Grantor Retained Annuity Trusts - GRATs

In my February 2011 Newsletter, I talked about ways a person could use the two year window provided in the Tax Compromise of 2010 to leverage a person's gifting opportunities, reducing a person's taxable estate. One strategy that can be used and would not consume any, or only minimally consume, your lifetime gift tax exemption is the Grantor Retained Annuity Trust, or "GRAT." A GRAT is a form of irrevocable trust that allows the grantor to take a calculated risk to lower the grantor's taxable estate.

The grantor transfers specific assets or property into the GRAT. The language in the GRAT stipulates that every year the grantor will receive a fixed payment, i.e. an annuity payment, back from the trust over a fixed number of years. A typically time period for a GRAT is 2 to 5 years. At the end of the term, the remainder beneficiaries get whatever is left. For gift tax purposes, the value of the gift is calculated on day one, when the trust is created and funded, but the gift value is discounted, as discussed below.

The amount of the annuity payment that is required to be disbursed by the GRAT to the grantor is calculated using an interest rate that is determined by the IRS called the Section 7520 rate or the "hurdle" rate. Given the current low interest rate environment, the January 2012 hurdle rate is 1.40%. That is extremely low and increases the amount a grantor can pass to beneficiaries free of gift tax. In fact, most GRAT are calculated to have a gift value of zero. These are called Zeroed-Out GRATS or Walton GRATSⁱ . You must report the annuity payments on your individual income tax return, but any investment growth in excess of the Section 7520 interest rate passes to the trust's beneficiary free of gift tax.

The best way to demonstrate how a GRAT works is by giving an example. In this case, a grantor places $1 million worth of stock in the GRAT with a five-year term and a Section 7520 rate of 3 percent. At the end of each year, based on financial calculations, the grantor would take annuity payments equal to $220,000 and based on discounting, the overall value of the gift would be $20,736. That gift value is determined by the present value of the $1 million reduced by $220,000 each year while earning 3 percent per year on the remaining balance.

The driving force is the hurdle rate. For instance, a three-year GRAT funded with $1 million and producing a 6% annual investment return would leave $78,476 tax free to a beneficiary if hurdle rate is 2.4%. If the hurdle rate was 5.8% like it was in March 2008, then only $4,405 would pass gift tax free. It is also key to place assets in a GRAT that have an expectation of great appreciation over the GRAT term like under-valued stocks, privately owned companies that are likely to go public or similar asset.

There are a couple of drawbacks to creating a GRAT. First, the grantor could die before the end of the term for the GRAT. If that happened then all of the property transferred to the GRAT would revert back into the estate of the grantor and would be in the grantor's taxable estate for estate tax purposes. Second, if the grantor survives the term, the trust asset will be transferred to the beneficiary and the annuity will stop and the grantor must have other assets that are sufficient to absorb the loss of income. Another drawback is that if the GRAT does not beat the hurdle rate, you are out the professional fees associated with setting up and running the GRAT. Lastly, the attractiveness of GRATS have been targeted by the Obama administration. The White house has proposed a minimum term of 10 years for GRATs. Given the current financial environment, GRATs could be eliminated completely.

GRATS are not for everyone but are a useful estate planning tool for those that might have under-valued assets and wish to pass on assets to their beneficiaries without consuming their lifetime gift tax exemptions.

Basics of Estate Planning: Will Clauses...Part III

The last two months (here and here), I described several of the introductory clauses that can be found in a typical Last Will and Testament. This month I will provide further definitions to some basic clauses found in your Will.

• Personal Representative Powers. Most wills simply state a personal representative will have all the powers necessary and provided by law to managing the estate administration. However, many attorneys explicitly state all the powers available in a will as a precaution. A testator can also limit the personal representative's powers to only those specifically provided in the will.
• Selling Real Estate. One of the more important powers that a testator can bestow on a personal representative is the power to sell real estate. Many state, like Virginia, provide that real estate controlled by a will "drops like a rock." This means real estate controlled by the will transfers immediately to the new beneficiaries upon the decedent's death. The personal representative has only minimal power over this realty and only must ensure its gets to the correct beneficiary. Thus, in Virginia, if there is need for the personal representative to sell any real property, the testator's will must expressly give the personal representative the power to sell the real property.
• Trust Management. Many wills establish trusts upon the testator's death. This type of trust is called a testamentary trust. Like a revocable trust, a trust management clause will provide instructions from the testator to the trustee of the testamentary trust. Instructions could include items like how to disburse property, naming beneficiaries of the trusts, length of the trust, etc.
• Signatures. For a will to be valid, it must be executed in the proper fashion. Without a signature, the will has not been executed and is not valid. It must be signed by the testator or at the direction of the testator. (Read about how this was be an issue in Gene Upshaw's Estate). The signature of the testator generally is on the last page of the will.
• Witnesses. The signing of the will must also be appropriately witnessed by the witnesses and their signatures must be signed on the will. The witnesses should be disinterested witnesses. A disinterested witness is one that will not inherit from the will or would inherit based on the intestate statutes. If an interested witness is a witness to the will that interested witness could be disinherited. Witness signatures are generally found below the signature of the testator.
• Attestation/Self-Proving Affidavit. The self-proving affidavit is a special document that is attached to a will that is signed by the same witnesses to the signing of the will. The self-proving affidavit indicates that all state procedures were followed, that the testator signed a will and that the testator did so willingly. The benefit of a self-proving affidavit is that it eliminates the need for witnesses to appear in a probate proceeding to testify about the validity of a will.
• Codicils. A codicil is a document that amends a will but does not replace the entire will. Amendments made by codicil may add or revoke small pieces of a will. For example, a codicil could change who is the personal representative. A codicil must conform to the same legal requirements as the original will and must be included with the will when the personal representative opens probate.

