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Some Guidance from the Final Regulations on Estate Tax Inclusion for GRATs, CRTs and QPRTs
Background
In June 2008, the Treasury Department adopted certain final regulations with respect to the application of Code Sec. 2036(a)(1) and 2039 to so-called “grantor retained interest trusts,” which
include grantor retained income trusts (“GRITs”), grantor retained unitrusts (“GRUTs”), grantor retained annuity trusts (“GRATs”), charitable remainder unitrusts (“CRUTs”), charitable
remainder annuity trusts (“CRATs”), a qualified personal residence trust (“QPRT”) and similar arrangements.
Code Sec. 2036(a)(1) provides that, where the decedent made a transfer and retained the right to the income from the property transferred, the property is included in the decedent's gross
estate for federal estate tax purposes. The section applies only where the decedent retains the right to receive the income for life or for one of two other periods: (1) for a period that does
not in fact end before the decedent's death; (2) for a period not ascertainable without reference to the decedent's death. For example, if the decedent retained the right to receive the income
from the transferred property for life, the section applies. If the decedent had instead retained the right to receive the income for a period of five years and died within the five-year
period, Code Sec. 2036 would apply on the ground that the right was retained for a period that did not in fact end before death.
Fundamental Rules of Proposed Regs. Retained
The final regulations adopt the basic rules of the proposed regulations which were issued a year earlier. First, the amount included under Code Sec. 2036(a)(1) where an annuity or unitrust
interest is retained is determined by dividing the annuity or unitrust amount by the so-called Code Sec. 7520 rate for the month of death. (The regulations essentially refuse to deal with
estate tax inclusion where alternate valuation under Code Sec. 2032 is elected. The preamble contends these issues should be addressed is regulations under that section but there is no
statement such regulations will be issued.) Second, the final regulations confirm that Code Sec. 2039 (relating to certain annuity or payments made pursuant to a contract, such as a pension
plan) does not apply, at least in general, to cause estate tax inclusion in a GRAT, GRUT, GRIT, CRUT or CRAT. See new Reg. § 20.2039-1(e).
Inclusions Even Where Full Value Is Retained
Although at least one commentator contended that Code Sec. 2036(a)(1) can apply only to the extent that an annuity of similar payment could not be paid from corpus (and, therefore, must be
paid from income), the final regulations do not adopt that position. Similarly, they reject that notion that the section does not apply if the grantor retained the entire value of what is
transferred to the trust (as in the case of a GRAT where the value of the retained annuity payments equals the value of the property transferred to the trust).
Potential Application to Private Annuities and ISGTs
Although not certain, certain statements in the preamble to the final regulations could be construed as indicating that the Internal Revenue Service may contend that property transferred in a
private annuity arrangement, where the obligor is not an individual but a trust or other fund, is included in the grantor’s estate. Similarly, the statements could be construed as indicating
that the IRS might argue that Code Sec. 2702 (which treats, in general, a retained interest in a trust as having a zero value, causing the entire value of property transferred to a trust to be
subject to gift tax) could apply to a private annuity where the obligator is a trust or other fund. Code Sec. 2702(b) contains exceptions for certain retained annuity or unitrust interests,
such as in the case of a GRAT or GRUT. Reg. § 25.2702-3 spells out detailed requirements in order for these exceptions to apply, which are not typically incorporated in private annuity
arrangements (such as prohibiting commutation or prepayment of the retained interest)1. In light of the statements in the preamble, it may be prudent to incorporate these requirements in a
private annuity arrangement, although arguably Code Sec. 2702 should not apply where the obligor under the arrangement has independent property that is liable to pay the annuity. See,
generally, J. Blattmachr & D. Zeydel, "Evaluating the Potential Success of a GRAT Against Competing Strategies to Transfer Wealth", Tax Management Memorandum, January 23, 2006, Vol. 47, No. 2;
BNA Tax Management, March 16, 2006, updated and republished in 41 Annual Heckerling Institute on Estate Planning (2007).
It is even possible that the preamble statement indicates that the IRS would take the position that a sale to a trust in exchange for a note (a so-called “installment sale to a grantor trust”2) could cause the purchasing trust would be included in the grantor’s estate under Code Sec. 2036 if the note owed to the grantor-seller is outstanding at his or her death. However, if the
trust has significant assets in addition to those purchased, it would seem that under the Supreme Court decision of Fidelity-Philadelphia Trust Co. v. Smith, 356 U.S. 274, 1 AFTR2d 2151 (1958)
(which appears to hold that the section would not apply to a payment if the obligation to pay is not chargeable solely to the transferred property, the amount payable to the decedent is not
dependent on the amount of the actual income the transferred property generates and the transferees' obligation to make the annuity payments to the decedent is a personal one) Code Sec.
