**Coming To A Wal-Mart Near You: Tax-Free GRATs**

**By Deborah V. Dunn, Kirkland & Ellis, Chicago. IL**

**I**n a victory for taxpayers, the Tax Court held in *Walton v. Comm’r.*, 115 T.C. No. 41 (2000), that Reg. Sec. 25.2702-3(e), Example 5 is an invalid interpretation of Sec. 2702. Example 5 has been relied upon by the Service to created a "deemed reversion" in the case of a fixed-term GRAT, thus making it impossible to structure a GRAT that will not generate a taxable gift. In light of *Walton*, tax-free GRATs have been sanctioned by the Tax Court.

**Calculation of GRAT Gift**

In general, the gift made to the remaindermen upon creation of a GRAT is equal to the value of the property transferred to the GRAT, less the value of the interest retained by the grantor. Nevertheless, if a transfer of an interest in trust is made to a member of one’s family, then the value of any interest in the trust retained by the transferor (or an applicable family member) is determined under Sec. 2702.

Under that section, any interest retained by the grantor that is a "qualified interest" is valued under the tables in Sec. 7520 (which are based on the Sec. 7520 interest rate), and any interest retained by the grantor that is not a qualified interest is valued at zero. A right to receive fixed amounts payable not less frequently than annually (i.e., an annuity) is a qualified interest. Sec. 2702(b)(1). Thus, the annuity retained by the grantor in a GRAT is a qualified interest and will be valued under the tables in Sec. 7520. Those tables determine the present value of the annuity using the Sec. 7520 rate as the discount rate.

If the grantor retains a reversionary interest in a GRAT (i.e., the right to receive the trust property if the grantor fails to survive the GRAT term), the interests in the GRAT will consist of three components: 1) an annuity interest for the shorter of a term of years or the grantor’s life, 2) the remainder (paid if the grantor survives the term), and 3) the reversion (paid if the grantor fails to survive the term). The GRAT term used by the Service to value the annuity interest is actuarially shorter than the stated term of the GRAT due to the possibility that the grantor will not survive for the entire term, in which case he may not receive the full amount of all of the annuity payments, thus decreasing the present value of the annuity interest and increasing the value of the reversion.

Only the annuity interest is subtracted from the value of the property transferred to the GRAT in determining the taxable gift. The value of the reversion retained by the grantor does not reduce the value of the gift because a reversion is not a qualified interest under Sec. 2702; the reversion is valued at zero for purposes of determining the value of the interest retained by the grantor. Thus, the taxable gift includes the value of the remainder and the value of the reversion.

** Example.** A 60 year-old person transfers $1 million to a 10-year GRAT that pays him $145,000 per year. If he fails to survive the 10-year term, the property reverts to his estate. The 7520 rate is 7.4 percent. Based on the Actuarial Tables, Book Aleph, Pub. 1457 (7-1999), the interests created under such GRAT would have the following values:

Value of annuity interest = $935,000 ($145,000 x 6.45)

Value of remainder interest = $0

Value of reversionary interest = $65,000

($1 million - $935,000 annuity - $0 remainder)

However, if the grantor retains the right to an annuity for a fixed term regardless of whether he is living (i.e., no reversion is created), the interests in the GRAT will consist of two components: 1) an annuity interest for a fixed term of years payable to the grantor or, if the grantor does not survive the term, to the grantor’s estate, and 2) the remainder interest (paid at the end of the term in all events). In such case, if the annuity interest is subtracted from the value of the property transferred to the GRAT in determining the taxable gift, the taxable gift should include only the value of the remainder because there is no reversion.

** Example.** A 60 year-old person transfers $1 million to a 10-year GRAT that pays him $145,000 per year. If he fails to survive the 10-year term, the remaining annuity payments will be paid to his estate. The Sec. 7520 rate is 7.4 percent. Based on the Actuarial Tables, Book Aleph, Pub. 1457 (7-1999), the interests created under such GRAT would have the following values:

Value of annuity interest = $1 million

($145,000 x 6.89)

Value of remainder interest = $0

**Example 5**

In Reg. Sec. 25.2702-3(e), Example 5 ("Example 5"), however, the Service took the position that if a GRAT is structured so that the grantor retains the right to an annuity for a fixed term — regardless of whether he is living (i.e., he does not retain a reversion entitling his estate to the GRAT property if he does not survive the term) — the right of the grantor’s estate to the remaining annuity payments is not a "qualified interest" for purposes of Sec. 2702 and thus valued at zero.1 The effect of such position is that the value of the annuity interest retained by the grantor is always reduced by the value of the possibility that the grantor will not survive for the entire term (i.e., the value of the contingent interest of the grantor’s estate), thereby increasing the value of the remainder transferred (i.e., the taxable gift). In other words, under Example 5, the computation of the taxable gift made upon creation of a GRAT always has a mortality component. In such case, the value of the GRAT remainder could never be "zeroed out" or, in other words, have a value of zero — and thus not result in a taxable gift — even where the annuity was payable for a fixed term without a reversionary interest and was expected to exhaust the trust principal by the end of the term under IRS annuity valuation tables.

