What Is A GRAT

What You Should Know About Your GRAT
(Grantor Retained Annuity Trust)
Or How To Make Large Gifts Without Paying Gift Tax Or Using Any Gift Tax Unified Credit

DISCLAIMER: The “BASIC” section of this memo is a brief, perhaps over-simplistic, overview of some of the more frequently asked questions concerning grantor retained annuity trusts (GRATs), a subclass in the family of split-interest trusts, where the grantor retains an annuity and at the end of the term the remainder passes to the grantor/donor’s beneficiaries. This memorandum should not be relied upon in any given situation without first consulting your tax advisor. The law in this area changes frequently, and I have not necessarily undertaken to keep this memo current, since that would be a full-time job.

STRUCTURE: The format I have chosen is question and answer. Further, I have divided this memo into two parts. The first part is entitled “BASIC,” and the second is entitled “TECHNICAL.” The BASIC Part can serve as a client disclosure memorandum. The technical part is worth reading, if you are a tax professional or if you simply want to know some of the issues, traps and other technicalities that must be confronted for a GRAT to be successful. The first part is also worth reading, whether you are a professional tax advisor, or a layperson who has or is contemplating establishing a GRAT. This memo may or may not have the TECHNICAL Section attached, but, if not attached, it will be produced upon request.

If you are a layperson (or client) who has or is contemplating establishing a GRAT, you are strongly advised to read this memo; again, with the proviso that before relying upon any specific statement, the layperson should run the issue by tax counsel, who can apply the law to the facts, and who can determine whether the matter treated is still current, given the fast pace of change in this area.

