One of the most common estate and gift tax arrangements used is the grantor retained annuity trust (GRAT). In determining the value of the gift of a successor interest in property (such as a remainder interest) passing to or for the benefit of a member of the transferor’s family (defined in Internal Revenue Code Section 2702(d)), IRC Section 2702 generally disallows a reduction for the value of an interest in the gifted property retained by the transferor. For example, if a property owner retains an income interest in an asset given to his child, the value of the gift is the value of the asset transferred, undiminished by the value of the income interest retained. However, Section 2702 provides that traditional tax (actuarial) valuation will apply if the transferor retains an annuity interest in the property. Accordingly, the actuarial value of an annuity interest in a GRAT may be subtracted from the value of the property transferred, thus reducing the value of the taxable gift to the actuarial value of the remainder interest.
A GRAT must be drafted to comply with the requirements set forth in the applicable Treasury Regulations under Section 2702. Unfortunately, the regulations don’t resolve all issues, such as whether there’s a minimum or maximum term for a GRAT, or whether a GRAT remainder interest must have a minimum value. Another uncertainty is the consequence, if any, of a GRAT that isn’t administered in accordance with its terms.
For example, the GRAT annuity must be paid within 105 days of its due date.1 In Atkinson v. Commissioner2, the U.S. Tax Court stated that a lifetime charitable remainder annuity trust (CRAT) includible in the decedent’s gross estate wasn’t a “qualified” CRAT under IRC Section 664 because no annuity payments were made to the decedent-annuitant during her lifetime even though the trust agreement required such payments to be made. In affirming the Tax Court, the U.S. Court of Appeals for the Eleventh Circuit stated, “Accordingly, since the CRAT regulations were not scrupulously followed through the life of the trust, a charitable deduction is not appropriate.” Thus, a perfectly drafted CRAT lost its charitable deduction because the trustees failed to administer the trust in accordance with its terms. The court implied that a CRAT that fails to make any distributions to the annuitant creates an unfair income tax advantage because funds aren’t being distributed to the taxpayer and subjected to current income taxation. In addition, a CRAT that accumulates all its assets is an end-run around the private foundation rules because even a private foundation is required to make minimum contributions to charity annually. A CRAT that fails to make annuity payments, but retains its tax-exempt status, gains an unfair income tax advantage without providing current benefits to charity.
Ensure Payments Are Made
Although the policy issues relating to CRATs and GRATs may be different, the IRS in audits has contended that, when the annuity isn’t paid within the 105-day grace period, the GRAT fails to qualify and the entire value of the property transferred to the GRAT is subject to gift tax.
Different approaches have been developed to ensure that the GRAT annuity will be treated as paid within the 105-day grace period set forth in Treas. Regs. Section 25.2702-3(b)(4). One approach is to terminate the trust as to a fraction, the numerator of which is equal to the value of the annuity payment and denominator of which is equal to the value of the trust estate. Another is to provide that a portion of the trust sufficient to satisfy the annuity vests in the grantor or the grantor’s estate.
Consider Sample Language
The following language may be considered:
Payments to Vest. If any portion of the annuity payable to the Grantor or the Grantor’s estate, as the case may be, on a particular date is not distributed in its entirety by the Trustee to the Grantor or the Grantor’s estate, as the case may be, by the end of the last day (the “Annuity Amount due date”) on which it must be paid in order for the Annuity Amount to be treated as a Qualified Interest, including any applicable grace period (such unpaid portion of the Annuity Amount being hereinafter sometimes referred to as the “undistributed Annuity Amount”), then, at the end of the Annuity Amount due date, the Annuity Property (as hereinafter defined) held by the trustee shall vest absolutely in the Grantor or the Grantor’s estate, as the case may be. The trust shall immediately terminate as to the Annuity Property, and the Trustee, in the Trustee's capacity as Trustee, shall have no further duties, power, authority or discretion to administer the Annuity Property notwithstanding any provision of applicable law or this Agreement to the contrary. If the Annuity Property shall remain in the hands of the Trustee after the Annuity Amount due date, the Trustee shall hold such property exclusively as nominee and agent for the Grantor or the Grantor’s estate, as the case may be. The Grantor hereby authorizes the Trustee, but only as nominee and agent for the Grantor or the Grantor’s estate, as the case may be, to invest the Annuity Property on the Grantor’s behalf or on behalf of the Grantor’s estate, as the case may be, with the same authority as the Grantor or the Grantor’s estate, as the case may be, could individually. The Trustee, both as Trustee and as such nominee and agent, is hereby relieved of any liability for commingling assets that have vested absolutely in the Grantor or the Grantor’s estate, as the case may be, with assets that remain part of the trust estate under this Article. Any Annuity Property that shall have vested in the Grantor as hereinbefore provided shall, upon the Grantor’s subsequent death, vest in the Grantor’s estate. For purposes of this Article, the term “Annuity Property” shall mean that a portion of the trust estate having a fair market value as finally determined for Federal gift tax purposes equal to the lesser of (x) all property held by the Trustee, in the Trustee's capacity as Trustee, at the end of the Annuity Amount due date or (y) the undistributed Annuity Amount. If the fair market value as finally determined for Federal gift tax purposes of the property then held by the Trustee is greater than the undistributed Annuity Amount at the end of the Annuity Amount due date, the Annuity Property shall consist of those assets having the lowest income tax basis as finally determined for Federal income tax purposes compared to their current fair market values as finally determined for Federal income tax purposes, and if more than one asset has the lowest basis for Federal income tax purpose, the Annuity Property shall consist of a proportionate share of each such asset. The Annuity Property shall include all income, appreciation and depreciation on all assets that are used to fund the Annuity Property and all other incidents of ownership attributed thereto.
- See Treasury Regulations Section 25.2702-3(b)(4).
- Atkinson v. Commissioner 115 T.C. 26 (2000), 309 F.3d 1290 (11th Cir. 2002), cert.denied 540 U.S. 946 (2003).