Valuable planning opportunity available using GRATs or GRUTs.

The Chapter 14 valuation rules, although generally less onerous than the Sec. 2036(c) anti-estate freeze rules they replaced, have narrowed the transfer tax planning opportunities available for intrafamily transfers in trust in which the transferor retains an interest. Nevertheless, several valuable planning opportunities remain - among them, the use of grantor retained annuity trusts (GRATs) and grantor retained unitrusts (GRUTs). GRATs and GRUTs are not only favored over other trusts for gift tax purposes, but may also result in overall transfer taxes that are significantly lower than if no trust had been created. Clients who are searching for ways to transfer assets to younger generation family members at a reduced transfer tax cost should consider this exciting new planning technique.

Gift tax consequences

of GRATs and GRUTs

Sec. 2702 - zero-value rule: For purposes of the Chapter 14 valuation rules, which generally apply to transfers between certain family members, the value of a remainder interest in a trust is determined by subtracting the value of the retained interest from the value of the entire property transferred; thus, the higher the value of the retained interest, the lower the value of the remainder. However, under Sec. 2702(a)(2)(A), in determining whether a transfer of an interest in a trust to a family member constitutes a gift (and if so, the amount of the gift), the value of the interest retained by the transferor generally is zero, unless the retained interest is a "qualified interest." In other words, the transferor is treated as having made a gift of the entire value of the property transferred to the trust, regardless of the value of the retained interest.

GRATS and GRUTS under Sec. 2702: The zero-value rule does not apply if the retained interest is a qualified interest. A qualified interest generally is an interest in a GRAT or a GRUT or any noncontingent remainder interest if all the other interests in the trust are GRATs or GRUTs. A GRAT is an irrevocable trust in which the transferor retains the right to receive a fixed amount payable not less frequently than annually - essentially, a fixed annuity. A GRUT is an irrevocable trust in which the transferor retains the right to receive amounts that are payable not less frequently than annually, and that are a fixed percentage of the fair market value of the property in the trust, determined annually.

The value of a retained interest in a GRAT or a GRUT is determined from valuation tables issued by the IRS under Sec. 7520, using an interest rate equal to 120% of the Federal midterm rate for the month in which the valuation date falls. Thus, the value of a gift in trust in the case of a GRAT or a GRUT is the value of the entire property transferred to the trust, less the value of the retained interest determined under the appropriate Sec. 7520 valuation table. (The Sec. 7520 tables are published each month in the Internal Revenue Bulletin.) See Example 1 above.

Example 1: Determining the Value of a Gift in Trust

Father, F, transfers $1,000,000 to a GRAT, retaining the right to receive an annual annuity of 7% ($70,000) a year for 10 years, with the remainder to his children. The value of the gift of the remainder interest, based on a 9.6% Sec. 7520 rate, is $562,388, computed as follows.

Total amount transferred to trust $1,000,000

Less value of retained interest:

Annuity payment $70,000

Present value factor from Table B

    (IRS Publication 1457)                x  6.2516
                                                            437,612
  Value of gift                                          $  562,388

Assuming a combined Federal and state gift tax marginal rate of 55% F's gift of the remainder interest in trust would result in a total gift tax of $309,314.

Estate tax saving potential

A combination of three factors - the definition of adjusted taxable gifts, the credit for gift taxes paid, and two IRS rulings on computing the portion of a GRAT or GRUT includible in the gross estate of a transferor who dies during the trust term - appear to create a significant opportunity for saving transfer taxes through use of a GRAT or a GRUT.

If the transferor dies during the term of a GRAT, under Rev. Rul. 82-105, the amount includible in the transferor's gross estate is the amount of trust principal that would be necessary to generate the transferor's annuity amount, assuming an annual rate of return equal to the Sec. 7520 rate in effect at the transferor's death. That amount is calculated by dividing the annuity amount by the Sec. 7520 rate. Rev. Rul. 76-273 provides a similar rule for GRUTs. In addition, the ruling implied that the maximum amount includible under this rule was the entire value of the trust.