BASIC

WHAT IS A GRAT?	The acronym GRAT stands for grantor retained annuity trust.
HOW DOES A GRAT WORK?	The grantor/donor transfers property into a trust (a GRAT) that provides that the grantor will receive each year a fixed annuity, usually for a term of years. At the end of the term, the remainder beneficiaries get whatever is left. The gift involved equals the theoretical value of the remainder, determined by using the discount rate (or rate of return) specified in IRC §7520.
WHAT ARE SOME EXAMPLES OF HOW A GRAT MIGHT WORK?	At the risk of putting the cart before the horse, perhaps before the reader fully understands how a GRAT works, and before I have discussed the Walton[1] case, I am going to give some examples. In July of 2003, the government interest rates we are required to use for GRATs (the IRC[2] §7520 rate) was 3%. True, it is doubtful that it will ever be this low again, but since that is when this portion of the memo was written, I am going to use that rate.
What Is the Theoretical Size of a Remainder Interest in A $10 MILLION, 10-YEAR, GRAT, IF THE Assumed After Tax Rate of Return IS 3%?	According to my calculations, if $10 million were placed in trust for 10-years, and if approximately $1.17 million were distributed to the grantor each year, and if the assets earned 3%[3] per year (after tax and expenses, in effect), year in and year out, then the final payment of $1.17 million would equal the amount in the trust, and the remainder beneficiaries would get nothing. If, in the example, the return rate exceeds 3%, the remainder beneficiaries get the excess. If it is less than 3%, the beneficiaries get nothing, and the grantor essentially gets what is left of the trust property back. Hence, if the government tax tables assumed a 3% rate of return, which was the §7520 rate for July, 2003, then one would expect that the value of the gift to the remainder beneficiaries would be zero, or close to it.
What is a Quick Example of What the Remainder Beneficiaries Get Under the Facts Just Recited?	Under the example given, if the GRAT grew each year at precisely the 3% §7520 rate used in the assumptions, there would be no remainder left at the end of the term. If it grew at 5%, the remainder would be $1,543,814. At 10%, the remainder jumps to $7,253,895. At 14%, the remainder jumps to a whopping $14,402,997!
What is the Gift Tax Value of the Remainder Interest According to the IRS’ Previous Position?	Until recently, the IRS’ view was that the GRAT just described would result in a taxable gift of $1,028,064, if the grantor was age 65. The gift would be less if the grantor was younger, and more if older. What does age have to do with it? The “reason,” according to the IRS’ former position, that the gift would be $1,028,064, instead of zero, was that the grantor might die prior to age 75, in which case the remaining payments of $1.17 million per year would pass to the grantor’s estate, rather than to the grantor. The actuarial odds of this happening were factored into the value of the gift by discounting the value of the retained interest, which had the mathematical effect of increasing the value of the gift (despite the fact that the estate of the donor would receive the “gift,” and that the donees would not ever receive the gifted property). The portion of the retained interest that represented this contingency was treated by the IRS as something other than a “qualified interest.” In the IRS’ former view, it followed, somewhat bizarrely, that the interest passing to the estate of the grantor was “to be treated as” a gift to the remainder beneficiaries.
What is the New Rule regarding Zeroed Out GRATs?	As indicated above, until recently, it was not possible to be sure that a “zeroed out” GRAT would work. Again, 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 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: that it was strained at best, and entirely lacking in formal logic at worst. Fortunately, the Tax Court, in Walton[4], 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[5]). Walton[6] declared the regulations invalid on this point. *The IRS recently acquiesced to the Walton* case and announced that was withdrawing Treas. Reg. §25.2702-3(e), Ex. (5).[7]**
Why are GRATs So attractive, Post-Walton?	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.
Can a Person Make a MultI-Million Dollar Gift Without Paying Gift Tax?	Under Walton, to which the IRS has now acquiesced, the gift to the remainder beneficiaries, if properly structured, can always be zero, or close to it. The grantor’s age is now irrelevant. Thus, despite the draconian impact of Sec. 2702 on transfers where the retained interest is not a “qualified interest,” the economic realities discussed above can be used in a GRAT to shift all of the benefits of over-performance to the donees, with little or no transfer cost to the donor. This is easily done under a GRAT by making the “qualified retained interest” almost large enough to equal to the theoretical value of the entire interest, because in that case the gift tax value of the GRAT is close to zero. In that situation, if the property transferred to the GRAT out performs the Sec. 7520 interest rate assumptions, the benefits of the excess growth inures to the donees (remainder beneficiaries); but if the GRAT does not grow at the Sec. 7520 rate, the detriment to the donor/grantor is minimal, because the gift was close to zero in any case. It follows the upside potential is unlimited, and yet the downside potential is nominal at most. This is a very desirable set of contingencies, obviously.
	The above examples clearly demonstrates how a taxpayer can make a multi-million dollar gift without paying any gift tax. No, it is not a sure thing. What has to happen is that the return rate on the GRAT must exceed the §7520 rate. But that is all that is required —that, and a large transfer to the GRAT, all or a portion of which will be returned to the grantor over time in the form of an annuity, whose value is determined based upon an assumed rate of return equal to the §7520 rate.
HOW DOES A GRAT COMPARE WITH AN OUTRIGHT GIFT?	There are two primary theoretical advantages that an outright gift might be preferable to a gift of a remainder under a GRAT, but those advantageous are largely illusory when viewed from the grantor’s perspective. The basic distinction is one of certainty verses uncertainty. (1) There is the risk that the GRAT will fail to perform at the §7520 rate. However, under a zeroed out GRAT, there is little downside to the grantor in this event. (2) There is the risk that the grantor will fail to live out the term. Again, if the GRAT is zeroed out, there is little downside to the grantor in this event. Moreover, it might be possible to “insure” against this contingency.
	If a GRAT grew at precisely the §7520 rate, and the grantor outlives the term, the result of an outright gift of the gift tax value of the remainder ought to produce just about the same result as a GRAT, except for the virtually never noticed fact that the §7520 rate does not take income taxes into account, and an outright gift growing at the §7520 rate is treated for tax purposes as if it would grow tax free in a GRAT, in effect (i.e., as far as the remainder beneficiaries were concerned). An outright gift will presumably be subject to income taxes.
	Certainty vs. Uncertainty. If there are limited assets to work with, the outright gift provides a certainty not available under a GRAT. There are two primary uncertainties with which the beneficiaries of a GRAT must contend. (1) First, the GRAT may under-perform the §7520 rate. (2) Secondly, if the grantor fails to survive the term, the property is includible in the grantor’s estate, and in that case the beneficiaries achieve nothing under the GRAT.
	(1) The failure of the GRAT to achieve a rate of growth exceeding the §7520 rate could be a disaster if §25.2702-3(e), Ex. 5 were good law. However, given the IRS acquiescence in Walton, we are safe in assuming that Ex. 5 is invalid. Therefore, by reducing the value of the gift to close to zero, there is little to lose if the trust under-performs the §7520 growth rate, and everything to gain if it outperforms it. Hence, there is therefore little to lose if the trust under-performs the §7520 growth rate and if the gift is structured to be close to zero. There is everything to gain if it outperforms it.
	(2) The other principal risk with a GRAT is the risk of the grantor’s premature death. If the grantor fails to survive the term, the property, or a portion of it, is includible in the grantor’s estate, and the beneficiaries achieve little or nothing. The risk of a premature death can be offset by term insurance, but only if the grantor is healthy and of a reasonable age. In the case of a zeroed out GRAT, the risk of premature death has little other downside potential, and the upside is unlimited. This particular downside is perhaps more important if there are limited assets to work with. In summary, the outright gift provides certainty, with a transfer tax cost, and the GRAT provides uncertainty, with little or no cost.
What Are Some Examples of How an Outright Gift Might Compare to a GRAT?	Most importantly, and as amply illustrated below, if a GRAT outperforms the §7520 rate, there is a multiplier effect, which makes it far superior to any outright gift. To see whether a GRAT makes sense, as well as to understand the dynamics involved, it may be useful to compare what would happen if the grantor simply made an outright gift of the $1,028,064 on which the grantor of the GRAT would be taxed under the IRS theory, pre-Walton. The results may surprise you.
	An outright gift of $1,028,064 (the gift tax value of a 10-year, $10 million pre-Walton GRAT, established by a 65 year old), would produce $1,341,306, if it grew (tax free) at 3% for 10-years. That is distinctly better than a GRAT, which would produce nothing at the end of the term under these assumptions, and which, pre-Walton, would be treated as a $1 million gift to boot. On the other hand, given the IRS acquiescence in Walton, the gift, if made under a GRAT, could be structured to be nominal. The amount passing to the remainder beneficiaries under the GRAT will be nothing, but if the gift is zeroed out, the gift tax will be zero as well. No harm, no foul. At 5%, the pot of money remaining in the case of an outright gift of $1 million at the end of 10-years would be $1,594,765, which is not too far off what a zeroed out $10 million GRAT would produce as well.
	At a 10% rate of return, however, an outright gift of $1,028,064 would produce $2,423,970 at the end of 10-years, but the ending principal in a $10 million GRAT (on which $1,028,064 was treated as a taxable gift pre-Walton) would be $7,253,895! At a 14% rate of return, an outright gift of $1,028,064 would produce $3.3 million at the end of 10-years, but there would be $14,402,997 in the GRAT! So at the higher rates of return, even a pre-Walton GRAT is looking pretty good, and results in much more wealth being shifted transfer tax free than an outright gift. Post-Walton, the results are just that much better, since the gift is zero, instead of $1 million.
What Size Outright Gift WOuld Produce a $7,253,895 at the End of 10-Years, at a 10% Growth Rate?	According to my calculations, if you made an outright gift of $2,796,690, and the donee was able to achieve a 10% (after-tax!) rate of return, the donee would have $7,253,895[8] at the end of the term. Under a GRAT, using the example given ($10 million, 10-year, 3% interest), this same result would be achieved by making an adjusted taxable gift of $1,028,064 under the IRS theory pre-Walton, or zero, under the Tax Court’s position. This is pretty dramatic, when you think about it, and might make you wonder just how and why a GRAT will outperform an outright gift to such a astonishing extent under these rates of return.
Why Does the Math Produce Such Favorable Results For a GRAT When Compared to an Outright Gift, When the Return Rates Substantially Exceed the §7520 Rate?	Why does the math work out so dramatically in favor of the GRAT, as compared to an outright gift, when the §7520 rate of return is substantially exceeded? The answer, I think, is that over the 10-year period in the examples, the grantor of the GRAT is continuing to draw down the annuity as if the principal were only growing at 3% per year; and since, in the examples, it is growing at 5%, 10%, or 14% per year, it is compounding geometrically at a rate greater than the §7520 rate assumed. The effects of this compounding are leveraged because the initial principal is $10 million, not $1,028,064[9] (!) as in the case of the outright gift. This makes a GRAT that outperforms the §7520 rate far superior to an outright gift (of the transfer tax value) even pre-Walton.
	*But it gets even better if Walton* is good law, because the gift is not $1 million; it is zero, or close to it. So, one cannot even make a fair comparis*on between an outright gift equal to the transfer tax value of the remainder, because the transfer tax value of the remainder is zero, or close to it, making a post-Walton* GRAT is something almost too good to be true.
WHAT ARE THE RESULTS OF A $10 MILLION 10-YEAR GRAT IF WALTON APPLIES, AND IF THE §7520 RATE IS 3%, AND IF THE GRANTOR SURVIVES THE 10-YEAR TERM?	*As indicated above, the results improve dramatically as a result of Walton.* In that case, using the assumptions stated in the question to the left, which are the same as under the previous example, except that this time the grantor’s age is irrelevant, the taxable gift is zero (instead of $1 million!). All of the other gift tax savings stated in the previous examples are the same, except that this time, there is no (or virtually no) taxable gift, so that the downside potential for the GRAT is reduced to practically nothing and the upside remains the same, which is to say, the upside potential is unlimited but the downside potential is limited; and the limit is an extremely low figure at that. *In short, the amount of tax leveraging in a Walton* GRAT is about as great as one can imagine.**
What dOes it Take to Zero Out a 10-Year Grat AND Do you really Want to zero it out?	A ten year fixed term GRAT that pays out a 11.72305% annuity each year at a time when the §7520 rate is 3%, will produce a gift of zero. By reducing the annuity from 11.72305% to 11.72000%, the taxable gift goes from zero to $2606. It is probably advisable to use an annuity rate that produces a small taxable gift, larger than zero, for reasons to be explained later.
Why is It that The Value of the Remainder Under a GRAT is Less if the §7520 Rate is Lower and Why is that A Good Thing?	Please permit me one extended digression in this and the next Q&A, which should perhaps be saved for the TECHNICAL Section of this memoranda, but which I want to discuss because the topic receives so little attention in the literature. 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 apprehended. 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.
Why is It that The Value of the Remainder Under a Charitable Lead Trust iS Less if the §7520 Rate is Lower, and Why is that A Bad Thing?	A charitable lead trust (CLT) is like a GRAT, if the grantor is retaining the lead interest. The remainder beneficiaries get what remains at the end of the term. However, instead of a taxable gift, which you have with a GRAT, you have a charitable deduction. Hence, with a GRAT, you want the value of the remainder to be low (so that the taxable gift will be low); but in a CLT you want the value of the remainder to be high, so that you get a higher charitable deduction. It follows that if the higher the §7520 rate, the better a CLT is for the donor; whereas the opposite is true in the case of a GRAT.
Why is It that The Value of the Remainder Under a QPRT (House GRIT) is Less if the Interest Rate Assumption is Higher and Why is that a Good Thing?	A qualified personal residence trust (QPRT) or “House GRIT” produces a better gift tax result if the §7520 rate is higher, the opposite of a GRAT. Why? In a GRAT, the interest rate is fixed, so the value of the annuity (the retained interest) is inversely related to the §7520 rate: i.e., the higher the §7520 rate relative to the annuity, the less valuable the retained interest and the more valuable the gift. A QPRT (or any GRIT for that matter) is also inversely related, but in reverse: you have retained the income interest (in effect), and if the income interest is high, what you have retained is worth more than if the prevailing interest rate is low.
	Think of the theoretical rate of return being on an investment (in this case, it could be the rental value of your house). If interest rates are low, the return is low, and so is the value of what you retained. Like a GRAT, but in reverse, the value of the gift (the remainder interest) is inversely proportional to the value of the retained interest. So, the more valuable the retained interest (which is more valuable the higher the assumed rate of return or §7520 rate), the less the taxable value of the gift.
	In point of fact, the kids get the house at the end of the term no matter what the §7520 rate was at the time the QPRT was established, and the parent(s) got to live in the house during the term with no obvious difference in the value of living there to them; so the whole economic analysis of true value is almost entirely theoretical. The real world value of living in the house is actually quite independent of the prevailing interest rates, unless selling, renting, or mortgaging the house and investing the proceeds is a real option. Therefore, all one really needs to know is that the higher the §7520 rate the lower the value of the remainder interest in a QPRT, which likewise means that the higher the §7520 rate the less size of the taxable gift.
Why is a GRIT more Effective if the Actual Rate of Return Is Low?	In a QPRT, the actual rate of return is zero —or maybe the rental value of the home, depending how you look at it. If interest rates are high, the value of a retained income interest is high, and the value of the remainder is commensurately lower. If the GRIT is investing in assets that produce growth at the expense of fiduciary accounting income, and if all that has been retained is the right to fiduciary accounting income, then, in effect, value is being shifted from the life tenant/grantor to the remainder beneficiaries. That is why GRITs were so popular, prior to the advent of Chapter 14, which effectively stopped this technique where applicable family members retained an interest and the remainder beneficiaries were “members of the transferor’s family,” except in the case of a QPRT. However, as will be mentioned again later (because it is worth repeating) GRITs are unaffected by Chapter 14 if none of the remainder beneficiaries is a member of the family. “Significant others” come readily to mind as potential beneficiaries, as well as nephews, nieces and cousins.
