Revisiting promissory notes to pay a GRAT's annuity amount.

• Author: Pompilio, Gerard
• Position: Grantor retained annuity trust

Tax advisers strive to devise strategies to aid clients in accomplishing their personal and financial goals with minimum tax cost. One technique with potential for significant transfer tax savings is the grantor retained annuity trust (GRAT). In order to avoid onerous gift tax consequences and achieve its objectives, a GRAT for the benefit of the settlor's family must meet the requirements for a "qualified interest" under Sec. 2702.

Tax advisers must be careful to ensure that GRAT documents meet the technical requirements of Sec. 2702 and the regulations thereunder so that the interest retained by the grantor constitutes a "qualified interest." Under Sec. 2702(a), for gift tax purposes, the value of a retained interest in property transferred in trust to, or for the benefit of, a family member (as defined in Sec. 2704(c)(2) is zero, unless such interest is a qualified interest (as defined in Sec. 2702(b)). Therefore, without a qualified interest, the gift tax value of such a transfer is the property's full fair market value (FMV) without reduction for the retained interest.

Sec. 2702(b)(1) provides that a qualified interest includes the right to receive fixed amounts payable not less frequently than annually (a "qualified annuity interest"). Regs. Sec. 25.2702-3 contains the following requirements for such an interest:

* The interest must consist of an irrevocable right to receive a fixed amount, which could be a stated dollar amount or a fixed percentage or fraction of the initial FMV of the property transferred to the GRAT.

* The fixed amount must be payable to, or for the benefit of, the interest holder for each tax year of the GRAT.

* The governing instrument must contain provisions that:

1. Prohibit distributions to any person other than the qualified annuity interest holder;

2. Fix the term of the GRAT;

3. Prohibit commutation (prepayment) of the annuity amount;

4. Prohibit additional contributions to the GRAT;

5. Satisfy Regs. Sec. 1.664-2(a)(1)(iii) (adjustments for incorrect determination of FMV), when the annuity is stated in terms of a fraction or percentage of the initial FMV of the property transferred to the GRAT; and

6. Satisfy Regs. Sec. 1.664-2(a)(1)(iv) (computation of the annuity amount in case of short tax years and the GRAT's last year).

Clients are generally advised to fund a GRAT with assets that they anticipate will generate the highest return over the trust term in order to obtain the greatest transfer tax leverage. The...