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ESTATE PLANNING WITH GRATs AFTER WALTON
Jay D. Waxenberg
Proskauer Rose LLP
1585 Broadway
New York, NY 10036
212-969-3606
. February 26, 2003
I. Background
A. With the passage of the Omnibus Budget Reconciliation Act of 1990 and the
enactment of Code Section 27021, Congress sanctioned a relatively simple means of
transferring property at little, if any, gift tax cost: the Grantor Retained Annuity
Trust, commonly referred to as a "GRAT."
B. When properly structured, a GRAT can pass to a beneficiary most of the future
appreciation of the transferred property at virtually no gift tax cost and with no
significant adverse tax consequences if the trust property does not appreciate.
C. A typical GRAT is a trust which pays an annuity annually to the Grantor for a fixed
number of years. The annuity amount is generally either a fixed dollar amount or a
stated percentage of the initial market value of the trust. (The Grantor Retained
Unitrust ("GRUT") is a similar device, not discussed here, in which the annual
payments vary with the value of the fund.)
D. At all times during the term of the GRAT, the Grantor will receive the predetermined
annuity amount, regardless of how much income the trust actually generates or
whether its value rises or falls. To the extent that the income is insufficient to cover
the annuity payments, trust principal will be returned to the Grantor each year.
1
All references are to the Internal Revenue Code of 1986, as amended
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E. At the end of the GRAT period, the property remaining in the trust passes tax free to
the ultimate beneficiaries of the trust, typically the Grantor's children or other family
members.
F. The most popular use of GRATs has been the short-term "zeroed-out" GRAT in
which the term is limited to two or three years and the annuity amount is maximized
in order to produce as small a taxable gift as possible. In this way, anticipated short-
term growth in the trust assets can be availed of without risking longer-term
uncertainty, and the risk of depreciation is neutralized by minimizing the gift tax cost.
1. By shortening the term of the GRAT and adjusting the size of the annuity, the
gift can be nearly "zeroed-out," and the chance that the program will be
foiled by the grantor's death within the term of the trust will be drastically
reduced.
G. Formulas - Of particular appeal is the fact that the GRAT also removes the risk of
undervaluing a closely held business interest for gift tax purposes. With an outright
gift, there is no way to guard against a substantial gift tax deficiency if the value of
the property is questioned by the Internal Revenue Service. But, if instead the gift is
the remainder interest in a GRAT, and if the annuity amount is expressed as a
percentage of the initial value of the trust principal, rather than a specific dollar figure,
any increase in the value of the business determined on the audit of the gift tax return
would result almost entirely in an increase in the value of the retained interest and, in
turn, in only a nominal gift tax increase.
H. Note that the GRAT is a "grantor trust" for income tax purposes, which means that
all of its income and deductions are included on the grantor’s personal tax return, as
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if there had been no transfer at all, until the property passes free of trust to the
beneficiaries. If at the end of the initial GRAT term there are continuing trusts for the
beneficiaries, these can be structured as grantor trusts for the additional tax benefits
in having the grantor continue to pay income taxes attributable to the property held in
the trust.
I. Gift splitting issues - If the grantor does not survive the term of the GRAT and split
the gift of the remainder with his or her spouse, the spouse will not have his or her
adjustable gifts reduced by the value of the gifts includable in the grantor’s estate.
This could result in additional gift taxes or loss of a portion of the unified credit.
J. Generation-skipping - GST exemption cannot be allocated to a GRAT during the
GRAT period because of the ETIP rules under Section 2642(f) of the Code. If you
want to allocate GST exemption after the GRAT term, make sure you have a
continuing trust with at least one non-skip person as a possible beneficiary (to avoid
a direct skip at the end of the GRAT term) and consider severance before allocating
exemption.
II. Governing Instrument Requirements
A. Annuity amount payable to the donor must be fixed and irrevocable. Treas. Reg.
§25.2702-3(b)(1)(i).
B. Annuity amount payable to or for the benefit of the donor at least annually. Treas.
Reg. §25.2702-3(b)(1)(i).
C. Must provide for adjustments for incorrect valuations if annuity amount is stated as a
fraction or percentage of the initial fair market value of the property contributed.
Treas. Reg. §25.2702-3(b)(2).
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D. Must provide for proration of annuity amount for any short taxable year. Treas.
Reg. §25.2702-3(b)(3).
E. Must prohibit additional contributions to the trust. Treas. Reg. §25.2702-3(b)(5).
F. Must prohibit distributions to or for the benefit of any person other than the donor
during the term of the annuity. Treas. Reg. §25.2702-3(d)(2).