Who IS a Member of the Family?	(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).[10]
Who Are Applicable Family Members?	An “applicable family member” is a person who is either (a) the transferor’s spouse, (b) an ancestor of the transferor or the transferor’s spouse, or (c) the spouse of any such ancestor.[11] Siblings, nephews and nieces and unrelated “significant others” don’t count.
How Do Income Taxes Figure into the Economic Analysis?	In making economic comparisons of different transfer tax strategies, it is often overlooked that the theoretical rates of return used for transfer tax purposes fail to take income taxes into account. It is as if it were assumed that the rate of return would be tax-free, and it seldom is. In a sense, this failure to account for income taxes in the assumed rates of return overstates the value of the expected rate of return. This error is multiplied if the assumed rate is treated as compounding over time, overstating the probable future value of an outright gift.
	A GRAT, on the other hand, will be taxed to the grantor, to the extent that distributions are made to the grantor during the term, and perhaps even if not distributed, to the extent that the grantor is taxed under the grantor trust rules and not reimbursed for it. (On this point, there is an extended discussion later in the TECHNICAL Section.) Very dramatic examples can be given about the long term transfer tax savings of having the grantor pay the tax attributable to assets in a grantor trust (which makes the trust grow like an IRA); however, that discussion should perhaps be deferred, and placed in a memoranda devoted to that subject alone.
	For now, suffice it to say that for purposes of determining value, it is assumed that the trust is growing at the §7520 rate. But that fails to account for the effect of income taxes, which could cut down what the trust is really earning by, say, one-third. The grantor’s annuity is fixed, however, and the grantor is treated as having received the full amount, without reduction for taxes. Since the grantor is taxed on the distribution, this enhances the value to the remainder beneficiaries.
	Ironically, this perhaps overstates the value of the retained interest (e.g., the grantor may really only be getting, say, 66% of the fixed annuity, after tax, but is getting credited with 100%). If true, it would seem to follow that the value to the remainder beneficiaries is understated commensurately for transfer tax purposes (which is a good thing), particularly if the taxes are paid by the grantor outside the trust. The paradox is that this is probably true even though, as stated above, the lower the §7520 rate, the greater the value of the retained interest. That is because even though the §7520 rate may be overstating the rate of return, the less the grantor receives, the more the remainder receives, which is why I made the point earlier about the fact that the assumed rate of interest and the actual rate of distribution are two separate arithmetical concepts, which should not be confused in making a financial analysis of the economics of the arrangement. I mention all this in passing, since I think it is worth considering, but have elected to eschew for now giving it the full technical treatment that it deserves.
WHAT IS THE INTEREST RATE USED FOR GRAT TAX CALCULATIONS; i.e., WHAT IS THE §7520 RATE?	The interest rate used to compute the amount of a taxable gift to a GRAT is called the IRC §7520 rate, and it is 120% of the federal mid-term rate in effect at the time of the gift. This is computed— by using an interest rate (rounded to the nearest 2/10^thsof 1 percent) equal to 120 percent of the Federal midterm rate in effect under section 1274(d)(1) for the month in which the valuation date falls.[12] Note that the lower the federal mid-term rate, the smaller the gift.
	Interestingly, if a charitable deduction is involved, §7520 gives the taxpayer a break: If an income, estate, or gift tax charitable contribution is allowable for any part of the property transferred, the taxpayer may elect to use such Federal midterm rate for either of the 2 months proceeding the month in which the valuation date falls for purposes of paragraph (2).[13] [Emphasis added.] This 2-month period to choose the §7520 rate does not apply to a GRAT. I point this out, because some have confused the rules (including me, only briefly, thank goodness).
WHY IS A GRAT AN ATTRACTIVE ESTATE PLANNING TECHNIQUE?	A GRAT is an attractive estate planning technique for a number of reasons. The main reason is that although a GRAT is a gift, and is theoretically subject to gift tax, the gift is measured by the present value of the remainder interest. If the remainder interest in a 10-year GRAT was expected to be $10 million, given current interest rate assumptions, the gift would not be $10 million; instead it would be the amount of money that would produce $10 million if invested (tax-free!) at the assumed interest rate. If the assumed rate of return was 3% (the §7520 rate in July of 2003), $7.4 million would produce $10 million at the end of 10-years, and therefore, so would an up-front gift of that amount; except that, interestingly, an up-front gift would not grow tax free. This is an often overlooked point worth considering.
	With a GRAT, we can gamble that the rate of return will exceed the §7520 rate. If it does, we win, and can potentially win big. If the rate of return does not exceed the §7520 rate, we lose the gift tax on the value of the remainder. But if we make the annuity rate high enough, and rely on the Walton[14] case, the gift tax on the remainder will be negligible, meaning that if we lose, we lose little.
WHY IS IT IMPORTANT FOR GIFT TAX PURPOSES, THAT A RETAINED INTEREST Be A “QUALIFIED INTEREST”?	If a grantor transfers property in trust, for the benefit of an “member of the transferor’s family,” and the grantor or “applicable family member” retains an interest in the trust, IRC §2702 provides that unless the interest is a “qualified interest,” the grantor will be treated as having made a gift of the entire trust at the time of the transfer. In other words, unless the interest retained by the grantor is a “qualified interest,” the government will ignore the value of the grantor’s retained interest, treating the interest retained as worth zero, so that the gift made is the total value of the property transferred to the trust, rather than the value of the remainder (which was all that was actually transferred). The value of the remainder is obviously less than the value of the remainder plus the retained life estate.
WHAT IS THE “SUBTRACTION METHOD” FOR VALUING A GIFT?	The valuation method described immediately above is sometimes called the “subtraction method” because, if a beneficiary of a trust is a member of the transferor’s family, and the transferor or an applicable family member retained an interest in the trust, §2702 treats the gift as being equal to the entire value of the transfer in trust, minus the value of any qualified retained interests. If a retained interest is not a “qualified interest,” then there is nothing to subtract, which is usually not good. The so-called “subtraction method” is derived from §2702(a)(1)&(2), which provide:
	(a) Valuation rules. (1) In general. Solely for purposes of determining whether a transfer of an interest in trust to (or for the benefit of) a member of the transferor’s family is a gift (and the value of such transfer), the value of any interest in such trust retained by the transferor or any applicable family member (as defined in section 2701(e)(2)) shall be determined as provided in paragraph (2).
	(2) Valuation of retained interests. (A) In general. The value of any retained interest which is not a qualified interest shall be treated as being zero. (B) Valuation qualified interest. The value of any retained interest which is a qualified interest shall be determined under section 7520.[15]
WHAT IS A GRIT AND HOW IS IT DIFFERENT FROM A GRAT?	A GRIT, including a QPRT, is more beneficial if the prevailing interest rate (as reflected in §7520) is high, but the actual return on the investment, as measured by fiduciary accounting income, rather than growth, is low. A typical example where growth potential is high, but fiduciary income is low would be a ranch, or a house GRIT (QPRT). A GRIT is a Grantor Retained Income Trust. Unlike a GRAT, the grantor does not retain a fixed annuity; but, rather, retains only the income from the trust, which could be very low, if the trust is invested in growth stocks or undeveloped real estate, for example. Another example of a GRIT, one of the few that is actually sanctioned by statute, is the Qualified Personal Residence Trust (QPRT), under which the grantor transfers the home, usually to the children, retaining a life estate in the home (the right to live there) for a term of years. This is an example of the principle that low income producing assets make the best GRITs, whereas the opposite is true of a GRAT.
	GRITs were very popular for a while; so popular, in fact, that Congress responded by enacting the very complicated Chapter 14 of the IRC, 2701-2704. It is IRC §2702 that forces us to use a GRAT or some other form of “qualified interest” instead of a GRIT, where the remainder beneficiary is a member of the family (except in the case of a QPRT or “House GRIT”).
	Tax planning attorneys were able to manipulate the system by investing the GRIT in low dividend high growth stocks, or even in undeveloped real estate, which produced little “income” but nevertheless appreciated in value. Sometimes the appreciation in value was due to the fact that little “income” was produced. This is certainly the way growth stocks often work. Obviously this technique favored the remainder beneficiaries over the life beneficiary, which was just fine, since the life beneficiary’s objective was to inflate the value of the retained income interest for gift tax purposes.
HOW IS A GRIT TAXED FOR TRANSFER TAX PURPOSES IF A BENEFICIARY IS A Family Member?	Because the grantor’s retained income interest under a GRIT is not a “qualified interest,” it will be taxed for transfer tax purposes as if the grantor had retained nothing, if any beneficiary of the trust is an “member of the family.”
Who IS a Member of the Family? (Again)	(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).[16]
WHO IS AN APPLICABLE FAMILY MEMBER? (Again)	An “applicable family member” is a person who is either (a) the transferor’s spouse, (b) an ancestor of the transferor or the transferor’s spouse, or (c) the spouse of any such ancestor.[17]
WHAT IF NONE OF THE BENEFICIARIES OF THE GRIT IS A Member of the family.	If no member of the transferor’s family is a beneficiary, then a gift under a GRIT is determined by measuring the value of the remainder using the current interest assumptions found in §7520. A GRIT, therefore, is still a useful technique to consider if the beneficiary is not a “member of the family”; for example, if the beneficiary is a “significant other” to whom the grantor is not married, or a nephew, niece or cousin.
WHAT EXACTLY IS A GRAT?	A GRAT is basically a trust into which the grantor transfers property, retaining “the right to receive fixed amounts payable not less frequently than annually”[18] (a/k/a a “qualified annuity interest”) for a term of years. After the expiration of the term, the annuity ends, and what is left is used for the benefit of family members. A qualified annuity interest is a species of qualified retained interest; thus, if a GRAT is used, the value of the gift to the remainder beneficiaries can be determined by subtracting the value of the annuity retained by the grantor from the value of the property transferred to the trust.
WHAT IS A QUALIFIED ANNUITY INTEREST?	Technically, term “qualified annuity interest” is one that meets all of the requirements specified in Treas. Reg. §25.2702-3(b) and (d). These requirements are too numerous to mention or to discuss in detail here (although they are quoted, almost verbatim, in the TECHNICAL Section of this memo). In general, however, the annuity must be a fixed amount payable no less frequently than annually.
WHY DID CONGRESS REQUIRE THE ANNUITY TO BE A FIXED RATE?	The requirement that the annuity be fixed was intended to discourage grantors from using low income assets (as was common in GRITs) to artificially inflate the true value of the remainder, in contrast to the computed value of the remainder, which then, as now, was determined by applying an assumed interest rate tied to federal rates that are redetermined monthly.
WHAT HAPPENS IF THE GRANTOR DIES PRIOR TO THE EXPIRATION OF THE TERM INTEREST?	Probably the single greatest downside to creating a GRAT is that, if the grantor fails to survive the term, either all of the GRAT corpus is includible in the estate of the grantor under IRC §2039,[19] or a portion of it is includible under §2036. The IRS believes that both §§2036 and 2039 apply here.[20] Arguably, only §2036 applies. If true, then less than the entire corpus would be includible. The amount includible would presumably be computed under the principles annunciated in Rev Ruls. 76-273 and 82-105,[21] meaning that the portion of the value of the trust includible in the grantor’s gross estate at death would be the amount necessary to generate the annuity amount per year, determined using the §7520 rate in effect at the date of the grantor’s death. It is also possible that §2038 would apply if a power of appointment were retained; and, of course, §2033 would apply to the portion of the GRAT payable to the grantor’s estate.
In Light of Walton, what Should Happen to the GRAT Upon the Settlor’s Death?	Some GRAT forms provide that if the Settlor dies prior to the expiration of the term the amount includible in the Settlor’s estate should be paid over to the Settlor’s estate. This may be desirable, but not necessarily sufficient. In light of Walton, I suggest that the GRAT ought to at least provide that: If the Settlor dies prior to the expiration of the Term, payments of the annuity amounts shall continue to be paid to the Settlor’s personal representative (executor/administrator) as a part of the Settlor’s general probate estate. Whether or not the document should additionally provide that such payments shall be increased or augmented as necessary to cover any estate taxes attributable to the payments is another matter.
Does §2035 Apply to a 2-YEAR GRAT, If the Grantor Survives the 2-Year term, But Dies Within 3-Years?	I am not positive about whether §2035 would operate to require a grantor to survive for another year after the termination of a two year GRAT in order to keep the GRAT out of the grantor’s estate, but at the moment this strikes me as a distinct possibility. IRC §2035(a) provides: (a) Inclusion of certain property in gross estate. If— (1) the decedent made a transfer (by trust or otherwise) of an interest in any property, or relinquished a power with respect to any property, during the 3-year period ending on the date of the decedent's death, and
	(2) the value of such property (or an interest therein) would have been included in the decedent's gross estate under section 2036, 2037, 2038, or 2042 if such transferred interest or relinquished power had been retained by the decedent on the date of his death, the value of the gross estate shall include the value of any property (or interest therein) which would have been so included.[22] [Emphasis added.]
What is the §2001(b)(2) Adjustment?	As indicated above, if the grantor dies within the term, all or a portion of the GRAT will be includible in the grantor’s estate for estate tax purposes; however, in that case, the grantor’s estate should be entitled to an IRC §2001(b)(2) adjustment —explained below—, reducing the grantor’s adjusted taxable gifts.
	(b) Computation of tax. The tax imposed by this section shall be the amount equal to the excess (if any) of— (1) a tentative tax computed under subsection (c) on the sum of— (A) the amount of the taxable estate, and (B) the amount of the adjusted taxable gifts, over * * * * For purposes of paragraph (1)(B), the term “adjusted taxable gifts” means the total amount of the taxable gifts (within the meaning of section 2503) made by the decedent after December 31, 1976, other than gifts which are includible in the gross estate of the decedent. [23]
	Adjusted taxable gifts are gifts that would otherwise be added to the taxable estate when determining the estate tax. The §2001(b)(2) adjustment ameliorates the effect of having the GRAT included in the estate, but the taxpayer is still out the time-value use of the money used to pay any gift tax, which tax was, in effect, paid early. Of course, if no gift tax was paid, because the value of the gift and all future gifts remain within the grantor’s lifetime applicable exclusion amount, then there is, obviously, no loss of the time-value use of the money.
WHO CAN BE THE TRUSTEE OF A GRAT During Its Initial Term?	There is no rule, specifically applicable to GRATs alone, that would restrict who can be the trustee of a GRAT. For example, there is no prohibition against the grantor serving as trustee. If the GRAT consists of voting stock in a closely held business, however, care is called for. IRC §2036(b)(1)&(2) provide:
	(1) In general. For purposes of subsection (a)(1), the retention of the right to vote (directly or indirectly) shares of stock of a controlled corporation shall be considered to be a retention of the enjoyment of transferred property. (2) Controlled corporation. For purposes of paragraph (1), a corporation shall be treated as a controlled corporation if, at any time after the transfer of the property and during the 3-year period ending on the date of the decedent's death, the decedent owned (with the application of section 318), or had the right (either alone or in conjunction with any person) to vote, stock possessing at least 20 percent of the total combined voting power of all classes of stock.[24] [Emphasis added.]
	What this means is that if the GRAT holds stock in a “controlled corporation,” the grantor may have to survive not only the term, but three years after the term, in order to avoid inclusion under §2036.[25]
