The House on June 15 passed a small-business tax bill that essentially would eliminate the use of GRATs as an effective estate planning tool for most senior family members. In a 247-170 vote, lawmakers approved the Small Business Jobs Tax Relief Act of 2010 (H.R. 5486). The bill was moved in conjunction with a broader nontax bill aimed at small businesses, the Small Business Lending Fund Act of 2010 (H.R. 5297). The two bills are expected to be merged.
The House previously passed most of the tax provisions of H.R. 5486 in March as part of the Small Business and Infrastructure Jobs Tax Act of 2010 (H.R. 4849). Under the new bill, small businesses could exempt from tax any capital gains from the sale of some section 1202 small-business stock issued between March 15, 2010, and January 1, 2012. In addition, the legislation would revise the nondisclosure penalty for reportable and listed transactions by making the penalty "proportionate to the underlying tax savings", raise the deduction for start-up expenditures from $5,000 to $20,000, and exempt Small Business Administration guaranteed loans from the "at risk" rules for nonrecourse loans. Download the JCT technical explanation here.
The bill removes crude tall oil from the section 40 cellulosic biofuel producers credit and sets a 10-year minimum term for grantor retained annuity trusts. To comply with budgetary rules in the 5-year budget window, the bill also would temporarily raise by 7.75 percentage points the corporate estimated tax payments factor for firms with more than $1 billion in payments due in July, August, and September 2015; the payments would be correspondingly reduced in the subsequent quarter.
The bill will do nothing to help small business and it essentially relies on permanent tax increases to fund temporary spending. Only small firms organized as C corporations will benefit will benefit from the capital gain exclusion. Even then, a variety of restrictions apply. For example, investments in service corporations like law, engineering or consulting firms, farms, hotels, restaurants or natural resource extraction businesses are not eligible. To benefit from this you would have to find a qualifying small C corporation, buy the stock at original issue and hold on to it for at least five years. The only way that is going to happen is by accident! Nevertheless, given the current climate in Congress, it appears to be par for the course.
If this provision is enacted, it essentially will eliminate the use of GRATs as an effective estate planning tool for taxpayers who are age 65 or older. The reason is that a GRAT does not save any estate tax if the person who establishes the GRAT dies during the GRAT term. Requiring a GRAT to have a minimum term of 10 years means that the person who establishes the GRAT must survive more than 10 years to get any benefit from the use of the technique. Thus, the probability of failure rises as the age of the grantor increases.
For example, based on tables complied by the IRS based on the 2000 census, here is a list of the probabilities of someone surviving a 10 year term if the term begins at a certain age:
Age of the Individual | Probability of Surviving
a 10-Year Term | Probability of Failure |
65 | 78.5% | 21.5% |
70 | 67.9% | 32.1% |
75 | 53.4% | 46.6% |
80 | 36.3% | 63.7% |
85 | 19.9% | 80.1% |
These life expectancies are based the IRS unisex tables. Presumably, the life expectancy of someone contemplating a GRAT transaction would be better depending on their general health, access to health care, and family attributes. Nevertheless, reference to the above table points out that it probably would not be advisable to use a GRAT for someone over age 70 if the failure rate could approach 1 in 3.
Our preference has been to use defective grantor trusts in place of GRATs. However, GRATs are useful when the sale to the defective grantor trust involves the use of a self-cancelling installment note (SCIN), which is then transferred to a GRAT. If the individual dies prematurely, the unpaid balance of the note is cancelled (which is a “win” from an estate planning perspective) and if the individual survives his or her normal life expectancy, nearly all of the self-cancelling premium will be transferred to the GRAT beneficiaries.
There is no doubt that Congress is going to essentially “kill” GRATs; is only a matter of time. As a result, if you have been considering a GRAT transaction, get it done now!