Proposed legislation would impose restrictions on grantor retained annuity trusts and potentially grantor trusts more broadly

In detail

The GRATS Act not only introduces new requirements for the establishment and operation of GRATs, but also appears to alter the tax treatment of certain transactions involving grantor trusts generally and the deemed owner of such trusts. If enacted, the Act would greatly impact the tax benefits of setting up a GRAT and would affect many common grantor trust gift and estate tax planning techniques.

Observation: Despite its name, the GRATS Act appears to do more than simply address grantor retained annuity trusts based on the actual bill text. The legislation also includes proposals that would appear to modify the income and gift tax treatment of various transactions involving other grantor trusts.

The GRATS Act would impose several new requirements on grantor retained annuity trusts, including: 

• Require a GRAT to have a minimum term of fifteen years and a maximum term of the life expectancy of the annuitant plus ten years.
• During the GRAT term, the annuity would not be allowed to decrease.
• Require the remainder interest in the GRAT at the time of transfer to have a minimum value that is (1) at least equal to the greater of 25 percent of the fair market value of the property transferred to the trust or $500,000, and (2) not greater than the fair market value of the property transferred to the trust for gift tax purposes. 

Observation: Many GRATs are set up as “zeroed out” meaning there are nominal gift tax consequences when setting one up. This allows for “failed” GRATs (GRATs that do not pass on any assets after termination) to have minimal negative gift/estate tax ramifications as there is little to no gift tax exemption allocated upon creation of the GRAT. Requiring a minimum value for gift tax purposes, in the case of a failed GRAT, could result in gift tax exemption or gift tax paid without having any assets transferred from the grantor.

The legislation also includes two main proposals that would appear to modify the income and gift tax treatment of certain grantor trusts: 

• Transfers of property for consideration between a trust and the deemed owner will be treated as a sale or exchange for income tax purposes, unless the trust is fully revocable by the deemed owner, an asset-backed securities trust, or any other grantor trust which is identified by the Secretary “as appropriate to exclude” from this provision. Transfers would include any satisfaction of an annuity or any discharge of debt.

Observation: This proposal would effectively revoke Revenue Ruling 85-13, which holds that transactions between a grantor trust and the deemed owner of the grantor trust are ignored for income tax purposes. This could impact GRATs that satisfy annuity payments with appreciated assets and grantor trusts that have outstanding loans even if these trusts were put in place before the effective date of the bill. The legislation would also treat a grantor trust and the deemed owner of such trust as related parties, in which case any loss realized on a sale or exchange would not be recognized.

• An amount equal to any income tax paid by the deemed owner of the grantor trust on the income of such trust will be treated as a gift for gift tax purposes unless the owner is reimbursed by the trust within the same calendar year. This provision does not apply to fully revocable grantor trusts. The amount of the gift cannot be reduced by the use of any deductions such as the charitable deduction or marital deduction or it appears, the annual exclusion in section 2503(b).

Observation: As the income tax generated by the grantor trust is a liability of the grantor, it is unclear whether the regular reimbursement by the trust could be deemed a section 2036 estate tax risk. This would also be in conflict with Rev. Rul. 2004-64 which held that payment of income tax by the grantor in this situation is not a gift. Rev. Rul. 2004-64 also held that reimbursement by the trust (if required by the trust or as an implied understanding between the trustee and grantor) could cause the trust to be includible in the grantor’s estate.