WHO CAN BE THE TRUSTEE OF A GRAT After The Initial Term?	Whether or not the grantor should serve as trustee after the expiration of the term interest, depends on whether the grantor’s powers are sufficiently limited to avoid including the trust property in the grantor’s estate under §2036. Presumably, an ascertainable standard would suffice (according to sparse case law); but, unlike §2041, there are no explicit regulations under §2036 that can be relied upon.
CAN THE ANNUITY IN A GRAT INCREASE EACH YEAR?	Treas. Reg. §25.2702-3(b)(1)(ii) states that it is permissible for the annuity amount to increase by up to 120% per year. (ii) Fixed amount. A fixed amount means— (A) A stated dollar amount payable periodically, but not less frequently than annually, but only to the extent the amount does not exceed 120 percent of the stated dollar amount payable in the preceding year; or (B) A fixed fraction or percentage of the initial fair market value of the property transferred to the trust, as finally determined for federal tax purposes, payable periodically but not less frequently than annually, but only to the extent the fraction or percentage does not exceed 120 percent of the fixed fraction or percentage payable in the preceding year.[26]
	This may be useful, especially in the case of a heavily discounted closely held corporation where 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 §7520 rate, as hoped, the extra amount left in the trust is not only outperforming the §7520 rate but it is earning additional dollars for the remainder beneficiaries at the higher rate while doing so.
CAN THE ANNUITY IN A GRAT DECREASE EACH YEAR?	Treas. Reg. §25.2702-3(e), Ex. (3) clearly allows the annuity to decrease without apparent limit: Example (3). S transfers property to an irrevocable trust, retaining the right to receive $50,000 in each of years 1 through 3 and $10,000 in each of years 4 through 10. S’s entire retained interest is a qualified annuity interest.[27] 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)[28] rather than §2039, which unfortunately is a position with which the Service is unlikely to agree.[29]
WHAT IS THE INFAMOUS EXAMPLE 5?	Treas. Reg. §25.2702-3(e), Ex. (5) states: Example (5). 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[30] 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.[31]
	The last five words of that example “or until A’s prior death” were construed by the Service (IRS) to mean that in valuing the qualified interest retained (the value of which is subtracted from the entire transfer in trust in order to obtain the amount of the gift for gift tax purposes), the possibility that A might die would have to be factored in as an unqualified interest. This meant that the value of A’s retained interest (under the subtraction method) would be reduced by the actuarial likelihood of A’s dying during the term. For an older person, this possibility could substantially decrease the value of the retained interest, thus substantially and commensurately increasing the value of the gift of the remainder. This is the position that the IRS took, and lost, in the celebrated Walton[32] case, in which the full Tax Court (theoretically as many as 19-members) unanimously held Example 5, as interpreted by the IRS, to be invalid.
IF EXAMPLE 5 IS GOOD LAW, CAN THE GIFT EVER BE REDUCED TO ZERO?	If Example 5 is good law, the gift of the remainder interest will always have at least some value, because there will always be the possibility that the grantor will not survive the term, and this possibility, according to Ex. 5, has a value that cannot be subtracted from the gift to the trust in arriving at the value for gift tax purposes. Thus, the gift can never be zero. In fact, PLR 9444033 and Rul. 77-454, 1977-2 C.B. 351 suggest that even if Ex. 5 is not good law, some minimal actuarial value (close to zero, but not zero or less) may be necessary to assure that the GRAT is still good. This is the basis for the “exhaustion test” discussed later.
WHAT WERE THE FACTS IN THE WALTON CASE?	The facts as stated in the Walton opinion were, in the words of the Court, as follows: Prior to April 7, 1993, petitioner was the sole owner of, and held in her name, 7,223,478 shares of common stock of Wal-Mart Stores, Inc., a publicly traded entity. Then, on April 7, 1993, petitioner established two substantially identical GRAT’s, each of which had a term of 2 years and was funded by a transfer of 3,611,739 shares of the above Wal-Mart stock. The fair market value of the Wal-Mart stock on that date was $27.6875 per share, and the consequent initial fair market value of each trust was $100,000,023.56.
	According to the provisions of each GRAT, petitioner was to receive an annuity amount equal to 49.35 percent of the initial trust value for the first 12-month period of the trust term and 59.22 percent of such initial value for the second 12-month period of the trust term. In the event that petitioner’s death intervened, the annuity amounts were to be paid to her estate. The sums were payable on December 31 of each taxable year but could be paid up through the date by which the Federal income tax return for the trust was required to be filed. The payments were to be made from income and, to the extent income was not sufficient, from principal. Any excess income was to be added to principal.
	Upon completion of the 2-year trust term, the remaining balance was to be distributed to the designated remainder beneficiary. Petitioner’s daughter Ann Walton Kroenke was the beneficiary so named under one trust instrument; petitioner’s daughter Nancy Walton Laurie was named in the other. * * * * The assets of each GRAT were exhausted upon the final payment of stock in June of 1995, as all income and principal had been distributed to petitioner pursuant to the scheduled annuity payments. Since the aggregate amount of annuity payments called for by each trust instrument was $108,570,025.58 (49.35 percent x $100,000,023.56 + 59.22 percent x $100,000,023.56), each GRAT resulted in a $14,465,475.01 shortfall in annuity payments to the grantor and left no property to be delivered to the remainder beneficiary. . . .
	Petitioner now concedes on brief that the gift occasioned by each GRAT should be valued at $6,195.10, while respondent asserts that the taxable value of each gift by petitioner is $3,821,522.12.[33]
	So, the grantor owed either (a) $3.8 million , or (b) $6000 (times 2) and change, depending on whether or not Ex. 5 was good law. This is a significantly different outcome, one which amply illustrates the importance of the decision. Since the beneficiaries got nothing, by virtue of the fact that the stock depreciated over the two year period, resulting in a $30 million shortfall in the annuity payments, it was a rather good outcome. Paying almost $4 million in gift tax where the beneficiaries received nothing would certainly have been a high price to pay. GRATs are a gamble in any case, but the odds improve considerably if the cost of losing is $6000 instead of $3.8 million!
WHAT WAS THE ISSUE IN THE WALTON CASE?	Again, using the words of the Court: [A]ccording to respondent, only the value of an annuity payable for the shorter of 2 years or the period ending upon petitioner’s death may be subtracted from the fair market value of the stock in calculating the value of the taxable gift made by reason of petitioner’s establishment of the GRATs. Respondent concludes that the present value of the retained qualified interest in each GRAT was $96,178,501.88 and the taxable gift $3,821,522.12 (consisting of the estate’s contingent interest of $2,938,000.00 and the remainder interest of $883,522.12).
	Conversely, petitioner maintains that for valuation purposes under section 2702, each GRAT is properly characterized as creating only two separate interests: (1) A retained annuity payable for a fixed term of 2 years, and (2) a remainder interest in favor of her daughter. Petitioner further asserts that the former, in its entirety, is a qualified interest within the meaning of the statute. Accordingly, it is petitioner’s position that the retained interest to be subtracted in computing the amount of the taxable gift occasioned by each GRAT is to be valued as a simple 2-year term annuity, without regard to any mortality factor. Using this method, petitioner calculates the retained annuity as having a value of $99,993,828.90, such that each GRAT effected a gift of $6,195.10.
	To the extent that Example 5 would appear to suggest otherwise, petitioner avers that the example is an invalid and unreasonable interpretation of section 2702. Petitioner argues that the example is unsupported by statutory language or legislative history and is inconsistent with other regulations and examples, especially section 25.2702-3(d)(3), Gift Tax Regs. In the alternative, petitioner claims that even if Example 5 is a permissible interpretation of the statute on substantive grounds, it is procedurally invalid as issued in violation of the notice and comment provisions of the Administrative Procedures Act, 5 U.S.C. sec. 553 (1994).[34]
WHAT WAS THE HOLDING OF THE WALTON CASE?	A unanimous decision of the full Tax Court (possibly as many as 19 judges, but I counted only 13 names in the opinion) found Ex. 5[35] to be invalid. [B]ecause petitioner could not as a matter of law give an interest in property to her estate, she by default retained all interests in the 2-year term annuities set forth in the trust documents. Such interests thus were, as required by the regulations, “held by the same individual both before and after the transfer in trust.” Sec. 25.2702-2(a)(3), Gift Tax Regs.[36] * * * * [W]e decline respondents invitation to treat term annuities payable to a grantor or the grantor’s estate as having two separate “holders” for purposes of the regulatory requirement of section 25.2702-3(b)(1)(i), Gift Tax Regs., that the annuity amount “be payable to (or for the benefit of) the holder of the annuity interest for each taxable year of the term.”[37] * * * * We hold that Example 5 is an unreasonable interpretation and an invalid extension of section 2702 ^[fn2] . . . Accordingly, the qualified interest retained by petitioner in each GRAT here is an annuity payable for a specified term of 2 years.[38]
WHAT IS THE EFFECT OF THE WALTON CASE ON THIS MEMO?	Because the case was unanimously decided by the full Tax Court, I am assuming that Walton will not be overturned by the courts. I could be wrong. As long as there is a risk that Walton will be reversed, you should run the numbers under both scenarios, in order to appreciate the size of the downside risks, and project them. However, because factoring mortality into the equation considerably complicates things, I have elected not to discuss, at least not in the “BASIC” section of this memo, the technical issues that it presents. Sometimes, it is thought, the adverse effects of example 5 can be ameliorated by making the GRAT a joint GRAT with a spouse. This is a complicated issue that is not treated in the “BASIC” portion of the memo. It is also one in which the Service has reversed itself.[39] The issue is discussed at greater length in the section of this memo under the heading “TECHNICAL,” if that portion is attached.
CAN A GRAT BE AMENDED?	The IRS position, as reflected in TAM 9717008,[40] is that it would violate public policy to allow a GRAT to be amended, even if only to satisfy the IRC and the regulations regarding GRATs. This probably does not mean that the inclusion of such a provision, even if ineffective according to the IRS, is necessarily a bad idea.
CAN A GRAT SATISFY THE ANNUITY WITH A PROMISSORY NOTE or From Funds Borrowed From the Grantor?	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.[41] In TAM 9604005 the IRS reached the same conclusion as that found in the final regulation just quoted, but ruled further that it would also be impermissible for the grantor to loan money to the GRAT. There does not appear to be any prohibition against the GRAT borrowing money from an unrelated party (or perhaps from a related party) to pay the annuity. Such third-party borrowing should not be an indirect borrowing from the grantor, which might be the case if the grantor guaranteed or secured the debt with his or her own assets. Borrowing from a party related to the grantor could be attacked if it could be shown that this was an indirect borrowing from the grantor, but is otherwise not expressly prohibited by any authority of which I am presently aware.
IS IT PERMISSIBLE TO HAVE A GRAT WHERE THE ANNUITY EXCEEDS 50% OF THE INITIAL VALUE OF THE GRAT CORPUS, OR WHERE THE REMAINDER IS LESS THAN 10% OF THE INITIAL VALUE?	The IRS will not ordinarily issue a ruling on a GRAT where the annuity exceeds 50% of the initial fair market value of the GRAT corpus, or where the remainder is less than 10% of that value.[42] 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. One recalls that 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 statutes, 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. One supposes that the Service’s reasoning might be similar to its concerns, expressed in Rev. Rul. 77-454[43] and Treas. Reg. §25.7520-3(b)(2)(1), that if the probability of exhaustion is so great that there is theoretically no gift of anything (other than the potential for appreciation in excess of the assumptions), then there is no gift of a remainder interest; and consequently, the interest retained is not a qualified interest.[44] That form of reasoning is a stretch, admittedly, but does find support in Rev. Rul. 77-454, discussed below. However, just because an annuity will exceed 50% of the initial fair market value of the GRAT corpus does not mean that it will be exhausted, even if the corpus grows at no more than the §7520 rate.
	Treas. Reg. §25.2702-3(b)(ii)(A) specifically defines a “fixed amount” as including “a stated dollar amount.” However, because of the possibility of revaluation, it might be better to define the retained interest as a fixed percentage, so that one does not run afoul of the issue just discussed.
Might thE Ruling Provision Just Discussed Become the Basis For Future Legislation?	Allow me to speculate that the ruling position just described could easily be converted to a statutory amendment that would go a long way toward closing the door opened by Walton. You will recall that something similar happened to charitable remainder trusts, which now are required to reserve a remainder for the benefit of charity actuarially equal to at least 10% of the initial corpus, contrary to what was the law for a long time. Although it took a while, it finally became well know that under prior law a charitable remainder trust would qualify as tax exempt, even if all that charity was actuarially expected to get was $1. It was only then that Congress reacted. This could easily happen to the GRAT, though naturally I would be disappointed.
WILL A GRAT QUALIFY IF THE ACTUARIAL ASSUMPTIONS LEAD TO THE CONCLUSIONS THAT THE GRAT WILL BE EXHAUSTED?	PLR 9444033 interprets Rev. Rul. 77-454[45] as supporting the conclusion that— [W]here a fixed amount to be paid from a trust in the form of annuity to the grantor may exhaust the corpus of the trust prior to the maximum stipulated term of the annuity, the value of the retained annuity interest is no greater than the present value of the payments receivable until the exhaustion of the fund. Rev. Rul. 77-454, 1977-2 C.B. 351.[46] What exactly this means is not clear to me, but it may mean that the value of the retained annuity cannot be greater than the amount transferred, or the GRAT will not qualify.
HOW IS A GRAT TAXED FOR INCOME TAX PURPOSES?	How a GRAT is taxed for income tax purposes may depend, in theory, on whether the GRAT is wholly (entirely) or partly a “grantor trust.” Under the grantor trust rules, the grantor is taxed on the income of the trust, as if the trust did not exist. If the GRAT is a grantor trust as to ordinary income, then the grantor will be taxed on the ordinary income, whether it exceeds the annuity or not. In practice, the annuity will usually exceed the ordinary income. If an amount equal to all of the distributable net income (DNI) is distributed in cash each year, that income will be taxed to the grantor/annuitant whether the GRAT is a “grantor trust” or not.
	If the GRAT is a “grantor trust” as to corpus, then the grantor will be taxed on the capital gains too. It is important to know whether your GRAT is a grantor trust or not, and if so, whether it is a grantor trust as to income or as to income and corpus (i.e., capital gains and loss purposes). If you are unsure about the status of your GRAT as a grantor trust, ask your tax advisor for an opinion. The grantor trust issue is discussed at greater length in the section of this memo headed “TECHNICAL,” if that section is attached.
How Are Grats Taxed?	A GRAT is probably a “grantor trust” under Subpart E of Subchapter J[47] of the IRC, at least with respect to the income of the GRAT, and probably for all purposes, since corpus must be used if necessary to satisfy the fixed annuity payments. Thus, the trust will not pay income taxes on the income; instead, the grantor will, because a “grantor trust” is ignored for income tax purposes.[48] If the annuity exceeds the income, then it will not make any difference whether the trust is a grantor trust or not, since income is generally carried out and taxed to the distributee under normal trust income tax rules. However, if ordinary income exceeds the annuity payment, the grantor would owe taxes on it if the trust is a grantor trust.
IS A GRAT A GRANTOR TRUST?	If you read PLR 9449012 and the several others like it, discussed in the TECHNICAL Section, you would conclude that a GRAT is virtually always a grantor trust in its entirety, under §677(a), both as to income and corpus, so long as the annuity is paid out of income and if income is insufficient, out of corpus, which is almost always the case. Unfortunately, the subject is more complicated than the PLRs suggest, and they cannot be relied upon with impunity. It is probably safe to conclude, as did the IRS, that virtually all GRATs are grantor trusts in their entirety, but that conclusion is not without some doubt; and if this is a matter of utmost importance, you might want to ask your attorney to take extra measures to increase the odds that grantor trust treatment will be wholly achieved.
