Planning With GRATs*
by
Carlyn
S. McCaffrey
Weil, Gotshal & Manges LLP
Richard
A. Oshins
Oshins & Associates, P.C.
and
Noel
C. Ice
Cantey & Hanger, L.L.P.
Prepared
*
Copyright 2003,
I.......... INTRODUCTION.............................................................................................................. 1
II......... DEFINING THE GRAT...................................................................................................... 5
A........ In General................................................................................................................ 5
B......... The Regulations’ Governing Instrument
Requirements................................................ 7
1......... The Annuity Amount..................................................................................... 8
2......... Additional Contributions to a GRAT........................................................... 12
3......... Commutation.............................................................................................. 13
4......... Amounts Payable to Other Persons............................................................. 13
5......... Term of the Annuity.................................................................................... 14
III....... GIFT TAX ASPECTS....................................................................................................... 15
A........ In General.............................................................................................................. 15
B......... Spousal Annuities................................................................................................... 17
C........ Valuation Formulas................................................................................................. 18
D........ Termination............................................................................................................ 19
IV....... ESTATE TAX ASPECTS................................................................................................. 19
A........ Gross Estate Inclusion............................................................................................ 19
1......... Code Sec. 2036......................................................................................... 19
2......... Code Sec. 2033......................................................................................... 21
3......... Code Sec. 2039......................................................................................... 21
B......... Reducing the Risk of Inclusion................................................................................ 22
C........ Impact on the Grantor’s Adjusted Taxable
Gifts...................................................... 24
D........ Estate Tax Apportionment on Donor’s
Premature
E......... Marital
V........ GENERATION-SKIPPING TRANSFER TAX ASPECTS.............................................. 26
A........ In General.............................................................................................................. 26
B. Techniques to Reduce
the Generation-Skipping Transfer Tax.......................................... 27
1......... Changing the Transferor.............................................................................. 27
2.........
VI....... INCOME TAX ASPECTS................................................................................................ 29
A........ The Grantor Trust Rules......................................................................................... 29
1......... Income Tax Risks on Termination of
GRAT................................................ 32
2......... Loss of Basis Step-Up at Grantor’s
VII...... TRANSFER TAX ADVANTAGES OF GRATS.............................................................. 34
A........ In General.............................................................................................................. 34
B......... Valuation Formula.................................................................................................. 34
C........ The GRAT as an Estate Freeze............................................................................... 35
D........ Advantages of Short-Term GRAT.......................................................................... 37
E......... Advantage of Single Asset GRAT........................................................................... 39
F......... Advantage of Retaining an Annuity
with a Value Substantially Equal to the Value of Property Transferred............................................................................................................ 39
Planning With GRATs
By
CARLYN S. MCCAFFREY, RICHARD A. OSHINS AND NOEL C. ICE
Some of the most successful techniques devised by estate planners
capitalize on generally accepted assumptions used to value gifts of partial interests
in property. These assumptions do not always accurately reflect the actual or expected
future performance of a particular property interest. Since the transfer tax has
no post-transfer adjustment mechanism to redress unfulfilled valuation predictions,
the portion of an asset’s value that was not recognized at the
Transferors create partial interests in property by dividing complete interests concurrently or temporally. Concurrent fractionalization carves a property into partial or undivided interests such as tenancies in common. The owner of Greenacre, for example, can divide it in half by giving her child a one-half undivided interest as a tenant-in-common. The value for transfer tax purposes of an undivided interest in a particular property is generally less than its pro rata portion of the value of the property as a whole.[1] Another example of concurrent fractionalization is the division of controlling corporate or partnership interests into minority interests. The values of such interests are commonly discounted well below their proportionate share of the entity’s assets.[2]
In contrast, temporal fractionalization divides property on
a
A temporal division is usually, but not necessarily, accomplished
through the mechanism of a trust. The transferor transfers property to a trustee
subject to the terms of a trust instrument that defines how the beneficiaries are
to share or benefit from the property. The trust instrument, for example, could
direct that one beneficiary receive the income from the transferred property (or
enjoy the possession of it) for a specified period of
When a transferor gives a temporal interest in property and
retains another interest, the value of her gift is determined according to actuarial
tables prescribed by the Treasury pursuant to Code Sec. 7520.[3]
The tables use an interest rate equal to 120% of the federal mid-term rate in effect
under Code Sec. 1274 on the date of the gift. The interest rate is changed monthly.
This method achieves a sensible result in the case of a gift of the right to receive
income from property for a period of
There are at least two significant problems with this approach from the standpoint of economic reality. First, the valuation is based on a prediction that the property will produce an income stream consistent with the applicable interest rate and that its value will not increase or decrease. If the property produces income at a rate lower than the applicable interest rate, the income interest will have been overvalued. If the property appreciates in value, the remainder interest will have been undervalued.
Second, the approach ignores the fact that the Code Sec. 7520 rate is derived from taxable interest rates paid on a principal sum that will not itself be subject to income tax. When a donor divides property between a retained income interest and a remainder interest, she converts her interest into a fully taxable interest, and converts the interest given to her donee into a tax-free interest. By paying current income tax on all of the income she receives, she enables the interest given to her donee to grow tax free up to her original basis in the property.[4]
Suppose in a month when the Code Sec. 7520 rate is 4%, an individual transfers $100,000 to a trust to pay her the income for 10 years, remainder to her child. The value of her retained interest is $32,444 and the value of her gift to her child is $67,556. If the valuation predictions were fulfilled, at the end of the 10 years, the transferor would have $48,024 and the child would have the original $100,000. The key test here is that the proportions between what they have remain the same. The child has 67.5% and the transferor has 32.4%.
This is unlikely to happen. Even if the property produces an annual 4% return and the principal does not increase in value, the predictions will turn out to be wrong because of the income tax impact on what the transferor has retained. Suppose the transferor’s income tax rate is 35%. At the end of the 10 years, she will have only $29,300 - - about 23% of what she and her child both have, instead of the target 32.4%
If the property doesn’t produce the 4% current return and if its value actually appreciates, the disparity between the gift tax valuation and reality becomes greater. Suppose the property produces an overall annual return of 4%, but only 2% is current income and the rest is appreciation. At the end of the 10 years the transferor will have only $15,000.[5] Her child will have $122,000, $22,000 of which will be subject to income tax, leaving her with about $118,600, after tax.[6] In this case, the transferor will have only 11% of the combined amount instead of 32.4%. This was very successful estate planning. The transferor paid a gift tax on 67.5% of an asset and actually removed 89% of it from her gross estate.
The Service has no way of compensating for this because the transfer tax system does not contain any post-transfer mechanisms for adjusting values after a gift has actually been made, no matter how erroneous the valuation turns out to be with hindsight.
From the standpoint of the Service, the problem is compounded
by the fact that investment decisions will play an important role in determining
whether the return obtained from an investment is received in the form of current
income or in the form of capital appreciation held for ul
Much has been written about the transfer tax benefits of splitting property interests temporally. Those interested in helping individuals transfer wealth intact to their children and more remote descendants have extolled the advantages;[7] others whose concern lies with the integrity of the transfer tax system have condemned the technique as a loophole exploited by the wealthy.[8]
Congress listened to the latter group and in 1990 took a step reflective of its 1969 reform of split-interest charitable gifts.[9] It significantly reduced the valuation advantage of gifts of temporal interests, first by directing that the value of the gift be determined by subtracting the value of the transferor’s retained interest from the value of the entire property, and then by imposing a general rule that assigns a zero value to most types of retained temporal interests.[10] The consequences of the application of the new rule are draconian. Under Code Sec. 2702, unless the retained interest is a “qualified interest” or unless one of the section’s exceptions applies, the value of a gift by a parent of a remainder interest in property to her child will be equal to the property’s total value regardless of how long the child must wait to receive it.[11]
Code Sec. 2702 contains a number of exceptions to its zero valuation rule. Some of these exceptions continue to furnish estate planning opportunities reminiscent of those available prior to Code Sec. 2702’s enactment. This outline focuses on one of them ‑ the Grantor Retained Annuity Trust, the “GRAT”[12] It explains what it is and discusses the transfer and income tax consequences of its creation and administration.
As discussed above, the economic
reality is that if property placed in a split-temporal-interest trust produces income
at a rate lower than the applicable interest rate, the income interest will have
been overvalued, and if the property appreciates in value, the remainder interest
will have been undervalued. Since the income interest is always going to be over
or under-valued, it makes sense under our gift tax system to arrange matters, if
possible, so that the benefits of overvaluation inure to the donees while minimizing
the cost to the donor in the event of an undervaluation. This can, it turns out,
be relatively easy to accomplish, due to the fact that there is a very low fixed
floor on the risk of overvaluing the retained income interest: that floor is between zero and a thousand dollars,
say. But there is no ceiling on the possibility
of undervaluing the retained interest, since if the property appreciates, it
can appreciate to anything, and all of that appreciation can inure to the benefit
of the donee without being subject to gift tax. This is the key to the reason that
GRATs, post Walton, work so well.
Until recently, it was not possible
to be sure that a “zeroed-out” GRAT would work. The “reason,” according to the IRS’
former position, that a GRAT would always result in at least some significant gift
tax, particularly where the donor was an older person, was that the grantor might
die prior to the end of the GRAT’s term, in which case the remaining payments under
the GRAT would not pass to the grantor. The actuarial odds of this happening were
factored into the value of the gift by subtracting the value of this contingent
annuity or unitrust interest from the value of the retained interest, increasing
the value of the gift commensurately (even though the “gift” remained in the grantor’s
estate). Virtually all commentators thought this interpretation to be unsupported
by the statute: strained at best, and entirely lacking in formal logic at worst.
Fortunately, the Tax Court, in Walton[13], had the good sense to agree with the commentators and disagree with
the IRS, despite the fact that the IRS position is contained in the interpretive
regulations (the infamous Ex. 5[14]). Walton[15] declared the regulations invalid
on this point. The IRS recently acquiesced
in the Walton case and announced that
it was withdrawing Treas. Reg. §25.2702-3(e), Ex. (5).[16]
A GRAT, as the term “grantor retained annuity trust” suggests,
is a trust that pays an annuity to its grantor for a specified period of
Example 1: Jennifer transfers $1,000,000 to a trust. The terms of the trust instrument require the trustee to pay her $80,000 per year for 10 years. At the end of the 10 years, any property remaining in the trust is to be paid to her son Patrick.
If the terms of the trust satisfy the requirements described below, the grantor’s interest is a “qualified annuity interest” and Code Sec. 2702’s zero valuation rule does not apply to it.[17] Instead, the value of the grantor’s retained annuity interest is determined under Code Sec. 7520.[18]
Congress has sanctioned the GRAT because its structure seems to preclude the manipulation of investment decisions for the purpose of shifting economic enjoyment between the income and remainder beneficiaries. The annuitant is entitled to receive the annuity no matter what the trust’s income is. Thus, a trustee whose object is to maximize the interest of the trust’s remainder beneficiaries would have no incentive to maximize growth opportunities at the expense of current income.[19] So long as the total return, be it income or appreciation, is consistent with the Code Sec. 7520 rate, a GRAT’s annuitant and its remainder beneficiaries will each receive their appropriate share of trust assets.
The advantage, from the government’s point of view, of the
GRAT over the trust that pays income to an income beneficiary for a specified period
of
Example 2: Suppose that the trust described in Example 1 required that Jennifer receive all trust income for 10 years (a grantor retained income trust or GRIT) rather than an $80,000 annuity. If the Code Sec. 7520 rate is 8%, the value of Jennifer’s retained interest (in the absence of Code Sec. 2702’s zero valuation rule) will be the same. The right to receive an $80,000 annuity for 10 years is worth $536,806 as is the right to receive all of the income from a $1,000,000 investment for 10 years. The right to receive the remainder at the end of 10 years is worth $463,193. The fund is invested to produce annual income of 8% and no growth. If Jennifer invests her income distributions to achieve an 8% return, at the end of the 10-year period, Jennifer will have $1,158,925, and Patrick will have $1,000,000.
Example 2’s result is appropriate because it is consistent
with the relative values assigned to the income interest and the remainder interest
at the
As illustrated by Example 3, a change
in the form of the investment, after the gift tax has been fixed and computed, can
shift property to Patrick and away from Jennifer, even where the overall rate of
income and growth is the same as in Example 2 (i.e., 8%).
