Consider combining the tax benefits of a preferred family limited partnership with a GRAT.

• Author: Lusby, Roger W., III
• Position: Grantor retained annuity trust

Given the current historically low interest rates, many high-net-worth clients have looked at the estate tax benefits of a short-term grantor retained annuity trust (GRAT). Many of these GRATs have been structured as "zeroed-out" GRATs that require little or no use of the grantor's unified credit (see Walton, 115 T.C. 589 (2000)). And some of these GRATs have been structured with annuity payments that increase 20% per year over the term of the GRAT to potentially "leverage" the estate tax benefits (see Regs. Sec. 25.2702-3(b)(1)(ii)(A)).

A GRAT has many advantages, namely: (1) It is a technique that is statutorily allowed under Sec. 2702; (2) the regulations provide for a recalculation of the annuity amount in the event the "value" of the initial trust property is ever challenged (see Regs. Sec. 25.2702-3(b) (2)), which really reduces any valuation risk; and (3) with a "zeroed-out" GRAT, the grantor is only "giving up" the upside to the extent the overall investment return exceeds the Sec. 7520 rate. (The Sec. 7520 rate is 120% of the midterm applicable federal rate (AFR) under Sec. 1274(d)(1) for the month in which the property is contributed to the GRAT, rounded to the nearest two-tenths of 1%.)

While the grantor must survive the term of the GRAT to reap any estate tax benefits, the biggest disadvantage of a GRAT is that any generation-skipping transfer (GST) tax exemption may not be allocated to the GRAT until the end of the GRAT's term (see Sec. 2642(f)). This is often referred to as the end of the estate tax inclusion period (ETIP) (see Oshins and Sederbaum, "Generation-Skipping and the GRAT: Sale or Gift of the Remainder," 30 Estate Planning 259 (June 2003)). This is particularly important for clients who desire to minimize transfer taxes for generations so as to pass wealth on effectively to grandchildren and great-grandchildren. The amount of GST tax exemption that must be allocated at the end of the GRAT term is equal to the value of the assets held in the trust on that date. Due to the uncertainty of the amount of GST tax exemption needed to ensure the trust is not subject to GST tax, many taxpayers and planners choose to not include beneficiaries other than the current generation. Many will choose to use their GST tax exemption in planning with more certainty.

To avoid these disadvantages, the authors have suggested that certain high-net-worth clients might achieve superior results by using a preferred family limited partnership...