CAN A GRAT REQUIRE THAT THE GRANTOR BE REIMBURSED FOR INCOME TAXES ATTRIBUTABLE TO THE ANNUITY?	The Service has ruled that an interest is a qualified interest despite a provision that permitted the grantor to be reimbursed for federal income taxes attributable to trust income in excess of that otherwise distributable.[49] As you might expect, such a clause will not decrease the gift tax value of the remainder.
MUST A GRAT REQUIRE THAT THE GRANTOR BE REIMBURSED FOR INCOME TAXES ATTRIBUTABLE TO THE ANNUITY?	There are informal indications that the Service will insist on a provision requiring the trust to reimburse the grantor for income taxes before it will issue a favorable private letter ruling. This position is reflected in the fact that most of the recent rulings have involved trusts that expressly contain just such a provision.[50]
IS THE FAILURE TO REIMBURSE THE GRANTOR FOR INCOME TAXES A GIFT TO THE TRUST?	Most tax practitioners believe that if the grantor trust rules compel the grantor of a grantor trust to pay income taxes on trust income, and the grantor does so, that the grantor has in no meaningful sense of the word made a “gift” in doing what the IRC compels the taxpayer to do. However, the Service, while not yet prepared to formally commit to the proposition, apparently believes that there may be an issue here. PLR 9444033 had the following paragraph, which may perhaps reflect the Service’s position:
	Further, each proposed Trust agreement requires the trustee to distribute to the grantor, each year during the trust term, the amount necessary to reimburse the grantor for the income tax liability with respect to the income received by the trustee and not distributed to the grantor. Under this provision, a grantor will not make an additional gift to a remainderperson in situations in which a grantor is treated as the owner of a trust under sections 671 through 679, and the income of the trust exceeds the amount required to satisfy the annuity payable to the grantor. Ordinarily, if a grantor is treated as the owner of a trust under section 671 through 679, the grantor must include in computing his tax liability the items of income (including the income in excess of an annuity), deduction, and credit that are attributable to the trust. If there were no reimbursement provision, an additional gift to a remainderperson would occur when the grantor paid tax of any income that would otherwise be payable from the corpus of the trust. Accordingly, since there is a reimbursement provision, we rule that, if the income of either trust exceeds the annuity amount, the income tax paid by the grantor on trust income not paid to the grantor will not constitute an additional gift to the remainderpersons of the Trust.
	However, the IRS partially retracted its position as reflected in 9444033 when it issued 9543049, which provided: [A]fter reconsidering the language addressing the gift tax consequences of the reimbursement clause in each trust, the Service has decided to delete the second full paragraph on page 6 of the ruling. I believe that the second full paragraph on page 6 of the ruling is the one referred to in the immediately preceding quotation; however, the deletion was made only after an additional reiterative finding that there were reimbursement provisions in the instrument, and so the effect of this change is still unclear.
WHAT ARE THE ARGUMENTS THAT COULD BE MADE FOR DISQUALIFYING A GRAT BECAUSE IT HAS AN INCOME TAX Reimbursement CLAUSE, OR BECAUSE IT DOES NOT HAVE SUCH A CLAUSE?	The taxpayer is sort of in a damned if you do and damned if you don’t position here. It could be argued that the extra payments to the grantor by the trust do not fall within the definition of “qualified payments,” because it is not a “fixed amount.” True, the Service seems disinclined to raise this argument,[51] but it is there nevertheless. One could argue that the statute imposes limits on excess payments made by a GRAT to the settlor over the “fixed amount” called for by the statute; but, one presumes, since the extra payments are in derogation of the remainder interest, and thus disfavor the taxpayer, the government has understandably been very liberal in this area.
	On the other hand, the failure to include such a clause (or to otherwise reimburse the grantor) has from time to time been considered by the IRS to be the equivalent of a gift to the trust.[52] If such failure to reimburse the trust were considered an additional gift, the GRAT could be disqualified under Treas. Reg. §25.2702-3(b)(5) which provides: (5) Additional contributions prohibited. The governing instrument must prohibit additional contributions to the trust.[53] Now, if the governing instrument contains a clause prohibiting additional contributions, and if the failure to reimburse the grantor is an additional contribution, then the governing instrument already says all it needs to say to be qualified on its face; and, arguably, the trust terms would be sufficient to authorize, or perhaps compel, the trustee to make such reimbursement. With that thought in mind, it might be best to leave the instrument silent regarding the reimbursement issue, thus leaving all options open.
WHEN MUST THE ANNUITY BE PAID?	(4) Payment of the annuity amount in certain circumstances. An annuity amount payable based on the anniversary date of the creation of the trust must be paid no later than 105 days after the anniversary date. An annuity amount payable based on the taxable year of the trust may be paid after the close of the taxable year, provided the payment is made no later than the date by which the trustee is required to file the Federal income tax return of the trust for the taxable year (without regard to extensions). If the trustee reports for the taxable year pursuant to §1.671-4(b) [Grantor Trust] of this chapter, the annuity payment must be made no later than the date by which the trustee would have been required to file the Federal income tax return of the trust for the taxable year (without regard to extensions) had the trustee reported pursuant to §1.671-4(a) of this chapter.[54]
Why Wait to Pay the Annuity?	Since the Service allows a deferral of 105 days or three and half months, depending on whether annual payments are on a calendar year or a fiscal year, why not take advantage of the delay? After all, it only means that more interest is potentially accruing for the benefit of the remainder beneficiaries in the interim. This seems to me to be one very good reason for making the payments no more frequently than annually. I am assuming, perhaps incorrectly, that the delay does not reduce the value for gift tax purposes of the retained annuity interest. At the moment, I know of no authority directly on point.
Can the annuity Be Paid as of the Anniversary Date of the Contribution, Rather than as of the End of Trust’s Taxable Year?	The annuity amount may be paid on a date or dates based on the anniversary date of the trust’s creation, rather than on the basis of the trust’s taxable year.[55] How is this calculated. Well, there is software that does this, but the software that I use only makes the calculations based on full 12-month periods. If the GRAT is a grantor trust, which is most likely, then presumably it would be on a calendar tax year. This means that unless funded on January 1, there will be a short taxable year. However, the annuity can still be based on the anniversary of the creation of the trust, and it probably simplifies the calculations to use this method. If the grantor will get the annuity sooner than otherwise, as would happen if the first annuity year were a short year requiring proration, common sense would tell you that the value of the retained interest is greater (and the value of the remainder less), but just how much greater or lesser is something that my software does not tell me. Rumor has it that Jonathan Blattmachr hires an actuary to compute the values. If that is a luxury you can afford, then that it one solution.
When Must an Annuity be Paid, If the Annuity is Payable More Frequently thaN Annually?	If the annuity is to be paid more frequently than annually, as is expressly allowed,[56] it is not clear to me whether a grace period is permitted.
WHAT HAPPENS IF THE IRS DISAGREES WITH THE INITIAL VALUE PLACED ON THE TRUST ASSETS?	(2) Incorrect valuations of trust property. If the annuity is stated in terms of a fraction or percentage of the initial fair market value of the trust property, the governing instrument must contain provisions meeting the requirements of §1.664-2(a)(1)(iii) of this chapter (relating to adjustments for any incorrect determination of the fair market value of the property in the trust).[57] [Emphasis added.] The requirement that an adjustment be made is actually somewhat of an advantage to the taxpayer as it presumably means that the trust will not be disqualified as a result of a valuation error that is corrected. The regulation does not specifically address a Code Sec. 2702(b)(1) GRAT (where the interest “consists of the right to receive fixed amounts payable not less frequently than annually”). This is one reason why it is generally inadvisable to state the annuity in terms of a dollar amount. Interestingly, Treas. Reg. §1.664-2(a)(1)(iii), which is cross-referenced, does refer to a “stated dollar amount.” Even assuming that adjustment is permissible in the case of retained annuity defined as a stated dollar amount, the result of the adjustment will not affect the amount of the annuity, but will affect the value of the gift, presumably by increasing it, perhaps unexpectantly.
	1.664-2(a)(1)(iii) provides, in part: If the stated dollar amount is so expressed and such market value is incorrectly determined by the fiduciary, the requirement of this subparagraph will be satisfied if the governing instrument provides that in such event the trust shall pay to the recipient (in the case of an undervaluation) or be repaid by the recipient (in the case of an overvaluation) an amount equal to the difference between the amount which the trust should have paid the recipient if the correct value were used and the amount which the trust actually paid the recipient. Such payments or repayments must be made within a reasonable period after the final determination of such value.
MUST PRORATION OF THE ANNUITY AMOUNT TAKE PLACE FOR THE FIRST SHORT TAXABLE YEAR, OR IF THE LAST PAYMENT IS FOR A SHORT PERIOD?	Proration of the annuity amount is required for the first short taxable year, if there is one and if the amount is payable on the basis of the taxable year. Proration of the annuity amount is required if the last payment is for a short period. The procedure is described in Treas. Reg. §25.2702-3(b)(3): (3) Period for payment of annuity amount. The annuity amount may be payable based on either the anniversary date of the creation of the trust or the taxable year of the trust. In either situation, the annuity amount may be paid annually or more frequently, such as semi-annually, quarterly, or monthly. If the payment is made based on the anniversary date, proration of the annuity amount is required only if the last period during which the annuity is payable to the grantor is a period of less than 12 months.
	If the payment is made based on the taxable year, proration of the annuity amount is required for each short taxable year of the trust during the grantor’s term. The prorated amount is the annual annuity amount multiplied by a fraction, the numerator of which is the number of days in the short period and the denominator of which is 365 (366 if February 29 is a day included in the numerator).[58] [Emphasis added.]
MAY ADDITIONAL CONTRIBUTIONS BE MADE TO A GRAT?	(5) Additional contributions prohibited. The governing instrument must prohibit additional contributions to the trust.[59]
WHAT IS A GRUT, AND WHY IS IT NOT POPULAR?	A GRUT is like a GRAT except that the annuity is revalued every year as a fixed percentage of the then present value of the trust. The reason it is not popular, and not discussed in this memo, is that the GRAT is more effective than a GRUT if the trust corpus appreciates. (If the trust does not appreciate, neither type of trust is effective.) If the trust appreciates, then under a GRUT, much of that appreciation is shifted back to the grantor, which is not exactly the point of the exercise. Thus, the remainder beneficiaries of the GRUT will almost always receive less than the remainder beneficiary of the GRAT, even if the value for transfer tax purposes is the same. If the estate planning point is to shift as much growth to the remainder beneficiaries without increasing the transfer tax, a GRAT is preferable to a GRUT. I will not belabor this issue here.
WHAT ASSETS GIve A GRAT THE MOST UPSIDE POTENTIAL?	Multiple short-term GRATs, consisting of volatile assets with little or no diversity, obviously make the most of the potential leveraging. The only arguments that the Service could raise is that the failure to diversify somehow is not permissible, and that multiple GRATs should be merged and averaged. The authority for this position is presently not convincing. The return on longer term well-diversified GRATs will be smoothed out, decreasing the leverage and the up-side potential that GRATs are capable of delivering.
What is the Effect of the Grantor’s Health on the Utility of a GRAT?	If the grantor dies during the GRAT term, the GRAT, or a portion of it, is included in the grantor’s estate, meaning that the grantor loses the time-value of any gift tax paid, and otherwise derives little or no estate tax benefits from the technique. A healthy grantor has a greater likelihood of getting the most out of a GRAT, obviously, since the healthier the grantor, the more likely the grantor will outlive the term. The likelihood of death within the term can be mitigated by using a short-term, followed by re-Gratting for another short-term. Two years is probably the shortest term allowable. Term life-insurance can also be employed to mitigate the risks.
Is a SALE to an Intentionally defective grantor trust (an IDGT) a viable alternative to a grat?	We have talked about grantor trusts above, and they are discussed at length in the TECHNICAL Section of this memo (if one is attached). Estate planners lately have been going to lengths to “intentionally” create trusts that are treated as grantor trusts. In the old days it would have been appropriate to label such a trust as defective, since at one time grantor trust treatment was to be avoided. Now that it is often desirable to have a trust taxed as a grantor trust —because of the lower rates, for one thing—, it is perhaps inappropriate to call such a trust “defective,” but we do so any, but make it clear that we know what we are doing by calling it intentionally so.
	As previously indicated, a GRAT is probably a grantor trust in its entirety, whether we want it to be so or not. (We usually want it to be so, however). As an alternative to a GRAT, many estate planners simply set up an “intentionally defective grantor trust” (an IDGT), and have it buy an asset (such as an interest in a heavily discounted closely held business) on an installment sale basis. Under the principles of Rev. Rul. 85-13,[60] the sale should not result in capital gains.
	This is no different than a gift to a GRAT, but in an IDGT there is no rule that says that one must use 120% of the Federal Mid Term rate as the rate of interest on an installment note. The rate of interest must be reasonable, but most people think 100% (not 120%) of one of the IRC §1274 rates should be reasonable.[61] Furthermore, if the grantor dies during the term, only the remaining payments on the note should be includible in the estate. Finally, there is no additional mortality factor to contend with of the Ex. 5 variety. (Although I hate to mention it, it is coincidentally true that there is no 709 Gift Tax Return reported on the sale to an IDGT, and so, it is unlikely to attract a reexamination at death.)
	Like Buridan’s ass who, after being placed equidistant between two bales of hay, starved to death, I, for a long time, was torn between whether to use a GRAT or an IDGT in any given situation. I have finally listed toward the GRAT (avoiding starvation) for several reasons. The first is that the GRAT is a technique specifically sanctioned by a statute (§2702), and I know what interest rate to use. Further, if I under-value the assets transferred to the GRAT, the regulations specifically allow (require) me to adjust the payout rate. Finally, Walton probably is effective to dispense with my worries about Ex. 5.
	On the other hand, in an IDGT, I have to guess at what is a reasonable rate of interest; and, if I guess too low at the interest rate or at the value of the asset transferred, I run the risk of having made a gift with a retained interest. I also have to make sure that there is enough security in the IDGT (10% of the value of the asset sold?) to support the installment sale as a bona fide sale and not a gift. It is important that there be no gift involved, because the interest retained is by definition not a “qualified interest” (since it is not a GRAT); and if it is not a qualified interest and it is a gift, then it is a gift of the entire interest, since the retained interest is valued at zero under the subtraction method mandated by §2702. Finally, the Service, on audit, has recently recharacterized a sale to an IDGT as a gift (treating the note to be equity I am told); this in a transaction that looks to me to be fairly conventional. The upshot of the audit is that a petition has been filed by the taxpayer to the Tax Court.[62] This is one to watch. So, on the whole, and for now, I favor the GRAT over the IDGT, but it is admittedly a close call.
WHAT SHOULD BE DONE WITH THE REMAINDER?	The GRAT could continue as an intentionally defective grantor trust following the term, so that the grantor could pay the income taxes on the trust, gift tax free. Or at least that would be the hope. It might even be possible for the grantor to continue to be a discretionary beneficiary if the trust were established in a jurisdiction where the grantor’s creditors could not reach the assets. In most states, if the grantor is a potential beneficiary, the trust would be considered self-settled, and if self-settled, then reachable by creditors, and if reachable by creditors, it would presumably be included in the grantor’s estate.
WHAT SHOULD BE THE TAXABLE YEAR OF THE TRUST?	Under IRC §644(a) the taxable year of a trust is required to be the calendar year. (It is somewhat uncertain whether that would apply to a less than wholly owned grantor trust.) As indicated previously, annual annuity payments may be paid on the anniversary of the contribution, or the calendar year.