Example 3: The trustee of the trust described in Example 2 invests the trust’s $1,000,000 to achieve an annual income of 4% and appreciation of 4%. Using the same assumptions as to Jennifer’s reinvestment, at the end of the 10 years, she will have only $678,680. What Jennifer has lost from this investment approach, Patrick will gain. The trust principal distributed to him at the end of the 10 years will be $1,480,244.
But for Sec. 2702, the result of Example 3 is a transfer to Patrick free of gift tax (and free of any other transfer tax) of $480,244. The GRAT structure prevents the result of Example 3. A GRAT would have made $80,000 annual payments to Jennifer even though the trust’s income was only $40,000. As a result, she would have $1,158,925 at the end of the 10-year term and Patrick would have only $1,000,000.
Prior to the enactment of Code
Sec. 2702 a grantor could retain an income interest in a trust (a GRIT), in
which the remainder passed to a “member of the family”[20] of the grantor, and compute
the value of the gift of the remainder for gift tax purposes at its actuarial
value.[21] The unstated assumption behind
the gift tax valuation method then applicable was that the trust was likely to produce
fiduciary accounting income commensurate with the statutory rate. However, as illustrated
by Example 3, this assumption could be easily proved wrong if the trustee, who often
was the grantor, invested for growth instead of income. In that case, as the example
illustrates, the value of the retained income interest would be overstated; and,
not coincidentally, the value of the gift of the remainder would be undervalued.
Code Sec. 2702 proscribed this valuation method in those cases where a beneficiary
is a “member of the family” of the grantor.
Under Code Sec. 2702, a GRIT for
a member of the family will be valued for gift tax purposes as if the entire
interest transferred to the trust were given to the remainder beneficiaries immediately.
This result occurs because the interest retained by the transferor is not a
“qualified retained interest”, and, thus, is treated as having a value of zero.
A qualified interest includes fixed amounts payable to the grantor, such as a GRAT
provides, but definitely does not include an indeterminate “income” interest, because
Congress realized that an indeterminate income interest is too easily subject to
manipulation by grantors who, after the gift, may seek or acquiesce in an investment
policy favoring the remainder beneficiaries.
Example 3 above illustrates the effect
that an investment strategy favoring growth over fiduciary accounting income can
have on what the income and remainder beneficiaries actually receive.
Code Sec. 2702(b)’s definition of a qualified annuity interest is a simple one. It requires only that the interest “consist[] of the right to receive fixed amounts payable not less frequently than annually."[22] The regulations, however, have superimposed an intricate web of requirements that are similar, but not identical, to the governing instrument requirements of charitable remainder annuity trusts and charitable lead annuity trusts.[23] These requirements are discussed below.
The regulations’ requirements must be satisfied by appropriate provisions in the trust’s governing instrument.[24] Apparently, if they are satisfied as of the date of the grantor’s transfer to the trust, the interest will be valued as a qualified interest.
The regulations do not impose any adverse consequences if the parties, the trustee, and the beneficiaries, subsequently decide to disregard a requirement contained in the trust instrument. For example, as discussed below, the regulations require that the trust instrument prohibit prepayment of the annuity. In many states, the creator of a trust, with the consent of all of the beneficiaries, may revoke or amend the terms of a trust.[25] What would the consequences be under Code Sec. 2702 if a trust that otherwise qualified as a GRAT were subsequently amended to provide a commutation clause?[26]
The regulations originally provided that the trust instrument must require that the annuity amount be payable for each taxable year of the trust. Most GRATs will be on a calendar year basis. The requirement that the annuity be payable for each calendar year meant that for GRATs that were started on a date other than January 1, the first annuity payment was required to be paid within, rather than at the end of, the first full year of its existence.[27]
A 2000 amendment to this regulation created more flexibility. The new regulation makes it clear that the annuity may be payable annually (or more frequently) based on the anniversary date of the trust as well as the taxable year of the trust.[28]
The trust instrument must require proration of the annuity payment made for a period of less than 12 months in the same manner as is required for charitable remainder annuity trusts under Treas. Reg. § 1.664-2(a)(1)(iv). A clause similar to the following would satisfy this requirement for a GRAT that requires payment of the annual amount in each taxable year of the trust:
In determining the annuity amount, the Trustee shall prorate such amount on a daily basis for any short taxable year and for the taxable year in which the Trust terminates.[29]
The annuity must be paid to the annuitant whether or not the
trust has produced income equal to the annuity. If income is insufficient, the trustee
must be required to invade principal to pay the annuity. Since the regulations’
requirements are all governing instrument requirements, they do not stipulate a
penalty for a trustee’s failure to make
The regulations require that the annuity must be paid no later than 105 days after the anniversary date of the creation of the trust if the annuity is payable based on the anniversary date and no later than the date on which the trustee must file the trust’s income tax return (determined without extensions) if the annuity amount is payable based on the taxable year of the trust.[31]
The trust instrument must require that the trustee actually pay the annuity amount to or for the benefit of the annuitant, referred to in the regulations as the “holder of the annuity interest.” It is not sufficient to give her the annual right (even a cumulative right) to withdraw the annuity amount.[32]
Nor is it sufficient for the trustee to issue notes to satisfy the annuity payment, since the effect of the issuance of notes is to defer the annuitant’s receipt of payment. The regulations state that the “issuance of a note, other debt instrument, option or other similar financial arrangement, directly or indirectly, in satisfaction of the annuity amount does not constitute payment of the annuity amount.”[33] The explanatory material that preceded the final regulation in the Federal Register makes it clear that borrowing from a third party to raise funds to pay the annuity amount will be permitted but that the step transaction doctrine will be applied if a series of transactions is used to achieve the same economic result as a borrowing from the grantor. For example, a borrowing by the GRAT from a bank to pay the annuity followed by a borrowing from the grantor to repay the bank would not be permitted. The use of the phrase “directly or indirectly” in the final regulations is intended to convey this idea.[34]
The regulations also provide that the GRAT instrument “must prohibit the trustee from issuing a note, other debt instrument, option, or other similar financial arrangement in satisfaction of the annuity . . . payment obligation.”[35]
The annuity amount must be a fixed amount. By this the regulations
mean an amount that is fixed in the trust instrument either in terms of a fixed
dollar amount or in terms of a fixed percentage of the initial fair market value
of the property transferred to the trust, as finally determined for federal tax
purposes.[36] The
Service will not ordinarily issue rulings on whether annuity interests are qualified
annuity interests under Code Sec. 2702 if the amount of the annuity payable annually
is greater than 50% of the initial net fair market value of the property transferred
to the trust, or if the value of the remainder interest is less than 10% of the
initial net fair market value transferred to the trust.[37]
If the ruling position of Rev. Proc. 2003-3 were actually
a requirement for qualification for a GRAT, a zeroed-out 2-year GRAT would be impossible
on two counts. (1) In order to zero out the GRAT, a payout of over 50% would be
required. (2) A zeroed-out GRAT, by definition, contemplates that the value of the
remainder will be less than 10% of the initial corpus.
A similar rule was adopted in legislation affecting
charitable remainder trusts (CRTs). Like the zeroed-out GRAT, but in reverse, it
used to be possible, prior to a change in the Code, to structure a CRT so that the
value of the remainder interest passing to charity was negligible. An easy way for
Congress to prevent the perceived abuse allowed by Walton type GRATs would be to legislate the provisions of Rev. Proc.
2003-3 into law.
.
Although not an issue addressed
by the Tax Court in Walton, it is notable
that the two proscriptions preventing a favorable ruling were violated in the Walton case. The second year’s annuity
in Walton was expressed as 59% of the
original value of the property transferred and the retained interest was .006%
of the initial value of the property transferred.
The regulations do not require that the fixed amount be the same for each year. The only requirement imposed on variations in amounts payable from year to year is the requirement that an amount payable in one year not exceed 120% of the amount payable in the prior year.[38] The following two examples illustrate the two ways of defining a qualified annuity interest:
Example 4: John transferred $1,000,000 to a 4‑year trust. The terms of the trust required the trustee to pay him an annuity of $100,000 in the first year, $90,000 in the second year, $50,000 in the third year, and $60,000 in the fourth year. After the fourth payment has been made to John, the trustee is required to distribute the remaining trust assets to his son Patrick.
Example 5: Jennifer transferred 100 shares of the X corporation to a 4-year trust. The terms of the trust required the trustee to pay her an annuity equal to 10% of the initial value of the trust assets in the first year, 12% in the second year, 14% in the third year, and 16% in the fourth year. In each case the value is to be the value as finally determined for federal tax purposes. After the fourth payment has been made to Jennifer, the trustee is required to distribute the remaining trust assets to her son Patrick.
If the trust property will appreciate over the term of the
trust at a uniform rate and if annuity payments will have to be made from trust
principal or from income that could have been invested to produce the same rate
of return as principal, a pattern of increasing annuity payments will produce more
value for the beneficiaries at the end of the term than would a pattern of constant
annuity payments. This may be particularly useful, especially
in the case of a GRAT is funded with discounted interests in an entity such as
a non-controlling interest in a closely held corporation when it is expected that
income might initially exceed the annuity payments, because the build up can serve
as leverage. In any case, if the GRAT outperforms the Code Sec. 7520 rate, the extra
amount left in the trust is not only outperforming the Code Sec. 7520 rate but it
is earning additional dollars for the remainder beneficiaries at the higher rate
while doing so.
Treas. Reg. §25.2702-3(e), Ex. (3)
clearly allows the annuity to decrease without apparent limit. It may be that the
decreases must be made in two year increments, at a minimum, on the theory that
what you have is a series of annuities, and that an annuity must be for more than
one year. However, this is unclear, since increasing the annuity each year, within
the 120% ceiling, does not pose a problem. A decreasing annuity might result in
less of an estate tax inclusion if the grantor dies during the term and if the taxpayer
is successful in arguing that inclusion is limited to §2036(a)(1)[39] rather than §2039, which unfortunately
is a position with which the Service is unlikely to agree.[40]
Table 1 below compares the two different approaches. The table assumes an initial principal of $1,000,000, a Code Sec. 7520 rate of 8% when the trust is created, an annual growth rate of 10%, a ten-year term, and an annuity pattern the value of which (at the start of the trust) is equal to $1,000,000. The annuity pattern set forth in column “[3]” increases by 120% per year; the one set forth in column “[5]” remains constant. The remainder beneficiaries receive 29% more when the annuity is set to increase by 120% each year than they would if the annuity remained constant throughout the term of the trust.[41]
Table 1
|
[1] |
[2] |
[3] |
[4] |
[5] |
|
Year |
Principal |
Annuity |
Principal |
Annuity |
|
|
10% Growth |
|
10% Growth |
|
|
1 |
$1,000,000 |
$50,268 |
$1,000,000 |
$123,291 |
|
2 |
$1,049,732 |
$60,322 |
$976,709 |
$123,291 |
|
3 |
$1,094,383 |
$72,386 |
$951,089 |
$123,291 |
|
4 |
$1,131,435 |
$86,864 |
$922,907 |
$123,291 |
|
5 |
$1,157,714 |
$104,237 |
$891,907 |
$123,291 |
|
6 |
$1,169,249 |
$125,084 |
$857,806 |
$123,291 |
|
7 |
$1,161,090 |
$150,101 |
$820,296 |
$123,291 |
|
8 |
$1,127,099 |
$180,121 |
$779,035 |
$123,291 |
|
9 |
$1,059,688 |
$216,145 |
$733,647 |
$123,291 |
|
10 |
$ 949,512 |
$259,374 |
$683,721 |
$123,291 |
|
Balance |
$ 785,089 |
Balance |
$628,802 |
|
The regulations permit the trustee to distribute amounts in excess of the annuity amount to the annuitant.[42] The distributions may be made from income or principal. The value, however, of any rights to receive payments in addition to the qualified annuity interest has a zero value for gift tax purposes.[43] As a theoretical matter, the Service could argue, depending on the types of distributions permitted or required, that such additional rights affect the value of the annuity interest. However, if the annuity, as a percentage of the initial fair market value, exceeds the Code Sec. 7520 rate, the retention of the right to receive any income in excess of the annuity amount should not affect the valuation of the annuity interest.[44]
Finally, the regulations require that, if the annuity amount has been defined as a percentage of or as a fraction of the value of the trust’s assets, the trust instrument contain a provision requiring adjustment of annuity amounts previously paid if an error was made by the trustee in determining such value. The adjustment clause must satisfy the requirements of Treas. Reg. §1.664-2(a)(1)(iii), which deals with a similar problem in connection with charitable remainder annuity trusts.[45] A clause similar to the following would satisfy this requirement:
If the net fair market value of the Trust assets is incorrectly determined, then within a reasonable period after the value is finally determined for federal tax purposes, the Trustee shall pay to the Donor (in the case of an undervaluation) or receive from the Donor (in the case of an overvaluation) an amount equal to the difference between the annuity amount property payable and the annuity amount actually paid.[46]
The regulations neither require nor explicitly permit interest to be paid on required adjustment payments.
