10 Year Minimum GRAT Approved by Ways and Means Committee

The House Ways and Means Committee has approved H.R. 4849. The “Small Business and Infrastructure Jobs Tax Act of 2010,” which contains a provision instituting a 10 year minimum for Grantor Retained Annuity Trusts (GRATs).  GRATs are commonly used to transfer wealth to younger generations at no or little gift tax costs.  The restriction would be effective upon enactment of the law.

If you are considering a GRAT, now is the time to act!

Click “Continue Reading” for the pertinent text from the report by the staff of the Joint Committee on Taxation.

Require Minimum Term for Grantor Retained Annuity Trusts (GRATs)

Present Law

Overview

Present law provides special rules for valuing certain transfers in trust of temporal

interests in property (such as annuity interests and remainder interests). 147 Present law also

provides rules for determining when a grantor of a trust will be treated as the owner of all or part

of the trust for income tax purposes.148 Grantor retained annuity trusts (GRATs) and charitable

lead trusts (CLTs) are two vehicles, often structured as grantor-owned, that are used to make

transfers of temporal interests in property.

Valuation of certain transfers in trust

In the event of a lifetime transfer in trust to (or for the benefit of) a member of the

transferor’s family where the transferor or an applicable family member retains any interest in

the trust, a special rule applies for purposes of determining the value of the transferor’s gift.149

In general, the value of any retained interest that is not a “qualified interest” is treated as zero.150

Therefore, where a transferor retains an interest that is not a qualified interest, the entire amount

transferred to the trust generally is treated as a gift by the transferor to the remainder

beneficiaries, which gift is subject to transfer taxation.151 The value of a retained interest that is

a qualified interest, on the other hand, is determined using rates and procedures described in the

Code for valuing temporal interests in property.152

For these purposes, the term “qualified interest” means: (1) any interest which consists

of the right to receive fixed amounts payable not less frequently than annually (i.e., a qualified

annuity interest); (2) any interest which consists of the right to receive amounts which are

payable not less frequently than annually and are a fixed percentage of the fair market value of

the property in the trust (determined annually) (i.e., a qualified unitrust interest); and (3) any

noncontingent remainder interest if all of the other interests in the trust consist of interests

described in (1) or (2) (i.e., a qualified remainder interest).153

A qualified interest is valued under procedures described in section 7520 using tables

prescribed by the Secretary of the Treasury and an interest rate (rounded to the nearest twotenths

of one percent) equal to 120 percent of the Federal midterm interest rate in effect under

section 1274(d)(1) for the month in which the valuation date falls. The tables and rates described

in section 7520 assume that the assets in a trust will grow at a relatively modest rate.

“Grantor trust” rules

For income tax purposes, a trust generally is a separate taxpayer. Under certain

circumstances, however, a grantor is treated as the owner of all or part of a trust for income tax

purposes.154 When a grantor is treated as owner of a trust, the grantor, when computing his or

her taxable income and credits, generally must include items of income, deductions, and credits

of the trust attributable to the portion of the trust deemed owned by the grantor for income tax

purposes.155

The Code includes a number of rules regarding when a grantor or another person is

treated as the owner of all or part of a trust for income tax purposes.156 A grantor may, for

example, be treated as the owner of a trust for income tax purposes where the grantor has: (1) a

sufficient reversionary interest in the corpus or income of the trust;157 (2) the power to control

beneficial enjoyment of the corpus or income of the trust;158 (3) certain administrative powers;159

(4) the power to revoke all or part of the trust;160 or (5) the power to distribute income to or for

the benefit of the grantor.161

A trust that is structured such that the grantor is treated as the owner for income tax

purposes, but not for gift or estate tax purposes, is sometimes referred to as an “intentionally

defective grantor trust.”

Grantor retained annuity trusts

A GRAT generally is an irrevocable trust in which the grantor retains an annuity interest

structured as a “qualified interest” under section 2702. The annuity interest must be an

irrevocable right to receive a fixed amount at least annually.162 The trustee must be required to

invade the principal of the trust in the event the income is insufficient to pay the qualified

annuity.

Assuming the transfer of assets to the trust is treated as a completed gift for gift tax

purposes, the gift to the remainder beneficiaries generally will be subject to gift tax as of the time

of the initial transfer of assets to the trust. Therefore, the grantor will be required to use a portion

of his or her gift tax exemption equal to − or, to the extent insufficient exemption remains, to pay

gift tax on − the value of the remainder interest determined as of the time the grantor funds the

trust. The annuity portion of a GRAT is valued using the procedures for valuing qualified

interests outlined in section 7520 (described above). To value the remainder interest in a GRAT,

the value of any qualified interest, as determined under section 7520, is subtracted from the value

of the property transferred to the trust.

When the grantor’s retained annuity interest expires, the trust assets are distributed to one

or more remainder beneficiaries identified in the trust instrument. Because the value of the

transferor’s gift for gift tax purposes is determined at the time of the transfer, if trust property

grows at a rate in excess of the growth rate assumed under section 7520, the excess appreciation

generally will pass to the remainder beneficiaries without further gift tax consequences to the

grantor. If, however, the grantor dies during the trust term, that portion of the trust necessary to

generate the annuity amount will be included in the grantor’s gross estate for estate tax

purposes.163 Such inclusion generally results in the loss of the transfer tax benefit of using a

GRAT.

A GRAT is a grantor trust; therefore, the grantor is treated as owner of the trust during

the term of the annuity interest, and the grantor generally must include in determining his or her

taxable income and credits the income, deductions, and credits of the trust.

Description of Proposal

The proposal adds certain requirements for an annuity interest retained by the transferor

to be treated as a qualified interest for purposes of the special valuations rules applicable to

transfers of a trust interest to a member of the transferor’s family: (1) the retained annuity

interest must have a term not less than 10 years; (2) the annuity (determined on an annual basis)

may not decline during the first 10 years of the annuity term; and (3) the remainder interest must

have a value greater than zero at the time of the transfer.

Effective Date

The proposal applies to transfers made after the date of enactment.

163 Sec. 2036.

147 See sec. 2702.

148 See secs. 671-679.

149 Sec. 2702(a)(1).

150 Sec. 2702(a)(2)(A).

151 The special valuation rule does not apply in certain excepted situations, including: (1) where the

transfer is not a completed gift; and (2) transfers to certain personal residence trusts. See sec. 2702(a)(3).

152 Sec. 2702(a)(2)(B); sec. 7520.

154 See secs. 671-679.

155 See sec. 671.

156 See secs. 673-677.

157 Sec. 673.

158 Sec. 674.

159 Sec. 675.

160 Sec. 676.

161 Sec. 677.

162 Treas. Reg. sec. 25.2702-3(b).153 Sec. 2702(b).