Are Grats Still Great After Recent Irs Rulings and Regulations and Rising Federal Rates?
| Pages | 206 |
| Publication year | 2021 |
70 CBJ 206. Are Grats Still Great After Recent IRS Rulings and Regulations and Rising Federal Rates?
Most individuals with significant assets who are concerned about estate and gift taxes, and who are able to make sizable gifts at the present time, are interested in techniques to transfer the maximum amount of property for the least transfer tax cost. Makin a current gift of property which is expected to appreciate is often desirable because, for transfer tax purposes i the property value is fixed at the time of the transfer rat-her than at e date of death.
In many cases, however, a donor who wishes to obtain the benefits of such an "estate freeze" may not want to give the property outright. Instead, the donor might wish to retain some of the benefits or control over the donated property for a further period of time. One useful technique for achieving both objectives, i.e. "freezing" the value of the property for transfer tax purposes at the time of the gift and retaining some measure of-control or benefits, is a transfer to a trust with a retained interest.
Under the gift tax, split interest gifts statutes have been valued differently than gifts of undivided interests. (fn1) An undivided interest is valued at the time of the gift by its fair market value for the particular property. This has been described as the price at which the property wo Id change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of all relevant facts. (fn2)
A split interest, such as a term interest, remainder, or life estate, is not valued by the price that could be obtained for it on the open market. Rather, it is valued by taking the market value
of the entire property and subtracting the value of the split i terest. Such an interest is calculated by reference to published actuarial tables which ascribe various factors to it. The factors represent the present worth of $1.00 for an equivalent term, using an IRS determined interest rate, and, where appropriate, a built in actuarial factor based on the life expectan% of the holder of the interest. (fn3) In the case of a gift of a remain er interest after a term, the factor is applied to the full value of the property to determine the value of the term interest. The latter's value is then subtracted from the fair market value of the entire property to obtain the balance, which will be considered as the value of the gift portion. (fn4)
In order to correct various abuses pertaining to artificially low valuation of the gift portion of split interests, particularly within the same economic unit (fn5), Congress has enacted legislation designed to assure that such transfers do not escape or improperly diminish taxation. The special valuation rules of Chapter 14 of the Internal Revenue Code, effective for transfers after October 8, 1990, (fn6) are the most recent congressional attempt to value intrafamily split interest transfers fully.
Internal Revenue Code Section 2702 addresses transfers (fn7) which are in trust, broadly defined (fn8). The general rule is that if
there is a transfer in trust, which is to or for the benefit of a member of the transferor's family (fn9), and there is a retention of an interest in the trust by the transferor or by an applicable family member (fn10), the retained interest will be valued at zero, making the entire value of the property subject to gift tax. (fn11) An exception to this harsh rule is made for a retained interest which is a "qualified interest." (fn12)
Grantor Retained Annuity Trusts, or GRATs, which meet the statutory and regulatory requirements, will qualify the retained interest to be valued according to Code Section 7520. (fn13) The remainder, or gift portion, A411 then be determined by subtracting the retained interest from the total value of the property. (fn14) By careful planning of the amount and term of the retained interest in relation to the applicable interest rate, the value of the remainder, which is the taxable gift portion, can be minimized. (fn15) A grantor can, therefore, still transfer a substantial amount of pror-ierty at a relati el I ift tax cost and without parting witfi all of the income or contro for a eriod of years.
