Winter 2001 Report

GRITs FOR A SPECIAL GROUP OF RELATIVES AND NON-FAMILY BENEFICIARIES

Grantor Retained Interest Trust. Until Congress altered the U.S. gift tax law a decade ago, a Grantor Retained Interest Trust ("GRIT") was a powerful estate planning tool that permitted a senior family member to leverage his or her available Unified Credit to transfer assets to junior family members with minimal or no current gift tax cost.

The GRIT worked like this: A senior family member, as "Grantor," would transfer assets to an irrevocable trust, retaining the right to all the trust income for a fixed term of years selected by the Grantor or until his earlier death. Assuming the Grantor survived the term of years, all assets remaining in the trust at that time would pass to the remaindermen (usually his descendants). If the Grantor did not survive the term, the GRIT would typically provide for the remaining trust assets to return ("revert") to the Grantor's estate.

The applicable U.S. gift tax Regulations permitted the Grantor to deduct from the fair market value of the transferred assets the present actuarial value of his retained interests (the right to all trust income plus the reversion) as determined under the IRS tables. Consequently, the value of a transfer to a GRIT for gift tax purposes could be far less than the total fair market value of the assets actually transferred to the trust. The terms of the GRIT would often be structured so that the amount of the taxable gift was less than the Grantor's available Unified Credit exemption, resulting in no up-front gift tax cost. The Trustee would then invest the trust assets for growth, aiming to deliver substantial assets to the junior family member free of estate or gift tax at the expiration of the fixed term.

To discourage the transfer of wealth to lower generations at a discounted gift tax value, the U.S. gift tax law was modified in 1989 and again in 1990 when Congress enacted special valuation, or "anti-freeze," rules. Under these new rules, the Grantor's retained interests in a GRIT would be assigned an actuarial value of zero, the Grantor would be treated as having made a taxable gift of the full, non-discounted value of the trust assets, and the allure of the GRIT all but disappeared for most prospective Grantors.

...all but disappeared. Under Code § 2702, the GRIT is no longer feasible for trust transfers that will benefit any "family member" who is one of the following: the Grantor's spouse, descendants, ancestors and siblings, as well as spouses of descendants, ancestors and siblings. However, under an important exception to the rules, the transfer tax benefits of a GRIT are still available whenever the remaindermen are relatives who fall outside the "family member" definition -- such as nieces, nephews or cousins -- or "non-family" beneficiaries such as friends of the Grantor.

Many clients will wish to benefit nieces, nephews, cousins, friends or a variety of other persons who are not treated as "family members" under the special valuation rules. Such persons could be the primary beneficiaries of an unmarried aunt or uncle, or the client may simply wish to benefit a close friend, the children of a friend, or a life-partner. Under such circumstances, the creation of a GRIT during lifetime can be an important way to accelerate the distribution of assets and, at the same time, save substantial transfer taxes by taking advantage of the GRIT valuation rules and the "tax exclusive" nature of the gift tax.

Example. Assume that a healthy 75-year-old aunt intends to leave $1 million of her $10 million estate to her niece and nephew under her Will. Approximately $2.2 million of the aunt's assets will be required -- after the payment of estate tax in the 55% marginal bracket under the current estate tax law -- to permit her Executor to ultimately distribute $1 million of estate assets to the niece and nephew.

Suppose the aunt instead uses $1 million of her appreciating assets to create a six-year GRIT in December 2000 with the niece and nephew as remaindermen of the trust. Under the applicable IRS valuation tables, the value of this gift is discounted to $486,000 because the actuarial value of the aunt's retained interests (all income for six years plus the reversion) is deducted from the total fair market value of the assets transferred to the trust. If the aunt applies $486,000 of her Unified Credit exemption equivalent upon creation of the GRIT, she will incur no U.S. gift tax to make the $1 million transfer in trust. (Avoiding the payment of any up-front gift tax may be prudent in a political climate in which some measure of U.S. estate tax reform is possible.) The aunt's objective -- reform or no-reform -- is to ultimately place the $1 million, plus any appreciation, in the hands of the niece and nephew free of gift tax when the term expires.

