Use of notes with GRATs or GRUTs.

• Author: Sanders, Russell
• Position: Grantor trusts

The IRS's recent responses in Letter Rulings (TAMs) 200010010 and 200011005, involving a grantor retained annuity trust (GRAT), may have broader implications than one might think.

Last year, the Service issued proposed regulations on the use of notes and other similar arrangements to satisfy the annuity and unitrust obligations of a GRAT and a grantor retained unitrust (GRUT). According to the proposed regulations, retained interests in trusts created after Sept. 20, 1999 (the effective date for the proposed regulations) capable of being satisfied by notes or similar arrangements are no longer considered "qualified interests" under Sec. 2702. In addition, trust instruments must now contain a clause specifically prohibiting the use of notes and other similar arrangements to satisfy the trust's annuity or unitrust obligations. Transition rules are provided for trusts created before the effective date of the proposed regulations.

The IRS believes these modifications to the regulations are necessary to ensure that, when a donor transfers property and retains an interest therein, the value of the donor's retained interest is "readily" ascertainable. According to the Service, delaying payment through the use of a note (described as merely a promise to pay in the future) alters the true value of the transferor's retained interest.

In response, practitioners have proposed two alternative arrangements to comply with the new mandates. A GRAT/GRUT could sell its property to a third party for installment notes and transfer these notes to a donor in satisfaction of its obligation. Equally feasible, a GRAT/GRUT could pledge its property as collateral for a loan and use the loan proceeds to satisfy its obligation. Because of the involvement of a third party, both alternative arrangements lessen the possibility of collusion between the donor and the trust and should make valuations more accurate. Moreover, both arrangements seem to provide a fair and workable solution for trusts facing cashflow problems.

However, practitioners have already pointed out that the preamble to the proposed regulations implies that neither of these arrangements is really viable. In both arrangements, the GRAT/GRUT continues to use a note to meet its payment obligation, thus violating the intent of the proposed regulations. The note's use in the second alternative is one step removed, but the preamble to the proposed regulations clearly states that the IRS will apply the...