G. Term of the annuity interest must be for the life of the term holder, a specified
number of years or for the shorter (but not the longer) of those periods. Treas. Reg.
§25.2702-3(d)(3).
H. Must prohibit commutation of the donor's interest. Treas. Reg. §25.2702-3(d)(4).
I. Must prohibit the use of a promissory note, other debt instrument, option or other
similar arrangement to satisfy annuity amount. Treas. Reg. 25.2702-3(d)(5)(i).
III. Valuation Issues
A. The creation of a GRAT constitutes a gift to the ultimate beneficiaries for gift tax
purposes, but the value of that gift is only the initial value of the assets transferred to
the trust reduced by the present value of the annuity the grantor has retained.
1. Prior to the Walton case (discussed below), if the grantor made a large
transfer to a GRAT, a substantial gift tax could be payable because the most
a grantor could retain as a "qualified interest" under Example 5 of Treas.
Reg. Section 25.2702-3(e) was an annuity for the shorter of the term of the
GRAT and the grantor’s death. This possibility that the grantor could die
before the term of the GRAT ends results in the remainder always having
some value for gift tax purposes. With large transfers, even though a gift tax
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might be payable, if the assets contributed to the trust did not increase in
value, nothing would be transferred to the beneficiaries.
2. Example: A 75 year old grantor transfers $2,000,000 to a GRAT for a
2-year term, reserving an annuity of $1,084,760 (54.238%)
per year. Assuming a Section 7520 rate of 5.6%, the value of
the grantor’s retained annuity should be $1,999,972.01 and
the value of the remainder interest should be $27.99. Using
Example 5, the value of the grantor's retained interest would
be $1,917,855.68 and the remainder (i.e., the gift) $82,144.32.
3. Revenue Ruling 77-454 - Even assuming Example 5 is valid, in theory the gift
in the above example could be reduced by increasing the size of the annuity.
However, Revenue Ruling 77-454 and Treas. Reg. 25-7520-3(b)(2)(v) stand
for the position that the trust assets have to be sufficient to make all the
possible annuity payments assuming a rate of return equal to the Section
7520 rate on the date of the transfer. This prevents increasing the annuity
rate and makes it impossible to "zero-out" a GRAT if Example 5 is valid.
4. Revocable spousal annuity - Prior to 1977, if a grantor did not want to take a
position contrary to Example 5, it was possible to reduce the gift tax payable
on the creation of the GRAT by having the grantor give his or her spouse the
right to the unpaid annuity at the grantor's death if he or she died before the
GRAT term ended. The grantor retained the right to revoke this continuing
annuity. Treas. Reg 25.2702-2(d)(1) states that an annuity payable to the
grantor’s spouse will be considered retained by the grantor if it is subject to a
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right of revocation by the grantor. By structuring a GRAT in this fashion,
one could substantially decrease the gift tax payable on creation. In 1993 and
1994, a number of private letter rulings2 approved this technique of reducing
the value of a remainder interest in a GRAT.
a. In 1997, a number of Technical Advice Memoranda took a position
counter to the prior private letter rulings.
b. In 1999, the IRS modified several private letter rulings consistent with
the TAM.3
c. In Cook v. Comm'r, 115 T.C. 15 (2000), aff’d 88 AFTR2d 2001-
6485 (CA-7, 2001), the Court held that a spousal revocable annuity
interest commencing upon the death of the grantor before the
termination of the fixed term of his or her annuity interest does not
reduce the taxable gift resulting from the creation of the GRAT.
d. The Tax Court decided a second spousal revocable annuity interest
case by following Cook in Patricia M. Schott, 81 TCM 1600 (2001).
The Ninth Circuit, reversing the Tax Court in Schott v. Comm'r, 9th
Circuit, No. 02-7007 (Feb. 18, 2003), held that an annuity retained by
the grantor followed by a spousal revocable annuity interest
commencing upon the death of the grantor before the termination of
2
Letter Rulings 9352017, 9449012, 9449013, 9448018
3
See for example Letter Ruling 19951031 modifying 9449012 and Letter Ruling
199937043 modifying 9352017
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the fixed term of his or her annuity interest is a qualified interest and
will reduce the taxable gift resulting from the creation of the GRAT.
B. The Walton Decision
1. In Audrey J. Walton v. Comm'r, 115 T.C. 589 (2000), a unanimous en banc
opinion, held Example 5 "an unreasonable interpretation and an invalid
extension of section 2702."
2. The Court held that in valuing the remainder interests for the GRATs in
Walton (which had been drafted to provide for the annuity to be paid to the
grantor, or her estate, for 2 years regardless of whether she survived the
GRAT term), the fact that the grantor could possibly die during the GRAT
term was to be ignored.
a. Accordingly, a GRAT now may be "zeroed out" with no taxable gift.
