The IRS recently issued final Sec. 2036 regulations1 that demonstrate how to calculate the portion of a graduated grantor retained annuity trust that is includible in the estate of a grantor who predeceases the term of the trust. The regulations provide that the includible portion is the lesser of (1) the fair market value of the trust corpus on the decedent’s date of death or (2) a computed amount. The computed amount generally equals the total of (1) the amount of corpus required to generate the annuity payable in the trust year during which the decedent’s death occurs and (2) the present values of the amounts of corpus necessary to generate the graduated annuity balances for each trust year following the year during which the decedent’s death occurs.2 Given the relatively large number of variables3 included in the computation addressed in the regulations, broad and universal generalizations for planning purposes are impossible. The regulations do, however, provide practitioners a reminder that planning discussions with clients considering graduated grantor retained annuity trusts should include a review of the potential consequences presented if the grantor dies prematurely. The regulations may even provide the opportunity in such cases, by managing the percentage of the trust value that is annuitized, to plan for the transfer of assets free of estate and gift taxes.
Graduated grantor retained annuity trusts allow grantors to maximize the growth period for property transferred to the trust by requiring successively larger annuity payments throughout the trust term. Such an annuity, as compared to one with level payments for example, has the tendency to lengthen the period during which property is allowed to grow in value inside the trust. Often referred to as “back load” annuities, the annual increase in annuity payments is generally limited to no more than 20% of the annuity payment of the immediately preceding year.
The final4 regulations outline the computation of the computed amount as the corpus required to fund the annuity and the present value of the corpus required to fund increases in the annuity.
The portion of the trust’s corpus includible in the decedent’s gross estate for Federal estate tax purposes is that portion of the trust corpus necessary to provide the decedent’s retained use or retained annuity, unitrust, or other payment (without reducing or invading principal). In the case of a retained annuity or unitrust, the portion of the trust’s corpus includible in the decedent’s gross estate is that portion of the trust corpus necessary to generate sufficient income to satisfy the retained annuity or unitrust (without reducing or invading principal), using the interest rates provided in section 7520 and the adjustment factors prescribed in § 20.2031-7 (or § 20.2031-7A), if applicable.5
The base amount is the amount of corpus required to generate the annuity, unitrust, or other payment payable for the trust year in which the decedent’s death occurs. See paragraph (c)(2)(i) of this section for the calculation of the base amount.6
The periodic addition in a graduated retained interest for each year after the year in which decedent’s death occurs is the amount (if any) by which the annuity, unitrust, or other payment that would have been payable for that year if the decedent had survived exceeds the total amount of payments that would have been payable for the year immediately preceding that year.7
For each trust year in which a periodic addition occurs (increase year), the corpus amount is the amount of trust corpus which, starting from the decedent’s date of death, is necessary to generate an amount of income sufficient to pay the periodic addition, beginning in the increase year and continuing in perpetuity, without reducing or invading principal. For each year with a periodic addition, the corpus amount required as of the decedent’s date of death is the product of two factors: the first is the result of dividing the periodic addition (adjusted for payments made more frequently than annually, if applicable, and for payments due at the beginning, rather than the end, of a payment period . . .) by the section 7520 rate (periodic addition / rate); and the second is 1 divided by the sum of 1 and the section 7520 rate raised to the T power (1 / (1 + rate)^T). The second factor applies a present value discount to reflect the period beginning with the date of death and ending on the last day of the trust year immediately before the year for which the periodic addition is first payable.8
The regulations also provide that the amount includible in the estate of the decedent may not exceed the fair market value of the trust corpus at the date of the decedent’s death.
The amount includible in the gross estate in the case of a graduated retained interest is the sum of the base amount and the corpus amount for each year for which a periodic addition is first payable. The sum of these amounts represents the amount of trust principal that would be necessary to generate the annual payments that would have been paid to the decedent if the decedent had survived and had continued to receive the graduated retained interest. The amount of trust corpus includible in a decedent’s gross estate under this section, however, shall not exceed the fair market value of the trust corpus on the decedent’s date of death.9
Example in the Regulations
The regulations include, in the form of an example, a demonstration of the computed amount.10 The following is the language of that example, amended for purposes of the following discussion.
