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  • A Bi-Monthly Electronic Publication for Section Members
  • OCTOBER 2007

 

TE Article

 

Tax-Free Gifting: Comparing GRATs and Sales to Grantor Trusts

by
Steven Lavner
Senior Vice President
National Wealth Planning Strategies Group
U.S. Trust, Bank of America Private Wealth Management

  Tax-Free Gifting:

Comparing GRATs and Sales to Grantor Trusts

I.        Estate planning.

Estate planning involves the transfer of wealth to beneficiaries in a tax-efficient manner.

A.      At death.

For a married couple, tax-efficiency at the first spouse’s death typically involves utilization of the estate tax credit [1] and marital deduction. [2]   This combination results in no federal estate tax at the first death. [3]    On the death of the surviving spouse, if the estate exceeds the applicable federal exclusion, federal estate tax will generally be due.  For many clients, the prospect of making the government the majority beneficiary [4] of their estate is sufficient motivation to consider means of reducing the transfer tax burden.

B.      Lifetime.  

1.       The primary strategy to reduce estate taxes involves lifetime gifts which are not subject to gift tax. [5]

2.       Gifts not subject to gift tax include those made pursuant to the annual exclusion, [6] the tuition and medical expense exclusion [7] and the gift tax credit. [8]  

3.       For many clients, utilization of these gifting strategies still leaves a significant portion of their estate subject to estate tax upon the death of the surviving spouse.  For such clients, additional opportunities for tax-free gifting may be attractive.  Two techniques which are often considered are a grantor retained annuity trust (GRAT) and a sale to a grantor trust.

II.     GRATs.  

A.      Summary.  

In a GRAT, a Grantor contributes property to a trust and retains the right to be paid an annuity for a specified term, based on an applicable interest rate.  Due to the retained annuity, there should not be a gift for gift tax purposes.  If the investment performance of the trust exceeds the applicable interest rate, any remainder at the expiration of the term is in effect a tax-free gift to the trust beneficiaries.  Unless the Grantor dies during the term, the trust property should not be includible for estate tax purposes.  GRATs are generally not used for generation-skipping planning.     

B.      Annuity.

1.       Section 2702, enacted in response to gift tax valuation abuses, provides that if an individual creates a trust for certain family members [9] and retains an interest in the trust, the value of the retained interest for gift tax purposes will be treated as being zero, unless the retained interest is a “qualified interest.” [10]  

2.       The value of any retained interest which is a qualified interest is determined under section 7520. [11]   Of the three types of qualified interests, [12] the one used in estate planning and that forms the basis of a GRAT is the “qualified annuity interest.”  

3.       A qualified annuity interest is an irrevocable right to receive either a stated dollar amount or a fraction or percentage of the initial fair market value of the property transferred to the trust.  The annuity does not have to be identical in each year, as long as it does not exceed 120 percent of the annuity amount in the preceding year. [13]

4.        In a typical GRAT, the Grantor contributes property to a trust [14] and retains the right to be paid an annuity equal to a percentage of the initial fair market value of the property transferred to the trust. [15]  

5.       The governing instrument must contain provisions relating to adjustments for any incorrect determination of the fair market value of the trust property. [16]  

6.       The annuity must be payable to the holder at least annually. [17]   The trust must prohibit distributions to any person other than the holder of the annuity during the term of the qualified interest. [18]

7.       The annuity may be payable based on either the anniversary date of the trust’s creation or the taxable year of the trust. [19]   If the annuity is payable based on the anniversary date, it must be paid no later than 105 days after the anniversary date.  If the annuity amount is payable based on the taxable year, it must be paid no later than the due date (without regard to extensions) of the trust’s income tax return. [20]

8.       The trust must prohibit commutation or prepayment of the annuity. [21]   For trusts created after September 20, 1999, the trust must prohibit the trustee from issuing a note or other debt instrument in satisfaction of the annuity. [22]

9.       Assuming the trust is a grantor trust [23] , the distribution of any appreciated property in satisfaction of the annuity should not cause the trust to recognize gain for income tax purposes. [24]