3. The government has not appealed the Walton decision nor has it acquiesced
in it.
IV. Drafting GRATs Today
A. Walton can be a blueprint for drafting GRATs today.
1. While you can still draft a GRAT for a fixed term of years or the sooner
death of the grantor, it may not make sense to do so because the gift cannot
be "zeroed-out."
B. In Walton, the grantor created 2-year GRATs with the second year annuity payment
equal to 120 percent of the first year annuity payment. If the grantor died during the
term, the remaining annuity payments were to be made to her estate.
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1. The annuity payments MUST continue to be paid to the grantor’s estate until
the end of the GRAT term.
2. If in lieu of continued annuity payments, the GRAT terminated with all of its
assets passing to the grantor’s estate, the reversion would not be valued as a
qualified interest under Section 2702. Accordingly, do NOT use this
approach.
C. Do not have the remainder of the GRAT pass to the grantor's estate (or pass
pursuant to a general power of appointment held by the grantor) if he or she dies
during the term of the GRAT.
1. The IRS might contend that, if the remaining annuity payments and the
remainder are left to the grantor's estate, a "merger" occurs resulting in the
remaining annuity payments being considered contingent and not treated as
retained by the grantor for valuation purposes.
D. Use a percentage formula to describe the annuity amount - If the annuity amount is
expressed as a percentage of the initial value of the trust principal, rather than a
specific dollar figure, any increase in the value of the assets contributed to the GRAT
determined on the audit of the gift tax return would result almost entirely in an
increase in the value of the retained interest and, in turn, in only a nominal gift tax
increase.
E. Short term GRATs are often more advantageous than longer term GRATs
1. Reduces risk of grantor's death during the GRAT term.
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2. Reduces the possibility that poor investment performance in one year will
"eat into" good performance in another year in order to satisfy the annuity
payments.
F. Marital Deduction Issues -
1. Typically, if the grantor is married and dies during the term of the GRAT, he
or she wants to avoid estate taxation by having the GRAT assets qualify for
the marital deduction.
2. Both the continuing annuity payments and the remainder must qualify for the
marital deduction.
3. Outright Marital Disposition - The easiest way to qualify for the marital
deduction is to provide for an outright marital deduction should the grantor
die prior to the termination of the GRAT term. In this case, the GRAT
should provide that:
a. The annuity will be paid to the grantor's estate (or revocable trust)
and provide in the grantor’s will or revocable trust for the annuity
payments to be made directly to the grantor’s surviving spouse.
(1) The GRAT also should provide that any income earned by
the GRAT in excess of the annuity (unlikely in a short term
GRAT) should be paid to the grantor's estate or revocable
trust as well.
(a) It is unclear whether upon the death of the grantor
during the GRAT term the amount included in his or
her estate is determined under Code Section
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2036(a)(1) or Section 2039. If inclusion is pursuant
to Section 2036(a)(1), providing for excess income to
be paid out as well ensures marital deduction
treatment.
(b) Treas. Reg. 25.2702-3(b)(1)(iii) permits the
distribution of excess income.
b. The remainder will be paid directly to the surviving spouse from the
GRAT.
4. Marital Disposition in QTIP Trust -
a. To qualify the remaining annuity payments and excess income
distributions for the marital deduction, they should be payable to a
QTIP trust under the grantor’s will or revocable trust. The QTIP
trust should provide that any distributions from the GRAT must be
characterized as income or principal in the same manner as
characterized by the GRAT itself in order to satisfy marital deduction
requirements.
b. The remainder should be distributed to a QTIP trust in one of the
three ways:
1. Establish a QTIP trust in the GRAT itself. It should not be
payable to the same trust as the annuity payments or the
merger issue discussed in IV.C.1. above might arise.
2. Establish a QTIP trust as a separate inter-vivos trust.
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3. Reserve to the grantor a special testamentary power of
appointment if the grantor dies prior to the termination of his
or her annuity interest. The grantor can exercise the power in
favor of the QTIP trust under his or her will, or, in default of
such exercise, the property can pass to the QTIP trust or to
the remaindermen of the GRAT.
a. Although reserving a special power of appointment
will cause inclusion of the full value of the property
remaining in the GRAT in the grantor's gross estate if
he or she dies during the fixed term, in a short-term,
zeroed-out GRAT, the entire value of the remaining
property will probably be includable in the grantor's
estate because of the high payout percentages.
b. The power of appointment adds an element of
flexibility for the grantor to bypass the spouse.
c. As long as the power of appointment is special, there
should be no merger issue as discussed in IV.C.1.
above.
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