By February, the Internal Revenue Service's Code 7520 rate had fallen to 2%, its lowest point in over a decade and rose to a still very low 2.6% in April. That historically low rate makes grantor retained annuity trusts (GRATs) a very attractive strategy for wealthy clients looking to grow and pass on their assets tax efficiently to their children. Advisors with wealthy clients take note: Amid the darkest of economic clouds, GRATs are a luminescent silver lining.

"A GRAT is a way of giving assets to someone else at a reduced gift-tax cost," explains estate lawyer Barbara H. Cane, who is based in Nyack, N.Y. "The idea is to squeeze as much value into giving as possible. GRATs are complicated, which is why they're only used by the high net worth, but they're useful tools because you're giving at a discount."

Anyone who wants to pass money to heirs can give $13,000 to each heir in outright gifts each year. But if they want to pass on more to one heir for example, now is an ideal time to do so through a GRAT. Why? Grantors are required to receive a certain income from the trust. That income is based on interest rates, and when interest rates are low, trust owners can draw less income, leaving a larger core of assets as principal. This principal and any interest on it can appreciate tax-free and grow over the life of the trust, which is then gifted to heirs.

This wouldn't work if the IRS 7520 interest rate were high. For example, if the rate were 10%, the market typically couldn't outperform the amount the trust holder would be forced to draw out as income, leaving nothing extra to heirs. In January 1989, for instance, the rate was 10%, and a two-year GRAT of $1 million would pay out $576,202 a year, leaving just $1.22 for heirs, Cane says. "If the grantor has to pay himself more, the investments in the trust have to perform better in order to generate money for the heirs," she says. This is called the "hurdle rate." (Cane notes that estate planners invariably use modeling software to calculate the likely outcome of GRATs. "If we didn't have access to software, no one would do it!")

If, however, the IRS 7520 rate is low, as it is now, investment returns on the principal are far more likely to exceed the income to the trust holder. It's true a 2.6% hurdle rate may be tough to beat in today's market, but when the market comes back, it should be easy to outperform. Since the interest earned or the appreciation of the principal isn't a direct gift from a wealthy grantor to a beneficiary, but rather simply interest earned by a trust that ostensibly exists to provide the wealthy parent with an income, the excess can pass on to heirs with no gift-tax liability. At the same time, the asset is conveniently removed from the trust holder's estate, which will lower estate taxes down the road.

HOW IT WORKS

Here's an example of a GRAT in action: One of Cane's clients set up a GRAT in December with $400,000. She set the term of the trust for five years because she expects the market will recover in that time. The client's goal is to give her daughter, who will graduate from college by then, a small chunk of money to help her get started in life. According to the modeling software and December's 7520 rate of 3.4%, the client will draw an annual income of $77,000 and, if her assumptions are correct that the market will appreciate by 10% over the next four years, the client's daughter will end up with a taxable gift of $30,000, or almost $21,351 after tax.

PLANNING FOR GRATS

GRATs tie up money for years at a time, so the first step is to figure out how much a high-net-worth client or couple needs to live on, so they won't be stuck if the market tanks. Todd Richman, vice president and GRAT expert at AllianceBernstein Wealth Management in New York City, calls this amount the client's "core capital," which must be calculated to do a GRAT strategy. Since the grantor won't be spending funds outside of the core capital, a GRAT is a tax-efficient way to get the excess out of their estates while they're still alive.

AllianceBernstein uses the example of a 60-year-old couple with $100 million in assets. They need $2 million per year, adjusted for inflation, to cover expenses. Modeling software predicts with 95% confidence that to meet this goal up to the last surviving spouse's death, the couple will need $63 million. That leaves them with excess assets of $37 million.