Revisiting promissory notes to pay a GRAT's annuity amount.

Tax advisers strive to devise strategies to aid clients in accomplishing their personal and financial goals with minimum tax cost. One technique with potential for significant transfer tax savings is the grantor retained annuity trust (GRAT). In order to avoid onerous gift tax consequences and achieve its objectives, a GRAT for the benefit of the settlor's family must meet the requirements for a "qualified interest" under Sec. 2702.

Tax advisers must be careful to ensure that GRAT documents meet the technical requirements of Sec. 2702 and the regulations thereunder so that the interest retained by the grantor constitutes a "qualified interest." Under Sec. 2702(a), for gift tax purposes, the value of a retained interest in property transferred in trust to, or for the benefit of, a family member (as defined in Sec. 2704(c)(2) is zero, unless such interest is a qualified interest (as defined in Sec. 2702(b)). Therefore, without a qualified interest, the gift tax value of such a transfer is the property's full fair market value (FMV) without reduction for the retained interest.

Sec. 2702(b)(1) provides that a qualified interest includes the right to receive fixed amounts payable not less frequently than annually (a "qualified annuity interest"). Regs. Sec. 25.2702-3 contains the following requirements for such an interest:

* The interest must consist of an irrevocable right to receive a fixed amount, which could be a stated dollar amount or a fixed percentage or fraction of the initial FMV of the property transferred to the GRAT.

* The fixed amount must be payable to, or for the benefit of, the interest holder for each tax year of the GRAT.

* The governing instrument must contain provisions that:

1. Prohibit distributions to any person other than the qualified annuity interest holder;

2. Fix the term of the GRAT;

3. Prohibit commutation (prepayment) of the annuity amount;

4. Prohibit additional contributions to the GRAT;

5. Satisfy Regs. Sec. 1.664-2(a)(1)(iii) (adjustments for incorrect determination of FMV), when the annuity is stated in terms of a fraction or percentage of the initial FMV of the property transferred to the GRAT; and

6. Satisfy Regs. Sec. 1.664-2(a)(1)(iv) (computation of the annuity amount in case of short tax years and the GRAT's last year).

Clients are generally advised to fund a GRAT with assets that they anticipate will generate the highest return over the trust term in order to obtain the greatest transfer tax leverage. The leverage arises from earning a rate of return in excess of the interest rate used to value the gift (the Sec. 7520 rate). For many clients, interests in partnerships and corporations that generate little or no current cash flow are often the assets that provide the maximum return potential in the form of appreciation in value. Consequently, clients are confronted with the problem of how the GRAT will pay the annuity amount. The annuity amount can be paid with cash or property. However, using appreciating property runs counter to the intention of establishing the GRAT, which is to transfer as much future value as possible to heirs at the least tax cost. The transfer of highly appreciable property back to the grantor in order to make the annuity payments puts value back into the grantor's estate.

In an attempt to retain appreciating property in the GRAT for eventual transfer to the remaindermen, some practitioners have used promissory notes issued by the GRAT to pay the annuity amount (or part thereof). Neither the statue nor the regulations address the issue of whether the use of a promissory note jeopardizes the annuity's status as a qualified interest under Sec. 2702(b). Many practitioners believe that using a note would constitute economic payment and not cause disqualification if the note is negotiable, bears interest at a market rate, is payable on demand and is secured by the GRAT's assets.

In Letter Ruling (TAM) 9604005, the IRS launched its first salvo at the use of notes to satisfy GRAT annuity payments. A husband and wife had established several GRATs each, with terms ranging from two to 14 years. The husband was sole trustee of all of the GRATs and the couple's children were the remaindermen. All of the GRATs were funded with shares of a closely held corporation that historically paid no cash dividends. Consequently, distributions of shares of corporate stock would be necessary to satisfy payment of the qualified annuity amounts, and such distributions would necessitate appraisals to determine the number of shares required to be transferred back to the grantor.

To avoid the need for appraisals and retain stock in the GRAT, each donor established an administrative trust to coordinate payment of their respective annuity amounts. At the time annuity payments were due, the donors would loan their respective administrative trust an amount necessary to make the annuity payments. The husband, as trustee, would cause the GRATs to borrow the funds and execute promissory notes for each GRAT in favor of the donors. Finally, the loan proceeds were then paid to the donors by the GRATs in payment of their annuity amounts. Initially, the notes did not carry any interest. Only after the Service initiated an examination were the notes repaid with interest.

The IRS held that because this strategy really deferred payment of the annuity amounts, the donors' retained interests did not constitute qualified interests, even though the express terms of the GRAT agreements satisfied the requirements of Sec. 2702. TAM 9604005 focused on an interpretation of the donors' intentions relative to payment of the annuity amounts. The Service believed it was clear from the facts that the GRATs would not have sufficient cash flow to pay the annuity amounts (in view of the corporate history of no cash dividends). Further, the IRS felt that the trustee would not distribute shares of stock in payment of the annuity amounts, because it would reduce the benefits of establishing the GRATs. Thus, the Service determined that there was never an intention that the annuity be paid either in cash or in kind, and that promissory notes were the intended payment mechanism from inception. In the IRS's view, the intended deferral of actual receipt of payment could not be characterized as the right to receive a fixed amount payable annually or more frequently.

In TAM 9604005, the Service also emphasized the lack of interest on the notes. Although it agreed with the taxpayers that an interest provision would have little effect for income tax purposes (since the GRATs were grantor trusts), it properly asserted that the donors were adversely affected in an economic sense (since they were not compensated for postponing their enjoyment of the annuity amounts). The donors also argued that the annuity payments were actually paid in cash. However, the IRS held that the circular cash flow had no economic substance, since the donors had the same amount of cash before and after payment of the annuity amounts.

Although this TAM is not binding precedent, it does reflect the Service's view that in these circumstances issuance of promissory notes does not constitute valid payment so as to satisfy the intent of Sec. 2702(b). Prudent advisers should think twice before advising clients to use promissory notes in satisfaction of a GRAT annuity payment.

Perhaps a better way to finance the payments would be for the GRAT to borrow from an unrelated third party. Unfortunately, the absence of cash flow for debt service and other factors may make this approach unavailable. In addition, there would be an interest cost that would have to be factored into the overall return calculation. The interest expense would be personal interest for which no income tax deduction would be allowed.

TAM 9604005 should be compared to Letter Ruling 9515039, in which the IRS ruled that in a situation involving a joint purchase, a note issued in satisfaction of the life tenant's annuity would not disqualify the life estate from being a qualified interest in certain circumstances. The note in this earlier letter ruling was a demand, interest-bearing note guaranteed by the remainderman with full recourse to her independent assets. The Service ruled that use of a note in satisfaction of an annuity payment is permissible if the remainderman and/ or guarantor possesses sufficient independent wealth to assure payment. (The ruling did not indicate what represented sufficient wealth.) It is not known whether the IRS's position in Letter Ruling 9515039 has changed in view of its analysis in TAM 9604005.

As a result of the uncertainty involved with the use of notes, the cautious approach would be to pay a GRAT's annuity amount only with cash or property. While annual valuations and distributions of property are often an administrative and costly headache, the transfer tax benefits of using a GRAT with rapidly appreciating assets often outweigh these disadvantages.