*Walton***and Tax-Free GRATs**

The validity of Example 5 has been questioned by many practitioners, and in *Walton v. Comm’r.*, the Tax Court agreed with those practitioners. In this case, a member of the Walton family (founders of Wal-Mart stores) created two 2-year, fixed-term GRATs and funded each GRAT with approximately $100 million of Wal-Mart stock (an amount that made expensive litigation justifiable). In the event that Ms. Walton died during the GRAT term, the remaining annuity payments were to be made to her estate. The actuarial value of the annuity payments to be made to Ms. Walton or her estate during the GRATs’ term equaled the value of the property transferred to the GRATs (i.e., they were economically zeroed-out).2 Thus, ignoring Example 5, the actuarial values of the remainders were zero.3

On Ms. Walton’s gift tax return, the value of the gift to the GRAT remaindermen was reported as zero, effectively throwing down the gauntlet as to the validity of Example 5. Not surprisingly, the Service picked up the gauntlet and issued Ms. Walton a deficiency notice of $4.5 million.

In an unanimous decision, the Tax Court sided with Ms. Walton, holding that Example 5 is an invalid interpretation of Sec. 2702. In so holding, the Tax Court reasoned that the *entire* annuity interest was retained by Ms. Walton because no transfer could be deemed to have been made to the taxpayer’s estate (an entity that would not come into existence until Ms. Walton’s death). In addition, the court reasoned that a fixed-term annuity, payable to the grantor or the grantor’s estate, is within Sec. 2702’s permissible parameters of a qualified interest, as elucidated by legislative history. Accordingly, the Tax Court concluded that because Congress meant to allow individuals to retain qualified interests for a specified term of years, and that the proper method for doing so is to make the balance of any payments due after the grantor’s death payable to the grantor’s estate, Example 5 was an unreasonable interpretation and an invalid extension of Sec. 2702.

In light of *Walton*, taxpayers can create a GRAT *without triggering any gift tax* by creating a fixed term GRAT, the remainder interest of which is zeroed-out (a "tax-free GRAT").

**Estate Inclusion Issues with Tax-free GRATs**

However, the ability to create a tax-free GRAT does not eliminate the possible inclusion of all or part of the GRAT property in the grantor’s estate if the grantor dies during the GRAT term. In Field Service Advice 200036012 (May 12, 2000), the Service reiterated its position taken in two private letter rulings issued in the 1990s that if the grantor of a GRAT does not survive the GRAT term, the value of the entire trust corpus is includible in the grantor’s gross estate under Sec. 2039. However, those rulings were addressed to GRATs that were not for a fixed term, but rather distributed the remaining trust property to the remaindermen if the grantor died early.

Some commentators have opined that Sec. 2039 *does not apply* in the case of a fixed-term GRAT.4 Sec. 2039(a) provides that a decedent’s gross estate includes the value of an annuity or other payment "receivable by any beneficiary *by reason of* surviving the decedent" under any form of contract or agreement if, under the contract or agreement, an annuity or other payment was payable to the decedent for his life or for any period not ascertainable without reference to his death or for any period which does not, in fact, end before his death. Where the annuity payments continue to the grantor’s estate for the balance of a fixed term, the *remainder* interest will not be "receivable by any beneficiary *by reason of* surviving the decedent." Although it may be coincidental that the remaindermen also survived the grantor, surviving the grantor is not sufficient — they must survive the GRAT term. Thus, the remainder will be receivable by the remaindermen by reason of surviving the GRAT term. In contrast, where a GRAT ends on the earlier of the term or the grantor’s death, if the grantor does not survive the GRAT term, the remaindermen will receive their interest "by reason of surviving the decedent."

Nevertheless, Secs. 2036 and 2033 clearly apply to a fixed-term GRAT where the grantor does not survive the GRAT term. Under those sections, the amount includible in the grantor’s estate is the present value of the remaining annuity payments. See Revenue Ruling 82-105, 1982-1 C.B. 133. Such inclusion raises several issues that practitioners must carefully consider in determining whether to recommend a tax-free GRAT.

**Qualifying Remaining Annuity Payments for the Marital Deduction**

If the grantor dies during the GRAT term and the right to the remaining annuity payments passes to a surviving spouse, the value of the *annuity interest* will not qualify for the marital deduction if it constitutes a non-deductible terminable interest.5 An interest in property passing to the spouse is a non-deductible terminable interest if 1) another interest in the same property passed from the decedent to some other person for less than an adequate and full consideration, and 2) by reason of its passing, the other person may possess or enjoy any part of the property after the termination or failure of the spouse’s interest.6

The annuity interest of a GRAT seems to satisfy the requirements of a non-deductible terminable interest: 1) the annuity interest in the GRAT constitutes an interest in property, 2) another interest in the property passed from the decedent to some other person (i.e., the remainder interest passed to the remaindermen of the GRAT) and 3) by reason of its passing, such other person may possess or enjoy any part of the property after the termination or failure of the spouse’s interest in the GRAT.7 However, in the case of a fixed-term, zeroed-out GRAT, the remainder interest does not pass to a person "for less than an adequate and full consideration" because, in such case, the value of the remainder interest is zero. Accordingly, the annuity interest should *not* be a non-deductible terminable interest; that is, it should qualify for the marital deduction.