2036(a)(1) should not apply to an ISGT.
Pooled Income Funds, QPRTs, Farms and Residences
A pooled income fund, defined in Code Sec. 642(c)(5), is a trust maintained by a “public charity” which trust pays its income to one or more beneficiaries who have or for whom contributions
have been made to the trust, the remainder of which is irrevocable payable to or for the public charity that maintains the fund. A commentator suggested that the final regulations explain the
impact of the final Code Sec. 2036 regulations on pooled income funds that have been in existence for more than three years compared to ones that have not been in existence for at least that
time. That suggestion was rejected but the final regulations add new Example 5 to Reg. § 20.2036-1(c)(2), which explains the fair market value of the unit (or units) in the fund from which the
grantor was entitled to the income at the grantor’s death (or, by implication, on the alternate valuation date if elected under Code Sec. 2032) is in amount included in the grantor’s gross
estate under Code Sec. 2036(a)(1). Of course, if there is no successor to the grantor’s interest in the fund, there would be no estate tax generated, presumably, by the inclusion, although it
could have indirect ramifications for estate tax purposes.
In effect, under Code Sec. 170(f)(3)(i), a charitable deduction is permitted for the value of a donation to charity of a remainder interest in a personal residence or farm contributed where
the donor retains the right to use the property until death (or for a term of years). Although a commentator asked that the regulations to cover the “implications” for a charitable deduction
where such a remainder has been transferred to charity but, on account of the retained use for life, is included in the donor’s gross estate under Code Sec. 2036, the final regulations do not
address that issue. Example 2 of Reg. §20.2036-1(c)(1), however, has been added in the final regulations to confirm that, if the transferor transferred a personal residence to a third person
while retaining the right to use the personal residence for life or for a term of years, and if the transferor died during that term, the fair market value of the residence on the date of
death is includible in the transferor’s gross estate under Code Sec. 2036. Nevertheless, it seems appropriate that guidance be provided with respect to impact on the charitable deduction for a
gift to charity of a remainder interest in a farm or residence as the commentator requested. Because the property would be included in the transferor’s estate (as Example 2 confirms), it could
generate estate tax that could be apportioned to the property if there were a second life tenant.
The same comment could be made with respect to a pooled income fund or where a remainder in a farm is transferred and some individual may succeed to the contributor’s interest in the fund or
the farm when the contributor dies. In an analogous situation, the IRS has ruled that a trust does not qualify as a charitable remainder trust (“CRT”) described in Section 664 unless the
instrument requires that, in order for a successor unitrust or annuity interest to take effect. In light of Rev. Rul. 82-128 (in which the IRS required that each CRT which has a successor
beneficiary other than charity require that the successor interest take effect only if the successor beneficiary pays for any estate tax otherwise imposed on the trust at the grantor’s death),
it may be appropriate to have any person succeeding to an interest in a pooled income fund or a farm or residence the remainder of which has been contributed to charity to agree, at the time
the interest is created, to be responsible for any estate tax due on the interest upon the grantor’s death.
Certain CRT Matters
One clarification made by Example 3 Reg. § 20.2036-1(c)(2) is that, in determining the amount included, one must make an adjustment for the timing of payments from a charitable remainder
trust. That is, a stated payout rate (e.g., a five percent (5%) unitrust payment) must be adjusted to take into account when during the year it is paid) as explained in Reg. § 1.664-4(e)(3).
In response to requests for guidance, the final regulations add Examples 1 and 3 to Reg. § 20.2036-1(c)(2) dealing with charitable remainder trusts in which the grantor retained payments for a
term of years and died during such term. The Examples conclude that inclusion occurs in such cases essentially as it would had the payments from the charitable remainder trusts been for life.