Estate of the Month: Recent Hollywood Couple's Divorces Provide Perfect Teaching Moment

I do not think the average American is shocked to see Hollywood couple like Heidi Klum and Seal, Katy Perry and Russell Brand, Arnold Schwarzenegger and Maria Shriver separating and divorcing. News items like this are all over the internet and provide ample revenue for the numerous magazines strategically located at grocery store check-out lines. However, it does provide a teaching moment on estate planning. Divorce is one of those life-changing moments that can impact your estate plan. Regardless of whether you are a Hollywood power couple or an Average Joe your estate plans will need to be amended.

When divorce occurs, it's important to visit your attorney and start the process of updating your legal documents. For example, you could have your ex-spouse listed on your power of attorney, advanced medical decision, life insurance and/or other POD/TOD accounts. Without any changes to your estate plan your estranged spouse could have the power to empty your bank account, make medical decisions if you are incapacitated or inherit property.

All three local jurisdictions have code provisions declaring a divorce automatically revokes the provisions of the will that pertain specifically to your former spouse, but does not affect other provisions of the will. That means your ex-spouse could still inherit from the will. If your will doesn't specify state who will inherit instead of the ex-spouse, the property left to the ex-spouse would flow to your residuary clause and the beneficiary of which may also be your ex-spouse. Further, gifts to your ex-spouse's relatives would not be revoked from your will.

That is not all. Your joint ownership of property and designated beneficiaries in your non-probate assets also need to be addressed. Some states, like Virginia, have code provisions that will revoke death benefits from life insurance that designate the ex-spouses as beneficiary after there is a divorce or annulment.ⁱⁱ However, many states do not have these provisions. In other words, if the ex-spouse is still listed as the primary beneficiary on a life insurance policy, the ex-spouse will receive the life insurance.

Virginia even revokes an ex-spouse's right, upon entry of a divorce decree, to all contingent property rights, i.e. like joint-tenancy with right of survivorship in real property, bank accounts, etc.ⁱⁱⁱ Maryland is not as restrictive. An ex-spouse might inherit a non-probate asset in Maryland but not in Virginia. Thus, these issues become very state specific, and there are a number of Federal exemptions that trump state law like the ERISA statutes. Regardless, if you have not updated your designated beneficiaries to your non-probate assets to reflect a divorce and there is enough money involved, your estate will be going into litigation.

All three local jurisdictions require affirmative steps to remove an ex-spouse as a beneficiary of any revocable trust you created. An affirmative step would mean revoking the trust, amending or removing the ex-spouse from the trust.

There are several factors that might inhibit you from radically changing your estate plan during separation or divorce. First, barring invalidation, a pre-nuptial agreement will dictate how you can change your estate plan. If the "pre-nup" has provisions on estate planning, you need to abide by those provisions. Second, a good divorce decree will likely address estate planning issues. Unless you want to end up back in court, you should make sure your estate plan is in accordance with whatever the divorce decree states.

Lastly, the law considers you to be legally married until the judge signs the final dissolution decree ending the marriage. In the event you were to die or become disabled prior to the legal termination of your marriage and your estate plans were not updated, your estranged spouse may have legal control over your assets via your durable power of attorney, your medical decisions via your advanced medical directive and your estate via your will, if your ex-spouse was appointed personal representative. Further, many people file for separation and, even years later, never become divorced. In those cases, if the estate plan is not updated, problems will occur.

Without updating your estate plan, your spouse may be entitled to most, if not all, of your estate. That might be what you want, but I rarely see those instances. Estate planning is a journey where life events, like a divorce, act as marker to take a step back and update your plans. By updating your plan to reflect a divorce you can stop your estranged spouse from controlling you, your assets or inheriting instead of the appropriate beneficiary.

ⁱ Walton GRATS are named after a member of the Walton family that challenged the IRS on its gift tax rules related to GRATS and allowed the creation of Zeroed-Out GRATs. See Walton v. Commissioner, 115 TC 589 (2000).

ⁱⁱSee § 20-111.1. Revocation of death benefits by divorce or annulment.

ⁱⁱⁱSee § 20-111. Decree of divorce from bond of matrimony extinguishes contingent property rights.