Final Regs. on GRAT/GRUT qualified interest determinations.

The Service has issued final regulations (TD 8899) for determining whether a retained interest in a grantor retained annuity trust (GRAT) or a grantor retained unitrust (GRUT) is a qualified interest under Sec. 2702(b). The final regulations provide that the issuance of a note, other debt instrument, option or other similar financial arrangement, directly or indirectly, in satisfaction of an annual payment obligation, does not meet Sec. 2702(b)'s requirements.

The final regulations became effective on Sept. 5, 2000, adopting, with modifications, the proposed regulations published on June 22, 1999.

Background

Sec. 2702 applies to a transfer in trust that benefits a family member when a grantor retains an interest in the property transferred. If Sec. 2702 applies to a transfer, the value of the grantor's retained interest is zero for gift tax purposes (treating the grantor as making a gift of the entire value of the property), unless the retained interest is a "qualified interest"

A qualified interest includes (1) a right to receive, at least annually, fixed payments (a qualified annuity interest) and (2) a right to receive, annually, a fixed percentage of the trust corpus determined annually (a qualified unitrust interest).

Trustee May Borrow from Unrelated Party

Under the proposed regulations, the issuance of a note, other debt instrument, option or similar financial arrangement does not constitute a payment of the annuity or unitrust amount to a grantor as required by Sec. 2702. In addition, a retained interest is not a qualified interest under Sec. 2702, unless the trust instrument expressly prohibits the use of notes, other debt instruments, options or similar financial arrangements.

The final regulations acknowledge that a trustee may borrow required funds from an unrelated party to make a payment. However, the step-transaction doctrine will apply to a series of transactions used to achieve a result inconsistent with the regulations. For example, if a trustee borrows cash from a bank to make a required annuity payment and borrows cash from the trust's grantor to repay the bank, the transactions are combined as if the trustee issued a note for the annuity amount directly to the grantor. In the final regulations, the words "directly or indirectly" clarify this point.

The final regulations also clarify that a trust instrument provision expressly prohibiting the use of notes to satisfy the annual payments is not required for trusts established before Sept. 20, 1999. However, a retained interest in a trust established before that date is not a qualified interest if (1) notes are used after Sept. 20, 1999 to satisfy a payment obligation or (2) any notes issued to satisfy the annual payment before Sept. 21, 1999 were not fully paid by Dec. 31, 1999.

Proration 

The final regulations clarify the rules covering the period on which the annual payment must be based and the proration of the annuity or unitrust amount for short periods. The annuity or unitrust amount need not be payable based on the trust's tax year. Rather, it may be payable annually or more frequently (e.g., monthly, quarterly or semi-annually) based on the anniversary date of the trust's creation. In 1994, the language of the regulations was amended by TD 8536 to permit this type of payment, but the subtle change still resulted in confusion; the IRS took this opportunity to clarify the matter. For example, a trust providing for an annuity interest created on May 1 is not required to make payments based on the trust's tax year. Instead, the entire annual payment may be made by April 30 of each succeeding year of the trust term.

Grace Period

Although not mentioned in the preamble, Regs. Sec. 25.2702-3(b) (4) alters the long-standing rule that an annuity amount may be paid after the close of the tax year, provided the payment is made no later than the date by which the trustee is required to file the mast's Federal income tax return for the tax year (excluding extensions). This "grace period" is now available if an annuity amount is "payable based on the taxable year of the trust." The regulations confirm that the Service believes the additional time for payment should only be available if the payment is due at the end of the tax year. This reflects the IRS's concern that a payment might be unduly prolonged when a GRAT has an anniversary date annuity payment and a calendar-year tax year.

Recommendations

For GRATs or GRUTs created after Sept. 19, 1999, a trust document must expressly prohibit a trustee from issuing a note, other debt instrument, option or similar financial arrangement in satisfaction of the annuity or unitrust obligation. Notably, a qualification of a trust as a GRAT or GRUT under Sec. 2702 is relevant only for girl tax purposes. Therefore, once the statute of limitations expires on a gift tax return reporting a transfer, it is generally irrelevant whether the retained interest is a qualified interest under Sec. 2702.

FROM ROBERT COPLAN, WASHINGTON, DC