TECHNICAL

WHAT DOES RETAINED MEAN?	“Retained means held by the same individual both before and after the transfer in trust. In the case of the creation of a term interest, any interest in the property held by the transferor immediately after the transfer is treated as held both before and after the transfer.”[63]
WHAT DOES INTEREST MEAN?	“An interest in trust includes a power with respect to a trust if the existence of the power would cause any portion of a transfer to be treated as an incomplete gift under chapter 12 [i.e., the gift tax].”[64] If the grantor retained an interest in the trust, that portion would not be a completed gift.
WHAT IS A QUALIFIED INTEREST UNDER THE Statute?	According to the regulations, the term “qualified interest means a qualified annuity interest, a qualified unitrust interest, or a qualified remainder interest.”[65] The statute itself describes a “qualified interest” as follows: (b) Qualified interest. For purposes of this section, the term “qualified interest” means—
	(1) any interest which consists of the right to receive fixed amounts payable not less frequently than annually, (2) any interest which consists of the right to receive amounts which are payable not less frequently than annually and are a fixed percentage of the fair market value of the property in the trust (determined annually), and (3) any noncontingent remainder interest if all of the other interests in the trust consist of interests described in paragraph (1) or (2).[66]
WHAT IS A QUALIFIED ANNUITY INTEREST UNDER THE REGULATIONS?	Treas. Reg. §25.2702-3 should perhaps be added in toto as an appendix instead of putting only (b) and (d) here; but as (b) and (d) are to me the more relevant, I reproduce them in full below, for the curious. “Qualified annuity interest means an interest that meets all the requirements of §25.2702-3(b) and (d),”[67] which provide: (b) Special rules for qualified annuity interests. An interest is a qualified annuity interest only if it meets the requirements of this paragraph and paragraph (d) of this section. (1) Payment of annuity amount. (i) In general. A qualified annuity interest is an irrevocable right to receive a fixed amount. The annuity amount must be payable to (or for the benefit of) the holder of the annuity interest at least annually. A right of withdrawal, whether or not cumulative, is not a qualified annuity interest. 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.
	(ii) Fixed amount. A fixed amount means— (A) A stated dollar amount payable periodically, but not less frequently than annually, but only to the extent the amount does not exceed 120 percent of the stated dollar amount payable in the preceding year; or (B) A fixed fraction or percentage of the initial fair market value of the property transferred to the trust, as finally determined for federal tax purposes, payable periodically but not less frequently than annually, but only to the extent the fraction or percentage does not exceed 120 percent of the fixed fraction or percentage payable in the preceding year.
	(iii) Income in excess of the annuity amount. An annuity interest does not fail to be a qualified annuity interest merely because the trust permits income in excess of the amount required to pay the annuity amount to be paid to or for the benefit of the holder of the qualified annuity interest. Nevertheless, the right to receive the excess income is not a qualified interest and is not taken into account in valuing the qualified annuity interest. (2) Incorrect valuations of trust property. If the annuity is stated in terms of a fraction or percentage of the initial fair market value of the trust property, the governing instrument must contain provisions meeting the requirements of § 1.664-2(a)(1)(iii) of this chapter (relating to adjustments for any incorrect determination of the fair market value of the property in the trust).
	(3) Period for payment of annuity amount. The annuity amount may be payable based on either the anniversary date of the creation of the trust or the taxable year of the trust. In either situation, the annuity amount may be paid annually or more frequently, such as semi-annually, quarterly, or monthly. If the payment is made based on the anniversary date, proration of the annuity amount is required only if the last period during which the annuity is payable to the grantor is a period of less than 12 months. If the payment is made based on the taxable year, proration of the annuity amount is required for each short taxable year of the trust during the grantor’s term. The prorated amount is the annual annuity amount multiplied by a fraction, the numerator of which is the number of days in the short period and the denominator of which is 365 (366 if February 29 is a day included in the numerator).
	(4) Payment of the annuity amount in certain circumstances. An annuity amount payable based on the anniversary date of the creation of the trust must be paid no later than 105 days after the anniversary date. An annuity amount payable based on the taxable year of the trust may be paid after the close of the taxable year, provided the payment is made no later than the date by which the trustee is required to file the Federal income tax return of the trust for the taxable year (without regard to extensions). If the trustee reports for the taxable year pursuant to §1.671-4(b) of this chapter, the annuity payment must be made no later than the date by which the trustee would have been required to file the Federal income tax return of the trust for the taxable year (without regard to extensions) had the trustee reported pursuant to §1.671-4(a) of this chapter.
	(5) Additional contributions prohibited. The governing instrument must prohibit additional contributions to the trust.[68] * * * *
	(d) Requirements applicable to qualified annuity interests and qualified unitrust interests. (1) In general. To be a qualified annuity or unitrust interest, an interest must be a qualified annuity interest in every respect or a qualified unitrust interest in every respect. For example, if the interest consists of the right to receive each year a payment equal to the lesser of a fixed amount of the initial trust assets or a fixed percentage of the annual value of the trust assets, the interest is not a qualified interest. If, however, the interest consists of the right to receive each year a payment equal to the greater of a stated dollar amount or a fixed percentage of the initial trust assets or a fixed percentage of the annual value of the trust assets, the interest is a qualified interest that is valued at the greater of the two values. To be a qualified interest, the interest must meet the definition of and function exclusively as a qualified interest from the creation of the trust.
	(2) Amounts payable to other persons. 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. (3) Term of the annuity or unitrust interest. 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.
	(4) Commutation. The governing instrument must prohibit commutation (prepayment) of the interest of the term holder. (5) Use of debt obligations to satisfy the annuity or unitrust payment obligation. (i) In general. In the case of a trust created on or after September 20, 1999, the trust instrument must prohibit the trustee from issuing a note, other debt instrument, option, or other similar financial arrangement in satisfaction of the annuity or unitrust payment obligation.
	(ii) Special rule in the case of a trust created prior to September 20, 1999. In the case of a trust created prior to September 20, 1999, the interest will be treated as a qualified interest under section 2702(b) if— (A) Notes, other debt instruments, options, or similar financial arrangements are not issued after September 20, 1999, to satisfy the annuity or unitrust payment obligation; and
	(B) Any notes or any other debt instruments that were issued to satisfy the annual payment obligation on or prior to September 20, 1999, are paid in full by December 31, 1999, and any option or similar financial arrangement issued to satisfy the annual payment obligation is terminated by December 31, 1999, such that the grantor receives cash or other trust assets in satisfaction of the payment obligation. For purposes of the preceding sentence, an option will be considered terminated only if the grantor receives cash or other trust assets equal in value to the greater of the required annuity or unitrust payment plus interest computed under section 7520 of the Internal Revenue Code, or the fair market value of the option.[69]
HOW ARE RETAINED INTERESTS VALUED?	Under the “subtraction method,” which the statute appears to require, the value of the gift of the remainder interest is the value of the entire gift to the trust, minus the value of the retained interest. Thus, it is important to know the value of the retained interest. (b) Valuation of retained interests. *(1) In general.* Except as provided in paragraphs (b)(2) and (c) of this section, the value of any interest retained by the transferor or an applicable family member is zero. *(2) Qualified interest.* 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.[70]
HOW IS THE VALUE OF THE REMAINDER INTEREST DETERMINED?	The value of the remainder and the value of the retained interest are complementary of each other, adding up to the value of the property transferred to the gift. However, because the Service interprets the statute as mandating the subtraction method, the remainder is valued by reference to the value of the retained interest, rather than the other way around. The value of the retained interest (the annuity) must be subtracted from the gift to the trust in order to determine the value of the remainder for gift purposes. The value of the annuity (the retained interest) is determined under IRC §7520, which provides:
	For purposes of this title, the value of any annuity, any interest for life or a term of years, or any remainder or reversionary interest shall be determined — (1) under tables prescribed by the Secretary, and (2) by using an interest rate (rounded to the nearest 2/10 this of 1 percent) equal to 120 percent of the Federal midterm rate in effect under section 1274(d)(1) for the month in which the valuation date falls.
	If an income, estate, or gift tax charitable contribution is allowable for any part of the property transferred, the taxpayer may elect to use such Federal midterm rate for either of the 2 months preceding the month in which the valuation date falls for purposes of paragraph (2). In the case of transfers of more than 1 interest in the same property with respect to which the taxpayer may use the same rate under paragraph (2), the taxpayer shall use the same rate with respect to each such interest.[71] [Emphasis added.]
	As previously noted, the lower the federal mid-term rate, the smaller the gift. For how the value for gift tax purposes is actually determined, including taking the Dash 3 Ex. 5 mortality factor into account (which Walton says we can ignore) see PLR 9253031.
DO THE §2702 GRAT RULES APPLY TO A GRIT FOR A SPOUSE?	The rules under §2702 do not apply to a GRIT for a spouse, if the grantor retains no interest. 25.2702-2(d) Example (3). D transfers property to an irrevocable trust under which the income is payable to D’s spouse for life. Upon the death of D’s spouse, the trust is to terminate and the trust corpus is to be paid to D’s child. D retains no interest in the trust. Although the spouse is an applicable family member of D under section 2702, the spouse has not retained an interest in the trust because the spouse did not hold the interest both before and after the transfer. Section 2702 does not apply because neither the transferor nor an applicable family member has retained an interest in the trust. The result is the same whether or not D elects to treat the transfer as a transfer of qualified terminable interest property under section 2056(b)(7).[72]
	This is not all that good a deal, however, because the grantor has made a gift of the entire property anyway. True, the gift to the spouse should qualify for the marital deduction under the lifetime QTIP rules of IRC §2523(f)(2); but, if so, the entire remainder interest, plus unconsumed distributions made during the spouse’s lifetime, will be in the spouse’s estate.
DOES §2702 APPLY TO A GIFT THAT IS WHOLLY INCOMPLETE FOR GIFT TAX PURPOSES?	§2702 does not apply to a gift that is wholly incomplete for gift tax purposes. 25.2702-2(d) Example (4). A transfers property to an irrevocable trust, under which the income is to be paid to A for life. Upon termination of the trust, the trust corpus is to be distributed to A’s child. A also retains certain powers over principal that cause the transfer to be wholly incomplete for federal gift tax purposes. Section 2702 does not apply because no portion of the transfer would be treated as a completed gift. As was the case with a gift to a spouse, this is not such a good deal either, since the entire remainder interest will be in the grantor’s estate under IRC §2026, and any unconsumed distributions made during the grantor’s lifetime will be includible under §2031 as in the case of any other assets. Note that if the gift is partially complete (i.e., not wholly incomplete) then §2702 will apply.
IS A POWER TO REVOKE A QUALIFIED INTEREST OF THE GRANTOR’S SPOUSE A QUALIFIED INTEREST?	“Retention of a power to revoke a qualified annuity interest[73] (or unitrust interest) of the transferor’s spouse is treated as the retention of a qualified annuity interest (or unitrust interest).”[74] 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.” [75] As best I can tell, given the Service’s evolving/changing position, 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 me.
ARE THERE ANY REGULATORY EXAMPLES OF A POWER TO REVOKE A QUALIFIED INTEREST OF THE GRANTOR’S SPOUSE?	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).[76]
	Just how these examples are to be interpreted has never been clear to me. 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).”[77] 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 time the IRS indicated as much in a private letter ruling, but it has since backed off that position. See immediately below.
Is a Revocable Contingent Spousal Annuity a Technique still relevant, Post-walton?	In light of the IRS’ acquiescence in Walton[78], this whole issue may be more or less irrelevant, since payment to the grantor’s estate can achieve an even better result and because the grantor’s mortality is not a factor that need be considered. Given that 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.
WHAT EFFECT DOES A POWER TO REVOKE AN INTEREST IN A SPOUSE HAVE ON THE VALUE OF THE GIFT?	Apparently, under the Cook[79] case (perhaps in dictum),[80] it is fine to have a revocable spousal successor interest not contingent on surviving the grantor, but 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,[81] Example 5 is not valid, which my make the whole issue moot given the Service’s acquiescence[82] in Walton.
	On the other hand, in Schott v. Com.[83], 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 for valuation, 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 time. Query how the marital deduction figures in all this, if at all.
	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.
HOW MIGHT THE GRAT RULES AND MARITAL DEDUCTION OPERATE IF THE GRANTOR RETAINS THE RIGHT TO CONVERT THE GRAT INTO A QTIP TRUST?	What if the GRAT provides that if the grantor dies prior to expiration of the retained term interest (or if the trust is otherwise includible in the grantor’s estate) the GRAT will become a QTIP[84] trust? In that case, the trust should qualify for the marital deduction, but would that contingency disqualify the GRAT? Perhaps not, and perhaps that is the whole point behind §25.2702-2(d) Examples (6) and (7). In any case, there are at least two Private Letter Rulings where the Service ruled that a trust, designed as a GRAT that would convert into a QTIP on the grantor’s death during the term if the grantor did not revoke it, was not only a valid GRAT, but would qualify for the marital deduction if the conversion occurred. The GRATs (which incidentally also qualified as grantor trusts in their entirety) provided: [I]f the grantor dies during the term of the annuity, the annuity is continued to the grantor’s spouse or if the grantor’s spouse is deceased, to his estate, subject to revocation by the grantor prior to his death.[85]
	The taxpayers requested a ruling: If the grantor dies during the trust term and has not revoked the interest for the grantor’s spouse, the assets passing to the marital trust will qualify for the marital deduction under section 2056 in the estate of the grantor.
	The Service concluded: Under the terms of the marital trusts, the trustee is required (assuming the grantor has not revoked during the grantor’s life this right) to pay all trust income to the surviving spouse. The grantor’s surviving spouse will have the power to withdraw the entire trust corpus at any time. Accordingly, we conclude that, if by reason of the grantor’s death, the spouse succeeds to the described beneficial interest in the trust with the result that the trust property is includible in the grantor’s gross estate, then property passing to the marital trusts will be deductible under section 2056(a).[86]
FROM WHERE WAS THE INCOMPLETE GIFT RULE DERIVED?	The incomplete gift rule, which provides that §2702 does not apply to a gift that is wholly incomplete, is derived from §2702(a)(3): (3) Exceptions. (A) In general. This subsection shall not apply to any transfer— (i) if such transfer is an incomplete gift, (ii) if such transfer involves the transfer of an interest in trust all the property in which consists of a residence to be used as a personal residence by persons holding term interests in such trust, or (iii) to the extent that regulations provide that such transfer is not inconsistent with the purposes of this section. (B) Incomplete gift. For purposes of subparagraph (A), the term “ incomplete gift” means any transfer which would not be treated as a gift whether or not consideration was received for such transfer.[87] [Emphasis added.]
WHAT DOES “HELD IN TRUST” MEAN?	According to the statute: (c) Certain property treated as held in trust. For purposes of this section— (1) In general. The transfer of an interest in property with respect to which there is 1 or more term interests shall be treated as a transfer of an interest in a trust.
	(2) Joint purchases. If 2 or more members of the same family acquire interests in any property described in paragraph (1) in the same transaction (or a series of related transactions), the person (or persons) acquiring the term interests in such property shall be treated as having acquired the entire property and then transferred to the other persons the interests acquired by such other persons in the transaction (or series of transactions). Such transfer shall be treated as made in exchange for the consideration (if any) provided by such other persons for the acquisition of their interests in such property. (3) Term interest. The term “term interest” means— (A) a life interest in property, or (B) an interest in property for a term of years.
	(4) Valuation rule for certain term interests. If the nonexercise of rights under a term interest in tangible property would not have a substantial effect on the valuation of the remainder interest in such property— (A) subparagraph (A) of subsection (a)(2) shall not apply to such term interest, and (B) the value of such term interest for purposes of applying subsection (a)(1) shall be the amount which the holder of the term interest establishes as the amount for which such interest could be sold to an unrelated third party.[88]
HOW DOES THE STATUTE DEFINE APPLICABLE FAMILY MEMBER?	§2702(a)(1) provides: Solely for purposes of determining whether a transfer of an interest in trust to (or for the benefit of) a member of the transferor’s family is a gift (and the value of such transfer), the value of any interest in such trust retained by the transferor or any applicable family member (as defined in section 2701(e)(2)) shall be determined as provided in paragraph (2). [Emphasis added.]
