I.......... INTRODUCTION.............................................................................................................. 1

II......... DEFINING THE GRAT...................................................................................................... 5

A........ In General................................................................................................................ 5

B......... The Regulations’ Governing Instrument Requirements................................................ 7

1......... The Annuity Amount..................................................................................... 8

2......... Additional Contributions to a GRAT........................................................... 12

3......... Commutation.............................................................................................. 13

4......... Amounts Payable to Other Persons............................................................. 13

5......... Term of the Annuity.................................................................................... 14

III....... GIFT TAX ASPECTS....................................................................................................... 15

A........ In General.............................................................................................................. 15

B......... Spousal Annuities................................................................................................... 17

C........ Valuation Formulas................................................................................................. 18

D........ Termination............................................................................................................ 19

IV....... ESTATE TAX ASPECTS................................................................................................. 19

A........ Gross Estate Inclusion............................................................................................ 19

1......... Code Sec. 2036......................................................................................... 19

2......... Code Sec. 2033......................................................................................... 21

3......... Code Sec. 2039......................................................................................... 21

B......... Reducing the Risk of Inclusion................................................................................ 22

C........ Impact on the Grantor’s Adjusted Taxable Gifts...................................................... 24

D........ Estate Tax Apportionment on Donor’s Premature Death......................................... 25

E......... Marital Deduction................................................................................................... 25

V........ GENERATION-SKIPPING TRANSFER TAX ASPECTS.............................................. 26

A........ In General.............................................................................................................. 26

B. Techniques to Reduce the Generation-Skipping Transfer Tax.......................................... 27

1......... Changing the Transferor.............................................................................. 27

2......... Sale of the Remainder Interest to a Trust That is Exempt From the Generation-Skipping Transfer Tax............................................................................................... 29

VI....... INCOME TAX ASPECTS................................................................................................ 29

A........ The Grantor Trust Rules......................................................................................... 29

1......... Income Tax Risks on Termination of GRAT................................................ 32

2......... Loss of Basis Step-Up at Grantor’s Death.................................................. 33

VII...... TRANSFER TAX ADVANTAGES OF GRATS.............................................................. 34

A........ In General.............................................................................................................. 34

B......... Valuation Formula.................................................................................................. 34

C........ The GRAT as an Estate Freeze............................................................................... 35

D........ Advantages of Short-Term GRAT.......................................................................... 37

E......... Advantage of Single Asset GRAT........................................................................... 39

F......... Advantage of Retaining an Annuity with a Value Substantially Equal to the Value of Property Transferred............................................................................................................ 39

Planning With GRATs

By CARLYN S. MCCAFFREY, RICHARD A. OSHINS AND NOEL C. ICE

§1.01 INTRODUCTION

Some of the most successful techniques devised by estate planners capitalize on generally accepted assumptions used to value gifts of partial interests in property. These assumptions do not always accurately reflect the actual or expected future performance of a particular property interest. Since the transfer tax has no post-transfer adjustment mechanism to redress unfulfilled valuation predictions, the portion of an asset’s value that was not recognized at the time of transfer generally escapes transfer tax.

Transferors create partial interests in property by dividing complete interests concurrently or temporally. Concurrent fractionalization carves a property into partial or undivided interests such as tenancies in common. The owner of Greenacre, for example, can divide it in half by giving her child a one-half undivided interest as a tenant-in-common. The value for transfer tax purposes of an undivided interest in a particular property is generally less than its pro rata portion of the value of the property as a whole.[1] Another example of concurrent fractionalization is the division of controlling corporate or partnership interests into minority interests. The values of such interests are commonly discounted well below their proportionate share of the entity’s assets.[2]

In contrast, temporal fractionalization divides property on a time basis. For example, the owner of Greenacre can divide the property by giving her child the right to possess it for a period of time or the right to receive outright ownership of it after the expiration of a period of time. The period may be measured by reference to the life of an individual, typically the owner or the child, or some specified term of years.

