One of the tools that we use in our estate planning for larger estates (that is, those that face some sort of potential estate tax issue) is the Grantor Retained Annuity Trust. These trusts contain an annuity portion, as well as a part that is considered a gift to a future generation (usually the grantor’s children, but it could be someone else). Part of the calculation is dependent upon the interest rate. As a general rule, the lower the interest rate, the smaller the part that is considered a “gift.” You want to keep the gift portion as low as possible, so as to not use up the grantor’s total amount that they can give away.
Many times, we use GRATs to pass assets that are growing rapidly, as that growth is not captured in the taxable amount, but instead realized by the next generation. However, if interest rates rise, then the growth must rise along with that or else the benefit is negated. Below is a good article from the WSJ on just that point.
GRATs Could Lose Allure if Interest Rates Move Higher
If the Federal Reserve boosts interest rates this year, as is widely expected, at least one popular estate-planning tool may lose a bit of luster: grantor retained annuity trusts.
In recent years, these vehicles, known as GRATs, have been used commonly by wealthy individuals and families seeking to pass down appreciating assets to heirs without taking a big gift-tax hit and to lower their overall estate-tax burden.
GRATs work best when interest rates are low, however, so their popularity could wane if the Fed moves, according to some wealth managers and estate-planning pros. And that, they suggest, could set off a search for wealth-transfer techniques better suited to a higher interest-rate environment.
“As rates rise, that could take away some of the benefits of GRATs,” says H. Arthur Graper, managing director at Atlantic Trust Private Wealth Management in Denver.
Clearing the hurdle
GRATs are set up with terms of two years or more, and typically hold assets expected to grow in value at a fast clip, such as private-equity and leveraged investments. The person who creates the GRAT receives annuity payments over the term of the trust that add up to the asset’s original value plus an assumed rate of return set forth by the Internal Revenue Service for tax purposes. If the asset’s total pretax return exceeds the IRS’s so-called hurdle rate, the excess value passes to heirs free of estate and gift tax.
This hurdle rate, also known as the 7520 rate for the section of the tax code that outlines it, is based on 120% of the average interest rate for midterm Treasury obligations, says John Buttita, a tax attorney with Greenberg Traurig in Chicago. When interest rates are low, the hurdle rate is low, making it generally easy for a wider swath of assets to beat it. (April’s hurdle rate is 2%; last month’s was 1.8%.) Higher interest rates, on the other hand, lead to higher hurdle rates, making it more difficult for GRATs to be effective.
There are wealth-transfer techniques that hold up well when interest rates rise, however, and demand for them could grow should GRATs lose their sheen, financial pros say. One such alternative is the qualified personal resident trust, or QPRT.
These trusts, which function in a similar way to GRATs, typically hold primary residences or first vacation homes. Instead of an annuity payment, the grantor retains the right to live in the house during the length of the trust, says Adam von Poblitz, head of estate-planning at Citi Private Bank in New York.
Not only does a QPRT essentially freeze the value of a property at the time of creation, but the way the value of the gift resulting from the QPRT is calculated can lead to a lower gift-tax bill than if the residence was gifted outright.
“The retained interest of living in the house becomes more valuable if rates are higher, so you then save more on the gift,” says Mr. von Poblitz, adding that he expects to see more QPRTs created when rates rise.
Another potential GRAT alternative is a promissory note or intrafamily loan, says Mr. Buttita.
With an intrafamily loan, “you transfer the asset and the recipient gives you a note, so there’s no gift tax,” as long as the face amount of the note equals the value of the asset, says Mr. Buttita. And unlike the annuity and hurdle rate setup of a GRAT, the interest the “borrower” pays on the loan is based on 100% of the applicable federal rate, not 120% of the midterm rate, which for a three-year or less note in April would be 0.48%.
For those who are philanthropically inclined, charitable remainder trusts could be an attractive option if interest rates move higher, says Sally Mullen, chief fiduciary officer for U.S. Bank Wealth Management in Minneapolis.
In this setup, the grantor typically receives an income stream during the term of the trust, and the assets pass to charity when the trust terminates. The grantor is entitled to an income-tax deduction for the remainder interest that ultimately will pass to the charity, and the calculation of that deduction is partly based on the 7520 rate. If the 7520 rate is higher, the assumption is that the grantor can take a larger deduction, she says.
Of course, a GRAT could still be a smart choice during a period of rising rates, especially if it holds an asset that is appreciating quickly, such as a stake in a company expected to go public, experts say.
“Pre-IPO shares tend to pop after the initial offering, so you put those in a GRAT ahead of the IPO, anticipating that the stock will double or triple in value,” says Mr. von Poblitz. “Then, it doesn’t matter if the hurdle rate is 6% or 2% because your anticipated gains are so big.”
Ms. Mullen agrees, noting that rates would have to rise significantly, or the laws governing GRATs would have to change substantially, to give up on them altogether. “The GRAT is a very successful strategy if it’s employed appropriately,” she says.
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