	As can be seen, therefore, §2702(a)(1) defines “applicable family member” by cross-reference to §2701(e)(2), which in turn provides: (2) Applicable family member. The term “applicable family member” means, with respect to any transferor— (A) the transferor’s spouse, (B) an ancestor of the transferor or the transferor’s spouse, and (C) the spouse of any such ancestor.[89]
HOW DOES THE STATUTE DEFINE MEMBER OF THE FAMILY?	Recall that it is retention by an applicable family member, followed by a transfer to a member of the family, that triggers §2702. §2702(e) defines “member of the family” by cross-reference to §2704(c)(2), which in turn 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).[90]
Is a Nephew or Niece a Member of the Family?	Note that member of the family would not encompass nephews or nieces.
ArE there other definitions of Member of the Family Found in Chapter 14 That Do Not apply to 2702?	It is somewhat interesting that Chapter 14 contains two definitions of “member of the family,” one in §2704(c)(2), just quoted, and a slightly different definition in IRC §2701(e)(1), with which we are not directly concerned. For the curious, the IRC §2701(e)(1) definition reads: (1) Member of the family. The term “member of the family” means, with respect to any transferor— (A) the transferor’s spouse,
	(B) a lineal descendant of the transferor or the transferor’s spouse, and (C) the spouse of any such descendant.[91] This would not include a sibling or ancestor.
WHO IS A MEMBER OF THE FAMILY UNDER THE REGULATIONS?	The regulations, for once, are more straight forward than the statute: “With respect to any individual, member of the family means the individual’s spouse, any ancestor or lineal descendant of the individual or the individual’s spouse, any brother or sister of the individual, and any spouse of the foregoing.”[92]
WHAT IF AN INTEREST IS RETAINED ONLY WITH RESPECT TO A PORTION OF PROPERTY?	The Statute provides: (d) Treatment of transfers of interests in portion of trust. In the case of a transfer of an income or remainder interest with respect to a specified portion of the property in a trust, only such portion shall be taken into account in applying this section to such transfer.[93]
CAN A GRAT PROVIDE THAT THE GRANTOR WILL RETAIN THE GREATER OF AN OTHERWISE QUALIFIED INTEREST OR THE INCOME?	A GRAT may provide that the grantor will retain the greater of an otherwise qualified interest or the income; however, the value of the retained interest will not be increased as a result.[94] Of course decreasing the potential amount passing to the remainder beneficiaries, while not decreasing the size of the gift for gift tax purposes, is not something that a good estate plan would ordinarily seek to achieve.
CAN THE TRUST PREPAY THE ANNUITY?	Treas. Reg. §25.2702-3(d)(4) specifically requires that “[t]he governing instrument must prohibit commutation (prepayment) of the interest of the term holder.” What does this mean? It certainly means that the trustee cannot prepay the grantor’s interest (i.e., payoff the grantor early by giving the grantor an amount of money equivalent to the value grantor’s retained annuity). However, it is not certain that such a provision would be effective under state law.[95]
HOW ARE GRANTOR TRUSTS TAXED?	If the GRAT is wholly a “grantor trust” its existence is basically ignored for income tax purposes and all of the income, gains and losses are reported on the grantor’s Form 1040 in all events (or on the Form 1041 of a person treated as the grantor under §678). This treatment is mandated by IRC §671, if any of the conditions found in §§673-679 apply.
WHY MIGHT IT BE ADVANTAGEOUS FOR A GRAT TO BE TREATED AS A GRANTOR TRUST, AND WHAT DISADVANTAGES MIGHT THERE BE IF IT IS NOT?	It should be noted that a trust may be a grantor trust as to income, or as to corpus, or both. The grantor trust rules have been interpreted to mean that, if a grantor trust is a grantor trust for all purposes, then all transactions between the grantor and the trust are ignored, including transactions that would otherwise be treated as a taxable sale or exchange, which means that capital gains and losses cannot be recognized on transactions between a grantor and a grantor trust.[96] Further, if the grantor pays the income taxes of the trust, in an amount exceeding distributions, most practitioner do not think that this is a taxable gift, even though the trust may be augmented gift tax free as a result. The Service does not necessarily agree, and this issue is somewhat problematic in the case of a GRAT for special reasons that were discussed in the “BASIC” section of this memo. A gift to a trust, that is not a sale, should not result in gain or loss either, although there are some cases that cause concern in this area.[97]
	Even if a GRAT is not a grantor trust, a distribution to the beneficiary (in this case the grantor) will carry out DNI, resulting in a deduction to the trust and income to the annuitant/grantor. Usually, the distribution will exceed the ordinary income, making the issue somewhat moot regarding that income. However, if the trust sells assets, or is treated as having sold them, then the question of who pays the capital gains becomes important. If a distribution is made in kind (in non-cash assets), and the trust is not entirely a grantor trust, it is possible that such distribution could trigger capital gain, if viewed as a distribution in satisfaction of a pecuniary obligation of the trust, in much the same way as a distribution of assets to a creditor in satisfaction of a debt would trigger gain to the trust. Since it is very likely that a GRAT, especially a short-term GRAT, will have to distribute (back to the grantor) some of the original assets contributed, in order to satisfy its obligation to make the annuity payments, it would be a great disadvantage if gain were recognized on such a transfer.
IS A GRAT A GRANTOR TRUST?	If you read PLR 9449012, discussed in the next question, you would conclude that a GRAT is virtually always a grantor trust in its entirety, under §677(a), both as to income and corpus, so long as the annuity is paid out of income and if income is insufficient, out of corpus, which is almost always the case.
WHAT TRUST TERMS WILL CAUSE THE GRAT TO BE TREATED AS A GRANTOR TRUST?	The intricacies of the grantor trust rules should properly be the subject of a separate memo of about the same size as this one, so the subject is not being given its full due here. What I will do is try to briefly hit various sections of the IRC that might apply, and comment briefly upon some of them.
WILL A GRAT BE TREATED AS A GRANTOR TRUST UNDER §673(a)?	Under §673(a): The grantor shall be treated as the owner of any portion of a trust in which he has a reversionary interest in either the corpus or the income therefrom, if, as of the inception of that portion of the trust, the value of such interest exceeds 5 percent of the value of such portion.[98] If the grantor retained a reversion in the grantor’s estate in the event that the grantor dies before the GRAT term is out, and if, at the time of conversion, that reversion was worth more than 5% of the value of property contributed to the GRAT then §673(a) may do the trick.[99] However, here, as elsewhere in Subpart E, it is impossible to say with absolute certainty just how the grantor trust sections of the IRC will ultimately be interpreted.
	It may be too early to say what is the best strategy for a GRAT post Walton, but I am presently thinking that I would want to follow the Walton pattern fairly closely, which means that although I would want the annuity payments to continue to the estate in the event of death of the grantor prior to the end of the term, I am not sure that I would any longer want to simply provide for a complete reversion in the event the GRAT was included in the grantor’s estate. This would make the 5% test a little harder to meet, even if we had regulations telling us how to compute the test, which we don’t.
WILL A GRAT BE TREATED AS A GRANTOR TRUST UNDER §674(a)?	In 200001013, and 200001015, discussed below, the IRS ruled that the grantor was the owner of the income under §671, and was the owner of the corpus under §674(a) IRC §674(a) provides: (a) General rule. The grantor shall be treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the income therefrom is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party.[100] [Emphasis added.]
	§674(a) was interpreted in PLR 9152034:
	Under the terms of the of Trust, Taxpayer will receive an annuity payable first from income, and to the extent accumulated income is insufficient, from principal. In addition, during the Trust term, the trustee (a nonadverse party) will have the sole discretion to pay the Taxpayer all of the Trust’s net income (if there is any remaining after payment of the annuity). Therefore, under section 677, Taxpayer will be treated as the owner of the income portion of the Trust during the Trust term. Additionally, capital gains are accumulated and added to corpus and Taxpayer has a general testamentary power exercisable only by will to appoint the accumulated amounts. Therefore, under section 674(a), Taxpayer will be treated as the owner of the corpus portion of the Trust during the Trust term. Accordingly, Taxpayer will be treated as the owner of the Trust for purposes of section 671 during the Trust term.[101] This makes one wonder whether 677 is sufficient after all to cause the trust to be a grantor trust regarding income and corpus, without the aid of 674 or some other Subpart E section.
WHAT EXCEPTIONS TO §674(a) MIGHT THWART GRANTOR TRUST TREATMENT?	The rule in IRC §674(a), which provides that— [t]he grantor shall be treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the income therefrom is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party[102] is followed by a page and a half or so of exceptions, in 674(b)-(d) (see Appendix B), which in many cases swallow the rule. For instance, under §674(c):
	(c) Exception for certain powers of independent trustees. Subsection (a) shall not apply to a power solely exercisable (without the approval or consent of any other person) by a trustee or trustees, none of whom is the grantor, and no more than half of whom are related or subordinate parties who are subservient to the wishes of the grantor -- (1) to distribute, apportion, or accumulate income to or for a beneficiary or beneficiaries, or to, for, or within a class of beneficiaries; or (2) to pay out corpus to or for a beneficiary or beneficiaries or to or for a class of beneficiaries (whether or not income beneficiaries).
	A power does not fall within the powers described in this subsection if any person has a power to add to the beneficiary or beneficiaries or to a class of beneficiaries designated to receive the income or corpus, except where such action is to provide for after-born or after-adopted children. For periods during which an individual is the spouse of the grantor (within the meaning of section 672(e)(2)), any reference in this subsection to the grantor shall be treated as including a reference to such individual.
	In a number of PLRs where the grantor retained a general testamentary power of appointment if death was prior to expiration of the term, the Service ruled that the GRAT was a grantor trust regarding corpus, under §674(a).[103] §674 may be the most certain way to be assured of achieving grantor trust status is the grantor can find a suitable nonadverse party to hold the power to add beneficiaries within a class (other than after-borns), but at the risk of having the power exercised. The class can be narrow, but it must be large enough so that its existence is not threatened. Unlike 675(4)(C), this power can be held in a fiduciary capacity. In any case, particular care must be taken to avoid any of the other many exceptions to 674(a).
WILL A GRAT BE TREATED AS A GRANTOR TRUST UNDER §675(4)(C)?	Under IRC §675(4): A power of administration is exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity. For purposes of this paragraph, the term “power of administration” means any one or more of the following powers: * * * * (C) a power to reacquire the trust corpus by substituting other property of an equivalent value. [Emphasis added.] This power is elucidated further in Treas. Reg. §1.675-1(b)(4)(iii): (iii) A power to reacquire the trust corpus by substituting other property of an equivalent value. If a power is exercisable by a person as trustee, it is presumed that the power is exercisable in a fiduciary capacity primarily in the interests of the beneficiaries. This presumption may be rebutted only by clear and convincing proof that the power is not exercisable primarily in the interests of the beneficiaries. If a power is not exercisable by a person as trustee, the determination of whether the power is exercisable in a fiduciary or a nonfiduciary capacity depends on all the terms of the trust and the circumstances surrounding its creation and administration.[104]
	One would think that a circumstance that would be dispositive on the question of whether the power is exercisable in a fiduciary capacity or not would be one where the power is specifically stated to be non fiduciary[105]; but, for some bizarre and inexplicable reason, the Service has insisted at times that even such an explicit statement is not enough.[106] In PLR 9416009, the facts stipulated included the following statement: Section 15 of the proposed trust agreement provides that during the annuity term, the grantor, if living, in her sole discretion and without consent of the trustees, shall have the power in a non- fiduciary capacity to *acquire*[107] the trust corpus by substituting other property of an equivalent value. [Emphasis added.]
	This was apparently not clear enough for the Service, though it boggles the imagination why: Section 675(4) provides that the grantor shall be treated as the owner of any portion of a trust in respect of which a power of administration is exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity. For purposes of this section, the term “power of administration” means any one or more of the following powers: A) a power to vote or direct the voting of stock or other securities of a corporation in which the holdings of the grantor and the trust are significant from the viewpoint of voting control; B) a power to control the investment of the trust funds either by directing investments or reinvestments, or by vetoing proposed investments or reinvestments, to the extent that the trust funds consist of stock or securities of corporations in which the holdings of the grantor and the trust are significant from the viewpoint of voting control; or C) a power to reacquire the trust corpus by substituting other property of an equivalent value.
	Section 1.675-1(b)(4) of the Income Tax Regulations provides, in part, that if a power is not exercisable by a trustee, the determination of whether the power is exercisable in a fiduciary or nonfiduciary capacity depends on all the terms of the trust and the circumstances surrounding its creation and administration. Accordingly, the circumstances surrounding the administration of Trust will determine whether Taxpayer holds the power of administration in a nonfiduciary capacity. This is a question of fact, the determination of which must be deferred until the federal income tax returns of the parties involved have been examined by the office of the District Director where the returns are filed. Therefore, we cannot determine at this time whether Taxpayer would be treated as the owner of Trust under section 675(4). Provided that the circumstances indicate that Taxpayer holds a power of administration exercisable in a nonfiduciary capacity, Taxpayer will be treated as the owner of the proposed trust under section 675.[108] [Emphasis added.]
	There are a couple of possible problems with the reacquisition or substitution power. One issue might be whether the gift is complete in such case. I find that hard to take seriously. Another issue is whether the power is a retained §2036 power. If so, that would not be fatal, but it might require (via §2035) that the grantor not only survive the term, but survive an additional three years as well. Finally, I am not sure whether there is a difference between reacquiring assets transferred initially, and acquiring new assets whose form has changed (presumably the proceeds of assets initially transferred).
WILL A GRAT BE TREATED AS A GRANTOR TRUST UNDER §677(a)?	It seems clear that the trust would be a grantor trust as to income under 677(a), but whether it is also a grantor trust as to corpus under that section alone is problematic. Nonetheless, in addition to PLRs 9449012, 9449013, quoted and discussed elsewhere, there are a bevy of PLRs under which the Service seemed quite satisfied that a GRAT would be wholly a grantor trust by virtue of 671(a) alone, if the annuity was payable from income and, if income was insufficient, from principal.[109]
	IRC §677(a) provides: (a) General rule. The grantor shall be treated as the owner of any portion of a trust, whether or not he is treated as such owner under section 674, whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, *may be* -- (1) distributed to the grantor or the grantor’s spouse; (2) held or accumulated for future distribution to the grantor or the grantor’s spouse; or (3) applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor’s spouse (except policies of insurance irrevocably payable for a purpose specified in section 170(c) (relating to definition of charitable contributions)). [Emphasis added.]
	This subsection shall not apply to a power the exercise of which can only affect the beneficial enjoyment of the income for a period commencing after the occurrence of an event such that the grantor would not be treated as the owner under section 673 if the power were a reversionary interest; but the grantor may be treated as the owner after the occurrence of the event unless the power is relinquished. PLRs of 9449012 and 9449013 found in favor of grantor trust treatment of a GRAT because— The grantor is the owner of the entire trust under section 677(a) because article I(B) provides that the annuity installment is to be paid from income and, to the extent income is not sufficient, from principal. Therefore, the grantor will be considered the owner of the entire trust for purposes of section 671 until the earlier of the grantor’s death or the termination of the trust.[110]
	It would be nice if that were all we needed to know, or if we could rely on the Service’s holding and reasoning in these PLRs. Unfortunately, the story may or may not be quite as simple as the above quoted material would have one believe, and so a more extended discussion of the issue is called for, and to some extent has already been given. Under §677, the trust would be entirely a grantor trust if a nonadverse party can distribute corpus to the grantor after the term, but that would put the trust into the estate of the grantor in most states, since such a trust would be self-settled and in most cases therefore reachable by the creditors of the grantor’s estate.
WHAT IS AN EXAMPLE OF A GRAT THAT THE SERVICE FOUND TO BE WHOLLY A GRANTOR TRUST UNDER §677(a), FOLLOWED BY §678 ALONE?	There are many Private Letter Rulings where the Service has found a GRAT to be entirely a grantor trust. In PLR 9449012, and its twin, 9449013 (discussed above for their holding that a revocable QTIP provision in the GRAT did not disqualify the trust as a GRAT, and that if the QTIP provision was not revoked that the trust would qualify for the marital deduction), the Service found the trust(s) were entirely grantor trusts. In so ruling, the Service discussed the grantor trust issue fairly thoroughly, and in a manner that sets forth the issues and the law well enough to bear quoting from at length:
	Section 671 provides that when the grantor or another person is treated as the owner of any portion of a trust, there shall be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust that are attributable to that portion of the trust to the extent that such items would be taken into account under chapter 1 of the Code in computing the taxable income or credits against tax of an individual.
	Sections 673 through 677 specify the circumstances under which the grantor is regarded as the owner of a portion of a trust. Section 677(a)(1) provi

