Use of notes with GRATs or GRUTs.

The IRS's recent responses in Letter Rulings (TAMs) 200010010 and 200011005, involving a grantor retained annuity trust (GRAT), may have broader implications than one might think.

Last year, the Service issued proposed regulations on the use of notes and other similar arrangements to satisfy the annuity and unitrust obligations of a GRAT and a grantor retained unitrust (GRUT). According to the proposed regulations, retained interests in trusts created after Sept. 20, 1999 (the effective date for the proposed regulations) capable of being satisfied by notes or similar arrangements are no longer considered "qualified interests" under Sec. 2702. In addition, trust instruments must now contain a clause specifically prohibiting the use of notes and other similar arrangements to satisfy the trust's annuity or unitrust obligations. Transition rules are provided for trusts created before the effective date of the proposed regulations.

The IRS believes these modifications to the regulations are necessary to ensure that, when a donor transfers property and retains an interest therein, the value of the donor's retained interest is "readily" ascertainable. According to the Service, delaying payment through the use of a note (described as merely a promise to pay in the future) alters the true value of the transferor's retained interest.

In response, practitioners have proposed two alternative arrangements to comply with the new mandates. A GRAT/GRUT could sell its property to a third party for installment notes and transfer these notes to a donor in satisfaction of its obligation. Equally feasible, a GRAT/GRUT could pledge its property as collateral for a loan and use the loan proceeds to satisfy its obligation. Because of the involvement of a third party, both alternative arrangements lessen the possibility of collusion between the donor and the trust and should make valuations more accurate. Moreover, both arrangements seem to provide a fair and workable solution for trusts facing cashflow problems.

However, practitioners have already pointed out that the preamble to the proposed regulations implies that neither of these arrangements is really viable. In both arrangements, the GRAT/GRUT continues to use a note to meet its payment obligation, thus violating the intent of the proposed regulations. The note's use in the second alternative is one step removed, but the preamble to the proposed regulations clearly states that the IRS will apply the step-transaction doctrine when more than one step is used to avoid the technical application of the regulations. Nonetheless, some practitioners continue to believe that the Service does not intend such literalism. Consequently, they argue that at least the second alternative mentioned should satisfy the proposed regulations, as long as the circumstances surrounding the use of the note are not otherwise abusive.

At present, however, based on two recent rulings, even the second alternative may not be viable. Simplifying the facts somewhat, in TAMs 200010010 and 200011005, a taxpayer transferred stock in a closely held corporation to a GRAT and named trusts for the benefit of two nephews as remainder interest holders. The GRAT's only asset was the closely held stock; thus, to make the annuity payments, the GRAT borrowed money from a second trust. As each annuity payment became due, a loan document with the second trust was executed, stipulating the loan was due in one year with interest. However, rather than paying these loans as contracted, each loan was extended for another year and the current year's borrowing was added to it. This continued throughout the annuity period, and the stock was ultimately transferred to the remainder trusts subject to the outstanding loan. Based on these facts (and presumably relying on Sec. 677(a)), the Service ruled that a GRAT was a wholly owned grantor trust, and, as such, its assets and liabilities were treated as the taxpayer's assets and liabilities for income tax purposes. Thus, when the GRAT transfers the closely held stock and the associated liability to the remainder trusts (i.e., separate taxable entities), the IRS considers the taxpayer as having disposed of the closely held stock to the remainder trusts, and the amount realized includes the liabilities from which the taxpayer is discharged as a result of the disposition.

These rulings demonstrate that the second alternative likely would require the donor to recognize income if the annuity period or unitrust period expired before all of the loans incurred by the GRAT/GRUT were repaid. Further, these rulings appear to extend to all debts incurred by a GRAT/ GRUT during the underlying annuity or unitrust period--not just those debts incurred specifically to satisfy the annuity or unitrust payment.

Some practitioners argue that if a GRAT/GRUT borrows from a third party and uses the proceeds to satisfy an annuity or unitrust payment, such borrowing should not violate the proposed regulations. However, as illustrated in TAMs 200010010 and 200011005, if a GRAT/GRUT does borrow from a third party, there may be negative income tax consequences associated with such borrowing, whether the loan is incurred to pay the annuity or unitrust payment or for some other reason.

(Author's note: The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG LLP.)

FROM RUSSELL SANDERS, J.D., LL.M., WASHINGTON, DC