C.      Trust term.  

1.       The trust term must be fixed at the creation of the trust, and may be for the Grantor’s life, for a specified term of years, or for the shorter of those periods. [25]   

2.       In order to achieve the best tax result, the term of a typical GRAT is for a specified term of years.  Because of the risk of the Grantor’s death during the term, a short term is often selected. [26]   A short term also prevents good investment performance during one period from being diminished by poor performance in a subsequent period. [27]

3.       Although a short term is generally preferable, in certain cases a longer term may be beneficial.  This may occur where the 7520 rate is expected to increase during the longer term.  In that case, the lower initial 7520 rate can be locked in for the entire longer term.  By instead using successive short-term GRATs, the subsequent GRATs would be measured by the then higher 7520 rates.

D.     Gift tax.  

1.       It is generally desirable to structure the GRAT so the Grantor’s contribution of property is not treated as a gift for gift tax purposes (often referred to as a zeroed-out GRAT).  This requires that the Grantor retain a sufficient annuity amount for the trust term which would consume the entire property plus interest at the 7520 rate.  In order to take into account the possibility of a valuation adjustment by the IRS, the annuity amount is typically expressed as a percentage of the initial value of the trust property, which should then self-adjust for any valuation changes. [28]

2.       In order for the GRAT to be zeroed-out, the Grantor must be treated as retaining the annuity for the full trust term.  The IRS originally took the view, as reflected in its regulations, that the annuity would be treated as a qualified interest only for the shorter of the term of the trust or until the Grantor’s prior death. [29]   In response to the taxpayer victory in Walton, [30] the IRS has changed its view and the revised regulations now provide that the annuity will be treated as a qualified interest for the full term if it is payable to the Grantor, and to the Grantor’s estate for the balance of the term if the Grantor dies. [31]  

3.       Despite the revised regulations, the IRS may assert that a zeroed-out GRAT violates public policy based on the often cited Procter case. [32]  

E.      Tax-free gift.  

1.       The GRAT will generate a tax-free gift for the remainder beneficiaries if its investment performance exceeds the 7520 rate.  

2.       Assume a $1,000,000 zeroed-out GRAT is created based on a 7520 rate of 5.8%, which pays an annuity of $544,000 to the Grantor (or to the Grantor’s estate if the Grantor dies) for 2 years.

a)       If the trust earns 5.8% or less each year, the Grantor will receive the entire trust property and there will be nothing left after 2 years for the remainder beneficiaries.  Although the GRAT will not be successful, the Grantor will be in the same position as if the GRAT was never created.  

b)       If, however, the trust out-performs the 7520 rate by earning more than 5.8%, the Grantor will receive the annuity payments and there will also be property left for the remainder beneficiaries after the trust term ends.  

3.       The investments of a GRAT may be monitored in order to help achieve out-performance. [33]   If the GRAT has out-performed but the term has not yet ended, it may be desirable to lock-in the gains and prevent any subsequent under-performance from diminishing the initial gains.  This may be accomplished by having the Grantor purchase the trust property for its higher fair market value. [34]   Conversely, if the GRAT has initially performed poorly, it may also be advantageous for the Grantor to purchase the trust property and then transfer it to a new GRAT at its lower fair market value.  

F.       Estate tax.       

1.       The GRAT should be structured to avoid inclusion of the trust property in the Grantor’s estate. [35]   If, however, the Grantor dies during the annuity term, the trust property will be includible in the gross estate. [36]

2.       If the Grantor is survived by a spouse, it may be desirable to qualify the trust property for the marital deduction. 

a)       Prior to Walton and the revised regulations, it was common for GRATs to contain a contingent reversion to the Grantor’s estate in the case of death during the term.  In that case, marital qualification could easily be achieved by an appropriate provision in the Grantor’s will. [37]  

b)       Pursuant to Walton and the revised regulations, if the Grantor dies during the term, the remaining annuity amounts must continue to be paid to the Grantor’s estate.  Marital qualification for the annuity payments could then be obtained by a provision in the Grantor’s will, but it is then necessary to separately qualify any trust remainder for the marital deduction. [38]  