Example: On Nov. 1, 2011, D transfers assets valued at $2 million to a graduated grantor retained annuity trust (GRAT). Under the terms of the GRAT, the trustee is to pay to D an annuity for a five-year term that is a qualified interest described in Sec. 2702(b). The annuity amount is to be paid annually at the end of each trust year, on Oct. 31. The first annual payment is to be the largest dollar amount that may be paid based upon the annuity payment rate, term, and back load percentage of the trust. Each succeeding payment is to be 120% of the amount paid in the preceding year. Income not distributed in any year is to be added to principal. If D dies during the five-year term, the payments are to be made to D’s estate for the balance of the GRAT term. At the end of the five-year term, the trust is to terminate and the corpus is to be distributed to C, D’s child. D dies on Jan. 31 of the third year of the GRAT term. On the date of D’s death, the value of the trust corpus reflects a 5% annual growth rate, the Sec. 7520 interest rate is 6.8%, and the adjustment factor from Table K of Regs. Sec. 20.2031-7 is 1.0000. D’s executor does not elect to value the gross estate as of the alternate valuation date pursuant to Sec. 2032. On Nov. 1, 2011, the Sec. 7520 rate was 2.4%. The planned annual rate of growth in value of the trust assets was 5%. The annuity payment rate of the trust was 2.4% and 25% of the value of the assets transferred to the trust was annuitized.11
Trust Remainder Value Anticipated at Trust Inception
Based upon the facts in the above example, Exhibit 1 demonstrates the indicated remainder value of the trust anticipated at the inception of the trust arrangement. The demonstration includes the economic value transfer computation and the transfer tax computation. The difference between those two computations at the end of the trust term is the balance of value expected to be transferred free of wealth transfer taxes. In Exhibit 1, since the ending economic value transfer balance, $1,964,943, exceeds the ending transfer tax balance, $1,688,850, the difference, $276,093, is the balance expected to pass to beneficiaries of the trust wealth transfer tax free.
Computed Includible Amount
Based upon the facts of the above example, Exhibit 2 demonstrates the computed includible amount outlined in the regulations. The balance includes the amount necessary to fund the recurring portion of the annuity stream and its annual increases.
Trust Corpus Values and Computed Inclusion Amount
Exhibit 3 demonstrates the relationships between the trust corpus values12 and the computed inclusion amount as reflected in the above example and tables. Since the computed includible amount of $2,162,683 is greater than the trust corpus value of approximately $2,067,000 (see Exhibit 4, below), the amount includible in the gross estate of the decedent is the trust corpus value.
Since the entire trust corpus value is includible in the gross estate of the decedent, no value is transferred as a result of the trust that is free of wealth transfer tax. That is, as a result of the transferor’s premature death, none of the $276,093 anticipated to be transferred free of wealth transfer tax when the trust was created was realized.
Annuitized Percentage Planning Opportunities13
Because the computed inclusion amount is, effectively, the amount necessary to fund the annuity balances in perpetuity, the computed inclusion amount will exceed the fair market value of the trust for a short-term trust when more than a relatively modest percentage of the trust is annuitized. In the above example, for instance, the computed inclusion amount exceeded the trust corpus value, for a five year trust, when only 25% of the value transferred to the trust was annuitized.
The computed inclusion amount, however, is relatively sensitive to the annuitized percentage. As a smaller percentage of the trust value is annuitized, all other things being constant, the computed inclusion amount decreases. If the computed inclusion amount is less than the trust corpus value, the computed inclusion amount is the balance includible in the estate of the decedent,14 and, even in the case of the predeceasing grantor, the trust achieves a transfer free of wealth transfer tax.
