IRS takes position that GRATs cannot be zeroed out.

Since the enactment of Sec. 2702, if a grantor wants to reduce the gift tax value of property transferred to a split-interest trust, the retained income interest must generally be an annuity or a unitrust interest. For example, a parent could transfer closely held stock (or other assets expected to appreciate) to a grantor retained annuity trust (GRAT) retaining a right to receive a fixed annuity for a term of years, following which the property would go to his children. The gift tax value of the remainder interest equals the value of the property transferred to the trust reduced by the actuarial value of the retained annuity interest,

Planners initially believed that the GRAT presented a golden opportunity to "zero out" the amount of the gift, thereby making the transaction a no-lose proposition from a transfer tax perspective. Specifically, it seemed apparent that by increasing the annuity payout rate and the trust term in the right combination, the present value of the annuity would increase to the point where it equaled the value of the property. When this happened, the gift tax value of the remainder theoretically dropped to zero. However, in Letter Ruling 9239015 the IRS has taken the position that zeroed out GRATs cannot be done.

Valuing the GRAT annuity

The present value of a term-of-years annuity is generally determined by multiplying the annuity's dollar amount by an actuarially determined annuity factor. The annuity factor is dependent on (1) the trust term, (9,) the Sec. 7520 rate and (3) the frequency of the payout (e.g., annual, quarterly). Proposed regulations were recently issued under Sec. 7520 that provide guidance and tables for valuing term interests and remainders in property. The relevant tables are also contained in Publication 1457. Essentially, Sec. 7520 dictates the rate of return that assets in a split-interest trust will be assumed to earn over the trust term. The rate for transfers made during a given month appears in Table V of the AFR revenue ruling issued around the twentieth of the preceding month.

Transfer tax benefits may be obtained with a GRAT if the assets in the trust actually produce a total return (yield plus appreciation) in excess of the rate of return actuarially assumed under Sec. 7520. If the trust assets outperform the Sec. 7520 rate, the present value of the assets actually passing to the remainderman at the end of the trust term will be greater than the gift tax value of the remainder.

The IRS view

Regs. Sec. 25.2702-31eL Example II) appears to take the position that the value of a retained annuity interest for gift tax purposes is based on the right to receive the annuity for the fixed term or until the death of the annuitant, whichever comes first. Thus, the planner cannot zero out the value of the remainder with an annuity whose present value is determined using Table B of Publication 1457 (i.e., a "straight" term of years annuity). The Service will apparently argue that a gift always results because the retained annuity's value must incorporate the probability of the grantor's death during the GRAT term.

Letter Ruling 9239015 expresses the IRS theory as to why the practitioner cannot reestablish the zero-out result simply by increasing the annuity payout enough so that the annuity value (taking the probability of death into account) equals the value of the property transferred. Relying on Rev. Rul. 77-454, the letter ruling held that when the fixed annuity to be paid from a trust will exhaust the corpus of the trust before the end of the trust term, the value of the retained annuity is the present value of the right to receive the payments until the fund is exhausted or until the prior death of the annuitant, rather than the value computed from the actuarial tables based on the stated term of the trust.

Example: Grantor G, age 60, transfers stock with a value of $1,000,000 to a 10-year GRAT when the Sec. 7520 rate is 7.4% (the rate/or December 1992). The annuity is set at 14.502% of the trust corpus, or $145,020, to be paid annually at the end of the year. The value of this annuity (using Table B of Publication 14571 is $999,985. However, if the annuity is valued based on the first of the 10-year term or G's death, it is worth only $927,171, resulting in a gift of $72,829. If the annuity amount were increased above $145,020 in an attempt to get the annuity's value to equal the trust property, the trust corpus would be actuarially exhausted before the end of the 10-year term.

It may still be possible to get quite close to a zeroed out GRAT by having a married grantor give (subject to a retained power to revoke) his spouse the right to receive the GRAT annuity for the balance of the trust term if the grantor dies during the term. Examples (6) and (7) of Regs. Sec. 25.2702-2(d) indicate that this revocable contingent spousal annuity is to be treated as a qualified retained interest along with the grantor's annuity under Sec. 2702. If this interpretation is sustained, the advantage would be that the retained annuity increases in value when based on the GRAT term or sooner death of both of two spouses. The power to revoke retained by the grantor should prevent the spousal contingent annuity from being a completed gift for gift tax purposes. If successful, this approach can permit the remainder value in many GRATs to be reduced to less than 1% of the value of the transferred property.

From Robert B. Coplan, Esq., Washington, D.C.