If the value of the initial
transfer is understated, the taxpayer will not incur gift tax if the the
annuity is expressed as a percentage of, or fraction of, the initial fair
market value of the transferred assets. When the annuity is expressed as fixed
dollar amount, the value of the annuity will not be adjusted and a re-valuation
will result in a gift of the amount of undervaluation. Therefore, the annuity
should never be expressed in terms of a dollar amount when the value of the
contribution is uncertain.
The trust instrument must prohibit additional contributions to the trust.[47] This requirement is arguably inappropriate because a post-creation transfer could never adversely affect the value of the retained annuity interest and would be fully subject to gift tax. The gift tax would be imposed on the addition because it could not increase the amount of the grantor’s annuity interest.[48]
The trust instrument must prohibit “commutation."[49] By this term, the regulations refer to the pre-payment by the trustee of the annuitant’s annuity interest. This requirement is also arguably inappropriate because a commutation clause requiring that the pre-payment amount equal to the then actuarial value of the annuitant’s remaining annuity payments could not be used to reduce the value of the annuitant’s interest in the trust.[50]
It is likely that the Service’s reason for prohibiting commutation
was to prevent termination of a GRAT at a
What if instead of having the
trust prepay the grantor the value of the grantor’s interest, the grantor sells
the interest to a third party? Is that a commutation (prepayment)? Presumably
not, though the IRS might not agree with this conclusion. This issue is
discussed later in this article.
Although commutation is
prohibited, there are no governing instrument requirements in the regulations
that require the GRAT to explicitly preclude a sale of the annuity. However,
Treas. Reg. §25.2702-3(b)(1) states:
“The
annuity amount must be payable to (or for the benefit of) the holder of the
annuity interest at least annually.”
More importantly, perhaps,
Treas. Reg. §25.2702-3(d)(2) provides:
“The
governing instrument must prohibit distributions from the trust to or for
the benefit of any person other than the holder of the qualified annuity or
unitrust interest during the term of the qualified interest.” (Emphasis added.)
The
proper interpretation of the prohibition against commutation should be that the
Trustee herself cannot pay off the income interest which would, in effect,
terminate the arrangement prematurely. If the Grantor’s continuing interest is
terminated externally, rather than internally, this should not be a commutation
since the split interest arrangement is continued until the last annuity is
finally paid.
The trust instrument must prohibit payments from the trust before the expiration of the qualified interest to or for the benefit of any person other than the annuitant.[51] The charitable lead trust regulations contain a similar provision.[52]
The term of the qualified annuity interest must be fixed in the trust instrument and must be for (i) the life of the annuitant, (ii) a specified term of years, or (iii) the shorter of those two periods.[53]
These requirements are not imposed by the statute. Code Sec.
2702(b)(1) does not impose any limitations on the period over which the fixed amounts
are payable. The regulations’ requirements as to the permissible term of a GRAT
differ from the corresponding charitable lead trust requirements[54]
in two respects. First, the charitable lead trust regulations do not require that
the measuring life or lives be the life or lives of individuals who have interests
in the trust. Until recently, the measuring life could be any life at all. There
was no requirement that the individual have any relationship to the trust, the donor,
or the trust beneficiaries. Recently issued final Treasury Regulations, which generally
apply to transfers to inter vivos charitable lead trusts made on or after
Second, the charitable lead trust regulations permit a trust to be measured by a life or lives plus a number of years.
The GRAT regulations contain one example that is inconsistent with the regulations’ general rule characterizing an annuity payable over a term of years as a qualified interest. Treas. Reg. § 25.2702-3(e), Example 5[57] provides as follows:
“A transfers property to an irrevocable trust, retaining the right to receive 5 percent of the net fair market value of the trust property, valued annually, for 10 years. If A dies within the 10-year term, the unitrust amount is to be paid to A’s estate for the balance of the term. A’s interest is a qualified unitrust interest to the extent of the right to receive the unitrust payment for 10 years or until A’s prior death."[58]
The effect of this example, if correct, would be to reduce the value of A’s 10-year annuity to the value of an annuity payable until the earlier to occur of her death or the expiration of the 10-year period. Under Example 5 (just quoted), the portion of the retained interest that represented the death contingency is treated as something other than a “qualified interest.” It follows, somewhat bizarrely, that the interest passing to the estate of the grantor would “be treated as” a gift to the remainder beneficiaries.
Example 5 is also inconsistent with two other examples that also appear in Treas. Reg. § 25.2702-3(e). Both Examples 2 and 3 characterize annuity payments made over a term of years as qualified interests with no limitation related to the life span of the annuitant.[59] In Example 2, U transfers property to an irrevocable trust and retains the right to receive $10,000 per year in the first three years, $12,000 per year in the next three years, and $15,000 per year in the next four years. The example concludes that U’s interest is a qualified annuity interest in each of the ten years except that the interest in year seven is qualified only to the extent of $14,400 because of the 120% limitation on year-to-year annuity increases. Similarly, Example 3 concludes that S’s right to receive $50,000 in each of the first three years of her trust and $10,000 in each of the next seven years is a qualified annuity interest in its entirety.
In
Code Sec. 2702(a)(2)(B) provides that the value of a qualified annuity interest will be determined under Code Sec. 7520. This means that the value of a gift to a trust in which the grantor has retained a qualified annuity interest will be determined by subtracting from the value of the property transferred to the trust an amount equal to the actuarial value of the retained annuity.[62] Consider the following example:
Example 6: Jennifer
transferred $1,000,000 to a trust to pay her $100,000 per year for 10 years. At
the end of the annuity term, the trust property is required to be paid to her son
Patrick. At the
However, in determining the actuarial value of an annuity, the annuity is not deemed payable for the entire period if, using the Code Sec. 7520 rate, the trust funds would be exhausted before the last annuity payment is to be made.[65] For this purpose, measuring lives must be deemed to survive to 110 years of age.[66]
Example 7: The facts are the same as in Example 6 except that Jennifer, who is 50 years of age, retains an annuity payable for life rather than for a 10-year term. If Jennifer survived to age 110, the annuity may continue for 60 years. The actuarial value of the right to receive $100,000 per year for 60 years is $1,237,660. Since the present value of an annuity for a term of 60 years exceeds the corpus, the annuity may exhaust the corpus before all payments are made. Thus, the annuity must be valued as if payable for a term of years equal to the number of years in which the fund is projected to be exhausted or the prior death of the annuitant. If the trust property generates income and appreciation of 4% per year, the trust will be able to pay Jennifer $100,000 per year for only 13 years and will be able to make a final payment of $2,485 at the end of the 21st year. The value of Jennifer’s retained interest is the sum of the present values of these two amounts. The right to receive $100,000 per year for the shorter of 13 years or the life of a 50 year old individual has a present value of $957,460. The right to receive $2,485 at the end of 14 years if a 50 year old individual is alive has a present value of $1,265. The sum of the two is $958,727. The amount of Jennifer’s gift to Patrick, therefore, is $41,273.[67]
The value of the retained interests in a GRAT will generally increase as the Code Sec. 7520 rate decreases. This is so because a decrease in the deemed rate of current return will tend to make the right to receive fixed amounts in the future more valuable. This is the opposite of a GRIT or QPRT[68]. Why is that?
First, note that what we are
looking for is the sum of money needed to produce x amount at the end of the
term if it grows at the §7520 rate. This initial sum of money is the true value
of the gift. It is obviously true and fundamental to the analysis that the more
the grantor receives, the less the value of the remainder. And yet, the lower
the §7520 rate, the greater the value of the retained interest under a GRAT,
and the greater the value of the retained interest under a GRIT (including a
QPRT). Clients sometimes consider this a paradox needful of further
explanation. At the risk of further obfuscation, perhaps, an attempt to
illuminate the valuation question follows.
The more the grantor receives,
the less the remainder beneficiaries receive. This is easily comprehended. . It
is equally easy to understand that if interest rates are high, and if the
grantor is receiving “all of the income,” the value of the grantor’s interest
is greater than if interest rates are lower. This is because what the grantor
receives is relative to the prevailing interest rate. What has just been
described is what the grantor retains in a GRIT.
Unlike the beneficiary of an
income interest, the beneficiary of a fixed annuity (the grantor of a GRAT) receives
an amount that bears no direct relationship to the prevailing rate of return. The
only function that the prevailing rate of return (represented by the Sec. 7520
rate) plays in the equation is in ascribing value to the annuity. Unlike an
income interest, the annuity under a GRAT is fixed. It is what it is,
regardless of the Sec. 7520 rate. What the beneficiary receives is not tied to
the Sec. 7520 rate at all.
The value of what the annuitant/beneficiary
receives is another matter entirely. The greater the current assumed rate of
return, the less the value of an annuity that is fixed absolutely in a manner
not tied to the prevailing Sec. 7520 rate. The
analysis is similar to the bond market. If the prevailing interest rate for
bonds is 5% and you own a 10% bond, your 10% bond is worth more than it would
be if the prevailing interest rate for bonds were 15%. It follows that in a
GRAT —which, like most bonds, pays a flat rate—, the greater the assumed rate
of return (represented by the Sec. 7520 rate), the greater the gift tax value
of the remainder, which is the converse of the GRIT or QPRT.
Thus, if interest rates are low,
a retained annuity is worth more than it would be if interest rates were higher.
Accordingly, the lower the §7520 rate,
the less size of the taxable gift, and that is what is desired in a GRAT.
To the contrary in a GRIT, of
which a QPRT is a species. In a GRIT, the lower the prevailing rate of return
(represented by the Sec. 7520 rate), the less the value of the retained income
interest (which in a QPRT is represented by the right to live in the home), and
the value of the gift of the remainder is commensurately greater.
The table below shows the effect of changes in the Code Sec. 7520 rate on the amount of the taxable gift attributable to the creation of a 10-year GRAT with a required annuity equal to 12.33% of the initial value of the trust property.[69]
Table 2
|
|
Value of Retained Interest
as % of Property Transferred |
Value of Gift as % of Property Transferred |
|
4.00% |
100.00% |
0.00% |
|
5.00% |
95.20% |
4.80% |
|
6.00% |
90.74% |
9.26% |
|
7.00% |
86.59% |
13.41% |
|
8.00% |
82.73% |
17.27% |
|
9.00% |
79.12% |
20.88% |
A qualified annuity payable to the husband of the grantor will be treated as an annuity retained by the grantor if she has retained the power to revoke it.[70] For example, suppose that Jennifer, the grantor described in Example 6, had directed the trust to pay the $100,000 per year to her husband John rather than to her and that she had retained the power to revoke the annuity. If the trust provisions otherwise satisfy the governing instrument requirements discussed above, John’s annuity will be treated as having been retained by Jennifer.[71]
The gift tax consequences of a life-
In light of the IRS’ acquiescence
in Walton[73], this issue is irrelevant
for prospective planning purposes, since payment to the grantor’s estate can achieve
an even better result, because the grantor’s mortality is not a factor that need
be considered. Since there are still a number of GRATs existing that contain the
revocable contingent annuity feature, an extended discussion of this abstruse issue
is perhaps still in order.
This is a complicated issue. It is
also one in which the Service has reversed itself.[74] The idea springs from Treas.