A temporal division is usually, but not necessarily, accomplished through the mechanism of a trust. The transferor transfers property to a trustee subject to the terms of a trust instrument that defines how the beneficiaries are to share or benefit from the property. The trust instrument, for example, could direct that one beneficiary receive the income from the transferred property (or enjoy the possession of it) for a specified period of time, and that after the expiration of that period, another individual receive the property outright.

When a transferor gives a temporal interest in property and retains another interest, the value of her gift is determined according to actuarial tables prescribed by the Treasury pursuant to Code Sec. 7520.[3] The tables use an interest rate equal to 120% of the federal mid-term rate in effect under Code Sec. 1274 on the date of the gift. The interest rate is changed monthly. This method achieves a sensible result in the case of a gift of the right to receive income from property for a period of time (an “income interest”) or the right to receive the property after a period of time (a “remainder interest”) if the property produces an income stream consistent with the applicable interest rate and if its value does not increase or decrease.

There are at least two significant problems with this approach from the standpoint of economic reality. First, the valuation is based on a prediction that the property will produce an income stream consistent with the applicable interest rate and that its value will not increase or decrease. If the property produces income at a rate lower than the applicable interest rate, the income interest will have been overvalued. If the property appreciates in value, the remainder interest will have been undervalued.

Second, the approach ignores the fact that the Code Sec. 7520 rate is derived from taxable interest rates paid on a principal sum that will not itself be subject to income tax. When a donor divides property between a retained income interest and a remainder interest, she converts her interest into a fully taxable interest, and converts the interest given to her donee into a tax-free interest. By paying current income tax on all of the income she receives, she enables the interest given to her donee to grow tax free up to her original basis in the property.[4]

Suppose in a month when the Code Sec. 7520 rate is 4%, an individual transfers $100,000 to a trust to pay her the income for 10 years, remainder to her child. The value of her retained interest is $32,444 and the value of her gift to her child is $67,556. If the valuation predictions were fulfilled, at the end of the 10 years, the transferor would have $48,024 and the child would have the original $100,000. The key test here is that the proportions between what they have remain the same. The child has 67.5% and the transferor has 32.4%.

This is unlikely to happen. Even if the property produces an annual 4% return and the principal does not increase in value, the predictions will turn out to be wrong because of the income tax impact on what the transferor has retained. Suppose the transferor’s income tax rate is 35%. At the end of the 10 years, she will have only $29,300 - - about 23% of what she and her child both have, instead of the target 32.4%

If the property doesn’t produce the 4% current return and if its value actually appreciates, the disparity between the gift tax valuation and reality becomes greater. Suppose the property produces an overall annual return of 4%, but only 2% is current income and the rest is appreciation. At the end of the 10 years the transferor will have only $15,000.[5] Her child will have $122,000, $22,000 of which will be subject to income tax, leaving her with about $118,600, after tax.[6] In this case, the transferor will have only 11% of the combined amount instead of 32.4%. This was very successful estate planning. The transferor paid a gift tax on 67.5% of an asset and actually removed 89% of it from her gross estate.

The Service has no way of compensating for this because the transfer tax system does not contain any post-transfer mechanisms for adjusting values after a gift has actually been made, no matter how erroneous the valuation turns out to be with hindsight.

From the standpoint of the Service, the problem is compounded by the fact that investment decisions will play an important role in determining whether the return obtained from an investment is received in the form of current income or in the form of capital appreciation held for ultimate distribution to the remainder beneficiary. As a result, the trustee has the power to affect the extent to which the assumptions used to value the temporal interests are fulfilled.

Much has been written about the transfer tax benefits of splitting property interests temporally. Those interested in helping individuals transfer wealth intact to their children and more remote descendants have extolled the advantages;[7] others whose concern lies with the integrity of the transfer tax system have condemned the technique as a loophole exploited by the wealthy.[8]

Congress listened to the latter group and in 1990 took a step reflective of its 1969 reform of split-interest charitable gifts.[9] It significantly reduced the valuation advantage of gifts of temporal interests, first by directing that the value of the gift be determined by subtracting the value of the transferor’s retained interest from the value of the entire property, and then by imposing a general rule that assigns a zero value to most types of retained temporal interests.[10] The consequences of the application of the new rule are draconian. Under Code Sec. 2702, unless the retained interest is a “qualified interest” or unless one of the section’s exceptions applies, the value of a gift by a parent of a remainder interest in property to her child will be equal to the property’s total value regardless of how long the child must wait to receive it.[11]

Code Sec. 2702 contains a number of exceptions to its zero valuation rule. Some of these exceptions continue to furnish estate planning opportunities reminiscent of those available prior to Code Sec. 2702’s enactment. This outline focuses on one of them ‑ the Grantor Retained Annuity Trust, the “GRAT”[12] It explains what it is and discusses the transfer and income tax consequences of its creation and administration.

