Qualified Annuity Can Be Based on Two Lives

A transferred 11,400 shares of SCS nonvoting common stock to herself as trustee of the P qualified annuity trust, a grantor retained annuity trust (GRAT). P provided that 11.54% of the initial net fair market value (FMV) would be paid to the grantor commencing on June 1, 1994, and ending 15 years later or (if sooner) on the grantors death. If A died before the end of the 15-year term, the annuity would be paid to her spouse for the balance of the term, unless the right had been previously revoked by the grantor. If the spouse did not survive the grantor or if the grantor had revoked the spouses interest, the annuity payments would cease; the remaining GRAT property would be held in trust for the surviving spouse or for the grantors descendants.

On the same date, As spouse R transferred 11,400 shares of SCS nonvoting common stock to himself as trustee of the Q qualified annuity trust, also a GRAT. The annuity payments were identical in material respects to Ps. For the Q Trust, if the grantor survived the 15-year term, the remaining GRAT assets would be held in trust for the grantors spouse (if then living) or otherwise for the grantors descendants. For P, if the grantor survived the 15-year term, the remaining GRAT assets would be held in trust for the grantors descendants.

A and R each filed a gift tax return for 1994, showing two taxable gifts of $35,959, based on the FMV of the transfer to each trust ($4,046,197) minus the value of each two-life annuity ($4,010,238). The IRS disqualified the annuities and assessed gift tax deficiencies against A of $126,680, and against R of $137,953. The Tax Court held that an annuity measured by two lives was unqualified, because it could extend beyond the life of the term holder. It rejected As and Rs reliance on Regs. Sec. 25.2702-2(d), Example 7.

Analysis

A qualified interest is defined under Sec. 2702(b) as:

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 FMV of the property in the trust (determined annually); and

3. Any noncontingent remainder interest if all other trust interests consist of interests described in 1 or 2 above.

In addition, Regs. Sec. 25.2702-2(a)(5) states that a:

Qualified interest means a qualified annuity interest, a qualified unitrust interest, or a qualified remainder interest. Retention of a power to revoke a qualified annuity interest (or unitrust interest) of the transferors spouse is treated as the retention of a qualified annuity interest (or unitrust interest).

Regs. Sec. 25.2702-2(d) sets forth the following examples:

Example 6: A transfers property to an irrevocable trust, retaining the right to receive the income for 10 years. On expiration of 10 years, the trust income is payable to As spouse for 10 years if living. On expiration of the spouses interest, the trust terminates and the trust corpus is payable to As child. A retains the right to revoke the spouses 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), Sec. 2702 applies. As power to revoke the spouses term interest is treated as a retained interest for Sec. 2702 purposes. Because no interest retained by A is a qualified interest, the amount of the gift is the FMV 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 As spouse (subject to As right of revocation) are qualified annuity or unitrust interests. The amount of the gift is the FMV of the property transferred to the trust, reduced by the value of both As qualified interest and the value of the qualified interest transferred to As spouse (subject to As power to revoke).

On the face of it, As and Rs trusts fit within Example 7 of Regs. Sec. 25.2702-2(d) and, thus, are qualified and deductible from the value of their gifts. The annuity in each trust is a fixed percentage of the capital to the grantor for life, then to the grantors spouse, with a fixed term of 15 years if the grantor and spouse live that long. A two-life annuity table makes the value of the gift ascertainable. The value of the grantors power to revoke is treated as the retention of a qualified interest, as specified in Regs. Sec. 25.2702-2(a)(5).

The IRS argues, however, that A and R have contingent and, thus, unqualified interests, and that the provision in Example 7 that the spouse be living did not make that gift contingent (and hence unqualified). However, neither the statute nor the regulations exclude contingent interests as such. Every annuity given to a person, if living, is contingent on that persons survival; yet life annuities, as such, are not excluded by the statute or the regulations.

The IRS also argues that the beginning date for the spouses interest is not fixed, because it depends on the grantors death. This argument merely restates an unfounded objection to life annuities. As the end of the grantors life can be ascertained with acceptable probability by an annuity table, so can the date and duration of the spouses annuity.

Regs. Sec. 25.27023(d)(3) states, [t]he 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. The IRS argued that, as term holder is singular, the use of the lives of two term holders is invalid. However, singulars normally include plurals, just as he normally includes she.

In Cook, 269 F3d 854 (7th Cir. 2001), the Seventh Circuit held an annuity to a grantor and spouse (if living) to be unqualified. However, there was an additional contingency in the trust, which could not be ascertained by any annuity table (the grantor and spouse had to be married at the time the spouses annuity began).

The annuity created by each trust, for the lives of the grantor and spouse or 15 years, is as qualified as the annuity in Example 7 paying a fixed amount for 10 years to the grantor, then to the spouse if living. As the Tax Court pointed out the principal objective of section 2702 was to prevent undervaluation of gifted interests. A two-life annuity, based on the lives of the grantor and spouse with a 15-year limit, falls within the class of easily valued rights that Congress meant to qualify.

Patricia A. Schott, 9th Cir., 2/18/03

Reflections: In Schott, the court held that the IRSs interpretation of Regs. Sec. 25.2702-2(d), Example 7 (not the regulation itself ) to exclude the contingency of the spouse being alive at the time the annuity begins, is unreasonable and invalid. In Audrey J. Walton, 115 TC 589 (2000), the Tax Court held that Regs. Sec. 25.2702-3(e), Example (5), was an unreasonable interpretation and invalid extension of Sec. 2702. That decision upheld an annuity payable to the grantor for two years or, if sooner, until she died; in the event of her death, the rest of the two-year annuity was payable to her estate, and the remainder to designated beneficiaries.