Estate planning professionals can supply an array of estate planning techniques: using the applicable exclusion amount, generation-skipping planning, irrevocable life insurance trusts, family limited partnerships, charitable remainder trusts, charitable lead trusts, qualified personal residence trusts and sales to defective grantor trusts. Clients can use many of these tools in any particular family situation. Nevertheless, even after implementing these techniques, further planning is still needed, not only to move more wealth to avoid estate tax, but also to meet the perceived financial needs of the matriarch and patriarch of the family. The reciprocal grantor retained annuity trust (GRAT) is a technique that goes one step further in meeting these two objectives.
This reciprocal GRAT concept has also been discussed by Marjorie Stephens in Drafting Split Interests-GRATs; Joint Contribution Annuity Trusts; Sales to Defective Grantor Trusts; Intentionally Defective Grantor Trusts (including Community Property Issues), 10th Annual Advanced Drafting: Estate Planning and Probate Course (State Bar of Tex. 1999). In her article, Stephens states that Richard Covey has found reciprocal GRATs to be substantially more beneficial than a straight GRAT or a revocable spousal GRAT. See also Richard B. Covey, Practical Drafting 3402 (U.S. Trust Co. Oct. 1993); Jonathan G. Blattmachr and Georgiana J. Slade, 836 T.M. Partial Interests-GRATs, GRUTs, QPRTs (Section 2702) A-51 (BNA 1996).
The concept of reciprocal GRATs is really very simple. Code § 2702, its accompanying regulations, specific examples in those regulations and PLR 9848004 give guidance for determining what to do and not to do.
The best way to describe the reciprocal GRAT technique is to outline the steps and results of the technique in an example. First, each spouse creates a long-term (usually 15-20 year) GRAT providing for remainder interests in their children. In his GRAT, the husband retains an annuity payment for two years and provides that his wife will receive the annuity for the remaining term, unless the wife's interest is revoked. With a 20 year GRAT, the wife's interest would continue for another 18 years, if not revoked. A planner should not make the revocable annuity payments go for the life of the nongrantor spouse. Rev. Rul. 77-454 makes it clear that if the annuity payments are cut off before death, the clients get more bang for the buck. The combination of the couple's stacked annuity interest meets the requirement that GRATs have a long-term annuity interest. The wife's GRAT will have the same terms and conditions but for herself and her husband-a reciprocal GRAT.
Both spouses must survive the initial two year period of their respective GRATs. If they do not, both GRATs fail, and each GRAT will be included in the respective spouse's estate. If the couple survives the initial two year period, but one of the spouses does not survive the combined term of their GRATs, the deceased spouse's GRAT is includable in the deceased spouse's estate for estate tax purposes because the deceased spouse had, at the time of his or her death, the right to revoke the surviving spouse's interest in the deceased spouse's GRAT. See Treas. Reg. § 20.2036-1.
If both spouses survive the combined term of their GRATs, then the family becomes an immediate winner. Similar to the results achieved in traditional GRAT planning, the GRATs are not included in the couple's gross estates when they die. In this technique, the clients remove not only appreciation but also underlying GRAT property from their estates.
This result occurs because a 6% annuity amount over 20 years represents a lot of underlying value in the GRAT. If both spouses survive the first two years of their GRATs and one of the spouses dies after the second year but before the term of the GRATs, the family becomes a winner on the GRAT of the surviving spouse. The property in the surviving spouse's GRAT immediately passes to the children on the death of the first spouse to die, but is not included in the deceased spouse's gross estate. Under this arrangement, the clients win on one GRAT and lose on one GRAT, but this risk is known when the transaction is consummated.
As to the GRAT on which the clients lose (the GRAT created by the spouse who dies first and that is includable in the deceased spouse's gross estate), the GRAT is designed to qualify for the marital deduction and the surviving spouse will have a qualifying income interest for life on which to live.
Reciprocal Trust Doctrine Not Applicable
This technique does not generate a reciprocal trust problem. Although the two trusts parallel each other, the property of one of the GRATs is includable in the estate of the first spouse to die. In other words, the clients are facing estate tax inclusion of one-half of the property used to create the GRATs when the first spouse dies. At that time, the GRAT of the surviving spouse terminates and the assets of the surviving spouse's GRAT are distributed to the children who are the remainder beneficiaries of the GRAT as if the surviving spouse actually completed the term of the GRAT. Because the surviving spouse has no interest in the GRAT, there will be no cause for inclusion of the GRAT assets in his or her gross estate at his or her death. The result of the surviving spouse's GRAT is no different for estate tax whether both spouses survive their respective GRAT terms or the first spouse to die causes the second spouse's GRAT to terminate early.
