The IRS recently examined whether a Grantor Retained Annuity Trust (hereinafter “GRAT”) could be held valid despite the fact that it omitted certain key language. In a GRAT, the Grantor transfers property into the irrevocable trust in exchange for the right to receive an annuity for a fixed period of years (“the retained interest”) based upon the IRS monthly interest rate commonly known as the Section 7520 rate. The retained interest must constitute a “qualifying interest” under the Code. When the term of the GRAT ends, the balance of trust assets are distributed to the trust remainder beneficiaries.
The value of the taxable gift, if any, is determined by reducing the fair market value of the assets transferred to the GRAT by the amount of the retained interest (i.e., the annuity). The larger the retained interest, the smaller the taxable gift. It is noteworthy that GRATs can now be “zeroed-out” which has unlimited upside as there is no gift tax due whatsoever. In a “zeroed-out” GRAT, the grantor takes back an annuity which soaks up all of value of the property transferred. The grantor generally must outlive the term of the GRAT for it to be effective. If the grantor dies before the end of the term, the portion of trust balance needed to generate the annuity payments comes back into the grantor’s estate.
The goal is for the GRAT to outperform the Section 7520 rate. Providing the GRAT outperforms the Section 7520 rate, any excess growth flows to the remainder beneficiaries’ tax free. Consequently, this is a great technique to remove portions of the grantor’s taxable estate in a potentially tax free manner. GRATs work best with highly appreciating assets such as securities or closely held business interests.
In this matter, the draftsman failed to include language prohibiting the trustee from issuing a note, other debt instrument, option or other similar financial arrangement in satisfaction of the annuity obligation as required by § 25.2702-3(d)(6) of the Gift Tax Regulations. In other words, the governing language failed to make the retained interest a “qualified interest” under IRC § 2702(b)(1). After the state court issued an order reforming the trusts to include the language as required by the tax regulations, the grantor sought confirmation that their interest in each trust was a qualified one for federal gift tax purposes.
On balance, the IRS concluded that the trust instruments could be amended so as to qualify them as valid GRATs. The IRS found that the trust agreements themselves were established with the overarching intent that the retained interest be a qualified one so as to satisfy the tax criterion. Moreover, and pursuant to the judicial reformation of trusts to correct scrivener’s error, amendment is permitted where it was necessary to achieve the settlor’s tax objectives. Accordingly, the IRS held that the grantor’s retained interest was a qualified one thereby validating each GRAT under the tax law, effective as of the date each was created.
For more information or if you have any questions about estate planning and taxation, please contact Judson M. Stein, Chair of the Trusts & Estates Practice Group, at 973-230-2080 or email@example.com or John A. Grey and Lauren M. Ahern, Associates in the Trusts & Estates Practice Group.