G.     Generation-skipping planning.  

1.       The GRAT will involve a generation-skipping transfer if the remainder is payable to grandchildren or other skip persons. [39]   This would also occur if the remainder is payable to the Grantor’s issue and a child dies during the GRAT term leaving surviving children. [40]  

2.       Once a generation-skipping transfer occurs, GST tax will be due unless there has been an allocation of GST exemption. [41]   Since the remainder interest in a zeroed-out (or nearly zeroed-out) GRAT has a nominal value upon the creation of the trust, it would be advantageous if a nominal allocation could be made which would exempt the trust.  Unfortunately, it may not be possible to accomplish this and GRATs are therefore not generally used for generation-skipping planning.  

a)       The most straightforward way to exempt the GRAT is for the Grantor to allocate GST exemption against the nominal remainder value.  However, the so-called ETIP rules may preclude this result. [42]  

b)       Even if the ETIP rules prevent the Grantor from effectively allocating exemption, it might be possible for the remaindermen to gift or sell their interest and accomplish the same result.  In an analogous situation, however, the IRS did not allow this result. [43]

III.     Sales to Grantor Trusts.  

A.      Summary.  

In a sale to a grantor trust, a Grantor sells property to a trust in exchange for the trust’s promissory note.  The Grantor does not incur any capital gain and is not taxed on the interest payments.  The note is structured so that there is no gift for gift tax purposes.  If the investment performance of the trust exceeds the interest on the note, there is in effect a tax-free gift to the trust beneficiaries.  If the Grantor dies, the trust property is not includible in the estate. A grantor trust sale may also be used for generation-skipping planning.     

B.      Income tax.  

1.       Grantor trusts, also known as defective grantor trusts and intentionally defective grantor trusts (IDGTs), are trusts that are treated as owned by the Grantor for income tax purposes. [44]   All of the income and deductions of a grantor trust [45] are attributed and taxed to the Grantor, [46] instead of to the trust.    

2.       By qualifying the trust as a grantor trust, a sale of property by the Grantor to the trust may be made without incurring any capital gain. [47]   Similarly, the payment of interest by the trust is not taxed to the Grantor.    

3.       Since the favorable income tax treatment results from the grantor trust status of the trust, it is advisable to maintain such status until the note has been fully paid.  The death of the Grantor, however, would terminate grantor trust status.  If this occurs while the note is still outstanding, the income tax effect is uncertain. [48]  

C.      Estate tax.  

1.       It is important that the trust, while treated as owned by the Grantor for income tax purposes, not be treated as includible in the Grantor’s estate for estate tax purposes.  While many of the grantor trust provisions would also cause estate tax inclusion, certain provisions should not result in estate inclusion.  One such provision is the power to reacquire the trust corpus by substituting other property of an equivalent value. [49]   Other such provisions may include naming the Grantor’s spouse as a permissible beneficiary [50] and including authority to borrow from the trust without adequate security. [51]  

2.       It is equally important that the trust be structured to avoid adverse estate tax consequences.  Accordingly, the Grantor should not retain any interests or powers which would cause estate inclusion. [52]   In this regard, section 2036 is of particular concern.  The 2036 challenge attempts to re-characterize the note as a retained equity interest in the transferred property, instead of debt. [53]   If successful, the Grantor would then be viewed as having made a transfer with a retained interest under section 2036.  The retained equity argument will be strongest when the trust does not have sufficient independent funding to support the note.  Accordingly, many practitioners have adopted a rule of thumb that the trust have independent assets (often referred to as seed money) equal to at least 10 percent of the value of the property sold. [54]  

D.     Gift tax.  

1.       In order to avoid any gift tax, the Grantor must receive from the trust adequate and full consideration in money or money’s worth for the property sold. [55]   The consideration given by the trust is typically in the form of a promissory note.  In order for the note to constitute full consideration, it must have a face amount equal to the value of the property sold and bear interest at an appropriate rate.  

