Spousal Interests in GRATs Were Not Qualified Interests
The Tax Court, in Estate of Focardi, 1 held that revocable spousal interests contained in grantor retained annuity trusts (“GRATs”) were not qualified interests under Section 2702(b) and thus could not be used to reduce the value of the gifts to the GRATs.
In 1996, Claude Focardi established a two-year GRAT and a four-year GRAT. The provisions of the two GRATs were similar in all relevant respects, except for the term of years. The GRATs provided that if Claude died prior to the end of the GRAT term, and was survived by his wife, Nina, the annuity payments were to be made to Nina for the remaining GRAT term. The GRAT provided that Claude had the right to revoke Nina's interest in the GRAT.
Claude filed a gift tax return reporting the value of the gifts to the GRATs by reducing the value of the transferred property by the actuarially determined value of a two-life annuity (i.e., the present value of an annuity payable until the earlier of (1) the end of the applicable two- or four-year GRAT term, or (2) the death of both Claude and Nina). The IRS audited the gift tax return and determined that the gifts to the GRATs must be calculated by reducing the value of the transferred property by the value of a single-life annuity (i.e., the present value of an annuity payable until the earlier of (1) the end of the applicable two- or four-year GRAT term, or (2) the death of Claude).
The issue before the court was whether Nina's interest in the GRAT was a “qualified interest” as defined in Section 2702(b) so that her interest could be taken into account in valuing Claude's retained interest in the GRAT, thus reducing the amount of Claude's taxable gift to the GRAT. The Regulations under Section 2702 provide, in part, that a GRAT “[m]ust fix the term of the annuity or unitrust and the term of the interest must be fixed and ascertainable at the creation of the trust. The term must be for the life of the holder, for a specified term of years, or for the shorter (but not the longer) of those periods” 2 (emphasis added).
The IRS argued that Nina's interest was not a qualified interest because: (1) the spousal interest was not fixed and ascertainable since the spousal interest was contingent on Claude's failing to survive the applicable two- or four-year term, and (2) the spousal interest was not payable for the life of the term holder, for a term of years, or for the shorter of those periods.
The taxpayer, relying on Schott, 3 argued that Nina's interest was a qualified interest. The taxpayer contended that the Ninth Circuit in Schott concluded that a spousal interest is not disqualified simply because it is contingent upon a spouse surviving the grantor of the GRAT. The court in Focardi agreed with the IRS and held that the spousal interests in Claude's GRATs were not qualified interests because the term of the spousal interest was not fixed and ascertainable at the creation of the GRATs. The court found that the spousal interests were not fixed and determinable for two reasons. First, the spousal interests would not vest if Claude survived the GRAT term. Second, the duration of the spousal interests was dependent on how much of the term of the GRATs remained if Claude died during the GRAT term.
The court concluded that Nina's interests in the GRATs were not fixed and ascertainable because both the vesting and the duration of the spousal interests were dependent on Claude's death during the GRAT term. The court did not believe that the fact that the spousal interests could be assigned an actuarial value was sufficient to make Nina's interests in the GRATs fixed and ascertainable within the meaning of the Regulations. The court stated “[w]e do not believe that the ability to easily value a spousal interest is the linchpin for a finding that the spousal interest is a qualified interest.”
The court also held that Nina's interests in the GRATs failed the requirement of the Regulations that a GRAT term extend for the life of the holder, for a specified term of years, or for the shorter of the life of the holder or a specified term of years. The court contrasted the spousal interests of Nina with the interest of the spouse in Example 7 of Reg. 25.2702-2(d)(1).
The facts in Example 7 state that the grantor retained a qualified interest for ten years followed by a qualified interest in the grantor's spouse for a period of ten years, if the spouse is living at the end of the initial ten-year term. The court noted that in Example 7, the interest of the grantor's spouse was fixed and ascertainable at the time the GRAT was created, because the spousal interest was not contingent upon the grantor's death prior to the expiration of the initial ten-year term but rather was dependent solely on the survival of the spouse at the time of the termination of the initial ten-year term.
The taxpayer relied on the Ninth Circuit's holding in Schott. The GRAT in the Schott case provided for fixed annuity payments to the grantor until the earlier of the grantor's death or 15 years. If the grantor died before the end of the 15-year term, and the grantor's spouse survived the grantor, the annuity was to be paid to the spouse for the balance of the 15-year term. The grantor retained the right to revoke the spouse's interest. The Ninth Circuit held that the spousal interest was a qualified interest.
The Tax Court in Focardi declined to follow the Ninth Circuit's decision in Schott. The Tax Court relied instead on the legislative history of Section 2702, which indicated that Congress enacted that section, intending to “curb potential valuation abuse associated with intrafamily transfers of wealth.” 4 The Tax Court stated that “the possibility of such an abuse is present where, as here, it is not certain at the outset of the trusts that payments will ever be made under a survivorship annuity.”
The Tax Court also relied on its holding and that of the Seventh Circuit in Cook. 5 The GRAT in Cook provided that an annuity would be paid to the grantor until the earlier of five years or the grantor's death. If the grantor died before the end of the five-year term, the grantor's spouse—if she was married to the grantor at the time of his death—would receive the annuity amount for the balance of the five-year term. The Tax Court and the Seventh Circuit in Cook held that the spousal interest was not a qualified interest because the spouse's interest might never vest. The courts found that allowing a reduction in the value of a gift for an “ephemeral interest” would have the potential for valuation abuse.
In addition to relying on the legislative history of Section 2702 and the decisions in Cook, the Focardi court used—as support for its decision—the principle that the courts should accord substantial deference to the IRS in the interpretation of Treasury Regulations. In this regard, the court noted that the IRS had recently amended the Regulations under Section 2702 to provide that revocable spousal interests are not qualified interests. 6 While noting that these regulatory amendments were not binding on the parties because the GRATs at issue were created prior to the effective date of those amendments to the Regs., the court nevertheless viewed such amendments as persuasive.
We will have to wait to see if this case is appealed to the Eleventh Circuit, which has yet to decide a case involving contingent spousal interests. The use of the types of spousal interests involved in this case is rather limited following the amendments to the Regulations under Section 2702, unless the taxpayer is prepared to challenge the validity of those amendments. The reason for the use of spousal interests is to increase the value of the grantor's retained interest in a GRAT and thereby reduce the amount of the gift to the GRAT. The need to use spousal interests in GRATs has decreased substantially since the Tax Court's decision in Walton, 7 which upheld the validity of zeroed-out GRATs.
TC Memo 2006-56, RIA TC Memo ¶2006-056, 91 CCH TCM 936.
2 Reg. 25.2702-3(d)(4).
3 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.
4 136 Cong. Rec. at 30537-30538 (1990).
5 115 TC 15 (2000), aff'd 88 AFTR 2d 2001-6485, 269 F3d 854 (CA-7, 2001).
6 Reg. 25.2702-2(a)(6); Reg. 25.2702-3(d)(2); Reg. 25.2702-3(e), Example 8; Reg. 25.2702-3(e), Example 9.
7 115 TC 589 (2000).
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.