Nevertheless, a more conservative approach is to have the remaindermen *purchase* their interest in the GRAT, i.e., actually pay consideration for such interest. By so doing, the argument that the property would not pass to a person other than the surviving spouse "for less than an adequate and full consideration" may be more tangible. Of course, in order for the remaindermen to purchase their interest in the GRAT, such interest should have some value. In such case, the remainder interest in the gift-free GRAT should be structured to have a relatively nominal value, e.g., $1,000.

Of course, even if the annuity interest itself is not a non-deductible terminable interest, it still must pass to the surviving spouse in a manner that qualifies for the marital deduction. Clearly, if the remaining annuity payments will be paid directly to the surviving spouse or her estate, they should qualify for the marital deduction. One might logically conclude that if the remaining annuity payments are made to a qualified terminable interest property trust (QTIP trust), the annuity interest should still qualify for the marital deduction. However, Sec. 2056(b)(6) sets forth specific rules for qualifying proceeds under an annuity contract for the marital deduction. In particular, Sec. 2056(b)(6) provides that in order for the proceeds under an annuity contract to qualify for the marital deduction, the surviving spouse must have a general power of appointment over any annuity payments remaining at his or her death (if such payments will not be paid to the surviving spouse’s estate).

Further, Reg. Sec. 20.2056(b)-6(c)(2) implies that if the proceeds of an annuity contract are to be held in trust, such trust must meet the requirements of Reg. Sec. 20.2056(b)-5, i.e., it must be a general power of appointment (GPA) marital trust. In light of the foregoing, to ensure that the remaining annuity interest under a fixed-term GRAT qualifies for the estate tax marital deduction, the grantor’s estate planning instruments should provide that if the grantor’s spouse survives the grantor, the annuity payments payable to his estate will either 1) pass outright to the surviving spouse or to her estate or 2) pass to a GPA marital trust.

If the remaining annuity payments qualify for the marital deduction and, as discussed above, Sec. 2039 does not apply to the remainder interest of a fixed-term GRAT, then none of the GRAT property will be subject to estate tax at the grantor’s death if he fails to survive the GRAT term. If, however, Sec. 2039 does apply to the remainder interest of a fixed-term GRAT, the fact that the remainder interest did not pass to the remaindermen for less than full and adequate consideration will not eliminate estate tax on such interest because Sec. 2039 does not contain an exception for interests that do not pass for less than a full and adequate consideration.

Nevertheless, an alternative structure will qualify the remaining GRAT annuity payments as well as the remainder interest for the marital deduction. The GRAT could create a contingent remainder interest in favor of the grantor’s surviving spouse (i.e., if the grantor dies during the GRAT term, the remainder will pass to spouse rather than grantor’s descendants at the end of the GRAT term). In this case, both the remaining annuity payments and the remainder interest would pass to the spouse, and both would qualify for the estate tax marital deduction because no interest in the GRAT would pass to a person other than the surviving spouse.

**Estate Tax Issues**

If estate tax is triggered as a result of the inclusion of the remaining annuity interest in the grantor’s estate (e.g., because the remaining annuity interest/remainder interest does not pass to a surviving spouse in a manner that qualifies for the marital deduction) or inclusion of all of the GRAT property under Sec. 2039, the practitioner must consider how the payment of estate tax will be funded. In particular:

• The grantor’s estate will have access to GRAT property to pay estate tax only as, and to the extent that, annuity payments are made. The grantor (or his estate) is prohibited from having the right to commute his interest in the GRAT.8

• If property that would otherwise pass to a surviving spouse or charity is used to pay the estate tax on the GRAT property, additional estate tax will be triggered.

**Conclusion**

In light of *Walton*, the GRAT has become a more attractive estate planning technique because a GRAT now can be structured in a manner that will not generate a taxable gift. However, a tax-free GRAT necessitates careful planning to address the potential estate tax consequences of the grantor dying during the GRAT term.eu

**ENDNOTES**

1. See also Letter Ruling 9253031 (January 1, 1993).

2. See David A. Handler, "Economically Zero-ed Out GRATs Produce the Best Results," *Trusts & Estates*, January 1999 for a discussion of zero-ed out GRATs.

3. In fact, there was some discrepancy as to how to properly account for the timing of the annuity payments and the partial years involved in the GRATs at issue. The taxpayer conceded in its brief that the gift occasioned by each GRAT should be valued at $6,195.10.

4. See Bittker, *Federal Taxation of Income, Estates and Gifts*, Sec. 126.8.2 at 126-128; *Tax Management Portfolio*, 836 at A-34.

5. See Sec. 2056(b).

6. See Reg. Sec. 20.2056(b)-1(c).

7. It should be noted that the Sec. 2056 regulations clearly take the position that no marital deduction is allowed for a non-deductible terminable interest that is distributed to a QTIP trust or GPA marital trust. See Reg. Sec. 2056(b)-1(g), Example 5.

8. See Reg. Sec. 25.2702-3.