Reg. §25.2702-2(a)(5), second (and last) sentence. “Retention of a power to revoke
a qualified annuity interest[75] (or unitrust interest) of
the transferor’s spouse is treated as the retention of a qualified annuity interest
(or unitrust interest).”[76] This is a very puzzling and
peculiar rule, and what it means exactly has been the subject of much uncertainty.
Recall that the rules under §2702
do not apply to a GRIT for a spouse, if the grantor retains no interest. “Section
2702 does not apply because neither the transferor nor an applicable family member
has retained an interest in the trust.” [77]
It appears, given the Service’s evolving/changing
position, that the spouse’s interest can qualify if the grantor has retained a predecessor
interest, if the spouse’s interest is not contingent on surviving the grantor. The
contingency that it may be revoked is another matter, and seems to be required,
which is one reason that this whole area remains a mystery, at least to some.
A power to revoke an interest in
a spouse is not something mentioned in the statute, but it is mentioned in the regulations,
and it has caused much confusion, to many, including me. Two examples in the regulations
address this issue:
Example (6). A transfers property to an irrevocable trust, retaining the
right to receive the income for 10 years. Upon
expiration of 10 years, the income of the trust is payable to A’s spouse for 10
years if living. Upon expiration of the spouse’s interest, the trust terminates
and the trust corpus is payable to A’s child. A retains the right to revoke the
spouse’s interest. Because the transfer of property to the trust
is not incomplete as to all interests in the property (i.e., A has made a completed
gift of the remainder interest), section 2702 applies. A’s power to revoke the spouse’s term interest is treated as a retained
interest for purposes of section 2702. Because no interest retained by A is
a qualified interest, the amount of the gift is the fair market value of the property
transferred to the trust.
***Example (7). The facts are the same as in Example 6, except that both the
term interest retained by A and the interest transferred to A’s spouse (subject
to A’s right of revocation) are qualified annuity or unitrust interests. The amount of the gift is the fair market value
of the property transferred to the trust reduced by the value of both A’s qualified
interest and the value of the qualified interest transferred to A’s spouse (subject
to A’s power to revoke).[78]
Just how these examples are to be
interpreted has never been clear. We know from Treas. Reg. §25.2702-2(d) Example
(3) that the rules under 2702 do not apply to a GRIT for a spouse, if the grantor
retains no interest. We also know that the last sentence of Treas. Reg. §25.2702-2(a)(5)
states that the “[r]etention of a power to revoke a qualified annuity interest (or
unitrust interest) of the transferor’s spouse is treated as the retention of a qualified
annuity interest (or unitrust interest).”[79] But, is it safe to say that
term “qualified interest” includes the retention of a power to revoke a qualified
interest of someone other than the spouse? At one
Apparently, under the Cook[80] case (perhaps in dictum)[81], it is fine to have a revocable
spousal successor interest not contingent on surviving the grantor, but that only
the grantor’s single life expectancy can be considered, not the joint life expectancy
of the grantor and the grantor’s spouse, which is only relevant if Example 5 under
the Dash 3 regulation is valid. Under Walton,[82] Example 5 is not valid, which
may make the whole issue moot given the Service’s acquiescence[83] in Walton.
On the other hand, in Schott v. Com.[84], the Ninth Circuit reversed
the Tax Court and held that the joint life expectancy of the grantor and the grantor’s
spouse could be used, where the GRAT was structured as a two-life annuity, where
the only contingency was the right of the grantor to revoke the spouse’s interest.
Note that if the power to revoke
is exercised, there could be a completed gift to the remainder beneficiaries at
that
Again, after the Service’s acquiescence
in Walton, there are no obvious gift tax
reasons why a married grantor would want to provide for an annuity interest in the
grantor’s spouse, applicable if the grantor dies during the term, which successor
interest is subject to a testamentary power to revoke. In fact, if Walton is good law, then this may be a bad
idea, since Walton may hinge on the unexpired
term interest being payable to the grantor’s estate in the event the grantor dies
prior to the end of the term.
If an individual wants to give an interest in a difficult-to-value asset, such as an interest in a closely held business, the GRAT offers an opportunity to make the transfer without running a significant risk of unexpected gift tax. The gift tax risk can be reduced by the use of a formula to define the amount of the retained annuity. Consider the following example.
Example 8: Patrick owns all of the shares of the X corporation. He believes that X is worth $1,000,000 and that a 30% interest in X is worth $195,000, after applying a 35% minority discount. Patrick transfers 30% of the X corporation to a GRAT. The terms of the trust instrument provide him with an annuity of 12% of the initial value of the trust property payable for 10 years. At the end of the 10-year term, the trust property is to be paid to his daughter Kate. Assuming a Code Sec. 7520 rate of 4% and an initial value of $195,000, Patrick’s retained annuity is worth $189,795. His gift to Kate will be $5,205.[85]
If the Service successfully argues that the 30% interest in the X corporation is worth $390,000 instead of $195,000, the value of Jennifer’s gift to Patrick will increase only modestly. This is so because the increase will be restricted by the increase in the amount of Jennifer’s retained annuity caused by the GRAT’s annuity formula. If the value of the stock is determined to be $390,000, Jennifer’s annuity will double from $23,400 to $46,800. The present value of the right to receive $46,800 per year for 10 years is $379,590, leaving a taxable gift of only $10,410.
In contrast, if the GRAT had defined the annuity as a flat $23,400 (12% of $195,000), an increase in the value of the shares transferred to the GRAT from $195,000 to $390,000) would have increased Jennifer’s taxable gift from an expected $5,205 to $200,205.
When the annuity term ends and the remaining trust property is paid to the remainder beneficiary, no additional gift tax is imposed on the grantor. The grantor’s gift was complete for gift tax purposes when the trust was created. There is no mechanism in the gift tax that permits the assessment of an additional tax in the event the assumptions on which an original valuation was made prove to be inaccurate.
If the trust property generates a total return in excess of the Code Sec. 7520 rate used to value the annuity interest when the trust was created, there will be value in the trust in excess of the portion of the original trust that was subject to gift tax. This amount will pass to the remainder beneficiaries free of gift tax. Consider the following example:
Example 9: Suppose the shares of X that Patrick gave to the trust described in Example 8 produce a total return of 10% per year for the 10-year term of the trust. After Patrick has received all of the annuity payments to which he was entitled, the trust property will be worth $132,844, all of which is payable to Kate. If the property’s total return had been consistent with the Code Sec. 7520’s 4% rate used to value the annuity interest, she would have received only $7,705 at the end of the trust’s term.[86]
Example 9 illustrates one of the most important estate planning attributes of the GRAT - it permits a transferor to shift to the objects of her bounty any portion of the future return generated on her investments in excess of the original Code Sec. 7520 rate without paying a significant gift tax.
If a grantor dies while she has the right to receive further annuity payments from her GRAT, some portion, or all, of the GRAT will be included in her gross estate for federal estate tax purposes under Code Sec. 2036. This section requires that a transferor include in her gross estate the value of property transferred during her life if she retained for life, or for a period that did not end before her death, the right to the income from the transferred property.
The grantor of a GRAT does not explicitly retain the right to income. Instead, she retains the right to an annuity which may be more or less than the actual income received by the trust. The Service treats this type of retained interest as if it were the right to receive the income from a portion of the trust corpus. That portion is required to be included in the gross estate. The included portion is that fraction of the corpus which would be required to be invested at the Code Sec. 7520 rate in effect on the date of the grantor’s death to produce annual income equal to the required annuity payment.[87] Consider the following example:
Example 10: John
transferred $1,000,000 to a GRAT to pay him an annuity of $100,000 per year for
the lesser of 10 years or his remaining life
If a GRAT is established by joint contributions made by the beneficiary of the annuity interest and by the beneficiary of the remainder, and if each has contributed an amount equal to the actuarial value of her interest in the trust, Code Sec. 2036 ought not to apply on the death of the annuitant. Code Sec. 2036 applies only if the decedent has not received adequate and full consideration in money or money’s worth for her transfer.
In Private Letter Ruling 9515039,[88] the Service determined that Code Sec. 2036 did not apply in the case of such a joint purchase when the obligation to pay the annuity was guaranteed by the holder of the remainder interest who had sufficient assets, independent of her interest in the jointly purchased property, to satisfy the annuity. The Service cited Rev. Rul. 77-193[89] in support of its conclusion. In that ruling, the Service had concluded that Code Sec. 2036 did not apply to a transfer of property in exchange for the personal obligation of a transferee that was not satisfiable solely out of the transferred property and the amount of which was not determined by the size of the income generated by the transferred property. In the absence of such a guarantee, however, the Service may have characterized the annuity as a retained interest in property transferred by the decedent.
If the grantor has the right to receive annuity payments after her death, the correct measure of inclusion in her gross estate is unclear. Suppose, for example, that John, the grantor described in Example 10, had retained the right to receive $100,000 per year for 10 years, whether or not he lived for 10 years. Suppose further that on the date of his death, the actuarial value of his right to receive the last annuity payment was worth $95,346. The value of the final annuity payment should be included in his gross estate under Code Sec. 2033. To what extent does the inclusion of a portion of the trust under Code Sec. 2033 affect the amount of the inclusion under Code Sec. 2036?
There are at least three possible approaches. First, the inclusion could be limited to the larger of the two amounts. Under these facts, $1,000,000 would be included. Second, the inclusion could be the sum of the two amounts, in this case, $1,095,346. The third and perhaps the best approach is to determine which portion of the trust each section includes and to adjust for any double counting. In Example 10, one-half of the principal of the trust is required to be included under Code Sec. 2036 because John is deemed to have retained the right to the income from one-half of the principal. Since the final annuity payment, which is required to be included under Code Sec. 2033, could be made from either half of the trust, arguably, it should result in an additional inclusion of only half of the $95,346 or $47,673.
In several recent private letter rulings the Service took the position that the gross estate of a decedent who died before the termination of her right to receive an annuity from a GRAT must include the full value of the trust corpus under Code Sec. 2039(a).[90] This section requires inclusion of the value of an annuity or other payment receivable by any beneficiary by reason of surviving the deceased annuitant under a contract or other agreement under which an annuity or other payment was payable to the decedent.
The Service’s application of Code Sec. 2039 to an annuity paid under a trust instrument of which the decedent is the grantor or settlor is of questionable validity. Code Sec. 2039 appears to require a “purchase” of an annuity rather than a transfer subject to a retained interest. For this reason, Code Sec. 2039(b), which describes the amount includible, limits the includible amount to the amount of the survivor’s annuity (or other amount) proportionate to the amount of the “purchase price” contributed by the decedent. A grantor who transfers property to a trust in which she retains an annuity interest does not pay a purchase price for the annuity.
The use of the purchase price as the mechanism for determining the amount of inclusion suggests the necessity of a commercial or buyer-seller relationship between the decedent and the person making her annuity payments, a relationship that does not exist between the grantor of a GRAT and her trustee. The legislative history Code Sec. 2039, which was added to the Code in 1954, suggests that it was intended to codify the inclusion rule applicable to joint and survivor annuities purchased by a decedent that had developed under existing case law [91] and to extend it to certain annuities purchased for a decedent by her employer.[92] The transferor to a GRAT is not buying an annuity from her trust. She is simply making a transfer of property and retaining an interest in that property. The trustee assumes no personal obligation to make the required annuity payments to the transferor. If the trust assets are insufficient to make payment, the transferor has no claim against the trustee other than possibly a claim based on a charge of imprudent management of trust assets.[93]
If a transferor’s retained annuity interest is assumed to be an annuity for purposes of Code Sec. 2039(a), the Service’s position in the private letter rulings, nevertheless, should not apply to all GRATs. For Code Sec. 2039(a) to apply, not only must an annuity be payable to the decedent, but there must also be a payment to another beneficiary and that payment must be receivable by that beneficiary “by reason of surviving the decedent.”
In many cases, there will be no payment from a GRAT to another
on the transferor’s death. The transferor’s right to receive an annuity from her
GRAT does not end at her death. The annuity is payable for a fixed period of
In some cases, the risk of inclusion under Code Secs. 2036
and 2039 can be avoided by a post-transfer sale of the annuity interest to another.