If there are still concerns that the creation of reciprocal GRATs would somehow cause a reciprocal trust problem under United States v. Estate of Grace, 90 S. Ct. 147 (1969), then the clients can follow the guidelines set out in PLR 9643103. In this ruling, two spouses created irrevocable dynastic trusts but had different trustees, different beneficial interests and different powers of appointments or remainder beneficiaries.
In the reciprocal GRAT scenario, the husband could be trustee of his GRAT and the wife and an independent co-trustee could be trustees of her GRAT. In the husband's GRAT, the husband would not be given the right to receive additional payments from the GRAT in excess of his annuity amount and the husband's GRAT could be made a defective grantor trust by a particular grantor trust provision. In the wife's GRAT, the wife could be given the right to receive additional distributions from the GRAT in excess of the annuity payments; and the wife's GRAT would be a defective grantor trust using a different provision than the husband's GRAT. Finally, the remainder beneficiaries of the husband's GRAT would be the children, and the remainder beneficiaries of the wife's GRAT would be the husband and the children. Taking these steps should eliminate concerns about the reciprocal trust doctrine.
First Spouse's Death
Reciprocal GRATs are a very effective estate planning tool, because the clients get leverage when the property of the surviving spouse's GRAT is transferred to family members immediately at the death of the first spouse to die. The terms of each GRAT, however, must be drafted in such a way that, at the death of the first spouse to die, the property in the deceased spouse's GRAT will qualify for QTIP treatment.
The planner must build this feature into both GRATs, because QTIP treatment is likely to be necessary for one of the GRATs. Just because each trust may qualify for QTIP treatment does not mean that QTIP treatment must be elected. If the GRAT is to qualify for QTIP treatment, the planner would need to provide that the GRAT would convert the limited term interest for the surviving spouse to a qualifying income interest for life. In the alternative, the GRAT could provide that the assets of the deceased spouse's GRAT may be payable to the deceased spouse's estate. The traditional testamentary documents would then dispose of the GRAT property in a manner that qualifies for the marital deduction.
Regulatory Support for Reciprocal GRATs
Several key provisions of the regulations support this technique. Key provisions under Treas. Reg. § 25.2702-2 are:
- Treas. Reg. § 25.2702-2(a)(5):
Qualified interest means a qualified annuity interest, a qualified unitrust interest, or a qualified remainder interest. Retention 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).
- Treas. Reg. § 25.2702-2(b)(2):
The value of a qualified annuity interest and a qualified remainder interest following a qualified annuity interest are determined under section 7520. The value of a qualified unitrust interest and a qualified remainder interest following a qualified unitrust interest are determined as if they were interests described in section 664.
Key provisions under Treas. Reg. § 25.2702-3 are:
- Treas. Reg. § 25.2702-3(b)(1)(i):
A qualified annuity interest is an irrevocable right to receive a fixed amount. . . .
- Treas. Reg. § 25.2702-3(d)(3):
The governing instrument must fix the term of the annuity or unitrust interest. The term must be for the life of the term holder, for a specified term of years, or for the shorter (but not the longer) of those periods. Successive term interests for the benefit of the same individual are treated as the same term interest.
Key examples under Treas. Reg. § 25.2702-2(d)(1) are:
- 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).
The following example supports this planning using Examples 6 and 7 and Treas. Reg. §§ 25.2702-2 and 25.2702-3 cited above. A transfers property to an irrevocable trust, retaining the right to receive a qualified annuity interest for 10 years. On expiration of 10 years, a qualified annuity interest is payable to A's spouse, if living, for 10 years. The term must be for the shorter of the life of the term holder or for a specified term of years. During the second 10 year period, the term holder is A's spouse. On expiration of the spouse's interest, the trust terminates and the trust corpus is payable to A's child. This means that the trust will terminate either after the second 10 year annuity term or at the death of A's spouse, whichever comes first. A retains the right to revoke the spouse's interest. Because the transfer of property to the trust is not incomplete for all interests in the property (i.e., A has made a completed gift of the remainder interest), Code § 2702 applies. A's power to revoke the spouse's term interest is treated as a retained interest for purposes of Code § 2702. 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 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.
