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Tax Law Update: February 2022

David A. Handler and Alison E. Lothes highlight the most important tax law developments of the past month.

• GRAT invalidated due to misplaced reliance on appraisal—In Chief Counsel Advice (CCA) 202152018, the Office of the Chief Counsel held that the taxpayer’s reliance on a valuation dated seven months prior to funding a grantor retained annuity trust (GRAT) wasn’t reasonable given the potential sale of the company for a higher value.

The taxpayer funded a GRAT in the middle of the year with shares of stock in a successful company. At the end of the prior year, the company had explored with investment advisors whether to sell to outside buyers. On the date the GRAT was funded, there were five open offers from other companies. The company continued to consider other offers as several of the bidders raised their offer prices.  

Meanwhile, the taxpayer funded the GRAT and calculated his retained interest based on a valuation obtained for reporting requirements for nonqualified deferred compensation purposes under Internal Revenue Code Section 409A as of the end of the prior year (about seven months before the GRAT funding date).

Ultimately, the company accepted an offer, and the taxpayer tendered a portion of his shares for three times the value set by the appraisal used for the GRAT. A year later, the balance of the company was sold for a price four times that of the appraisal.

The CCA recites the standard for valuing property for gift tax purposes under IRC Section 2512: the price at which such property would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts. Both parties are presumed to investigate reasonable facts, and “reasonable knowledge” includes facts that would be discovered during a negotiation, even if that information isn’t publicly available. Events that occur after the date of valuation may be considered if they were reasonably foreseeable as of that date. The value is a question of fact, and all relevant evidence must be considered.

The taxpayer argued that the appraisal was valid because it was only six months old and business operations hadn’t materially changed during that 6-month period. The Chief Counsel didn’t agree and cited several other cases in which mergers and corporate transactions occurring after the valuation date were considered in assessing the value of the shares because the willing buyers/willing sellers would have been aware of the significant negotiations taking place.

According to the CCA, the taxpayer’s intentional reliance on the outdated appraisal of the company when the company had received offers for purchase based on higher prices was misleading at best. GRATs are subject to special valuation rules set out in IRC Section 2702. To qualify as a GRAT under Section 2702, the taxpayer must retain an annuity of a fixed amount (either a fraction or percentage) of the initial fair market value (FMV) of the property used to fund the GRAT.  

Typically, taxpayers take comfort in the automatically adjusting feature of GRATs: If there’s a change in value of the initial gift, the GRAT self-adjusts the annuity due to the formula used to calculate the annuity payments, which is typically expressed as a percentage of the value contributed to the GRAT. However, in this case, due to the massive undervaluation of the property used to fund the GRAT, which ignored significant facts affecting value, the Chief Counsel determined that the annuity actually paid had no relation to the initial FMV of the GRAT. The intentional and egregious nature of the undervaluation was so significant that the Chief Counsel held there was an “operational failure” that was fatal to the GRAT, which apparently precluded adjustment. The Chief Counsel may have also been bothered by the fact that the taxpayer created a charitable remainder trust a few months after the GRAT for which it obtained a separate appraisal at a much higher value than that used for the GRAT, providing the taxpayer a higher tax deduction.

It seems the Chief Counsel could have reached a less drastic conclusion: that the GRAT was funded with a greater value than claimed, the annuity payments were based on a lower value and, as a result, the taxable gift on creation of the GRAT was greater. Instead, the CCA claims the annuity wasn’t a fixed percentage of the amount contributed but was based on a much lesser amount and, therefore, was invalid. 

• Electronic records retention period shortened from 75 years to 40 years—The Internal Revenue Service has announced on its website that it’s reducing the length of time it will hold estate tax returns and related gift tax returns on file from 75 years to 40 years. 

Taxpayers may want to request older estate tax returns before they’re destroyed, especially those returns that include related attachments such as appraisals, gift tax returns and other documents.  After Feb. 12, 2022, the IRS will no longer provide copies of returns more than 40 years old.

To obtain a copy of a tax return, use IRS Form 4506, Request for Copy of Tax Return and submit it (with the fee). 

• IRS issues 2022 inflation adjustments—For 2022, the unified credit amount, generation-skipping transfer tax exemption and annual exclusion gift amount are all adjusted upward for inflation as follows:

  • Annual gift tax exclusion gifts (IRC Section 2503) increase to $16,000 (up from $15,000).
  • Gift, estate and GST tax exemption amounts are $12.06 million for 2022 (up from $11.7 million).
  • Annual exclusion for a non-citizen spouse (Sections 2503 and 2523(i)(2)) is up to $164,000 (up from $159,000).
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