For example, suppose that John, the grantor described in Example 10, had sold his
annuity interest to his wife at the end of the first year of the GRAT. At that
The Service could take the position that such a sale would
result in the GRAT’s annuity ceasing to qualify as a qualified interest because
the annuity would no longer be payable to the original annuitant, referred to in
the regulations as the “holder of the annuity interest.” Such payments arguably
violate the requirements in the regulations that the annuity be paid to the holder
of the annuity interest[97]
and that no payments be made from the trust to any person other than the holder
of the annuity interest before the expiration of the qualified interest.[98]
Since the appropriate
An alternative approach is a post-transfer purchase by the grantor of the remainder interest.[100] For example, suppose that John, the grantor described in Example 10, purchased the remainder interest from Patrick at the beginning of the ninth year when the remainder interest had an actuarial value of $1,909,091. John’s death within the ten-year term would result in the inclusion of the full value of the trust property in his gross estate because he would own all of the trust property at his death. However, his estate would be reduced by the $1,909,091 he paid to Patrick for the remainder interest.[101]
Patrick’s sale of his remainder interest would result in his
recognition of gain to the extent the value of his proportionate interest in the
trust, 95%, exceeds 95% of the trust’s basis in its assets.[102] This result might be avoided by John’s purchase
for cash of all appreciated assets from the trust at some
If the creation of the GRAT was treated in part as a taxable gift, the amount of the taxable gift will be treated as an adjusted taxable gift in calculating the grantor’s estate tax base except to the extent that the GRAT is included in the grantor’s gross estate. The amount of any gift taxes payable on the gift will offset the estate tax calculated on the estate tax base. For example, suppose that John, the grantor described in Example 10, made a taxable gift of $300,000 when he created the GRAT and that the gift tax payable on this amount was $165,000. If John outlives the term of the GRAT, his adjusted taxable gifts will include the $300,000 taxable gift and the amount of his estate tax will be reduced by a portion of the $165,000 gift tax.[106]
If John dies within the term of the GRAT so that some portion
of the GRAT is included in his gross estate, the inclusion will eliminate some portion
of his adjusted taxable gifts. This is so because Code Sec. 2001(b) defines “adjusted
taxable gifts” as “the total amount of the taxable gifts (within the meaning of
section 2503) made by the decedent after
The amount by which a grantor’s adjusted taxable gifts should be reduced, however, is not always clear. In Example 10, for example, the inclusion of one-half of the GRAT in John’s gross estate should reduce his adjusted taxable gifts caused by the creation of the GRAT by one-half.
If, however, an amount was included in John’s gross estate under both Code Sec. 2033 and Code Sec. 2036, as would be the case if John retained the right to receive annuity payments after his death, arguably, an amount included under Code Sec. 2033 should not reduce the amount of his adjusted taxable gifts. This is so because the amount included under Code Sec. 2033 was not the subject of a gift by John. It represents part of what was retained by him. If the third approach discussed above in connection with measuring the amount included is adopted, the aggregate amount included would be $1,047,673. Of this amount 1,000,000/1,095,346 or $956,477 seems to be properly attributable to the Code Sec. 2036 inclusion. Conversely, 95,346/1,095,346 or $91,165 should be attributable to the Code Sec. 2033 inclusion. If $956,477 is the correct amount of the Code Sec. 2036 inclusion, since this represents 47.82% of the current value of trust, 47.82% of the $300,000 original taxable gift should be excluded from John’s adjusted taxable gifts.
In the event that some or all of the GRAT is included in the grantor’s gross estate for federal estate tax purposes, tax apportionment problems can arise if the beneficiaries of the GRAT are different from the beneficiaries of the grantor’s estate.
Example 11: The terms of John’s GRAT require that at the end of the GRAT term the remaining assets be paid to his son Patrick. John’s will provides that all of his estate’s assets be paid to his wife. If John dies before the end of the GRAT term and a portion of the GRAT is included in his estate, and if his will apportions estate taxes against his residuary estate, the additional estate taxes would be borne by the estate and paid from the assets passing to his wife; Patrick would receive the GRAT assets free of estate tax.
To avoid this result, the grantor’s Will could require that death taxes payable as a result of amounts included in the estate by reason of the GRAT be apportioned pro rata among the persons who benefit from the GRAT or against the GRAT itself. This will prevent the beneficiaries under the grantor’s Will from bearing a disproportionate amount of estate tax on the assets they receive.
The possible application of the marital deduction should be considered in connection with the creation of a GRAT. If a portion of a GRAT is included in the grantor’s gross estate, and if she is survived by her husband, the marital deduction could be disallowed for any portion of the included interest even if the transferor bequeaths her entire estate to her surviving spouse.
Suppose, for example, that the terms of the GRAT require any annuity amounts payable after the death of the grantor to be paid to the grantor’s estate and that, under the grantor’s will, these payments are to be made to the surviving spouse. Since the trust will end in favor of the remainder beneficiaries, the annuity payable to the surviving spouse will be a nondeductible terminable interest.[107] To avoid this result, the GRAT might give the grantor a power of appointment exercisable over such portion of the trust as is includible in her gross estate. She could then exercise this power in favor of her husband. If the grantor’s spouse is to receive both the remaining annuity payments and the property held in the GRAT at the end of its term, the nondeductible terminable interest rule will not apply.
Alternatively, the GRAT could provide that if the grantor dies during the term of the GRAT, the surviving spouse would receive the remaining annuity payments plus all of the trust income for the rest of his life. Her executor could then elect to treat the entire trust as qualified terminable interest property.[108] Since the election would be applicable only to that portion of the GRAT that was includible in the grantor’s gross estate, only that portion would be included in the spouse’s gross estate at death.[109]
Code Sec. 2702’s zero valuation rule does not apply for generation-skipping transfer tax purposes.[110] The nonapplicability is not helpful from a planning point of view because, in most cases, the generation-skipping transfer tax does not apply to a transfer to a trust in which the grantor has retained an interest or, if it applies at all, applies to all trust property, no matter how fragmented its interests are. Consider the following example:
Example 12: Jennifer transferred $1,000,000 to a trust to pay income to herself for 10 years, remainder to her granddaughter Kate. The amount of Jennifer’s gift to Kate will be $1,000,000 under Code Sec. 2702. For generation-skipping transfer tax purposes, however, the gift will be treated as a gift to a trust rather than to Kate.[111] As a result, no generation-skipping transfer tax will be imposed until the termination of Jennifer’s interest in the trust. On the termination of the trust, however, the full value of the trust will be subject to generation-skipping transfer tax.
The result described in Example 12 applies to GRATs as well as to retained income interests. As a result, on the termination of an annuitant’s interest in a GRAT, if the trust property is paid to or held for a skip person, such as the grantor’s grandchild, the property will be subject to the generation-skipping transfer tax.
To avoid this result, it may be advisable to provide that the remainder interest in a GRAT be divided among the grantor’s living children. If the grantor wants a deceased child’s children to receive the portion of the GRAT that the child would have received if the child had survived, it is preferable to provide for such grandchildren by direct compensating gifts or by compensating bequests in the grantor’s will.
Gifts and bequests to grandchildren who are children of a deceased
child are preferable since they will be protected from the generation-skipping transfer
tax by the so-called “predeceased parent exception."[112]
This exception may apply to transfers from a GRAT to a grandchild but only if that
grandchild’s parent is dead at the
If the predeceased parent exception is not available, outright gifts to grandchildren or gifts to trusts for their benefit are generally more tax efficient than transfers to grandchildren of remainder interests in trust. This is so because an outright gift is treated as a direct skip rather than a taxable termination or taxable distribution. The generation-skipping transfer tax imposed on direct skips will usually be lower than the generation-skipping transfer tax imposed on taxable distributions or taxable terminations.
If the grantor wants to designate a grandchild as the remainder
beneficiary of a GRAT, the only way to protect the ul
Because the grantor cannot make any allocation of her GST exemption
against the value of the GRAT assets passing to her grandchild until after the term
of her retained interest has expired, the exemption is allocated against the value
of the assets passing to her grandchild at that
If the GRAT investments out perform the Code Sec. 7520 rate
for the
It may be possible to protect a transfer to grandchildren at the end of a GRAT from the generation-skipping transfer tax by shifting the identity of the transferor with respect to the remainder interest. Suppose, for example, that the terms of a GRAT provided that the GRAT remainder would pass to a trust for the grantor’s daughter and the daughter’s children at the end of its term but that the daughter also had a testamentary general power of appointment over the remainder exercisable in the event the daughter died before the end of the GRAT term. If the daughter dies before the end of the GRAT term, the actuarial value of the GRAT remainder as of the date of her death will be included in her gross estate. Code Sec. 2651(a)(1)(A) provides that the transferor for generation-skipping transfer tax purposes in the case of property subject to the estate tax is the decedent in whose estate the property is taxed. The daughter’s death before the end of the GRAT term will, therefore, change the identity of the transferor from the original grantor to her daughter. When the GRAT property passes to the trust for the grantor’s grandchildren, there will be no generation-skipping transfer tax because the grantor’s grandchildren are not skip persons as to the grantor’s child.[113] The Service reached this conclusion in Private Letter Ruling 200227022.
In most cases, the use of a testamentary general power of appointment will not be an acceptable approach because it could expose the daughter’s estate to an unacceptably high estate tax. Suppose, for example, a 2-year GRAT was originally funded with $1 million. Suppose the grantor’s daughter died toward the end of the second year when the GRAT property was worth $2 million and the actuarial value of the remainder interest was $1.5 million. The daughter’s estate would be subject to estate tax on the full $1.5 million.
If a child of the grantor, rather than a trust for her benefit,
is the outright beneficiary of the GRAT, the same result should be achieved if she
makes a gift of her remainder interest. Code Sec. 2652(a)(1)(B) provides that the
transferor for generation-skipping transfer tax purposes in the case of property
subject to the gift tax is the donor. The child’s gift of the remainder interest
before the end of the GRAT term should, therefore, change the identity of the transferor
from the original grantor to her child.[114]
Because the child has transferred her entire
interest, the ETIP rule will not apply; she has not retained an interest which
would cause inclusion in her estate if she died immediately after the transfer.
In Private Letter Ruling 200107015, the Service, in a situation involving
a charitable lead annuity trust rather than a GRAT, concluded that the transfer
of a remainder interest by a child of the grantor shifted the identity of the transferor
only to the extent of the portion of the trust assets equal to the present value
of the remainder interest. Although the fact pattern in
the ruling was somewhat convoluted, and the transaction involved in the ruling
was the transfer of a remainder interest following a CLAT, where the rules for
allocating GSTT exemption are different than the ETIP rules applicable for a
GRAT, the obvious lesson is that the IRS can be expected to apply the same
reasoning in both to rule against the taxpayer. The Service ruled that there
would be two transferors as of the date of the assignment, the remainderman
with respect to the portion of the trust equal to the present value of his
remainder interest and the creator of the original trust as to the balance. Thus,
upon the end of the annuity term, the original transferor’s interest, which
generally would represent the bulk of the assets, would be subject to the GSTT.
For example, if the child gifted her remainder interest in a $1 million GRAT
at a
The Service’s position is based
on policy, that the purpose of IRC§2642(e) and (f) is to prevent the use of
these types of leveraging transactions to circumvent the application of the GSTT.
Many commentators believe that the Service’s position is technically
In order to protect against an immediate generation-skipping transfer tax on the termination of the GRAT if the Service successfully argues that the child does not become the transferor or that she becomes the transferor as to only a portion of the GRAT, the donee of the child’s gift of her remainder interest should be a trust for the benefit of the child’s children, and the trust should be structured so that it is a non-skip person as to the original transferor. Non-skip person status could be accomplished, for example, by including the child’s spouse or her siblings as additional trust beneficiaries. If the donee is a non-skip person as to the original transferor, no generation-skipping transfer tax will be imposed when the GRAT remainder is paid to that donee.
In such instance, the trust
should also contain language which would enable the transfer tax to be
converted from a generation-skipping tax to an estate tax by use of a general
power of appointment if the issue is ul
Many practitioners believe that
an estate owner’s inability to use generation-skipping leveraging with the GRAT
technique can be finessed by having the remainder beneficiary either gift or
sell her remainder interest to a dynastic trust a reasonable amount of
For instance, if at the
Even if there is no GST exempt
trust then in existence, there appears to be no proscription as to the creation
of a new trust, although the Service would have a better chance to prevail on
the theory that it was all a part of a single integrated transaction, or a form
over substance theory.