2.       The face amount of the note should equal the value of the property sold.  Often, however, such property does not have an objective value, such as shares of a closely-held business or other property subject to a valuation discount.  Particularly in such cases, the initial determination of value may be subject to future changes by the IRS.  To eliminate any possible gift, it would be advantageous if the face amount could self-adjust for any subsequent valuation changes.  However, such adjustment provisions have not generally been permitted. [56]  

3.       The appropriate interest rate to be used for the note is determined by reference to I.R.C. section 7872, [57] which refers to the applicable federal rate under section 1274(d). [58]    

4.       As indicated, the IRS may attempt to re-characterize the sale transaction as a transfer with a retained interest.  If this argument were to prevail, not only could there be adverse estate tax consequences, but there could be adverse gift tax consequences as well. [59]  

E.      Tax-free gift.  

As indicated, the promissory note should bear interest based on the applicable federal rate under section 1274(d).  Accordingly, the success of this technique will depend on whether the property sold to the trust generates a return that is greater than the applicable federal rate.  Any such over-performance will in effect be a tax-free gift from the Grantor to the trust beneficiaries.  

F.       Generation-skipping planning.

1.       In order to leverage the transfer tax savings, it may be desirable to structure the Grantor trust as a generation-skipping trust.

2.       In order to avoid any generation-skipping transfer tax, GST exemption must be allocated to the trust. [60]   In order to fully exempt the trust, an allocation should be made against the initial gift of seed money, so that the trust will have an inclusion ratio of zero. [61]  The sale of property to the trust should not require any additional allocation to maintain the trust’s exempt status.  

IV.      Comparison of GRATs and Grantor Trust Sales.  

A.      Tax-free gift.  

1.       In order for a GRAT to be successful and generate a tax-free gift, it must experience investment performance greater than the section 7520 rate.  This rate is equal to 120 percent of the Federal midterm rate under section 1274(d).  

2.       The corresponding hurdle rate for a grantor trust sale is the applicable Federal rate under section 1274(d).  Since this rate may be lower than the GRAT rate, it should be easier for the sale to succeed in generating a tax-free gift.  

B.      Gift tax.  

1.       If a GRAT is fully or even nearly zeroed-out for gift tax purposes, there is a risk the IRS may disallow it on public policy grounds.  If the IRS succeeded, it is uncertain what the gift tax consequences would be.  Since the regulations appear to allow zeroed-out GRATs, some practitioners may not be too concerned about this risk.  If there is concern, it could be dealt with by creating a GRAT which includes a taxable gift.  

2.        The grantor trust sale has more gift tax risk than a GRAT.  The IRS may claim the promissory note represents a retained interest in the property sold.  Since the retained interest would not be a qualified interest under section 2702, the IRS could argue there has been a gift of the entire property.  This risk may be dealt with by having sufficient seed money in the trust to support the payments on the note.  The greater gift tax risk involves a revaluation of the property.  It is not certain whether this risk may effectively be dealt with by some form of adjustment provision.  This risk may be somewhat managed by leaving a portion of the gift tax credit to cover any taxable gift resulting from a valuation increase.

C.      Estate tax.  

1.       The death of the Grantor during the GRAT term will generally cause the entire trust property to be included in the estate.  This risk may be managed by selection of a short term, taking into account the Grantor’s age and health.  If the Grantor dies during the term and has a surviving spouse, a contingent marital deduction provision would at least defer any estate tax until the second death.  

2.       In a grantor trust sale, the death of the Grantor while the note is outstanding should not cause the trust property to be included in the estate (although the note itself will be included.)  However, there is some risk the IRS will assert estate inclusion pursuant to section 2036, particularly where the trust does not have sufficient independent funding to support payments on the note.  

D.     Generation-skipping planning.

 

1.       The ETIP rules may preclude generation-skipping planning with a GRAT.

  2.       The grantor trust sale affords a much better opportunity to accomplish generation-skipping planning.  Assuming the trust is structured to avoid inclusion in the Grantor’s estate, an allocation of GST exemption may be made to exempt the trust from any tax.  