Example 2: Assume the same facts as in Example 1. Assuming that the Sec. 7520 rate is still 9.6% at F's death, the amount that would be includible in F's gross estate under Rev. Rul. 82-105 if he were to die during the 10-year trust term would be $729,167, computed as follows.

$70,000 annuity amount / 9.6% Sec. 7520 rate = $729,167

The transferor's estate tax is computed on the sum of the taxable estate (i.e., gross estate less allowable deductions) and adjusted taxable gifts - other than gifts includible in the decedent's gross estate (Sec. 2001(b), last sentence). Consequently, the amount of the earlier gift that resulted when the GRAT or GRUT was established should not be added to the taxable estate for purposes of computing the tentative estate tax (but see the cautionary comment below). On the other hand, there is nothing to prevent the estate from reducing the tentative tax by the full amount of gift tax paid on that gift. See Sec. 2001(b)(2) and the worksheet for line 9, Form 706, United States Estate and Generation-Skipping Transfer Tax Return.

Following the facts and calculations in Examples I and 2, on what amount is F's tentative estate tax computed? According to Sec. 2001(b), the tentative tax is computed on the sum of the taxable estate (i.e., gross estate less allowable deductions) and adjusted taxable gifts, other than gifts includible in the decedent's gross estate. F's gift of the remainder interest clearly is includible in his gross estate under Sec. 2036(a); thus, the original amount of that gift (i.e., $562,388) is not to be added to the taxable estate for purposes of computing the tentative estate tax. On the other hand, there is nothing to prevent F's estate from reducing the tentative tax by the full amount of gift tax paid on that gift (i.e., $309,314). See Example 3 above.

Example 3: Comparing an Outright Transfer With a GRAT Transfer

Assume the same facts as in Example 1 and 2, except that only a portion of the gift is included in the gross estate ($729,167, rather than $1,000,000), and the tentative tax is reduced by the full amount of gift tax paid ($309,314). This will result in significant transfer tax savings for F if he uses a GRAT, as illustrated in the final column labeled "Savings" in the "With GRAT" table.

Without GRAT
         Years        Future
         until         asset           Estate       Net to
         death        value(*)          tax          heirs
           1        $1,330,966(*)(*)   $732,031   $598,935
           2         1,354,133          744,773    609,360
           3         1,378,923          758,408    620,515
           4         1,405,447          772,996    632,451
           5         1,433,829          788,606    645,223
           6         1,464,197          805,308    658,889
           7         1,496,690          823,180    673,510
           8         1,531,459          842,302    689,157
           9         1,568,661          862,764    705,897
          10         1,608,467          884,657    723,810
  * The amount in the "Future asset value" column assumes a beginning asset
balance of $1,309,314 ($1,000,000 + $309,314 of gift taxes F will not incur
because he is not making a transfer to a GRAT), a 7% after-tax return on
investment of those assets, and a $70,000 annual payout.
  ** For example, $1,330,996 = $1,309,314 + ($1,309,314 x 0.07) - $70,000.

[TABULAR DATA OMITTED]

The National Office of the IRS has indicated informally that this interpretation of the operation of Rev. Rul. 82-105 and Sec. 2001(b) is correct, provided the value of the amount brought back into the estate under Sec. 2036(a) exceeds the amount of the post-1976 gift associated with the original transfer. According to the IRS'S interpretation of Sec. 2001(b), if the amount brought back into the estate is less than the amount of the post-1976 gift associated with the original transfer, the post-1976 gift is reduced only by the amount brought back into the estate under Sec. 2036(a) - not by the entire amount of the post-1976 gift. Currently, there are no regulations explaining the provisions of Sec. 2001 (b). Moreover, the IRS has not issued any rulings that indicate that this is the correct interpretation of Sec. 2001(b).

In Example 3, the amount pulled back into the estate under Sec. 2036(c) ($729,167) exceeded the amount of the post-1976 gift associated with the original transfer ($562,388). Therefore, the entire post-1976 gift was eliminated by the last sentence of Sec. 2001 (b). The benefits illustrated in the "With GRAT" table are unchanged under the Treasury's interpretation.

Is there another position?