The GRIT need not involve the outright distribution of the trust assets to the niece and nephew. Although the aunt's interest in the trust must end upon expiration of the six-year term, she could just as easily structure the GRIT so that the assets would continue to be managed in further trust for the niece and nephew.

Variable Factors. For U.S. gift tax purposes, the value of a Grantor's transfer to a GRIT will be affected by these factors:

• The length of the fixed term of the GRIT, as selected by the Grantor;
  
  
• The IRS "applicable rate" of interest for the month in which the GRIT is created;
  
  
• The Grantor's age, which is used to separately determine the present value of the retained income interest and the possibility of a "reversion" (the right to have the trust assets returned to the Grantor's estate if she dies during the term); and
  
  
• The fair market value of the assets used to fund the GRIT.

When interest rates are higher, the GRIT becomes a more powerful technique. This is because a higher interest rate will produce a greater actuarial value for the Grantor's retained income interest for the term of years. This, in turn, reduces the value of the potentially taxable gift and means that the Grantor can expend less Unified Credit to avoid or reduce the up-front gift tax.

A longer term will of course make it less likely that the Grantor can survive the term. The silver lining, though, is that the longer term also increases the actuarial value of the Grantor's retained income interest and the reversion, which again reduces the amount of the taxable gift.

Four Caveats: (1) Like most lifetime trusts with potential tax advantages, the GRIT is irrevocable. Once created, the interests of the remaindermen are more or less locked in and the Grantor cannot alter the trust terms.

(2) The transfer tax advantages associated with the GRIT will be lost if the Grantor dies during the fixed term. In that case, the trust assets will be included in the Grantor's gross estate, just as if she had never made the transfer. But because any Unified Credit applied to the transfer for U.S. gift tax purposes is restored and will be available to the Executor of the Grantor's estate to reduce estate tax at death, the GRIT is regarded by some as a no-lose proposition.

(3) If a Grantor were married, she would normally not want to gift-split with respect to a transfer to a GRIT. When an election to gift-split is made, the result is that half of the transfer is treated as having been made by the Grantor's spouse. While any portion of the Grantor's Unified Credit applied to the transfer will be restored if she dies during the fixed term, any of her spouse's Unified Credit will not and would be wasted.

(4) The Grantor of a GRIT should be prepared to place the assets in the hands of a Trustee who can make appropriate asset allocation decisions, or who will retain a professional investment advisor for this purpose.

INTEREST RATES IMPACT PLANNING

As in the case of the GRIT, the real success of a particular estate planning action for U.S. gift tax purposes may depend in large part on the prevailing IRS interest rate used to determine the actuarial values of retained income, annuity or remainder interests in a trust. Such values are derived from the tables published monthly by the IRS under Code § 7520. Estate planning strategies that benefit from higher interest rates should be of interest to estate planners due to two recent developments:

• In 1999, the IRS valuation tables were updated to take into account more recent mortality statistics. Because the new tables reflect longer life expectancies, income interests for life have greater value and remainder interests have a lesser value than under prior law and the old tables.
  
  
• Interest rates have risen over the last two years. In February 1999, the IRS applicable interest rate under § 7520 was 5.6%. In mid-2000, the IRS interest rate rose to 8%, and as of December 2000 it stood at 7%. (It has since fallen to 6.8% for January 2001.) A higher interest rate means that retained income interests are accorded more value and will reduce a Grantor's taxable gift whenever he or she has retained an income interest. Nevertheless, with some economists now predicting that interest rates will most likely continue to fall in coming months, the time to take advantage of somewhat higher rates may be slipping away.

Certain planning techniques permit clients to capitalize on the updated IRS valuation tables and a higher § 7520 interest rate. In addition to GRITs for a special class of relatives and non-family beneficiaries, such techniques include the Personal Residence Trust, which is used to hold and transfer title to residential real property and is available for transfers to descendants and any other family members as beneficiaries. A higher applicable interest rate under § 7520 at the death of a testator creating a charitable remainder trust in his or her Will also makes it easier to satisfy the requirement that the charitable remainder must equal or exceed 10% in order to qualify for the charitable deduction.

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