E.      Conclusion.

  

Both GRATs and grantor trust sales are effective estate planning techniques which may allow for tax-free gifting.  While the GRAT has less gift tax risk, the sale may yield a greater tax-free gift and should allow generation-skipping planning.  Accordingly, the sale may have greater risk and greater reward than the GRAT.  By understanding the risks and benefits, practitioners and clients will be able to decide which technique is best suited for a particular circumstance.  

                                                                                                              

Steven LavnerSenior Vice President
National Wealth Planning Strategies Group
U.S. Trust, Bank of America Private Wealth Management
114 West 47 th Street
New York, NY  10036
(212) 852-3543
slavner@ustrust.com
   

Steven Lavner is a Senior Vice President in the National Wealth Planning Strategies Group of U.S. Trust, Bank of America Private Wealth Management, where he works with clients on all aspects of estate planning.   Prior to joining U.S. Trust in 1998, he was Counsel to the New York City law firm of Kaye Scholer LLP beginning in 1980, where he specialized in trusts and estates law.  He is a frequent speaker on issues relating to estate planning and taxation.

Mr. Lavner earned his B.A. from New York University in 1977, graduating magna cum laude.  In 1980, he received his J.D. from New York University School of Law, where he was a journal member of the Annual Survey of American Law.  He was admitted to the New York Bar in 1981.

Note: This material is current as of the date specified and is for informational purposes only. It is not a solicitation, or an offer to buy or sell any security or investment product, nor does it consider individual investment objectives or financial situations.

Information in this material is not intended to constitute legal, tax or investment advice. You should consult your legal, tax and financial advisors before making any financial decisions. If any information is deemed “written advice” within the meaning of IRS Regulations, please note the following:

IRS Circular 230 Disclosure: Pursuant to IRS Regulations, neither the information, nor any advice contained in this communication (including any attachments) is intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

While the information contained herein is believed to be reliable, we cannot guarantee its accuracy or completeness. United States Trust Company, National Association, is an indirect wholly owned subsidiary of Bank of America Corporation .

[1] See I.R.C. section 2010.  The “applicable exclusion amount” is $2 million for decedents dying in 2007 and 2008, and $3.5 million for decedents dying in 2009.  The federal estate tax is scheduled to be repealed for decedents dying in 2010, and then reinstated in 2011 with a $1 million exclusion amount. 

[2] See I.R.C. section 2056.

[3] Depending on the state of domicile, there may be state estate tax due at the first death.  This will typically occur where the state exemption is less than the federal exclusion.

[4] The maximum federal estate tax rate is 45 percent for decedents dying in 2007 to 2009.  See I.R.C. section 2001(c).  Depending on the state of domicile, state estate tax may increase the tax burden to more than half of the taxable estate.   

[5] It may also be advantageous to consider lifetime gifts which are subject to gift tax.  Unless death occurs within 3 years of the gift [see I.R.C. section 2035(b)], the effective gift tax rate is lower than the effective estate tax rate.  However, paying gift tax may have adverse tax consequences if at the time of death there would otherwise be little or no estate tax due to subsequent changes in the law.

[6] See I.R.C. section 2503(b).  The annual exclusion for 2007 is $12,000.

[7] See I.R.C. section 2503(e).

[8] See I.R.C. section 2505.  The gift tax applicable exclusion amount is $1,000,000. 

[9] See I.R.C. sections 2702(e) and 2704(c)(2).

[10] I.R.C. section 2702(a).  Accordingly, if property is transferred in trust subject to the retention by the Grantor of non-qualified interests, the value of the gift for gift tax purposes would be the value of the entire property transferred.

[11] I.R.C. section 2702(a)(2)(B). 

[12] See I.R.C. section 2702(b) and Regulations section 25.2702-2(a)(6).

[13] Regulations section 25.2702-3(b). It may be desirable to structure the annuity amount as an increasing series of payments in order to allow the trust assets to appreciate while held in the trust.  In contrast, one commentator has suggested a GRAT with a very large first year annuity and a nominal second year annuity.  The goal of such a front-loaded GRAT is to duplicate the results that would be achieved by a one year GRAT.   See Zero-Out GRATs and GRUTs – Can Still More Be Done?, Harry F. Lee, Tax Analysts-Tax Notes, May 14, 2007.

