Federal Securities Laws and Administration of the Grantor Retained Annuity Trust

• Citation: Vol. 9 No. 1
• Publication year: 2003
• Author: By Diana Hastings Temple, Esq. and Nicholas Unkovic, Esq.

FEDERAL SECURITIES LAWS AND ADMINISTRATION OF THE GRANTOR RETAINED ANNUITY TRUST

By Diana Hastings Temple, Esq.^* and Nicholas Unkovic, Esq.^**

I. INTRODUCTION

While the grantor retained annuity trust ("GRAT") may have found its place in the sun with the volatile market for technology stocks, its actual administration in the same environment presents quite a few issues the planner needs to address while drafting the instrument. This article presents some of these issues under the federal securities laws.¹ While this article does not discuss issues under any state's "Blue Sky" laws, it is important for the practitioner to review those laws.²

Assume your client is the founder and president of a company that had its initial public offering ("IPO") more than two years ago. The stock is traded on a national securities exchange. All the "lock-up agreements" required by the underwriters of the IPO, which otherwise may have prohibited transfers to a greater extent than securities laws preventing transfer, have now expired but all of the client's share certificates include a restrictive legend because the client is an "affiliate." The client owns less than ten percent, but more than five percent, of the company. He has not acquired or disposed of any shares which, when aggregated with other shares acquired or disposed of over the past twelve months, would exceed one percent of the company's outstanding stock. The significance of these particular facts will become apparent in the discussion below.

The client has a young child whom he would like to benefit with a gift of his common stock in anticipation of a potential, although hopeful, rise in the value of the stock. With a volatile stock market for the company's industry, however, it is just as likely that, over the next two or three years, the stock will decline in value. Subsequent sales of the stock are anticipated.

You have suggested that your client establish a GRAT where he would retain a right to receive a certain pecuniary amount of the trust's assets each year. At the end of the GRAT's stated term, any remaining assets would be distributed to a trust for the benefit of the client's child (the "Child's Trust"). The right retained by the client, on a discounted present value basis, would equal the fair market value of the assets initially transferred to the GRAT. In this way, should there be any appreciation in the value of the assets in the GRAT, the Child's Trust would benefit, but, should there be any depreciation in the value, your client will not lose much, if any, of his "applicable credit amount" applied to the current value of the stock transferred to the GRAT. The client likes the idea and agrees to serve as the trustee of the GRAT in order to retain control of the investments. You have suggested that the term of the GRAT be two years and that annual payments be made on the anniversary date of the GRAT (a "fiscal year GRAT").³

Your client also likes the idea of paying the income taxes on any capital gains in the GRAT. In this way, he would be making an additional indirect "gift" to the Child's Trust by allowing the GRAT assets to grow in an "income-tax-free" environment.⁴ In order to ensure that the GRAT is a "grantor trust" for income tax purposes as to any ordinary income as well as any capital gains, and to preserve the client's ability to buy back the shares should he decide to do so, you have suggested that your client retain the I. R.C. § 674(c)(4) power to substitute assets of equivalent value. Furthermore, an independent trustee would have the power to reimburse the grantor for any increase in the grantor's income tax liability that is attributable to the GRAT.⁵

The terms of the Child's Trust (the remainder beneficiary of the GRAT) are suggested to provide that income accumulates for the child's life with distributions permitted for support and education. Your client would like to be trustee of this trust as well as the GRAT, again in order to keep investment control over the assets. An independent trustee, however, would have the power to terminate the trust during the child's lifetime by distributing the assets held therein to the child. At the child's death, the assets would be subject to a general power of appointment in the child, and you made this suggestion in order to include the assets in the child's taxable estate so as to avoid application of the generation-skipping transfer ("GST") tax to the assets in the Child's Trust at the child's death.⁶

II. "RULE 144" REGISTRATION ISSUES FOR SUBSEQUENT SALES

Companies that sell shares of stock to investors in public markets are required under the Securities Act of 1933, as amended,⁷ (the "Securities Act") to adhere to a rigorous registration and reporting regime designed to provide the public with adequate disclosure of the company's business. Under § 4(1) of the Securities Act, in the absence of an applicable exemption, persons who are "issuers, underwriters and dealers" are required to register their securities prior to a sale.⁸ Section 2(a)(11) of the Securities Act defines an "underwriter" as:

[A]ny person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking . . . .

Moreover, "affiliates" and any person who sells restricted securities may be deemed to be underwriters.⁹ "Restricted securities" are those acquired from the issuer or an affiliate of the issuer in one or a series of exempt private transactions without a public offering;¹⁰ the definition is not dependent on a restrictive legend actually appearing on the share certificates. Because the client may eventually sell his own remaining restricted shares or

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those gratuitously transferred to the GRAT or Child's Trust, he will need to determine if he must register the shares for sale or qualify for an exemption from such registration.

"Rule 144"¹¹ is a non-exclusive "safe-harbor" regulation adopted by the Securities and Exchange Commission ("SEC") that exempts qualifying sales of securities by "affiliates" or holders of restricted stock from the definition of "underwriter" and the registration process.¹² While all the Rule 144 requirements are important, the requirements with which the client and the fiduciary of the GRAT and the Child's Trust must be personally concerned are (i) whether either trust would be considered an "affiliate" for purposes of Rule 144, (ii) the "volume limitation" requirement and (iii) the "holding period" requirement.¹³

A. Is the Trust an Affiliate?

Under Rule 405,¹⁴ an "affiliate" for these purposes is "a person that directly, or indirectly . . . controls or is controlled by, or is under common control with, the person specified." Moreover, control is the "power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise."¹⁵ Certainly, directors, "C-level" executives (e.g., Chief Executive Officers, Chief Financial Officers, Chief Technology Officers) and other senior or policy-making officers would be affiliates, but many companies take an even more expansive view of who are the company's affiliates. In our example, the client should be treated as an affiliate as he is president of the company (i.e., "the person specified") and no doubt has the power to direct the management of the company.

The law is a little muddy when it comes to determining whether trusts are "affiliates" for these purposes. If a trust is not an affiliate, and the shares are not restricted, the trust need not comply with Rule 144 and its shares need not be aggregated with other, related "affiliates" for Rule 144 purposes.¹⁶ In SEC Release No. 33-6099, 1 Fed. Sec. L. Rep. (CCH) ¶ 2705H, (referred to herein as "SEC Release No. 33-6099") Question 31, at 2819-12 (August 2, 1979), the SEC took the position that even if a trustee is an "affiliate," the trust itself would not automatically be deemed an "affiliate."¹⁷ Later rulings, however, indicate that a trust may be considered an "affiliate" where the grantor/lead beneficiary is an "affiliate."¹⁸

In our example, the client is the grantor, lead beneficiary and trustee of the GRAT and is the grantor and trustee of the Child's Trust. Therefore, the conservative course would be for the client to treat the GRAT and the Child's Trust as "affiliates" for Rule 144 purposes.

B. Volume Limitations

The volume limitation requires that the maximum volume of stock that the holder of restricted securities may transfer pursuant to Rule 144 during any three-month period is limited to the greater of (i) one percent of the company/issuer's outstanding securities of the class, or (ii) the average weekly trading volume of the company/issuer's securities during the preceding four-week period.¹⁹ An affiliate must aggregate the affiliate's shares with those of (i) any relative or spouse (or relative of a spouse) who shares the "same home" with the affiliate ("Relative"), (ii) any trust or estate in which the affiliate or a Relative collectively owns ten percent or more of the total beneficial interest, (iii) any trust or estate of which the affiliate or a Relative serves as fiduciary, and (iii) other persons that agree to act "in concert" with the affiliate for the purposes of selling securities.²⁰

Because the client is an "affiliate" and serves as trustee, he will need to aggregate his individual shares with those of the GRAT or Child's Trust in order to determine if any subsequent sales of his individual shares fall within the volume limitation. Even if the client is replaced as trustee, aggregation with the GRAT's shares may still be required by him if he owns ten percent or more of the beneficial interest of the GRAT, and his shares would be aggregated with the...