Seventh Circuit Affirms GRAT Contingent Spousal Annuity Not Exempt from Gift Tax Liability

The Seventh Circuit, affirming the Tax Court, held that a contingent spousal annuity in a grantor retained annuity trust (GRAT) was not a qualified interest and, thus, not exempt from gift tax liability (William A. Cook, 10/22/01).

Facts

William and Gayle Cook each created GRATs providing for annual payments to a grantor for a term of years or until the grantor's earlier death. If the grantor survives the designated term, the remaining trust property is to pass to a trust for the grantor's son. However, if the trust ends due to the grantor's death before the expiration of the designated term, the trust property is directed to a contingent marital annuity trust (CMAT). Under the CMAT, the surviving spouse would receive any annuity payment that would have been paid to the grantor had the grantor survived the remainder of the designated term set forth in the GRAT.

All of the GRATs are irrevocable in all respects, except that each grantor retains the right to revoke the designation of his spouse as the successor annuitant. Also, the spousal interests are contingent on the Cooks remaining married.

The Cooks timely filed Federal gift tax returns, reporting the value of the transfers to their respective GRATs. They based the actuarial value of the retained annuity on the ages of both spouses, thereby creating a very small taxable gift and no gift tax liability. The IRS disagreed, concluding that the spousal interests contained in the GRATs did not meet the Sec. 2702 requirements and, therefore, were not "qualified interests" exempt from gift tax liability. The Service determined that only the grantors' individual interests could be considered qualified interests; only the grantor's age could be considered in the actuarial calculation.

Tax Court

Agreeing with the IRS, the Tax Court held that each of the interests created by the grantor in favor of the grantor's spouse was not a qualified interest and, therefore, had to be valued at zero under Sec. 2702(a)(2)(A). The court further noted that the revocable spousal annuity interests did not meet the standards of qualified interests under Sec. 2702, because the retained interests might extend beyond the shorter of a term of years or the period ending on the grantor's death. In reaching this conclusion, the court assumed (without explanation) that the designation "term holder" in Regs. Sec. 25.2702-3(d)(3) referred to the grantor.

Seventh Circuit

The Seventh Circuit rejected the Cooks' argument based on Walton, 115 TC 589 (2000), that the fixed-and-ascertainable standard was inappropriate. Further, the court distinguished this case from Walton because the contingent annuity was payable to the grantor's estate when the grantor died. However, under the Cooks' GRATs, the contingent spousal annuity meant that the grantor did not make a gift to himself or to his estate; therefore, the court found that the Tax Court properly treated the annuity as one for a term of years.

The court agreed with the Tax Court's interpretation of the regulations under Sec. 2702, finding that, to be deemed noncontingent, the terms of a remainder interest in a GRAT must be fixed and ascertainable at a trust's inception. In examining the Cooks' GRATs, the court found that the spousal interests in each were not qualified interests under Sec. 2702, because they were contingent. The court noted that under the GRATs, a spouse was only entitled to income if the spouse survived the grantor and the spouse and the grantor remained married. Because of those conditions, the court found that it was possible that a spouse's interest might never vest. The court noted that if "the value of a gift made in trust can be reduced by an ephemeral interest, potential for valuation abuse increases considerably." In light of the concern of valuation abuse and the possible manipulation of the residual interests contained in the GRATs, the interests were not qualified interests.

Further, the court agreed with the Tax Court's ruling that the spousal interests were not qualified interests because they violated the duration requirements of Regs. Sec. 25.2702-3(d)(3). When a grantor retains the right to revoke a spousal interest, that interest is deemed a grantor-retained interest. As such, it must be for the life of the holder, a term of years or for the shorter of both those periods. According to the court, the Cooks' spousal interests were impermissible, because they could exist for the grantor's life or for a term of years, regardless of which was shorter.

From Robert Coplan, Washington, DC