Increasing Annuity Payments
Guidance was requested where the annuity payment from a GRAT is to increase and the grantor dies during the annuity term. Although the preamble acknowledges such guidance “would be helpful and
appropriate,” it is stated that it needs further consideration. It will also be helpful to provide guidance where the payments are to decrease which likely will be used by many taxpayers as
that may be the most efficient way to structure GRATs.3
Walton Type GRATs
Many GRATs and GRUTs (sometimes called “Walton GRATs” after the famous case with that name) are drafted as a trust for a fixed term of years (a term GRAT or a term GRUT) and provide for
continuing payments to the grantor's estate if the grantor dies within the term, consistent with Example 5 of Reg. § 25.2702-3(e) in order to reduce the value of the taxable gift of the
remainder interest. The actuarial value of the right to receive post-death annuity payments seems to be includible in the grantor's gross estate under Code Sec. 2033. Example 2 to Reg. §
20.2036-1(c)(2), however, indicates, as does the preamble explaining that Example, that the amount from a GRAT included under Code Sec. 2036(a)(1) is not dependent upon whether payments
continue to be made after the grantor’s death or his or her estate.
It is likely, based upon the “divide the payment due the grantor by the Code Sec. 7520 rate” approach for inclusion set forth in the regulations, that the entire amount in a GRAT will be
included in the grantor’s gross estate under Code Sec. 2036(a)(1) because GRATs typically are short-term (to avoid the risk of death during the annuity term triggering the application of the
Code Sec.) and the rate, as a percentage of value contributed to the trust is large, in order to produce as very small value of the remainder which almost always will constitute a taxable
gift. But for any long-term/lower payout GRAT, it will be appropriate for guidance to be developed on the treatment of post-death payments required to be made to the grantor’s estate,
especially if those payments increase from year to year.
Examples and Their Prinicples
Example 1 of Reg. § 20.2036-1(c)(1)(ii) illustrates that Code Sec. 2036(a)(1) may apply to an outright transfer during life (as opposed to one in trust, for example) and even if the retained
use is for a term of years (as opposed to a use for life).
Example 1 of Reg. § 20.2036-1(c)(2)(iii) involves the death of a grantor who transferred $100,000 to a charitable remainder annuity trust which was to pay the grantor and then the grantor’s
child $7,500 annual. The trust was worth $300,000 when the grantor died and Code Sec. 7520 rate was then six percent. (The Example recites that the executor did not elect alternate valuation.)
The Example concludes that $7500 divided by .06, or $125,000 of the trust is included in the grantor’s estate under Code Sec. 2036(a)(1). The Example adds that the result would have been the
same if the grantor had retained the annuity payments for a term of years which did not end before the grantor died.
Example 2 of Reg. § 20.2036-1(c)(2)(iii) involves the death of a grantor who transferred $100,000 to a GRAT to pay the grantor $12,000 a year for ten years, the annuity to be made in monthly
installments. Because the payments are to be made monthly (as opposed to, for example, at the anniversary of the creation of the trust), the annual payment is adjusted to $12,326.40 so the
amount included is $12,326.40/.06, or $205,440.
Example 3 of Reg. § 20.2036-1(c)(2)(iii) involves the death of a grantor who transferred $100,000 to a charitable remainder unitrust to pay the grantor and reaches similar conclusions as those
in Example 2.
Example 4 of Reg. § 20.2036-1(c)(2)(iii) involves the death of a grantor who transferred property to a GRIT to pay the income to the grantor for 15 years at which time it would terminate in
favor of persons who are not member of the grantor’s family within the meaning of Code Sec. 2704(c)(2). (Of course, if the remainder beneficiaries had been members of the grantor’s family the
entire value of the home would have been subject to gift tax under the principles of Code Sec. 2702(a).) Because the grantor had retained the right to all income, the Example concludes the
entire trust is included in the grantor’s estate under Code Sec. 2036(a)(1).
Example 6 of Reg. § 20.2036-1(c)(2)(iii) involves a grantor who dies during the retained use term of QPRT described in Reg. § 25.2702-5(c). The Example concludes the entire value of the home
is included in the grantor’s estate. Again, for reasons that are not clear at all, the Example again states that the executor does not elect alternate valuation.
Summary and Conclusions
The final regulations provide guidance and make important clarifications as to the amount of certain retained interest trusts and similar transfers included under Code Sec. 2036(a)(1) in the
transferor’s gross estate when he or she dies during the retained interest term, whether the retained interest is an income interest, the right to use property or entitlement to an annuity or
unitrust payment. In general, the amount included is determined by dividing the payout rate at death by the Code Sec. 7520 rate then in effect. Unfortunately, the regulations are incomplete in
several respects. Because the preamble may suggest that it will be appropriate to consider incorporating all of the requirements for GRATs into a private annuity arrangement. The WTP form of
private annuity will be modified to offer that option Although, under the regulations, it seems likely that the entire amount in a GRAT will be included in the grantor’s gross estate if death
occurs during the annuity term, it seems that shorter-term/high payout GRATs continue to be appropriate to consider.
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