Interactive Legal Systems

The amendments to the GRAT regulations in 2004 and the increase in the gift tax lifetime exemption equivalent may mean a previously developed strategy will become more popular. It seems that what was originally labeled "Reciprocal GRATs"¹ has been "repackaged" recently as "Parallel GRATs."² It does not appear that these GRATs have been very popular. One reason may be that they were not well understood. In this article, they are discussed, with emphasis on when they appear to produce a beneficial estate planning result compared to other strategies. WTP has revised its GRAT form so Parallel GRATs may be created for married persons. You will find this option under Payment Patterns on the Payments During Term screen of the GRAT dialog.

What Is the Strategy

Each of husband and wife forms a GRAT with the following terms: (1) pay a fixed annuity to the grantor for a short period of years (such as two years) or until the death of the grantor; (2) if the grantor dies during the short fixed term, pay the annuity to the grantor's spouse; (3) after the initial short term, pay a fixed annuity to the grantor's spouse for the shorter of a much longer fixed term (such as 23 years) or until the death of the spouse; and (4) the grantor retains the power to revoke interest (3). It would seem that the grantor should also retain the power to revoke interest (2) to avoid a completed gift of the value of that interest since it does not qualify for a marital deduction. It may also be intended that interest (2) be treated as a qualified annuity interest that (together with interests (1) and (3)) can be subtracted from the value of the property transferred to the GRAT for purposes of determining the value of the taxable gift of the remainder interest in the GRAT passing, usually, to the grantor's descendants, although Examples 8 and 9 of Treas. Reg. §25.2702-3(e) would not appear to permit interest (2) to so qualify.

Gift Tax Consequences

Interests (1) and (3) should be qualified annuity interests for purposes of Treas. Reg. §25.2702-3(e) Examples 8 and 9 so that the value of those interests, taking into account the contingency of death, may be subtracted from the value of the property contributed to each GRAT for purposes of determining the value of the taxable gift of the remainder. (Example 8, however, provides that the spouse's annuity interest commences immediately upon the death of the grantor during the initial term and also provides that the grantor's power of revocation expires after the initial term.) If the grantor dies during the initial short term (e.g., 2 years) or during the succeeding long term (e.g., the following 23 years), the property in the grantor's GRAT, to the extent required, is included in the grantor's gross estate for Federal estate tax purposes. However, the interest of the grantor (that is, the first spouse to die) in the other spouse's GRAT expires without action on the part of the surviving spouse because, by its terms, it expires on the death of the first spouse to die. Therefore, the elimination of the first spouse to die's interest in the surviving spouse's GRAT should not cause the surviving spouse to make any additional taxable gift to the surviving spouse's GRAT even though upon the death of the first spouse to die, all of the property in the surviving spouse's GRAT will pass to or for the descendants. Accordingly, the surviving spouse's GRAT is "successful"; additional wealth would be transferred to the couple's descendants without additional gift and without estate tax. Indeed, the strategy is "better" the earlier the first spouse dies unless both spouses die within the first two years. The strategy should fail only if both spouses die during the initial two year term-as that will cause each GRAT to be included, according to the IRS, in the estate of the spouse who created it. The strategy will also be successful if both spouses survive both the initial 2 year terms and the succeeding 25 year terms of their GRATs, in the sense that property will be removed from the gross estates of the spouses but, on a time use of money basis, it probably will not have been any better than if the spouses had simply made completed gifts to their descendants of the amount of the taxable gifts they would have made in creating the GRATs.