Some individuals have suggested that, based on the literal language of See. 2001(b), last sentence, the entire post-1976 gift is eliminated, regardless of the amount includible in the gross estate under Sec. 2036(a). If this position is correct, there is some "slippage" in the amount of transfer tax that ultimately must be paid on a transfer involving a GRAT or GRUT that does not terminate prior to the death of the transferor. This slippage may result in significant transfer tax savings. See Example 4. on page 368.

Example 4: Comparing an Outright Transfer With a GRAT Transfer When GRAT Does Not Terminate Before Transferor's Death

F transfer $1,000,000 to a GRAT, retaining the right to receive an annual annuity of 1.5996% ($15,996) a year for 10 years, with the remainder to his children. The value of the gift of the remainder interest, based on a 9.6% Sec. 7520 rate, is $900,000, computed as follows.

Total amount transferred to trust $1,000,000

Less value of retained interest:

Annuity payment $15,996

Present value factor from Table B

      (IRS Publication 1457)               x 6.2516
  Value of gift                                             100,000
                                                          $ 900,000

Assuming a combined Federal and state gift tax marginal rate of 55%, F's gift of the remainder interest in trust would result in a total gift tax of $495,000. The inclusion of only a small portion of the gift in the gross estate (i.e., $166,625 ($15,996/0.096), rather than $1,000,000), and the reduction of the tentative tax by the full amount of gift tax paid ($495,000), can result in significant transfer tax savings for F if he uses a GRAT, as illustrated in the final column labeled "Savings" in the "With GRAT" table.

Without GRAT
         Years       Future
         until        asset           Estate      Net to
         death       value(*)          tax         heirs
           1      $1,583,654(*)(*)   $ 871,010    $ 819,914
           2       1,678,514           923,183      862,601
           3       1,780,014           979,008      908,276
           4       1,888,619         1,038,761    1,179,898
           5       2,004,827         1,102,655    1,232,655
           6       2,129,169         1,171,043    1,288,145
           7       2,262,215         1,244,218    1,348,016
           8       2,404,576         1,322,516    1,412,078
           9       2,556,898         1,406,294    1,480,623
          10       2,719,885         1,495,937    1,553,968
  * The amount in the "Future asset value" column assumes a beginning asset
balance of $1,495,000($1,000,000 + $495,000 of gift taxes F will not incur
because he is not making a transfer to a GRAT), a 7% after-tax return on
investment of those assets, and a $15,996 annual payout.
  ** For example, $1,495,000 + ($1,495,000 x 0.07) - $15,996.

[TABULAR DATA OMITTED]

Caution

It seems likely that the IRS would challenge an interpretation of Sec. 2001(b) that permits the elimination of a post-1976 gift in excess of the amount included in the gross estate under Sec. 2036(a). This challenge could be based on the argument that Sec. 2001(b) was designed to avoid double tax on post-1976 gifts that subsequently are pulled back into the decedent's gross estate and that the exclusion should be limited to the amount pulled back under Sec. 2036(a). Nevertheless, the statutory language under Sec. 2001(b) arguably does not include this limitation. Moreover, there.is an argument that if a gift involves the transfer of an interest in property that declines in value before it is pulled back into the transferor's gross estate under Sce. 2035, 2036 2037 2038 or 2043, the entire value of the earlier taxable gift is eliminated under Sec. 2001(b)

It is also possible that the Service could argue that the interest that is included in the transferor's gross estate and the post-1976 gift are two different interests. The value of the retained GRAT or GRUT interest is included in the transferor's gross estate under Sec. 2036(a). The post-1976 gift that is added to the gross estate in the calculation of the estate tax is the remainder interest. Arguably, these are two separate interests.

Valuable benefits remain

Even if the Treasury's interpretation of the operation of Sec. 2001(b) is correct, considerable advantages remain. The use of a GRAT or GRUT generally will be more beneficial than an outright transfer in which the post-1976 gift associated with the transfer is less than the value of the property that will be brought back into the transferor's gross estate under Sec. 2036(a). In addition, the use of a GRAT or GRUT generally will freeze the value of the retained interest in the transferor's gross estate at the capitalized value of the retained annuity or unitrust interest. As a result, the use of a GRAT or GRUT can provide significant transfer tax savings.