[14] The trust must prohibit additional contributions.  Regulations section 25.2702-3(b)(5).

[15] Although any income in excess of the annuity may be payable to the Grantor, the right to receive such income is not taken into account in valuing the annuity interest. Regulations section 25.2702-3(b)(1).

[16] Regulations section 25.2702-3(b)(2).

[17] Regulations section 25.2702-3(b)(1).

[18] Regulations section 25.2702-(3)(d)(3).

[19]   Regulations section 25.2702-3(b)(3).  If payment is made based on the anniversary date, proration is required only if the last period is less than 12 months.  If payment is made based on the taxable year, proration is required for each short taxable year.

[20] Regulations section 25.2702-3(b)(4).  The regulation appears to sanction the delay in payment of the annuity for 3½ months after the close of the annual period.  If the annuity is payable at the end of the annual period, the trust would have use of the payment for an extra 3½ months.  If the annuity is payable at the beginning of the period, query whether payment could be delayed for 15½ months.  In either event, it is not certain whether authorization in the trust to delay payment is required, and if so whether this would affect the valuation of the annuity.  See GRATs vs. Installment Sales to IDGTs: Which is the Panacea or are They Both Pandemics, Jonathan G. Blattmachr and Diana S.C. Zeydel, University of Miami School of Law, Heckerling Institute on Estate Planning, January 2007.

[21] Regulations section 25.2702-(3)(d)(5).

[22] Regulations section 25.2702-(3)(d)(6).  The regulation does not, however, prohibit the trust from borrowing from a third-party lender and then distributing the proceeds in satisfaction of the annuity.  This may be beneficial if the trust does not have sufficient liquid assets and it would be undesirable to distribute other assets to the Grantor.   

[23] A grantor trust is treated as owned by the Grantor for income tax purposes.  See I.R.C. sections 671-679.

[24] See Rev. Rul. 85-13, 1985-1 C.B. 184.  See, e.g., Private Letter Ruling 9519029 (February 10, 1995).

[25] Regulations section 25.2702-3(d)(4).

[26] Although there are no rules as to how short the trust term may be, many practitioners have generally adopted 2 years as the minimum trust term, based on the regulations and private letter rulings.  

[27] Similarly, if separate assets will be transferred to a GRAT, it is desirable to use separate GRATs for each asset class.  This would prevent good performance of one asset class from being diminished by poor performance of another class.  

[28] The regulations expressly sanction the use of an annuity expressed as a fraction or percentage of the initial value of the transferred property, as finally determined for gift tax purposes.  Regulations section 25.2702-3(b)(1)(ii)(B).

[29] This view was originally set forth in the infamous Example 5 of Regulations section 25.2702-3(e). 

[30] Walton v. Commissioner, 115 T.C. 589 (2000), IRS acquiescence in Notice 2003-72, 2003-2 C.B. 964.

[31] Regulations section 25.2702-3(e), Example 5.

[32] Commissioner v. Procter, 142 F. 2d 824 (4 th Cir. 1944).  In Private Letter Ruling 200245053 (July 31, 2002), the Service noted that the regulations should not be viewed as sanctioning a zeroed-out GRAT or even one with a nominal gift.  In Rev. Proc. 2005-3, 2005-1 C.B. 118 (January 3, 2005), the Service listed areas in which rulings or determination letters will not ordinarily be issued, including GRATs where the annuity amount is more than 50 percent of the initial value of the trust property or where the value of the remainder interest is less than 10 percent of the initial value of the property.  Some commentators have suggested that the GRAT regulations (permitting an annuity defined as a percentage of value as finally determined for gift tax purposes) constitute an override of Procter.  See Zero-Out GRATs and GRUTs – Can Still More Be Done?, Harry F. Lee, Tax Analysts-Tax Notes, May 14, 2007.

