value of the retained interest since at any age there is always some possibility the grantor will die during the term. The effect of taking mortality into account is obviously be more pronounced and more detrimental in the case of older grantors. The Service was undoubtedly correct that the contingent reversion must be valued at zero since it is not a qualified annuity interest. However, it was never clear why the annuity should not be valued as a right to receive a ten year fixed annuity if the annuity is required to be paid to the grantor s estate for the remainder of the ten year term should the grantor die during the period. Section 2702 provides that the value of any retained interest which is a qualified interest shall be determined under section 7520 and section 7520 would seem to require that if the annuity right continues for the entire term to the grantor or, if the grantor dies before expiration of the term to the grantor s estate, it should be valued on a straight term basis without taking mortality into account. The Service s position was apparently that an annuity retained by the grantor s estate is not a qualified interest because it was not retained by the grantor. This interpretation was found nowhere in the explanatory text of the Regulations, only in several of the examples. This was clearly an incorrect interpretation of the statute, since the right to receive the annuity for a fixed period of years, continuing to the grantor s estate if the grantor dies during the period, fits squarely within the definition of a qualified interest. The following discussion illustrates why it is so critical that GRATs be structured as Walton-type GRATs and why a taxable gift will result if they are not. Let s start by looking at how the value of the grantor s interest in a GRAT is calculated if the annuity does not continue to the grantor s estate. What we are now valuing is not the value of an annuity for X years, but the value of an annuity for X years or until the prior death of a person age Y. EXAMPLE: Assume a grantor age 65, a section 7520 rate of 7 percent and a ten year GRAT. The value of the annuity interest can be determined using commutation tables included in Internal Revenue Service Publication 1457 as follows: N factor for age minus N factor for age

19 divided by D factor for age 65 of = an annuity factor of This compares unfavorably with an annuity factor for a straight ten-year term (at a 7 percent section 7520 rate) of In order to understand what that factor of really means, let s compute it in another manner. An annuity factor is the income factor divided by the interest rate, so let us first compute the factor for income for a period of years or until the prior death of a person. This can actually be done without commutation tables by taking the income factor for the initial age and subtracting from it: the Table B term certain factor for the term of the trust, multiplied by the probability that the grantor will survive the term, multiplied by the income factor for the age at the end of the trust term. (The probability that the grantor will survive the term is calculated by taking the number of persons from Table 2000CM living at age 75 and dividing it by the number of persons from the table living at age 65.) Illustration: Using the same facts shown above, the calculation would be as follows: The income factor at age 65 from Table S is The term certain remainder factor for a ten-year term from Table B ( ) multiplied by the probability that the grantor will survive the term (64561/82224 or.78518) equals This multiplied by the income factor for the terminal age (.48180) equals minus equals.45016, which is the income factor for a term of years or until the prior death of the person. This is converted to an annuity factor by dividing it by the interest rate of 7 percent producing the final annuity factor of Effect of having to take into account mortality What is the effect of having to take into account mortality? Not surprisingly, for young grantors the effect will be minimal because the possibility of the grantor dying during the term will be much smaller than for older grantors. For example, the annuity factor for a ten year fixed term at a 7 percent section 7520 rate is Assume, however, that the annuity must take into account the possibility of the 19

20 grantor dying during the term, so that the factor represents not the right to receive an annuity for ten years, but the right to receive an annuity for ten years or until the grantor s prior death. Example: For a grantor age 30, the annuity factor is reduced a little bit, to However, for a grantor age 70, the value of the annuity is reduced to , a substantial reduction. But the greatest effect will be noticed where there is an attempt to zero out the value of the gift. As we saw above, one of the attractions of the GRAT is its no risk nature: if the property declines in value or fails to appreciate, there is no risk in creating the GRAT if it can be structured with no up front gift. However, if mortality is required to be taken into account in valuing the retained interest because the trust is not structured to comply with the Walton decision, it will be impossible to zero out the gift, and the gift will get larger at older ages. Why is it impossible to zero out a GRAT if mortality must be taken into the equation? Example: Grantor age 65 retains the right to an annuity for ten years. At a section 7520 rate of 7 percent, the annuity factor for the right to receive an annuity for ten years or until the prior death of a person age 65 is In order, therefore, to zero out the GRAT (assuming a $1,000,000 transfer) the annuity we would have to pay would be determined as follows: x = $1,000,000 This gives a value for the annual annuity of $155,502, substantially higher than the $142,377 ($1,000,000/7.0236) we would have to pay out for a straight term GRAT. We also saw that with growth equal to the section 7520 rate on which the annuity factor was calculated, the straight term of years GRAT exactly exhausts itself in 10 years, which is why the gift is zeroed out. If we put these higher annuity figures on a spreadsheet, however, we will see that in fact we will exhaust the trust before the end of the tenth year. The trust will only support the full annuity of $155,502 for eight years, followed by a payment of $131,360 in the ninth year as follows: GRANTOR RETAINED ANNUITY TRUST Zeroed out at a 7 percent section 7520 rate per Rev. Rul Mortality Taken into Account Opening Asset Plus: Less: Ending Year Balance Growth (Annuity): Balance 1 $1,000,000 $70,000 ($155,502) $914,498 2 $914,498 $64,015 ($155,502) $823,011 3 $823,011 $57,611 ($155,502) $725,120 4 $725,120 $50,758 ($155,502) $620,376 20