Adjusting the example above only to incorporate the indicated annuitized percentages reflected in the left-hand column, Exhibit 4 demonstrates (1) the wealth transfer balances anticipated at the inception of the trust, (2) the computed inclusion amounts, (3) the trust corpus values, and (4) the actual wealth transfer balances achieved.
Unfortunately, the scenario planning reflected in the above table depends on many variables, making sweeping generalizations difficult. It is important to note, though, that as the annuitized percentage decreases, both (1) the wealth transfer anticipated at inception of the trust and (2) the actual wealth transfer realized increase. For those practitioners who universally annuitize the entire value of the property transferred to the trust, this convergence of benefits might warrant a closer consideration of the role that “less than fully annuitized” trusts play in the practitioner toolbox. Likewise, for those practitioners who currently use “less than fully annuitized” trusts, this convergence might warrant review of the potential benefits of further decreasing the annuitized percentage employed.
The final Sec. 2036 regulations provide practitioners an important reminder that consideration of the inclusion rules should be a part of the communication with clients considering graduated grantor retained annuity trusts. The regulations also provide an opportunity for practitioners to revisit the opportunities presented by “less than fully annuitized” trusts and the impacts and potential benefits of managing the percentage of trust value that is annuitized.
1 T.D. 9555 applies to the estates of decedents dying on or after Nov. 8, 2011 (Regs. Sec. 20.2036-1(c)(3)).
2 Regs. Sec. 20.2036-1(c)(2)(iv), Example (7).
3 The computation in the regulations reflects the convergence of variables both at the date of transfer to the trust and at the date of death including (1) the Sec. 7520 rate at the date of transfer, (2) the annuity payment rate, (3) the trust term, (4) the date of transfer, (5) the fair market value, at the transfer date, of property transferred to the trust, (6) the backload percentage, (7) the planned and actual rates of asset value growth, (8) the percentage of the trust value annuitized, (9) the date of death, and (10) the Sec. 7520 rate at the date of death.
4 In April 2009, the IRS issued proposed Sec. 2036 regulations (REG-119532-08). In response to a request by commentators for a detailed example of the inclusion computation, the final version of the regulations includes Example 7, a “step-by-step illustration” of the computation.
5 Regs. Sec. 20.2036-1(c)(2)(i).
6 Regs. Sec. 20.2036-1(c)(2)(iii)(B)(1).
7 Regs. Sec. 20.2036-1(c)(2)(iii)(B)(2).
8 Regs. Sec. 20.2036-1(c)(2)(iii)(B)(3).
9 Regs. Sec. 20.2036-1(c)(2)(iii)(C).
10 Regs. Sec. 20.2036-1(c)(2)(iv), Example (7).
11 The example in the regulations includes a fixed $100,000 initial annuity amount and a fixed $3,200,000 trust corpus value at the date of death. Placing those two fixed amounts within the framework of the computational variables outlined above, the fixed initial annuity amount of the example in the regulations represents an annuitized percentage of approximately 34.4%. Likewise, the fixed trust corpus value at death represents an annual asset value growth rate of approximately 27.3%. By way of comparison, the annuitized percentage reflected in the example demonstrated in this article is 25% and the actual asset value growth rate so demonstrated is 5%.
12 The chart demonstrates the trust corpus value assuming a fixed and constant annual actual asset growth rate of 5%. Obviously, the demonstration is artificially simplistic to the extent that the actual rate of growth of value of assets held by the trust, rather than remain static, will invariably change over time.
13 Although, as they say, death is never a legitimate tax planning strategy, it is inevitable. Accordingly, it might be appropriate to discuss with clients, before implementing a graduated grantor retained annuity trust, the consequences of the grantor’s premature death on the planned transfer and the options related to the annuitized percentage.
14 Assuming the assets of the trust are not includible in the estate as a result of some other theory or mechanism.
Bryan Robertson is the managing director of Juris Valuation Advisors LLC in Lincoln, Neb. For more information about this article, contact Mr. Robertson at email@example.com.