IRS Proposed Rules Re GRATs
In response to the cases of Walton 1 and Schott, 2 the IRS has issued Proposed Regulations 3 amending the rules applicable to grantor retained annuity trusts (“GRATs”) and grantor retained unitrusts (“GRUTs”).
Facts and Analysis
In Walton, the Tax Court invalidated Example 5 of Reg. 25.2702-3(e). Example 5 addresses a GRUT with a term of ten years which provides that if the grantor dies during the ten-year term, the remaining unitrust payments are to be paid to the grantor's estate. Although the unitrust payments will continue if the grantor dies prior to the end of the ten-year term, Example 5 concludes that the unitrust payments constitute a qualified interest only for the shorter of ten years or until the grantor's death.
The court in Walton believed that neither the statute nor the legislative history supported the conclusion reached by Example 5. The court determined that an annuity or unitrust payable to a grantor for a term of years and to the grantor's estate if the grantor died prior to the end of the term was a qualified interest for the full stated term. The holding of Walton permitted GRATs to be structured so as to “zero out” the gift because an annuity for a term of years could now be valued without regard to the life expectancy of the grantor.
The IRS announced in Notice 2003-72 4 that it would follow the Tax Court's holding in Walton. The recently issued Proposed Regulations, in order to be consistent with the holding in Walton, amend the conclusion stated in Example 5 by now providing that the unitrust payments retained by the grantor constitute a qualified interest for the full stated term of ten years.
In Schott, the Ninth Circuit examined the circumstances under which a revocable spousal interest will constitute a qualified interest. A qualified interest includes not only a qualified annuity or unitrust interest but also a power by the grantor to revoke a qualified annuity or unitrust interest payable to the grantor's spouse. 5 If the grantor's spouse is granted a revocable spousal interest, then the grantor is treated as having retained the qualified annuity or unitrust interest payable to the spouse.
In Schott, a husband and wife each set up a GRAT providing for annuity payments to the grantor for the shorter of 15 years or until the death of the grantor. If the grantor died prior to the end of the 15-year term, the grantor's spouse was to receive the annuity payments for the remaining balance of the 15-year term, unless the grantor had revoked the spouse's interest.
The Ninth Circuit reversed the Tax Court and held that the annuity interest of each of the spouses was a qualified interest and that therefore the grantor's power of revocation of that annuity interest was also a qualified interest. The Ninth Circuit based its holding that the spousal interests were qualified annuity interests on the fact that a two-life annuity table would enable the value of the spouse's annuity interest to be ascertained.
The recently issued Proposed Regulations make clear the position of the IRS that a revocable spousal interest will constitute a qualified interest only if the spousal interest that is subject to revocation is itself a qualified interest. 6 In addition, the Proposed Regulations provide that the only permissible contingencies with respect to the payment of a qualified annuity or unitrust are: (1) the holder of the interest surviving until the commencement of the interest, (2) the holder of the interest surviving throughout the term of the interest, or (3) the grantor's right to revoke a spousal interest. 7
To illustrate the IRS' position, the Proposed Regulations introduce two new Examples. In the first Example, 8 the grantor of a GRAT retains the right to an annuity for a term equal to the shorter of ten years or the grantor's death. The GRAT also provides that upon the expiration of the grantor's term at the end of ten years or the grantor's prior death, an annuity is to be paid to the grantor's spouse, if then living, for a term equal to the shorter of ten years or the spouse's death. The grantor retains the right to revoke the spouse's annuity interest. The Example states that since the spouse's interest is a qualified annuity interest, the grantor's retained power of revocation is also a qualified interest retained by the grantor.
In the second Example, 9 the grantor of a GRAT retains the right to an annuity for a term equal to the shorter of ten years or the grantor's death. If the grantor dies prior to the expiration of the ten-year term, the annuity is payable to the grantor's spouse, if then living, for the shorter of the balance of the ten-year term or the spouse's death. The grantor retains the right to revoke the spouse's annuity interest.
The Example states that the spouse's interest is not a qualified annuity interest because: (1) it is not payable for either life, a specified term of years, or for the shorter of life or a specified term of years, and (2) the spouse's right to the payment of the annuity is not dependent solely on surviving the grantor but rather is dependent on an impermissible contingency—the failure of the grantor to survive the initial term. Accordingly, the Example concludes that the spouse's interest is not a qualified interest and therefore is valued at zero.
In light of the acquiescence of the IRS to the Tax Court's decision in Walton, the Proposed Regulations are helpful in that they conform the Section 2702 Regulations to the holding in Walton. The Proposed Regulations are also an attempt by the IRS to accomplish administratively the result it was unable to achieve in Schott. However, in light of the Tax Court's decision in Walton that makes “zeroed-out” GRATs possible, revocable spousal interests are not as necessary a planning option in attempting to reduce the amount of the taxable gift upon the establishment of a GRAT or GRUT.
1 115 TC 589 (2000).
2 91 AFTR 2d 2003-915, 319 F3d 1203 (CA-9, 2003), rev'g and rem'g TC Memo. 2001- 110, RIA TC Memo 2001-110, 81 CCH TCM 1600.
3 REG-163679-02, 69 Fed. Reg. 44476 (7/23/04).
4 2003-44 IRB 964.
5 Reg. 25.2702-2(a)(5).
6 Prop. Reg. 25.2702-2(a)(6).
7 Prop. Reg. 25.2702-3(d)(2).
8 Prop. Reg. 25.2702-3(e), Example 8.
9 Prop. Reg. 25.2702-3(e), Example 9.
Frank S. Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or firstname.lastname@example.org.