Final Regs. on GRAT/GRUT qualified interest determinations.

• Author: Weinberger, Mark
• Position: IRS rules on grantor retained annuity trusts and grantor retained unitrusts

The Service has issued final regulations (TD 8899) for determining whether a retained interest in a grantor retained annuity trust (GRAT) or a grantor retained unitrust (GRUT) is a qualified interest under Sec. 2702(b). The final regulations provide that the issuance of a note, other debt instrument, option or other similar financial arrangement, directly or indirectly, in satisfaction of an annual payment obligation, does not meet Sec. 2702(b)'s requirements.

The final regulations became effective on Sept. 5, 2000, adopting, with modifications, the proposed regulations published on June 22, 1999.

Background

Sec. 2702 applies to a transfer in trust that benefits a family member when a grantor retains an interest in the property transferred. If Sec. 2702 applies to a transfer, the value of the grantor's retained interest is zero for gift tax purposes (treating the grantor as making a gift of the entire value of the property), unless the retained interest is a "qualified interest"

A qualified interest includes (1) a right to receive, at least annually, fixed payments (a qualified annuity interest) and (2) a right to receive, annually, a fixed percentage of the trust corpus determined annually (a qualified unitrust interest).

Trustee May Borrow from Unrelated Party

Under the proposed regulations, the issuance of a note, other debt instrument, option or similar financial arrangement does not constitute a payment of the annuity or unitrust amount to a grantor as required by Sec. 2702. In addition, a retained interest is not a qualified interest under Sec. 2702, unless the trust instrument expressly prohibits the use of notes, other debt instruments, options or similar financial arrangements.

The final regulations acknowledge that a trustee may borrow required funds from an unrelated party to make a payment. However, the step-transaction doctrine will apply to a series of transactions used to achieve a result inconsistent with the regulations. For example, if a trustee borrows cash from a bank to make a required annuity payment and borrows cash from the trust's grantor to repay the bank, the transactions are combined as if the trustee issued a note for the annuity amount directly to the grantor. In the final regulations, the words "directly or indirectly" clarify this point.

The final regulations also clarify that a trust instrument provision expressly prohibiting the use of notes to satisfy the annual payments is not required for trusts...