If the remainder beneficiaries
are the then living children of the grantor, each such child could chose to
sell, give or retain their respective contingent remainder interest, presumably
subject to a valuation reduction based upon the chance that such child will not
survive the term. If the remainder beneficiaries was the child if living or
their estate, each child would have a vested interest subject to disposal.
The use of a trust as the
remainder beneficiary of the GRAT has the advantage of allowing the planner to
avoid recognition of gain on the sale by structuring the remainder trust and
the GST exempt trust as grantor trusts as to the same person[118] or grantor trust where
spouses are treated as the owner of the trust.[119] In drafting a GRAT in
contemplation of the possible sale or gift of the remainder interest, it is
important to be sure that the spendthrift clause is drafted in a manner which
will not preclude such a transaction.
If it is concluded that the IRS
analysis in Private Letter Ruling 200227022 is incorrect, there are various
alternatives that may be used to implement the remainder interest transfer. The
first issue is whether to design the transfer as a gift or a sale. If the
transfer is by sale, the equality of the consideration received is an issue and
is of utmost importance if the sale is to a trust where the
remainderman/beneficiary is a trustee and/or beneficiary of the trust receiving
the remainder interest. In order to avoid a gift by the GRAT remaindermen to
the dynastic trust, the purchase price paid by the dynastic trust should be the
fair market value of the remainder, as determined should be the fair market
value of the remainder, as determined under IRC§7520. If the sale is for less
than adequate consideration and the remainderman is a beneficiary of the acquiring
trust there would be estate tax inclusion under IRC§2036(a), and if the
remainderman was the trustee under IRC§2038.
A sale will also create income
tax exposure unless it is made to a trust that is defective as to the seller
(or seller’s spouse) if an individual or if a trust is the seller, both trusts
are grantor trusts as to the same person or that person’s spouse. A sale will
not require the use of the seller’s GSTT exemption or unified credit. If the
gift route is used, the transferor will be required to use GSTT exemption to
protect the continuation of GSTT exemption. The gift route would prohibit the
transferor from being the trustee or a beneficiary of the recipient trust A
sale is after than a gift with regard to avoiding a “step-transaction” argument
by the IRS since two gifts followed closely in
The grantor trust rules[122] generally apply to trusts that are required to or are permitted to pay trust income and principal to their grantors. Such a trust is usually referred to as a “grantor trust.” A trust may be a grantor trust in whole or in part. If a trust is wholly a grantor trust, all of its items of income, deduction, and credit are taken into account by the grantor in calculating her taxable income and credits.[123] This means that the grantor who receives a distribution from a grantor trust will not be taxed on the distribution itself. Instead, she will be taxed on trust income whether or not it is distributed to her.[124] In addition, transactions between the trust and its grantor are generally ignored for all income tax purposes.[125]
There are at least three significant benefits to a GRAT and its grantor that flow from full grantor trust status:
(1) No gain or loss is recognized when such a trust either sells an asset to or buys an asset from its grantor.[126] This principle permits a GRAT to use appreciated trust assets to satisfy its annuity obligation without recognizing gain.[127] It also permits the grantor to transfer property to the trust that is subject to debt in excess of basis, such as partnership interests with negative bases.[128]
(2) A grantor may make an interest-bearing loan to a GRAT without being required to include the interest in her gross income.[129]
(3) The trust will be permitted to hold shares in an S Corporation.[130]
The extent to which a GRAT will be required to be treated as a grantor trust is not clear. If the retained annuity interest is worth more than 5% of the value of the trust, the grantor will probably be treated as the owner of the trust accounting income portion of the trust[131] and may also be treated as owner of the entire trust[132] under Code Sec. 673. Since a GRAT must permit payments out of income or corpus, including income allocable to corpus, the grantor may also be treated as the owner of the corpus portion under Code Sec. 677.[133] In three recent private letter rulings, the Service took the position that a grantor’s contingent reversion in a GRAT (i.e., the right to receive all of the trust’s property in the event of her death before the end of the trust term) resulted in the grantor’s treatment as the owner of the trust if the contingent reversion was worth more than 5% of the value of the trust at its creation.[134]
Code Sec. 677(a)(1) provides that the grantor of a trust will
be treated as the owner of any portion of the trust if the income from that portion
may be distributed to her without
the consent of an adverse party. The Service in three recent rulings took the position
that Code Sec. 677(c)(1) applied to GRATs because of the possible distribution of
income and corpus to the grantor.[135]
In each of these rulings, however, the annuity amount was in excess of the Code
Sec. 7520 rate in effect at the
Because of the uncertainty whether a GRAT will be a full grantor trust and because it is likely to be desirable that it be so, the trust instrument should include a provision that will deliberately invoke grantor trust status. Giving a nonadverse trustee the power to enable the grantor or her spouse the right to borrow trust funds at a reasonable interest rate on an unsecured basis[136] or giving a trustee who is a related or subordinate party (such as a spouse or other close family member) the right to make distribution decisions among a class of beneficiaries[137] are good choices. Neither power should increase the trust’s vulnerability to transfer taxes.
A Code Sec. 675(4) power seems to be a safe choice of a provision to create grantor trust status. This provision treats the donor as the owner of any portion of a trust if certain administrative controls are exercisable by a person in a nonfiduciary capacity without the consent of a person in a fiduciary capacity. One of the administrative powers included in Code Sec. 675(4) is the “power to reacquire the trust corpus by substituting other property of an equivalent value.”
In Private Letter Ruling 9224029,[138]
the Service sanctioned a Code Sec. 675(4) reacquisition clause in a charitable lead
unitrust. The clause gave an individual identified as “A,” who was neither a fiduciary
nor a person with an adverse interest, “the right at any
The most recent private letter rulings, however, cast doubt on the usefulness of a reacquisition power as a means of creating grantor trust status. The reacquisition power described in these private letter rulings were virtually identical to the one described in Private Letter Ruling 9224029. Nevertheless, the IRS, pointing to Treas. Reg. § 1.675-1(b)(4),[141] concluded in these rulings that the question of whether the reacquisition power is exercisable in a fiduciary or nonfiduciary capacity is a question of fact that cannot be determined until the parties’ income tax returns have been examined by the Director of the District where the returns are filed.[142] For any taxpayers who are willing to proceed without a private letter ruling, however, it would appear that, absent contrary state law, if the grantor is not a trustee and expressly retains the substitution power in a “nonfiduciary capacity,” a substitution power remains a viable means of achieving wholly grantor trust status.
Several recent technical advice memoranda serve as a reminder that the termination of grantor trust status that can occur when the GRAT period terminates can be an income tax recognition event. The taxpayer described in Technical Advice Memoranda 200010010, 200010011, and 200011005[143] created a GRAT for the benefit of his nephews. The GRAT borrowed money from a third party to pay the annuity amounts. At the end of the GRAT term, the loans were outstanding. The GRAT terminated and distributed its property to trusts for the taxpayer’s nephews, subject to the notes. The Service concluded that the termination of the trust should be treated as a disposition by the taxpayer for income tax purposes and that the taxpayer had an amount realized under Treas. Reg. § 1.1001-2(a) on the disposition equal to the outstanding debt. Since his basis in the property was negligible, a large portion of the amount realized was subject to income tax.
The result in the technical memoranda seems appropriate but could have been avoided or at least postponed by providing that the trusts for the nephews that received the GRAT property at the end of the GRAT term were also grantor trusts treated as owned by the taxpayer for income tax purposes.
If an individual retains property until death, the individuals who receive that property at her death take it with an income tax basis equal to its fair market value at the date of death.[144] If the property has appreciated, the basis adjustment is a valuable consequence of including the property in the individual’s gross estate. If property is received from a successful GRAT, the trust property will not be included in the transferor’s gross estate and there will be no basis increase at death.
If an individual’s estate tax rate is likely to be higher than the income tax rate imposed on her heirs, the estate tax savings resulting from exclusion will generally more than compensate for the loss of the increase in basis. Consider the following example:
Example 13: John
transferred $1,000,000 worth of stock in the X Corporation to a GRAT to pay him
an annuity of 53% for 2 years. At the end of the 2 year period, any property remaining
in the trust will be paid to his daughter Kate. At the
To avoid the disadvantage of the loss of basis increase, the grantor could consider purchasing the transferred asset from the GRAT immediately before the termination of the GRAT while the trust is a grantor trust for income tax purposes. The ability to have the grantor acquire low basis assets income tax free is also available where the GRAT remainderman continues as a grantor trust for income tax purposes. Under either scenario the purchase can be made without income tax consequences to the grantor or to the trust.[145] The grantor receives the asset back. When she dies, the basis of the asset will be increased to its then fair market value. The trust will receive cash and will not be required to pay tax on the receipt of this cash. Alternatively, consideration could be given to using a trust provision that would result in the inclusion of the trust property in the grantor’s gross estate if the income tax savings attributable to the inclusion would exceed the estate tax savings of exclusion.[146]
The GRAT offers a virtually risk-free and an almost gift tax-free
method of shifting future income and appreciation to another. If the transferred
property produces a total return over the term of the GRAT in excess of the Code
Sec. 7520 rate of return that was used to value the grantor’s retained annuity and
if the grantor outlives the term of the GRAT, property will pass at the end of the
GRAT, gift tax-free, to the remainder beneficiaries. If the rate of return is equal
to or less than the Code Sec. 7520 rate, the original property and all of the income
it produces during the term of the GRAT will be returned to the grantor. Thus, the grantor has the entire downside economic risk of
a poorly performing investment an extremely attractive result from a planning
prospective. The ability to place the entire downside investment risk on the
grantor is not available to the planner with alternative wealth shifting
strategies such as low interest loans, installment note sales to a defective
trust, private annuities, freezes under Code Sec. 2701, etc. In such instance,
the donee or transferee has significant downside risk.
The form of GRAT that accomplishes the shift most effectively is a short-term, single-asset, low taxable gift GRAT. Consider the following example:
Example 14: Jennifer
transferred $1,000,000 worth of the shares of the X Corp. to a 2-year GRAT. Her
basis in the shares was $500,000. At the
Jennifer’s transfer to the GRAT, if her valuation of the shares was correct, is a taxable gift of $370. This is so because the present value of the right to receive $530,000 at the end of each of the next two 12-month periods is worth $999,630. The excess of this amount over $1,000,000, $370, is the amount of her taxable gift.
To some individuals, the ability to define a difficult-to-value
gift by means of a formula will be the most important advantage of establishing
a GRAT. Other taxpayer approaches toward minimizing valuation risks by means of
various types of adjustment clauses have generally been rejected by the Service.
Clauses that require post-transfer adjustments in the price of a purchased asset
or in the quantity of property transferred, if the value of the transferred property
is later determined to be greater than the original es
The use of a formula to define the amount of her annuity rather
than a provision that requires the payment of a specific dollar amount protects
Jennifer from any significant increase in the gift tax if the Service successfully
challenges her valuation. The consequence of a successful challenge would be an
increase in the amount of her annuity and only a small gift tax increase. For example,
suppose the Service successfully argued that the shares of X Corp. transferred to
the GRAT were worth $2,000,000, double her es
For individuals who want to make gifts of property that is difficult to value, combining a gift with a GRAT may permit the GRAT’s valuation formula to protect the gift from unanticipated gift tax. For example, suppose Jennifer wanted to transfer $500,000 worth of the shares of X Corp. to a trust for the benefit of Patrick. She believes that 100 shares have a value of $500,000 but is unwilling to pay a gift tax on any value of these shares in excess of $500,000. She could transfer 110 shares of X Corp. to the trustee under a trust instrument the terms of which require the trustee to divide the transferred property into two shares, one of which has a value equal to a fraction of the transferred property the numerator of which is $500,000 and the denominator of which is the value of the transferred property as finally determined for federal gift tax purposes. The other share would be composed of the balance of the transferred property. If the trust instrument requires the trustee to allocate the first share to a trust for Patrick and the second share to a GRAT which is required to pay Jennifer an annuity, defined by a formula, with a value equal to approximately the value of the second share, a decision by the Service to value the 100 shares at $1,000,000 instead of $500,000 will not significantly increase Jennifer’s gift tax liability. Instead it will result in an allocation of half of the 100 X shares to the GRAT. The allocation of extra shares to the GRAT will result in a substantial increase in Jennifer’s annuity and only a nominal increase in her taxable gift to the GRAT.