GRATs are most effective durmf times o ow federal interest rates. This is because the ca ated value of the retained interest will be higher. Thus, the grantor can transfer more value for a smaller annuity or shorter term. (fn16) Furthermore, if a low federal rate (fn17) is in effect, it will be easier for most rantors to fund the GRAT with higher yielding property or with property which is expected to appreciate at a rate higher than the IRS
rate over the term of the retained interest. (fn18)
Recently, however, the applicable interest rates have gone from 6.4%, in March, 1994, (fn19) to 9.6%, in January and February, 1995.(fn20) In Sef,tember, 1995, they are at 7.6%. Also, in several recent private etter rulings and in proposed amendments to regulations to Code §7520 published in June, 1994, (fn21) the IRS has shown its displeasure at efforts to zero out GRATs. Nevertheless, for many individuals, particularly those with property which is expected to outperform the current federal rate, GRATs remain a very im ortant tool in estate planning. Furthermore, several approveTprovisions such as contingent spousal annuities (fn22) and discretionary tax payment clauses (fn23) can enhance the tax benefits available to grantors of GRATs.
This article discusses the basic princip es of Grantor Retained Annuity Trusts and problems and opportunities associated with their valuation. It also examines the IRS position on key issues, as set forth in the proposed regulations to Code §7520, revenue rulings, and private letter rulings. It then evaluates whether GRATs are still worthwhile tools for planners and suggests strategies for maximizing the effective use of GRATs at the current time.
A. The Fundamentals
If there is a transfer in trust to or for the benefit of an applicable family member, as defined, and a retained interest by the grantor or a member of the grantor's family, the special valuation rules of Chapter 14 of the Internal Revenue Code will apply. (fn24) In order to avoid a taxable gift of the entire value of the transferred property, any retained interest must be a qualified interest. (fn25) To qualify an interest, the following requirements must be met:
1. Statutory Re utrements: The interest must consist of the right to recei) amounts payable not less frequently than annually. (fn26)
2. Regulatory Requirements : (fn27)
a. The qualified annuity interest must be an irrevocable right to receive a fixed amount payable annually or
more often. (fn28) "Fixed" means either a fixed dollar amount or a fixed percenta e of the initial fair market value of the property transteerred to the trust as finally determined for federal tax purposes. (fn29) An amount is fixed, even if it is changed annually, so long as the amount payable in any year does not exceed 120% of the amount payable in the preceding year. (fn30)
b. The governing instrument must:
i.Protibit distribution to or for the benefit of any person other than the holder of the interest during the term of the interest. (fn31)
ii. Specify the term of the annui in erest which may be K a fixed term, for the life o the annuitant, or for the shorter of these two periods.(fn32)
iii. Prohibit commutation (prepayment). (fn33)
iv. Include a provision requiring that the annuity amount will be adjusted in the case of short taxable years and in the case of the trust's last taxable year. (fn34)
v. Prohibit additional contributions.(fn35)
vi. Require that if the annuity amount is a percentage of the initial value of the trust assets and the trustee incorrectly values the trust assets, a compensating payment will be made either to or by the annuitant on account of the misvaluation. (fn36)
c. An interest in a GRAT will still be a qualified interest even if the annuitant has a right to the greater of the annuity distribution or the total of trust income. However, only the qualified interest will be valued. (fn37)
d. The trust must be a Grantor Retained Annuity Trust in every respect from the first day of its existence and throughout the term.(fn38)
B. Income Tax and Estate Tax Treatnwnt
1. Grantor Trust Status for Income Tax Purposes.
Because the grantor or applicable family member has retained certain rights to income and to nine al, he will be regarded as the owner of some portion, irnot iS, of the trust for inc-ome tax Purposes. (fn39) Thus, the transfer of assets to the trust and payment of annuity amounts to the grantor will have no federal income tax consequences. (fn40) Since an inevitable consequence of this type of trust is the inclusion of at least some portion of the property in the grantor's estate, if he dies during the term of the annuity, (fn41) there are no disadvantages in ensuring t at the trust has grantor status. Because there may be real advantages (fn42), care should be taken to assure that this status is achieved.
Generally, the requirement that a GRAT pay to the grantor trust income and principal, to the extent that income is insufficient, in satisfaction of the annuity payments, will cause the grantor to be the owner of the trust property during the term for income tax purposes. (fn43) Since it may be important for the grantor to be deemed the owner of the entire trust, i.e. where it is an S corporation shareholder...
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