The case presented in PLR 9848004 is an example of how not to structure a reciprocal GRAT. In that case, in each trust, the spouse's right to receive annuity payments was contingent on the grantor's death before the expiration of the seven year term. The IRS stated that this is the same interest considered in Treas. Reg. § 25.2702-3(e), Examples 5 and 6. These examples illustrate that the right to receive annuity payments, contingent on the grantor's death before the expiration of the grantor's retained term interest, is not a qualified interest. The IRS went on to state that, as is the case in Examples 5 and 6, the spouse's interest in each trust is not a qualified interest for purposes of Code § 2702(b). Furthermore, the spouse's interest does not satisfy the requirements of Treas. Reg. § 25.2702-3(d)(3). Under Treas. Reg. § 25.2702-3(d)(3), the term of the annuity interest must be for the life of the term holder, for a specified term of years or for the shorter (but not the longer) of those periods.
In PLR 9848004, the IRS stated that the spouse's annuity was not payable for the life of the spouse, for a specified term of years or for the shorter of those periods. Rather, the annuity was payable, if at all, for an unspecified period dependent on whether the grantor died during the term of the trust and the remaining term of the trust at that time. The IRS stated that the spousal interest presented in that case is different from that presented in Example 7 of Treas. Reg. § 25.2702-2(d)(1). The spousal interest is not dependent on the grantor's death during the annuity term or on the point in the annuity term that death occurs. The IRS went on to state that in Example 7, the annuity is payable in all events, assuming the spouse survives, and is payable for a specified term, or until the spouse's death, whichever is the shorter period.
FLPs and Reciprocal GRATs
The following is an example of how this technique works in combination with a limited partnership. Husband and Wife form a limited partnership, Securities, Ltd. Each of husband and wife creates a GRAT and transfers to that GRAT his or her 49.5% limited partnership interests in Securities, Ltd. If the property contributed to the limited partnership is community property, the partnership interests must first be partitioned so that the limited partnership interests contributed to the GRATs are the separate property of Husband and Wife, respectively. The terms of the GRATs are identical except that each will have a different grantor.
The term of each GRAT is 18 years or until the death of the annuity holder, whichever comes first. The annuity right is irrevocable. During the first two years of the GRAT, the grantor will receive the annuity payments. During years 3 through 18, the nongrantor spouse will receive the annuity payments subject to the grantor's right to revoke the spouse's payment right. If the grantor revokes the spouse's payment right, the right reverts to the grantor.
If a grantor dies during the term of the GRAT, the GRAT's assets will be paid to the grantor's estate and can be targeted for QTIP treatment. If the nongrantor spouse dies within the first two years, the GRAT created by the surviving grantor continues through the GRAT term for the surviving grantor's exclusive benefit. If the nongrantor spouse dies after the first two years but before the grantor dies, the assets of the GRAT created by the surviving grantor are immediately paid to the grantor's surviving children or nongeneration-skipping trusts for their benefit. Accordingly, if both spouses live at least two years but one spouse dies during the 18 year term, the transfer tax savings is lost for one GRAT but is accomplished for the other. If both spouses live out the 18 year terms, successful transfers will have been made to children for only two small applicable exclusion gifts, usually structured to be $10,000 to $20,000 each.
Assuming $6 million of securities in Securities, Ltd., a 33.3% discount for limited partnership interests and an annual annuity payment of $245,378 for each GRAT, each gift to a GRAT creates a taxable gift of $10,000 at formation.
The primary objectives of this technique are to enable retention of control in Husband and Wife as owners of the entity that is the general partner of Securities, Ltd., to retain annuity streams for Husband and Wife and to reduce transfer taxation substantially if at least one spouse lives more than two years.
The reciprocal GRAT technique provides estate planning professionals with another tool in their arsenal to achieve both of the competing goals of their clients: (1) an income stream from or access to their assets; and (2) the ability to move assets to their children in a manner that substantially avoids estate and gift taxes. The reciprocal GRAT meets many clients' objective to get wealth to their children in the future or after the death of one spouse but not immediately. This technique also provides substantial security to a surviving spouse who knows that one-half of the assets placed in the reciprocal GRATs will always be available to him or her for economic security.
If the methodology is followed as set out in the above example, the surviving spouse is also given the opportunity to control all assets of a limited partnership for which 49.5% of the limited partnership interests have been transferred to children or trusts for their benefit with nominal gift tax consequences. Few of the techniques available to estate planning professionals provide this significant level of gift and estate tax reduction and yet provide the continuing financial security that all clients desire.