The GRAT serves as a type of “estate freezing device.” The freeze is not complete since the grantor must receive a return at least equal to the Code Sec. 7520 rate. Any return in excess of this rate, however, passes to the remainder beneficiaries free of gift tax. The table below shows what Patrick would receive from the GRAT described in Example 14 at the end of the 2-year period using three different assumptions as to the return produced by the shares.
Table 3
|
Rate of Return |
Amount Passing to Patrick |
|
10% |
$97,000 |
|
15% |
$183,000 |
|
20% |
$274,000 |
Table 3’s figures are based on the assumption that the trustee transfers X shares back to Jennifer at the end of the first year to satisfy the annuity obligation. This distribution will not be an income tax recognition event to Jennifer since the trust is a full grantor trust.
The return to Patrick could be increased if, instead of distributing the X shares to Jennifer at the end of the first year, the trustee borrowed the $530,000 necessary to pay the annuity. As discussed above, such loan should not be made by Jennifer. The regulations provide that the right to receive an annuity payable in the form of notes does not constitute a qualified annuity interest.[149]
If the trustee were permitted to borrow to pay the annuity and if the GRAT property produces a total return in excess of the federal short-term rate, the use of the loan would increase Patrick’s return. The table below shows the increased return to Patrick attributable to the use of such a loan.[150]
Table 4
|
Rate of Return |
Annuity funded With |
Annuity Funded |
Difference |
|
10% |
$97,000 |
$141,096 |
$44,096 |
|
15% |
$183,000 |
$253,596 |
$70,596 |
|
20% |
$274,000 |
$371,096 |
$97,096 |
The 2-year term offers two advantages over a longer term.[151] First, it minimizes the possibility that a year or two of poor performance of the transferred property will adversely impact the over-all effectiveness of the GRAT. Consider the following possible 6-year growth pattern of $1,000,000 worth of X Corp.
Table 5
|
Year |
% Growth |
Value at Year End |
|
1 |
14% |
$1,140,000 |
|
2 |
8% |
$1,231,200 |
|
3 |
-15% |
$1,046,520 |
|
4 |
-0% |
$1,046,520 |
|
5 |
7% |
$1,119,776 |
|
6 |
10% |
$1,231,754 |
Suppose Jennifer had transferred her $1,000,000 worth of X Corp. shares to a 6-year GRAT to pay her an annuity of 19.07%. Assuming a Code Sec. 7520 rate of 4%, her taxable gift would have been $325, an amount comparable to the taxable gift incurred in connection with the transfer to the 2-year GRAT described above. At the end of the 6-year period, Patrick would receive nothing from the trust. The value of the GRAT has disappeared because of the poor performance of the shares in the third and fourth years. The better performances in the other four years were drained to make up for the poor years.
Table 6
|
Year |
% Growth |
Payment to Jennifer |
Value at Year End |
|
1 |
14% |
$190,700 |
$949,300 |
|
2 |
8% |
$190,700 |
$834,544 |
|
3 |
-15% |
$190,700 |
$518,662 |
|
4 |
0% |
$190,700 |
$327,962 |
|
5 |
7% |
$190,700 |
$160,220 |
|
6 |
10% |
$190,700
|
$0 |
If Jennifer, instead, had transferred
the same number of shares to three, successive 2-year GRATs over the same period
of
Table 7
|
Year |
% Growth |
Payment to Jennifer |
Value of GRAT |
Payment to Pat |
|
|
FIRST GRAT $1,000,000 |
|
|
|
|
1 |
14% |
$530,000 |
$610,000 |
|
|
2 |
8% |
$530,000 |
$128,800 |
$128,800 |
|
|
SECOND GRAT $1,102,400 |
|
|
|
|
3 |
-15% |
$584,272 |
$352,768 |
|
|
4 |
0% |
$352,768 |
$0 |
$0 |
|
|
THIRD GRAT $937,040 |
|
|
|
|
5 |
7% |
$496,631 |
$506,002 |
|
|
6 |
10% |
$496,631 |
$59,971 |
$59,971 |
The choice between a series of short-term
GRATs and a long-term GRAT is not as clear as the discussion above suggests. It
is possible, for example, that an increase in the Code Sec. 7520 rate between the
The second advantage the 2-year term has over a longer term
is the reduced exposure to the risk that the grantor will die during the term. As
discussed above, some portion of the trust will be included in the gross estate
of the grantor if she dies while the GRAT is in effect. Each
If a grantor has more than one asset whose future return she would like to protect with the GRAT technique, each asset should be transferred to a separate GRAT. Multiple GRATs for separate assets prevent underperforming assets from diluting the effectiveness of the good performers. The principle is the same as the one that recommends use of a chronological series of short-term GRATS rather than a single long-term GRAT to maximize the advantage to the remainder beneficiaries of the years of good investment return.
Suppose, for example, that Jennifer, the grantor described in Example 13, had two assets she wished to transfer to a 2-year GRAT - $500,000 worth of shares of the X Corp. and $500,000 worth of shares of the Y Corp. Suppose during the 2-year term of the GRAT that the shares of X increased by 10% per year and that the shares of Y decreased by 10% per year. If Jennifer had established a single GRAT and had funded it with the shares of X and Y, at the end of the 2-year term, there would be nothing in the trust to pass to Patrick. The excess return on the X stock was needed to compensate for the poor performance of the Y stock. On the other hand, if she had established two GRATs and had funded one with the shares of X and the other with the shares of Y, Patrick would have received property worth $48,500 at the end of the 2-year term.
The relationship between the value of the property transferred to a GRAT and the taxable gift caused by such transfer is a function of at least four elements: (1) the Code Sec. 7520 rate, (2) the number of years over which the annuity is to be paid, (3) when and how often the annuity is payable[152] and (4) the size of the annuity in relation to the value of the property transferred.
The grantor has little control over the Code Sec. 7520 rate.
Since the rate that will be in effect each month is announced before the end of
the preceding month, it is some
If the Code Sec. 7520 rate and the size of the annuity payment are held constant, the value of the annuity is increased when the number of years over which it is to be paid is increased. But, for the reasons discussed above, it is often preferable to select a short term for a GRAT.
For those grantors who are convinced of the utility of the short-term GRAT, the usual way of increasing the value of the annuity (and therefore decreasing the amount of the gift) will be to increase the amount of the annuity.
As a general rule, there is no advantage to the grantor in structuring a GRAT to produce anything other than a nominal taxable gift.[153] If the grantor wants to make a taxable gift, the taxable gift should be kept separate from the GRAT. These principles can be illustrated by comparing the results of the following alternatives:
Example 15: Jennifer creates a 2-year GRAT and transfers $1,000,000 worth of X Corp. stock to it. She retains the right to a 53% annuity. At the end of the 2-year term, the remaining trust property is to pass to Patrick. Her transfer, as indicated above, will result in a taxable gift of $370. Jennifer also makes an outright gift to Patrick of $1,000,000 worth of X Corp. shares. Her outright gift will result in a taxable gift of $1,000,000. Her total taxable gifts on account of these two transfers will be $1,000,370.
Example 16: Jennifer creates a 2-year GRAT with $2,000,000 worth of X Corp. stock and retains the right to a 26-1/2% annuity. At the end of the 2-year term, the remaining trust property is to pass to Patrick. Her transfer to the GRAT will result in a taxable gift of $1,000,370.
In each of Examples 15 and 16, Jennifer will be treated as having made the same amount of taxable gift.
If the shares produce a total return over the two years at least equal to the Code Sec. 7520 rate (which the examples assume to have been 4%), for example, both fact patterns produce the same value for Patrick. Assume, for example, a 10% annual growth rate. In Example 15, at the end of the two years, he will receive $97,000 from the $1,000,000 GRAT and his $1,000,000 outright interest in X Corp. will have appreciated to $1,210,000. In Example 16, he will receive $1,307,000 from the GRAT.
The low taxable gift GRAT proves its worth if the property does not grow at a rate at least equal to the Code Sec. 7520 rate. Assume a 0 growth rate. In Example 15, at the end of the two years, Patrick would receive nothing from the GRAT. He will retain his $1,000,000 outright interest in X Corp. In Example 16, Patrick will receive only $940,000 from the GRAT. A part of the taxable gift portion of the GRAT was used to pay the annuity. The low taxable gift GRAT approach has saved $60,000 for Patrick.
Although the Walton case appears to stand for the
proposition that the annuity can be structured so that it is equal in value to
the transfer to the GRAT, literally producing a zeroed-out GRAT, we recommend
that their should be a gift of at least a minimal amount.[154] A gift tax return would
then be required to be filed starting the statute of limitations running on the
valuation. This course of action should prevent a successful IRS attack if down
the road the IRS challenges the valuation of the annuity, determines that the
grantor was underpaid and the statute of limitations has run for the grantor to
enforce receipt of the underpayment from the remainder beneficiary.
The use of a GRAT can be extremely effective where assets
subject to a valuation discount, such as a non-controlling interest in a
closely-held business, are used to fund the GRAT and the annuity payments back
to the grantor are in cash or assets not subject to a discount. The benefit is
particularly dramatic during periods where interest rates are low. The cash
flow from the entity can be used to pay the annuity. In many instances, the
cash flow will be large as compared to the gift tax value of the original
transfer it can often sustain a relatively large annuity payout enabling the
term, and the concomitant risk of estate tax inclusion, to be compressed.
[1] E.g., Propstra v. Commissioner, 680 F.2d 1248
(9th Cir. 1982) (15% discount allowed); Estate of Forbes v. Commissioner, 81 T.C.M. 1399 (2001) (30%
discount allowed); Estate of Busch v. Commissioner, 79 T.C.M. 1276 (2000) (10%
discount allowed); Estate of Brocato v.
Commissioner, 78 T.C.M. 1243 (1999) (20% discount allowed); Williams v. Commissioner, 75 T.C.M. 1758
(1998) (44% discount allowed); Estate of
Barge v. Commissioner, 73 T.C.M. 2615 (1997) (25.95% discount allowed); Estate of Cervin v. Commissioner, 68
T.C.M. 1115 (1994) rev’d on other
grounds, 111 F.3d 1252 (5th Cir. 1997) (20% discount allowed); Lefrak v. Commissioner, 66 T.C.M. 1297
(1993) (30% discount allowed); Estate of
Feuchter v. Commissioner, 63 T.C.M. 2104 (1992) (15% discount allowed); Mooneyham v. Commissioner, 61 T.C.M.
2445 (1991) (15% discount allowed); Estate
of Youle v. Commissioner, 56 T.C.M. 1594 (1989) (12.5% discount allowed); Knight v. Commissioner, 115 T.C. 506
(2000) (15% discount allowed). In PLR 9336002 (May 28, 1993) the Internal
Revenue Service (the “Service”) took the position that the amount of the
discount should be limited to the costs of partitioning the property.
[2] E.g., Gross v. Commissioner, 272 F.3d 333 (6th
Cir. 2001) (25% discount allowed); Estate of Hoover v. Commissioner, 69 F.3d 1044 (10th Cir. 1995) (30% discount allowed); Estate of Ford v. Commissioner, 53 F.3d
924 (8th Cir. 1995) (20% discount allowed); Okerlund v. United States, 53 Fed. Cl. 341 (2002) (40% discount
allowed); Peracchio v. Commissioner,
2003 T.C.M. LEXIS 279 (Sept. 25, 2003) (6% minority and 25% lack of
marketability discounts allowed); Lappo
v. Commissioner, 86 T.C.M. 333 (2003) (15% minority and 24% lack of marketability
discounts allowed); Hess v. Commissioner,
86 T.C.M. 303 (2003) (15% minority and 25% marketability discounts allowed); Estate of
[3] Treas. Reg. § 25.2512-5(d). References to “Code Sec.” are
to sections of the Internal Revenue Code of 1986, as amended (the “Code”).