For example,³ the spouses are 60 years old at a time when the section 7520 rate is 6% and each transfers $1 million to a 25 year Parallel GRAT retaining a 6% annuity. It is not clear whether the structure is a 2 year initial term for the grantor or the grantor's spouse, followed by a 23 year term for the spouse, in each case with the interests created for the other spouse subject to a power of revocation, or whether it is simply a 25 year term for the spouse with a power of revocation, which should also work. Each spouse will be deemed to have made a taxable gift of the remainder interest of approximately $375,000. Each spouse will receive $60,000 each year. Assuming each GRAT, in fact, earns 6% per year, the assets in the GRAT will continue to be worth $1 million as long as the 6% annuity is paid out to the grantor or the grantor's spouse. Hence, if both survive the 25 year term, the descendants will then receive $2 million for a total taxable gift of $750,000. If the taxpayers had instead made gifts to their descendants of $750,000, the property would have grown (at 6% a year compounded) to about $3,200,000 or $1,200,000 more than from the GRATs. Hence, if both spouses survive the 25 year term, the descendants would have been better off with a "direct" gift equal to the taxable gifts of the remainder.

But these comparisons are difficult to make. For example, with the Parallel GRATs, the spouses get the annuity payments for life (or the end of the term), which may be important to them. Also, as discussed below, if one of the spouses does die within the 25 year term, the adjusted taxable tax made by that spouse when creating the GRAT is eliminated (and any unified credit restored and/or any gift tax paid creditable against estate tax).

The bottom line is the 25 year Parallel GRAT strategy appears to perform better than a straight gift, in the example, if one of the spouses dies within 16 years of the creation of the GRATs (and the survivor lives for at least two years so that the survivor's GRAT escapes estate tax inclusion). The reason is that at the death of the first spouse to die, the descendants will then receive $1 million and, based upon the premises, it will grow at 6% compounded annually thereafter. If the descendants receive it 16 years after the GRATs were created, the $1 million will grow to approximately $1.6 million in 9 years (from year 16 to the end of the 25 year period), the same amount they would have if a "straight" gift of $375,000 had been made at the beginning of the 25 year term and it had compounded at the rate of 6%. But, if the first spouse dies before year 16, the $1 million received from the GRAT created by the surviving spouse would have grown to more than $1.6 million by the end of 25 years, thus beating the straight gift. What has happened is that the value of the continuing annuity for the first spouse to die has been eliminated from the survivor's GRAT, but was counted for purposes of computing the taxable gift of the remainder up front. Thus, the taxpayers have gotten credit for an interest that "disappeared".

According to the current IRS mortality tables,⁴ the probability that a 60 year old will live at least 15 years is about 70%. But the Parallel GRAT strategy may produce a "better" result than a straight gift only if either spouse dies within 15 years. That probability is just about 50%, approximately half, indicating that the Parallel GRAT plan will produce about the same result, on average, as will a straight gift. Hence, the Parallel GRATs plan might be considered for implementation where it is expected that at least one spouse will live for at least two years but die before the end of "normal" life expectancy for someone of the same age. In any case where it seems a result better than a straight gift will occur based upon mortality, it may be preferable to consider other strategies such a "Parallel Private Annuities" (where each spouse creates a private annuity under which the payments will cease when the annuitant-spouse will dies)⁵ or a Split Purchase Annuity Trust or SPLAT^SM6 .

Estate Tax Consequences

If the grantor dies during the initial term (e.g., 2 years) of the grantor's GRAT or during the succeeding longer term (e.g., the following 23 years), the IRS will likely take the position the grantor's entire GRAT is included in the grantor's estate. If gift tax was paid upon creation of the GRAT, but more than three years have elapsed since the gift was made, the gift tax itself should escape estate tax. The grantor's applicable exclusion amount would be restored, and the grantor's estate should receive a credit against the grantor's estate tax for any gift tax paid.

Marital Deduction Issues

Because the death of one of the grantors during the initial two year term or during the subsequent twenty-three year term will cause estate tax inclusion, perhaps of the grantor's entire GRAT, it will be necessary to qualify the entire GRAT for the marital deduction. This can be done by revoking the spouse's interest, and paying the GRAT over to a QTIP trust for the spouse. Since these are not "Walton" GRATs, it would not be necessary to continue paying the grantor's annuity to the grantor's estate. If the grantor survives the initial two year term so that the grantor's spouse's annuity commences, the power to revoke the spouse's annuity on an ongoing basis should avoid a taxable gift until each annuity payment is actually paid to the spouse. At that point, the payment should qualify for the marital deduction for gift tax purposes as an outright transfer.