[33] See The Care and Feeding of GRATs – Enhancing GRAT Performance Through Careful Structuring, Investing and Monitoring,  Carlyn S. McCaffrey, University of Miami Law School, Heckerling Institute on Estate Planning.

[34] Assuming the trust is a grantor trust, this should not have adverse income tax consequences.  See Rev. Rul. 85-13, 1985-1 C.B. 184.  Conveniently, a common provision used to achieve grantor trust status is a power given to the Grantor to reacquire trust property by substituting assets of equivalent value.  See I.R.C. section 675(4)(C).

[35] Accordingly, the Grantor should not retain any interests in or powers over the trust that would result in estate inclusion.  In particular, it may be advisable to avoid naming the Grantor as a Trustee after the expiration of the GRAT term.

[36] There has been some uncertainty as to the application of sections 2036 and 2039 to GRATs.  This has been clarified by the issuance of proposed regulations by the IRS on June 7, 2007.  (A public hearing on the proposed regulations is scheduled for September 26, 2007.)  Pursuant to the proposed regulations, only section 2036, and not section 2039, will apply if the Grantor dies during the annuity term.  The amount includible in the gross estate is that portion of the trust necessary to yield the annuity amount, based on the appropriate section 7520 rate.  For most GRATs with a short term and a large annuity amount, this will result in full inclusion.

[37] Such a provision could provide for either an outright marital disposition or for a qualified terminable interest property (QTIP) trust.

[38] While it may appear advisable to provide for a contingent reversion to the Grantor’s estate which could easily be qualified for the marital deduction, this may not satisfy the requirement that the remaining annuity payments be made to the Grantor’s estate.  See The Walton GRAT and Marital Deduction Planning, Harry F. Lee and David L. Silvian, Taxes, July 2001.

[39] See I.R.C. section 2612.

[40] The death of a child during the term would not trigger the “move-up” rule under section 2651(e) for persons with a deceased parent.  In order for such rule to apply, the child would have to be dead at the time of the GRAT’s creation.

[41] See I.R.C. section 2632.

[42] If an individual makes a lifetime transfer which would be includible in the gross estate if such person died immediately thereafter, any GST allocation may not be made before the close of the estate tax inclusion period (ETIP).  I.R.C. section 2642(f).  Since the Grantor’s death during the GRAT term would result in estate inclusion, the ETIP rule would prevent an allocation until the termination of the GRAT period, at which time the remainder interest may have a much greater value.  The regulations, however, provide an exception to the ETIP rules if the possibility of estate inclusion is so remote as to be negligible.  Regulations section 26.2632-1(c)((2)(ii).  A possibility is considered negligible if it can be ascertained that there is less than a 5 percent probability of estate inclusion.  Since most GRATs are designed specifically to minimize the risk of estate inclusion, the exception may be applicable in many cases.  However, even if the exception applies, it is unclear as to how much exemption must be allocated in order to exempt the trust.  See GRATs and GST Planning – Potential Pitfalls and Possible Planning Opportunity, Edward M. Manigault and Milford B. Hatcher Jr., 20 Prob. & Prop. No. 6 (Nov./Dec. 2006).  A contrary view has been suggested that the ETIP exception should not apply even if the probability of the Grantor’s death is less than 5 percent.  The reason is that even if the Grantor survives the term, the trust property will have been returned to him as payment of the annuity, and will be therefore be includible in his eventual estate.   See Zero-Out GRATs and GRUTs – Can Still More Be Done?, Harry F. Lee, Tax Analysts-Tax Notes, May 14, 2007.

[43] In Private Letter Ruling 200107015 (November 14, 2000), an attempt to leverage the GST exemption was made by having a child remainderman of a testamentary charitable lead annuity trust assign his remainder interest to his children.  A ruling was requested that upon termination of the CLAT, the payment of assets to the child’s children would not be subject to the GST tax because the child would be treated as the transferor.  The IRS ruled that it would not allow such an arrangement to circumvent the statutory rule and stated it might disregard the form of the transaction and treat the decedent as the transferor for GST purposes.

[44] See I.R.C. sections 671-679.  

