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Grantor Retained Annuity Trust Legislation 10-Year Minimum Grant Requirement

On March 24 the U.S. House of Representatives passed a new Bill which would require a minimum 10-year period for grantor retained annuity trusts (GRATs).  The Bill was proposed, went through committee and was passed by the House in about 8 days.  It mirrored President Obama’s “Greenbook” proposal.  The new legislation regarding the GRATs is attached to an important Jobs Bill, so it seems likely to pass the Senate as well.  As written, the new law would be effective upon the President’s signing.  The Senate is in recess until April 12.  Once they reconvene, it could pass in a matter of days, though this is not a certainty.

The 10-year minimum period for GRATs will end the ability to use rolling short term GRATs to transfer appreciation in an investment portfolio to the heirs.  As you may know, the objective of a GRAT is to outperform the deemed IRS interest rate by concentrating positively correlated investments within the same GRAT to increase volatility within the GRAT (but not necessarily increasing the total volatility of all of an individual’s portfolios together).  If the GRAT investments outperform the assumed IRS rates, then the appreciation in the assets will pass free gift tax to the heirs, and the principal is returned to the settlor through the annuity payments.  If the GRAT investments underperform the IRS rate, then all of the GRAT assets are returned to the settlor through the GRAT payments.

By concentrating investments you are increasing the risk within a given GRAT (i.e., GRAT #1), but the overall risk is reduced by the existence of other GRATs (i.e., GRAT #2).  The investments in GRAT #2 are negatively correlated to the investments in GRAT #1.  But the investments with GRAT #2 are positively correlated to the other investments in GRAT #2.

    1. A current revocable trust investment portfolio typically contains a number of separate stocks
    2. For purposes of illustration, each share of stock will be treated as one piece of fruit in a larger basket of fruit.
    3. In this example, assume that the basket contains six oranges, six pears, six lemons, six watermelons and six apples.
    4. Assume that this is considered a diversified fruit basket under the guidelines of Uniform Prudent Investor Act (“UPIA”).
    5. Consider that we re-organize the fruit basket into five smaller baskets, each being its own GRAT, which are comprised as follows.

 

      1. GRAT #1: two oranges
      2. GRAT #2: two pears
      3. GRAT #3: two lemons
      4. GRAT #4: two watermelons
      5. GRAT #5: two apples

 

  1. Each of the five GRATs is not diversified within itself, since it contains concentrated investments in a single asset category.  This provides volatility within each GRAT.
  2. However, collectively, the GRATs are balanced as part of the larger portfolio and not volatile when taken in the aggregate.
  3. Additionally, the revocable trust, even after fruit has been removed to fund the five GRATs, continues to remain diversified within itself, holding the following:
    1. Four oranges
    2. Four pears
    3. Four lemons
    4. Four watermelons
    5. Four apples.

In this example, we have taken a vertical slice through all of the asset categories (i.e., fruit basket) within the revocable Trust’s balanced portfolio, and then re-grouped the securities (fruit) from the slice to put like investments (i.e., fruits) in the same GRAT (i.e., positive correlated investments). The revocable trust portfolio, although smaller, would remain diversified as before.

This planning option is likely to close very soon and is a great way to pass additional wealth down to the children without using up much, if any, of your federal gift tax lifetime exclusion.  The amount that can be placed in the GRAT is virtually unlimited since the annuity payments back to you, as the settlor, ensure that there is no gift.

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