GRATs eligible for grantor trust status.

An essential requirement of every grantor retained annuity trust (GRAT) is that it be a wholly owned grantor trust under Secs. 671-677. When S stock is transferred to a GRAT, the trust must be a grantor trust in order to be a qualified S shareholder. But regardless of the type of property transferred to the GRAT, grantor trust status is necessary to prevent gain from being triggered when trust property is used to satisfy part or all of the annuity payment requirement. This result flows from Rev. Rul. 85-13, which is cited by the IRS for the principle that gain or loss is not recognized on transactions between a grantor and his own grantor trust.

Early GRAT letter rulings sought a grantor trust ruling under Sec. 675(4), based on a trust provision conferring on the grantor a nonfiduciary power to substitute property of equivalent value for trust property. However, while Letter Ruling 9352017 issued a "clean" Sec. 675(4) ruling, other GRAT rulings issued simultaneously and subsequently under Sec. 675(4) have contained a caveat: Grantor trust status will be dependent on a factual determination by the district director that the grantor's power is actually held in a nonfiduciary capacity; see, e.g., Letter Rulings 9352004 and 9416009. While not enough to stand in the way of the transactions, these factual caveats left many grantors and their advisers with an unsettled feeling.

Fortunately, the Service has begun issuing clean grantor trust rulings under Sec. 677, which should make it easier for all GRATs to qualify. The first such ruling appeared in Letter Ruling 9415012, in which the IRS held that an S corporation GRAT was a wholly owned grantor trust eligible to hold S stock. The ruling based its Sec. 677 grantor trust conclusion on the fact that the grantor's annuity would be payable out of trust income, and out of principal to the extent necessary. (Two very recent GRAT rulings that did not involve S corporations reached similar conclusions. These rulings were issued to taxpayers during September 1994 and would have been released by the Service during December 1994.)

Because there is no settled case law supporting grantor trust status for the corpus of a trust based on a retained annuity interest, advisers should not rely on a Sec. 677 theory contained only in letter rulings. Additional grantor trust provisions (such as a Sec. 675(4) power) should be included, and a letter ruling could be sought for the GRAT if absolute assurance is desired. This seems worth considering, in light of the fact that well after the release of Letter Ruling 9415012, caveated Sec. 675(4) grantor trust rulings were issued to taxpayers setting up S corporation GRATs in Letter Rulings 9437022 and 9437023.