[45] A trust may be a grantor trust in whole or in part.  For purposes of this discussion, a grantor trust refers to a wholly grantor trust.

[46] If the Grantor pays the income tax on a grantor trust, that does not constitute a gift by the Grantor to the trust’s beneficiaries because the Grantor, and not the trust, is liable for the tax.  See Revenue Ruling 2004-64.

[47] The I.R.S. has ruled that transactions between the Grantor and his grantor trust are not recognized for income tax purposes.  See Rev. Rul. 85-13, 1985-1 C.B. 184. 

[48] See Income Tax Effects of Termination of Grantor Trust Status by Reason of the Grantor’s Death, Jonathan G. Blattmachr, Mitchell M. Gans and Hugh H. Jacobson, Journal of Taxation, September 2002.

[49]   I.R.C. section 675(4)(C).  The statute requires that this power be held in a nonfiduciary capacity.   In an often cited case, the Tax Court held that a decedent’s power to substitute property of equal value would not cause estate inclusion where decedent was bound to act in accordance with fiduciary standards.  Jordahl v. Commissioner, 65 T.C. 92 (1975).  The case appears to stand for the proposition that fiduciary standards, which can be implied from a requirement of equal value, are sufficient to avoid estate inclusion, even if held in a nonfiduciary capacity.  The Regulations provide that if a power is not exercisable by a person as trustee, the determination of whether the power is exercisable in a fiduciary capacity depends on all the trust terms and the surrounding circumstances.  Regulations section 1.675-1(b)(4). 

[50] I.R.C. section 677(a).

[51] I.R.C. section 675(2).

[52] See I.R.C. sections 2036 – 2038.

[53] See e.g. Private Letter Rulings 9251004 (September 4, 1992) and 9515039 (January 17, 1995).

[54] Unless the trust is already in existence with independent assets, this will typically require the Grantor to make an initial taxable gift.  Commentators have also suggested the use of guarantees to counter the retained equity argument.  See Using Beneficiary Guarantees in Defective Grantor Trusts, Milford B. Hatcher, Jr. and Edward M. Manigault, Journal of Taxation, March 2000.  An interesting variation has been suggested by having the Grantor make an additional transfer to the trust in a form which is incomplete for gift tax purposes.  See The Incomplete Equity Strategy May Bolster Sales to Grantor Trusts, Deborah V. Dunn, Domingo P. Such, III and Lucy K. Park, Estate Planning, February 2007.

[55] I.R.C. section 2512(b).

[56] There have been various attempts to limit the gift tax exposure of sales of uncertain value.  These include provisions requiring a retransfer of property to the donor, price adjustment provisions and defined-value clauses.  Based on public policy grounds and the often cited Commissioner v. Procter, 142 F.2d 824 (4 th Cir. 1944), these attempts have generally been unsuccessful in the courts.  However, there has been a recent taxpayer victory in McCord v. Commissioner, 461 F.3d 614 (5 th Cir. 2006), reversing 120 T.C. 358 (2003).  McCord involved a defined value clause that allocated any excess value to charitable donees.  Although the clause was upheld by the Fifth Circuit, it did not refer to Procter because it was not raised on appeal.  At the May 12, 2007 American Bar Association meeting, George Masnik of the I.R.S. addressed the Service’s response to McCord.  He indicated the Service does not agree with the Fifth Circuit’s characterization of the gift using the defined valuation clause.  Furthermore, the Service will continue to litigate this issue and would argue that such clauses are invalid as public policy violations.  

[57] See Frazee v. Commissioner, 98 T.C. 554 (1992).

[58]   For a term up to 3 years, the federal short-term rate applies.  For a term over 3 but not over 9 years, the federal mid-term rate applies.  For a term over 9 years, the federal long-term rate applies.

[59] Since the “retained” interest would not be a qualified interest under section 2702, the IRS could assert a gift of the entire property.

[60] Assuming that the trust has been structured to avoid inclusion in the Grantor’s estate, the ETIP rules should not prevent an effective allocation of exemption.  See I.R.C. section 2642(f).

[61] See I.R.C. section 2642(a).

 


 

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