As discussed above, the economic reality is that if property placed in a split-temporal-interest trust produces income at a rate lower than the applicable interest rate, the income interest will have been overvalued, and if the property appreciates in value, the remainder interest will have been undervalued. Since the income interest is always going to be over or under-valued, it makes sense under our gift tax system to arrange matters, if possible, so that the benefits of overvaluation inure to the donees while minimizing the cost to the donor in the event of an undervaluation. This can, it turns out, be relatively easy to accomplish, due to the fact that there is a very low fixed floor on the risk of overvaluing the retained income interest: that floor is between zero and a thousand dollars, say. But there is no ceiling on the possibility of undervaluing the retained interest, since if the property appreciates, it can appreciate to anything, and all of that appreciation can inure to the benefit of the donee without being subject to gift tax. This is the key to the reason that GRATs, post Walton, work so well.

Until recently, it was not possible to be sure that a “zeroed-out” GRAT would work. The “reason,” according to the IRS’ former position, that a GRAT would always result in at least some significant gift tax, particularly where the donor was an older person, was that the grantor might die prior to the end of the GRAT’s term, in which case the remaining payments under the GRAT would not pass to the grantor. The actuarial odds of this happening were factored into the value of the gift by subtracting the value of this contingent annuity or unitrust interest from the value of the retained interest, increasing the value of the gift commensurately (even though the “gift” remained in the grantor’s estate). Virtually all commentators thought this interpretation to be unsupported by the statute: strained at best, and entirely lacking in formal logic at worst. Fortunately, the Tax Court, in Walton[13], had the good sense to agree with the commentators and disagree with the IRS, despite the fact that the IRS position is contained in the interpretive regulations (the infamous Ex. 5[14]). Walton[15] declared the regulations invalid on this point. The IRS recently acquiesced in the Walton case and announced that it was withdrawing Treas. Reg. §25.2702-3(e), Ex. (5).[16]

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 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 that the upside potential is unlimited, and the downside risk is nominal. . This is a very desirable set of contingencies, obviously.

§1.02 DEFINING THE GRAT

[1] In General

A GRAT, as the term “grantor retained annuity trust” suggests, is a trust that pays an annuity to its grantor for a specified period of time. At the end of the period, the beneficial interest in the trust shifts to another beneficiary or beneficiaries.

Example 1: Jennifer transfers $1,000,000 to a trust. The terms of the trust instrument require the trustee to pay her $80,000 per year for 10 years. At the end of the 10 years, any property remaining in the trust is to be paid to her son Patrick.

If the terms of the trust satisfy the requirements described below, the grantor’s interest is a “qualified annuity interest” and Code Sec. 2702’s zero valuation rule does not apply to it.[17] Instead, the value of the grantor’s retained annuity interest is determined under Code Sec. 7520.[18]

Congress has sanctioned the GRAT because its structure seems to preclude the manipulation of investment decisions for the purpose of shifting economic enjoyment between the income and remainder beneficiaries. The annuitant is entitled to receive the annuity no matter what the trust’s income is. Thus, a trustee whose object is to maximize the interest of the trust’s remainder beneficiaries would have no incentive to maximize growth opportunities at the expense of current income.[19] So long as the total return, be it income or appreciation, is consistent with the Code Sec. 7520 rate, a GRAT’s annuitant and its remainder beneficiaries will each receive their appropriate share of trust assets.

The advantage, from the government’s point of view, of the GRAT over the trust that pays income to an income beneficiary for a specified period of time, is illustrated by the following ex