Tax Court Decision Increases Usefulness of GRATs

In the current period of uncertainty about the future of the estate and gift tax system, the grantor retained annuity trust (GRAT) is a viable technique for passing wealth to future generations without creating a current tax liability for the grantor. A recent Tax Court decision has enhanced the GRAT's attractiveness and provided an interesting insight into tax planning.

A GRAT typically involves the transfer of assets to a trust for a term of years. The transferor retains the right to fixed payments (the annuity) for the term, and the assets (if any) remaining in the trust at the end of the term pass to the intended donee (remainderperson) without any additional gift tax. To compute the value of the remainder interest, which is potentially subject to gift tax, the present value of the retained annuity stream is subtracted from the value of the assets initially transferred to the trust. To value the annuity stream, the IRS uses an interest rate, determined under Sec. 7520, in effect for the month that the assets are transferred to the trust. As a result of a recent Tax Court decision, a taxpayer can reduce the value of the remainder interest to a relatively small amount—even to zero—by varying the trust term and the amount of the annuity.

Exhibit 1 presents the projected results for a 60-year old person transferring $10 million to a three-year GRAT and retaining a $3,754,881 annual annuity, using a Sec. 7520 rate of 6.2% (the February 2001 rate) and yielding a 10% return over three years. The value of the remainder subject to gift tax is $185,867, while the amount transferred to the intended donee is $881,344. However, two caveats should be kept in mind:

• If the donor dies during the GRAT's term, the assets will be taxed in his estate and no gift or estate tax savings will have been achieved.
• If the assets' rate of return does not exceed the Sec. 7520 rate by a sufficient amount, all of the GRAT's assets will be returned to the donor.

In Audrey J. Walton, 115 TC 589 (2000), the taxpayer established two GRATs in April 1993, each with a term of two years and funded with Wal-Mart stock with a fair market value (FMV) of $100,000,023.56. The retained annuity was supposed to be $49,350,011.63 for the first year and $59,220,013.95 for the second year. However, over the two-year period the Wal-Mart stock fell in value, so that the taxpayer received back all of her Wal-Mart stock and $953,067.21 in cash (principally from dividends on the stock). Nothing was left for the remainderperson. The taxpayer conceded that a gift of $6,195.10 was made (i.e., the original value of the remainder interest), while the Service claimed that the gift's value was $3,821,522.12.

Under the terms of the GRAT, if the taxpayer died during the two-year term, the annuity would continue to the end of the term and be paid to her estate. The IRS contended that the following three interests were created:

1. An annuity payable to the taxpayer for two years;

2. A contingent interest of the taxpayer's estate to receive the annuity for the remainder of the term should she die during the two years; and

3. The remainder interest.

Under the statutory scheme, only the value of a "qualified interest" retained by the transferor may be subtracted in computing the value of the remainder interest given to the intended beneficiary. Under Sec. 2702(b), a "qualified interest" is:

1. Any interest that consists of the right to receive fixed amounts, payable not less frequently than annually;

2. Any interest that consists of the right to receive amounts payable not less frequently than annually and that are a fixed percentage of the FMV 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 1 or 2.

The Service's position was that the contingent interest of the taxpayer's estate was not a qualified interest, causing a large taxable gift. The taxpayer argued, contrary to the existing regulations, that the contingent interest of her estate was an integral part of her retained annuity, which was a qualified interest.

The court reviewed the legislative history of Sec. 2702, as well as the IRS's treatment of similar interests in valuing charitable remainder trusts, and concluded that a fixed-term annuity payable to the grantor or the grantor's estate is a "single, noncontingent annuity interest payable for a specified term of years to the undifferentiated unit of petitioner or her estate." This single interest was held to be a qualified interest, properly deductible in computing the value of the remainder for gift tax purposes. The court also invalidated the portion of the regulations containing a contrary rule.

The impact of the court's ruling on Exhibit 1 is to decrease the taxable gift from $185,867 to zero. Thus, if the court's decision becomes final, the GRAT technique could be implemented with virtually no risk. In the current period of relatively low interest rates, a GRAT is especially attractive, because the value of the income interest is considered larger. This allows a smaller annuity to produce a zero value for the remainder.

The Tax Court's decision is appealable to the Eighth Circuit. If the decision is affirmed or the Service concedes, the GRAT will become an even more attractive approach to transferring assets to future generations without incurring estate or gift tax liability.

From Robert E. Harrison, Richard A. Eisner & Company LLP, New York, NY