References to “Treas. Reg. §” are to the regulations promulgated under the Code
by Treasury. Prior to May, 1989, the value of gifts of annuities, income interests,
and remainders was determined in accordance with tables set forth in Treas.
Reg. § 25.2512-5(A). For gifts made on or after May 1, 1989, Code Sec. 7520
requires that valuation be determined under tables prescribed by Treasury that
use an interest rate (rounded to the nearest 2/10ths of 1 percent) equal to
120% of the federal mid-term rate in effect under Code Sec. 1274(d)(1) for the
month in which the gift is made. The federal mid-term rate is a rate based on
the average market yield on marketable obligations of the
The courts have some
This rationale should not permit a departure
from the tables for gifts made after
In addition, recent decisions in the estate tax context have also permitted departure from the valuation tables. See, e.g., Estate of Gribauskas v. Commissioner, 2003 U.S. App. LEXIS 17770 (2d Cir. Aug. 26, 2003) (holding that marketability restrictions, in this case a Connecticut law that prohibited the assignment of rights to lottery winnings, may render valuation under the Code Sec. 7520 tables “unreasonable and unrealistic,” thereby justifying departure from the tables); Estate of Shackleford v. United States, 262 F.3d 1028 (9th Cir. 2001) (upholding the district court’s finding that application of the valuation tables did not accurately reflect economic reality). But see Estate of Cook v. Commissioner, 82 T.C.M. 154 (2001) (denying departure from valuation tables under facts substantially similar to those in Estate of Gribauskas and Estate of Shackleford).
[4] For a more detailed discussion of this issue, see Gans, “GRIT’s, GRAT’s and GRUT’s:
Planning and Policy,” 11 Va. Tax Rev. 761 (1992).
[5] This assumes reinvestment of income distributions at 4%.
[6] This assumes a capital gains tax rate of 15%.
[7] See generally Abbin, “The Politics of
Transfer Taxation or Watching Sausage Being Made - Is Anyone in Charge?” The
Twenty-Fifth Annual Philip E. Heckerling Institute on Estate Planning, ¶ 400
(1991);
[8] E.g., Boyle,
“Evaluating Split-Interest Valuation,” 24
[9] Tax Reform Act of 1969, Pub. L. No. 91-172, § 201.
[10] Code Sec. 2702. This section was added to the Code as part
of the Omnibus Budget Reconciliation Act of 1990, Pub. L. No. 101-508, §
11602(a), 104 Stat. 1388 (1990). It is an integral part of Chapter 14 of the
Code, which is intended to provide a series of rules for discouraging a variety
of transfer tax valuation techniques, including recapitalizations of entities,
temporal divisions of property, and value-reducing agreements such as options
and buy-sell agreements.
[11] Code Sec. 2702 applies to any transfer of an interest in
trust to a family member of the transferor if the transferor or an applicable
family member retains an interest in the trust. The term “family member” means
the transferor’s spouse, any ancestor or descendant of the transferor or her
spouse, any sibling of the transferor, and the spouse of any such ancestor,
descendant, or sibling. Code Secs. 2702(e) and 2704(c)(2). The term “applicable
family member” means the transferor’s spouse, any ancestor of the transferor or
her spouse, and the spouse of any such ancestor. Code Secs. 2702(a)(1) and
2701(e)(2). Transfers of property in trust include transfers of temporal interests
in property not actually held in a formal trust. Code Sec. 2702(c). The
acquisition of a term interest in property by an individual, if a member of her
family as part of the same transaction or series of related transactions
acquires other interests, is also treated as a transfer in trust. Code Sec.
2702(c)(2).
[12] Other exceptions not discussed in this paper include the
grantor retained unitrust (Code Sec. 2702(b)(2)), the noncontingent remainder
interest (Code Sec. 2702(b)(3)), the Qualified Personal Residence Trust (Code
Sec. 2702(a)(3), and the tangible property trust (Code Sec. 2702(c)(4)).
[13] Audrey J. Walton v. Commissioner, 115
T.C. 589 (2000), acq. Notice
2003-72, 2003-44 IRB,
[14] Treas. Reg. §25.2702-3(e), Ex. (5).
[15] Walton, supra.
[16] Notice 2003-72, 2003-44 IRB,
[17] Code Sec. 2702(a)(2) and (b)(1); Treas. Reg. §
25.2702-2(a)(5) and (6); Treas. Reg. § 25.2702-2(b)(2).
[18] Code Sec. 2702(a)(2)(B).
[19] The trustee might, however, have an incentive to maximize
the possibility of a higher overall return by making speculative investments.
If the GRAT is structured initially with a zero or relatively small remainder
interest, the risk burden will be borne entirely or almost entirely by the
annuitant while the remainder beneficiary will enjoy the rewards but not the
risks of a successful speculative investment. In contrast, the grantor retained
unitrust, a sibling to the GRAT, eliminates this incentive. A unitrust interest
is an annuity the amount of which is determined by the annual value of the
property. Since the amount of the payments to the annuitant fluctuates with the
value of the trust property and the income that it earns, the benefits and
burdens of all investments are shared proportionately by the annuitant and the
remainder beneficiary.
[20] IRC §2704(c)(2) provides:
(2) Member of the family. The term “member of the family” means, with respect to any individual—
(A) such individual’s spouse,
(B) any ancestor or lineal descendant of such individual or such individual’s spouse,
(C) any brother or sister of the individual, and
(D) any spouse
of any individual described in subparagraph (B) or (C).
[21] This technique (the “GRIT” technique) is may still be viable when the
beneficiary is a nonspouse significant other, a niece, nephew, etc.)
[22] Code Sec. 2702(b)(1).
[23] Treas. Reg. § 25.2702-3(b) and (d). The Senate Explanation
(the Finance Committee explanation submitted by Senator Bentsen in connection
with the Senate version of OBRA ‘91, set forth in 136 Cong. Rec. S15629.03
(daily ed. Oct. 18, 1990)) stated that the requirements for the qualified
interests described in Code Sec. 2702(b) were intended to be similar to the
requirements for “charitable split interest trusts under section 664.” The
explanation preceding the proposed Code Sec. 2702 regulations (56 Fed. Reg.
14321 (
[24] The regulations define the term “governing instrument” as
“the instrument or instruments creating and governing the operation of the
trust arrangement.” Treas. Reg. § 25.2702-2(a)(9). This outline refers to the
governing instrument as the “trust instrument.”
[25] See, e.g., Cal. Prob. Code §15404; Fla. Stat.
§737.4032; and NY EPTL § 7‑1.9.
[26] The Service might take the position that an amendment is a
new transfer and, if the trust immediately after the amendment does not satisfy
the regulations’ requirements, subject the full value of the trust to gift tax.
An amendment, however, that resulted in the simultaneous termination of the
trust would probably not be vulnerable to a new application of Code Sec. 2702
since, immediately after the amendment, neither the transferor nor any other
family member would have an interest in the trust.
[27] Treas. Reg. § 25.2702-3(b)(1)(i).
[28] Treas.
Reg. § 25.2702-3(b)(3). T.D. 8899, 65 Fed. Reg. 53587 (
[29] This clause appeared in the trust instrument described in
PLR 9239015 (June 25, 1992). The Service determined that the annuity payment
required by that trust instrument was a qualified annuity interest.
[30] See Dickman v.
[31] Treas. Reg. § 25.2702-3(b)(4). It is not clear whether express permission in the trust instrument to delay a payment nominally due on a particular date to a later date will be reflected in a lower valuation for the annuity. Arguably, such an annuity does have a lower value because of the trustee’s power to deny the use of the annuity amount to the grantor for 105 days.
[32]
[33] Treas. Reg. § 25.2702-3(b)(1)(i).
[34] 65 Fed.
Reg. 53587 (
[35] Treas. Reg. § 25.2702-3(d)(5).
[36] Treas. Reg. § 25.2702-3(b)(1)(ii).
[37] Rev. Proc. 2003-3, 2003 I.R.B. 113, § 4.01(49).
[38]
[39] See Rev. Rul. 82-105 1982-1 C.B. 133.
[40] See, for example, PLRs 9345035 and 9451056.
[41] For another discussion of this technique, see Covey, Practical Drafting 5625
(April 1999). An increasing stream of annuity payments could increase the
portion of trust assets that would be includable in the gross estate of the
transferor if she died before the end of the annuity term. See discussion
below.
[42] Treas. Reg. § 25.2702-3(b)(1)(iii).
[43]
[44] A
similar issue arises under Code Sec. 2503 in connection with the qualification
of an income interest for the annual exclusion when the trustee of the trust
with respect to which the income interest exists also has the power to make
principal distributions to the income beneficiary. Treas. Reg § 25.2503-3 (b)
resolves this issue in favor of the taxpayer by providing, “[i]f a donee has received
a present interest in property, the possibility that such interest may be
diminished by the transfer of a greater interest in the same property to the
donee through the exercise of a power is disregarded in computing the value of
the present interest, to the extent that no part of such interest will at any
[45] Treas. Reg. § 25.2702-3(b)(2).
[46] This clause appeared in the trust instrument described in
PLR 9239015 (
[47] Treas. Reg. § 25.2702-3(b)(4).
[48] The requirement is apparently modeled after the charitable
remainder annuity trust’s governing instrument requirement that prohibits
additions to the trust after creation. Treas. Reg. § 1.664-2(b). The purpose
for the charitable remainder annuity trust requirement, however, is most likely
the prevention of the use of post-creation additions to avoid Code Sec.
664(d)(1)’s requirement that the annuity be equal to at least 5% of the initial
value of the trust. There is no corresponding requirement in the statutory
definition of a qualified interest under Code Sec. 2702. The charitable lead
annuity trust regulations do not contain a similar requirement, and there is no
reason to impose one either for charitable lead annuity trusts or for GRATs. See PLR 9506001 (September 28, 1994) in
which the Service conceded that there is no prohibition against additional
contributions to a charitable lead trust and that the grantor of a GRAT created
prior to the issuance of the regulations could have reasonably inferred from
this fact that there would be no prohibition against additions to a GRAT. As a
result, the Service ruled that the GRAT provided its grantor with a qualified
interest despite the absence of a prohibition against additions.
[49] Treas. Reg. § 25.2702-3(d)(4). See PLR 9412036 (
[50] This provision is reflective of a similar, arguably
erroneous, position that the Service has taken in the charitable lead trust
area. In Rev. Rul. 88-27, 1988-1 C.B. 331, the Service concluded that a
trustee’s right to prepay annuity amounts disqualifies a trust for treatment as
a charitable lead trust since the prepayment possibility makes it impossible to
determine the amount of each annuity payment at the outset of the trust. See GCM 39676 (
[51] Treas. Reg. § 25.2702-3(d)(2).
[52] Treas. Reg. § 25.2522(c)-3(c)(2)(vi)(f).
[53] Treas. Reg. § 25.2702-3(d)(3).
[54] Treas. Reg. § 25.2522(c)-3(c)(2)(vi)(a).
[55] Treas. Reg. §§ 1.170A-6(e); 20.205-2(e)(3)(iii); and 25.2522(c)-3(e). The regulations provide for certain exceptions to the effective date.
[56] Treas. Reg. §§ 1.170A-6(c)(2)(i)(a) and (ii)(a); 20.2055-2(e)(2)(vi)(a) and (vii)(a); and 25.2522(c)-3(e)(2)(vi)(a) and (vii)(a). A trust will satisfy the requirement that all noncharitable remainder beneficiaries are lineal descendants of the individual who is the measuring life, or that individual’s spouse, if there is less than a 15% probability that individuals who are not lineal descendants will receive any trust corpus.
[57] Note that example 5 was ruled invalid by Walton, infra, and that the Service has acquiesced in that decision. Notice
2003-72, 2003-44 IRB,
[58] The example describes a grantor retained unitrust rather
than a grantor retained annuity trust. The requirements as to the term of the
qualified payments are the same for both types of trusts.
[59] See also Treas. Reg. § 25.2702-2(d),
Examples 6 and 7.
[60] Audrey J. Walton v. Commissioner, 115
T.C. 589 (2000), acq. Notice
2003-72, 2003-44 IRB,
[61] Notice 2003-72, 2003-44 IRB,