Volume 1, Number 2
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IRC Section 2702 was enacted in 1990 i in response to what the Service perceived as valuation abuses by taxpayers in transferring assets to reduce the size of the taxable estate and/or minimize gift taxes.
Generally, Section 2702 provides that if one retains an interest in transferred property, that interest is not subtracted from the value using the valuation tables, unless the retained interest is a qualified interest in the form of an annuity or unitrust. Since an interest in either an annuity or a unitrust will generate income to the transferor, the ability to use favorable valuation tables and actuarial principles for diminishing value within an estate or for gift tax purposes was eliminated.
The regulations first proposed in April of 1991 and enacted in 1992 ii . Portions of the regulations were challenged in Private Letter Rulings and tax court litigation. Persistence and determination by the tax advisors have paid off. Those questionable sections of Regulation 25.2702-2 and 25.2702-3 have been litigated with favorable outcomes to the taxpayers.
Schott v. Commissioner, T.C.M. 2001-110, rev’d and remanded 319 F. 3d 1203 (9 th Cir. 2003) challenged the examples contained in example number 6 and 7 over the interpretation by the Service for regulation 25.2702-2 (a)(5). In an opinion that relies heavily upon Example 7, The Ninth Circuit concluded that the annuity created by each Schott trust for the lives of the grantor and spouse or fifteen years is as qualified as the annuity in Example 7 paying a fixed amount for ten years to the grantor, then to the spouse if living . And furthermore, a two-life annuity, based on the lives of the grantor and spouse with a limit of fifteen years, falls ‘within the class of easily valued rights’ that Congress meant to qualify.” Id. at 600.
Walton v. Commissioner, 115 T.C. 589 (2000) was the litigious challenge to Example 5 of 25.2702-3(e), the regulation and examples as to what are and are not a qualified interest. iii The Service, took the position that a GRAT cannot be zeroed out.
The Tax Court unanimously, en banc, agreed with the legal commentators and found that Example 5 was invalid and, thus, the Service’s position was unsustainable. The court specifically held that Example 5 was “an unreasonable and invalid extension of Section 2702.” iv
As a result, the Service acquiesced to the Tax Court decision in Walton and released Notice 2003-72. v The notice provided that a retained interest for a term of years and subsequently payable to the estate after the death of the grantor during that term will be treated as a qualified interest payable actuarially for a term of years and valued under Table B.
On July 26, 2004, the Service published newly proposed regulations vi to deal with both of these litigated issues. In response to Schott, the Service makes clear that the retention of a power to revoke a qualified interest is treated as a retention by the transferor of the interest.
Two new examples have also been added to illustrate the principals of this law. Example 8 provides an explanation and valuation for the successive spousal interests as well as valuation for the revocation. The example confirms both successive interests are completed gifts, even with the right to revoke, and both interests are qualified interest. Each interest reduces the value and each interest is valued as a single-life annuity. If the spousal interest is revoked, the effect is to make a completed gift to the remaindermen in the amount of the present value of the spouse’s revoked interest valued under section 7520 at the date the interest is revoked.
Example 9 takes example 8 further and defines what is not a qualified spousal interest. A has an interest for 10 years or until prior death. If A survives the term the trust is payable to C. However, if A dies, the interest is payable to the spouse for 10 years or until the spouse’s prior death. Upon the expiration of spouse’s interest, the trust is payable to C. A’s interest is a qualified interest, however the spouse’s interest is not. The spouse’s annuity is not fixed and ascertainable at the creation of the trust, because it is not payable for life, a specified term of years of the shorter of those periods. Rather, it would depended upon the number of years left after the original term after A’s death. Furthermore it is payable only if A dies prior to the expiration of the 10-year term. The spouse’s annuity is not solely dependent on the spouse’s survival, but rather is dependent upon the grantor’s failure to survive. The valuation of such a transfer would be based solely on the grantor’s interest of 10 years or until prior death.
The proposed regulations revise Example 5 and 6 of Reg. 25.2702-3(e) to comply with the pro-taxpayer ruling in Walton. Example 5 will now read such that a right of the estate to continue to receive the annuity or unitrust payments will be a qualified right for the term of years. An interest which exceeds the term will not be a qualified interest. vii
The new proposed regulations are set for public hearing on October 28, 2004 and will be effective for trusts created on or after July 26, 2004. Additionally the Service will not challenge any prior application of the changes to Examples 5 and 6 of 25.2702-3(e).
The result is what legal commentators have said all along. The intent of 2702 was not to preclude successive annuities or unitrusts that can be measured and valued on the date of transfer (spousal GRATs) and that a transfer to trust with little or no gift tax (Zeroed Out GRATs) are viable planning techniques and well within the frame work contemplated by Congress when enacting I.R.C. Section 2702.