What is the New Rule regarding Zeroed Out GRATs?

Why are GRATs So attractive, Post-Walton?

What Size Outright Gift WOuld Produce a $7,253,895 at the End of 10-Years, at a 10% Growth Rate?

Why Does the Math Produce Such Favorable Results For a GRAT When Compared to an Outright Gift, When the Return Rates Substantially Exceed the §7520 Rate?

What dOes it Take to Zero Out a 10-Year Grat AND Do you really Want to zero it out?

Why is It that The Value of the Remainder Under a Charitable Lead Trust iS Less if the §7520 Rate is Lower, and Why is that A Bad Thing?

Why is a GRIT more Effective if the Actual Rate of Return Is Low?

Who IS a Member of the Family?

Who Are Applicable Family Members?

WHAT IS THE INTEREST RATE USED FOR GRAT TAX CALCULATIONS; i.e., WHAT IS THE §7520 RATE?

WHAT IS A GRIT AND HOW IS IT DIFFERENT FROM A GRAT?

HOW IS A GRIT TAXED FOR TRANSFER TAX PURPOSES IF A BENEFICIARY IS A Family Member?

Who IS a Member of the Family? (Again)

WHO IS AN APPLICABLE FAMILY MEMBER? (Again)

WHAT IF NONE OF THE BENEFICIARIES OF THE GRIT IS A Member of the family.

In Light of Walton, what Should Happen to the GRAT Upon the Settlor’s Death?

Does §2035 Apply to a 2-YEAR GRAT, If the Grantor Survives the 2-Year term, But Dies Within 3-Years?

What is the §2001(b)(2) Adjustment?

WHO CAN BE THE TRUSTEE OF A GRAT After The Initial Term?

IS THE FAILURE TO REIMBURSE THE GRANTOR FOR INCOME TAXES A GIFT TO THE TRUST?

MUST PRORATION OF THE ANNUITY AMOUNT TAKE PLACE FOR THE FIRST SHORT TAXABLE YEAR, OR IF THE LAST PAYMENT IS FOR A SHORT PERIOD?

Is a SALE to an Intentionally defective grantor trust (an IDGT) a viable alternative to a grat?

Is a Revocable Contingent Spousal Annuity a Technique still relevant, Post-walton?