Prop. regs. affecting GRATs and GRUTs.

• Author: Tubandt, Deanna D.
• Position: IRS regulations; grantor trusts

In 1990, Congress passed Sec. 2702 to limit the benefits of certain trusts in which a grantor retains an interest in property and the remainder passes to a family member. The underlying conceptual advantage to grantor retained annuity trusts (GRATs) and unitrusts (GRUTs) has been to reduce the asset's value for gift and estate tax purposes. If the grantor retains an annual payout from the trust, the remainder interest subject to gift or estate tax is reduced in value. The primary difference between a GRAT and a GRUT is that the former specifies a fixed amount to be paid, while the latter specifies a fixed percentage of the trust assets. A key requirement of each is that payment to the grantor must be made at least annually.

Effective Sept. 20, 1999, satisfaction of this annual payment will be subject to a different rule under Prop. Regs. Sec. 25.2702-3, affecting GNATs or GRUTs created before and after that date.

Prop. Regs. Sec. 25.2702-3. provides that "[i]ssuance of a note, other debt instrument, option or similar financial arrangement in satisfaction of the annuity does not constitute payment of the annuity amount." A parallel amendment applies to satisfaction of a unitrust amount.

Any trust created before Sept. 20, 1999 must pay in full any notes or debt instruments distributed prior to this date; these trusts must comply by Dec. 31, 1999. Trusts created after Sept. 20, 1999 must include a specific provision prohibiting the trustee from issuing a note, option or other debt instrument to satisfy the annual payment requirement.

Traditionally, closely held family businesses created a GNAT or GRUT to provide for an orderly transfer of the business to younger family members. The older family member (as grantor) retained an annual payout under the trust terms. If the business did not produce sufficient income for the annual payment or the grantor did not require the income, the trustee may have issued a note to the grantor in lieu of the payment. If this had occurred over a period of several years, the amount the trust owed to the grantor could have been substantial. Under Prop. Regs. Sec. 25.2702-3, the trust would have until Dec. 31, 1999 to pay these notes, including interest (using the interest rate under Sec. 7520). If the trust does not do this, the grantor's retained interest will be treated as zero for gift and estate tax...