Wills, Trusts & Estates Prof Blog

Editor: Gerry W. Beyer
Texas Tech Univ. School of Law

Sunday, February 24, 2013

Note Comparing Alternative Plans for Great Reform

Samuel-r-scarcelloSamuel R. Scarcello (J.D. Candidate, Northwestern University School of Law, 2013) recently published his comment entitled Transfer Taxes in Flux: A Comparison of Alternative Plans for Great Reform, 107 Nw. U.L. Rev. 321 (2012).  The introduction to the article is below: 

Given only two guarantees in life - death and taxes - it seems puzzling that so many people fail to appreciate the one that keeps them breathing. Whether they appreciate it or not, the vast majority of Americans pay taxes, in one form or another, to the federal government each year. Most pay their share in the form of federal income, excise, and payroll taxes. The nation's wealthiest must navigate an additional layer: gift and estate taxes, collectively known, along with the generation-skipping tax, as transfer taxes.

A grantor retained annuity trust (GRAT) takes advantage of special provisions in the Internal Revenue Code (the Code) to facilitate the transfer of assets essentially outside the gift and estate tax system. In a GRAT, an individual places assets into an irrevocable grantor trust that pays back an annuity, the total present value of which generally equals, or comes close to equaling, the fair market value of the initial trust assets. If the grantor creates the trust so that the present value of the annuity and the fair market value of the initial trust assets are perfectly equal, then the GRAT contains no taxable gift and acquires the moniker "zeroed out." In such a case, beneficiaries receive - free of gift tax - whatever appreciation has accrued during the trust term above the fair market value of the initial trust assets, plus interest (at a rate dictated by § 7520 of the Code), upon the trust's expiration. If the two values are not equal, then the difference between the fair market value of the trust's initial assets and the present value of the annuity constitutes what is known as the initial trust remainder, the GRAT's optional taxable gift. Current regulations permit grantors broad powers to select the length, or term, of their GRATs and to structure the form and size of the annuity payments that they will receive.

Estate planners have held the GRAT in high esteem for over two decades because the technique delivers what amounts to upside-only potential. The GRAT's basic structure provides this have-your-cake-and-eat-it-too feature. When a GRAT fails to perform as desired, meaning the trust assets fail to appreciate above the § 7520 rate, the trust can simply dissolve with no cost to the grantor - except, of course, the cost of legal services rendered. On the other hand, when trust assets outperform the § 7520 rate, grantors can transfer wealth not without being subject to the gift or estate tax in quantities limited only by the amount of a GRAT's underlying asset appreciation.

As part of a broad effort to reform the Code and increase tax revenue, President Obama has repeatedly introduced proposals to restrict the use of GRATs. The President's most recent reform proposals would require GRATs to have (1) a minimum term of ten years, (2) an initial remainder interest value greater than zero, and (3) annuity payments that do not decrease during the term of the trust. Although these proposals have gained little traction in Congress, they highlight the need to strengthen GRAT rules in order to prevent abuses by the most aggressive grantors and estate planners.

To appreciate the logic underlying the President's proposals, the mechanics of another Code provision, § 2036, must be examined. Under § 2036, which concerns transfers made with retained life estates, if a grantor dies during the term of a GRAT, the GRAT's tax benefit - the gift-tax-free transfer of appreciation above the § 7520 rate - disappears, and the trust assets fall into the grantor's estate. Thus, the President's most significant reform proposal, requiring a minimum trust term of ten years, aims to increase the probability that GRATs will become worthless by mandating that they bear significant mortality risk.  Agreeing that reform is overdue, this Comment compares the President's plan with other potential proposals and offers an alternative solution: apply the gift tax at a one-half rate to GRAT transfers that currently enjoy tax-free status above a lifetime cumulative of $ 5 million and apply the tax in full once such transfers exceed a lifetime cumulative of $ 10 million.

Part I of this Comment describes the history and mechanics of GRATs in the transfer tax system. Part II examines the benefits that GRATs provide to the economy, our society, and the coherence of the Code. Part III advances a framework for reform and uses it to critique President Obama's proposals. Finally, Part IV presents four alternative proposals and applies the framework developed in Parts II and III to recommend a progressive reform that combines one of President Obama's proposals with two alternatives.


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