As indicated above, the grantor should retain the right to revoke the spouse's interest and the right to appoint all the property in the GRAT if the grantor does revoke the spouse's interest. In fact, the grantor should execute a Will or Codicil in which the grantor does revoke the spouse's interest and should exercise the power of appointment in the manner appropriate (e.g., to create a marital deduction trust for the spouse).

Reciprocal Trust Issues

Because each spouse is creating an annuity interest for the other spouse, the question arises whether the reciprocal trust doctrine under Estate of Grace v. U.S., 395 U.S. 316 (1969) is implicated. It can be reasonably maintained that the doctrine should not be implicated because the GRAT of each grantor (during the period that the potentially reciprocal spousal GRATs are in place) is included in the grantor's estate. Therefore, there is no need to "cross" the GRATs to accomplish estate tax inclusion. Additionally, the reciprocal trust doctrine causes inclusion only to the extent of the reciprocity; therefore, it would not matter if the two GRATs were not identical in value.

Economic Issues

If the strategy is successful as to one of the GRATs, the surviving spouse will no longer have access to the funds in the surviving spouse's own GRAT. (In contrast, during both spouses' lives, each would have an annuity interest in the other spouse's GRAT after the initial term making the funds of both GRATs available for lifestyle.) Like all successful estate planning strategies, wealth has been transferred to the next generation.

What if both spouses survive the initial term and the succeeding term of their respective GRATs? If both spouses were to create an interest in their respective GRATs for the other spouse to take effect after the entire annuity term (e.g., 25 years), the reciprocal trust doctrine would be implicated. However, it should not be implicated if only one spouse were to do so, and thus the economic result would be similar to the result if one of the spouses dies during the GRAT terms, the couple would have access to the assets of one of the GRATs. However, if the spouse with the beneficial interest then dies, the survivor would have no stated economic interest because we would be dealing with the survivor's own GRAT in which the survivor's interest expired after the initial two year term. Perhaps, the spouse with the beneficial interest could be given a special power of appointment to include the grantor as a beneficiary without causing the trust to be included in the gross estate of the spouse who created the trust. If such a strategy is implemented, it seems it may be best to create the trust in a jurisdiction (such as Alaska or Delaware) where creditors may not attached assets in a so-called "self-settled" trust. See, e.g., Estate of German v. United States, 7 Cl. Ct. 641 (1985).

Conclusion

It appears that the Parallel GRAT strategy may be appropriate to consider where it is anticipated that one of the spouses will live for at least two years and one will die prior to the time that a straight gift would catch up with the value of the GRAT remainder delivered to the descendants from the surviving spouse's GRAT (either upon the first spouse's death or the end of the initial short term (e.g., 2 years) after it was created, if later). Of course, the investment return that the descendants would receive on the straight gift may be different than the return "inside" the GRAT if the descendants are able to invest in a manner that is more successful than the trustee of the GRAT who may be inhibited by fiduciary duties that prohibit investment in a manner that jeopardizes the qualified annuity interest. Nonetheless, where the death of one of the spouses is not imminent but is expected to occur earlier than the average for someone of the same age, alternative strategies (such as private annuities) may also be considered.

1 Richard B. Covey in Practical Drafting (October 1993), at 3402

2 Current Developments, 40^th Annual Heckerling Institute (2006), by Richard B. Covey and Dan T. Hastings.

3 This example is taken from Current Developments, supra, although certain numbers are rounded in this article.

4 See Treas. Reg. § 20.2031-7(d)(7), Table 90CM.

5 See Rev. Rul. 69-74, 1969-1 CB 43 for a description of a private annuity.

6 See Tax Management Portfolio 836, p. A-58.

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