IRS Finalizes Regulations on Valuations of Interests in GRATs

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By Deborah M. Beers, Esq.

Buchanan Ingersoll & Rooney PC, Washington, DC

On July 14, 2008, the IRS released T.D. 9414, which addressed the valuation for federal estate tax purposes of a retained interest in certain trusts. The trusts affected include charitable remainder annuity trusts, charitable remainder unitrusts, grantor retained annuity trusts, grantor retained income trusts, grantor retained unitrusts, qualified personal residence trusts and personal residence trusts. In effect, the IRS concluded that, under §2036, the amount includible in the grantor's estate if he or she dies during the term of one of the foregoing types of trust is limited to the value of the remaining retained annuity or unitrust interest, which is not necessarily (although it may be), equal to the value of the entire corpus.

 

One of the open issues in the final regulations as issued in July 2008 was the amount includible in the estate of a grantor of a grantor retained annuity trust (GRAT) or grantor retained unitrust (GRUT) that is "graduated" - i.e., a trust in which the annuity or unitrust amount payable each year during the trust's term increases by a specified percentage (which may be no more than 20%).1 On April 30, 2009, proposed regulations (REG-119532-08) were published to address this issue with respect to graduated retained interests in transferred property whether or not held in trust.

In T.D. 9555,2 the IRS published final regulations providing guidance on what part of a trust is includible in a deceased grantor's gross estate if the grantor reserves a graduated retained interest in the trust. The 2009 proposed regulations were adopted with some changes.

Basic Methodology.  The basic methodology in the final regulations for computing the amount includible where the payment receivable by the grantor gradually increases is similar to - although more detailed than - that in the proposed regulation. It measures the amount of corpus needed to generate sufficient income to produce the payments that would have been due even after the decedent's death, as if the decedent had survived and continued to receive the retained interest.

Thus, the amount of corpus necessary to produce the retained graduated interest is the sum of the "base amount" and "corpus amount," as follows: (1) the amount of corpus required to generate sufficient income to pay, without reducing or invading principal, the annual amount payable to the decedent at the decedent's death (base amount) plus, (2) for each succeeding year of the trust, the amount of corpus required to generate sufficient income to pay, without reducing or invading principal, the "periodic addition" in the annuity, unitrust, or other payment for that year, deferred until the beginning date of that increase (corpus amount).  The periodic addition for each year after the year in which the decedent's death occurs is the amount (if any) by which the annuity, unitrust, or other payment that would have been payable for that year (if the decedent had survived) exceeds the total amount of payments for the year immediately preceding that year, provided that payments increase (and do not ever decrease).

Importantly, the total amount includible cannot exceed the value of the trust corpus on date of death.

The complicated formula set forth in the regulation is illustrated by the following example (based on "Example 7" in the final regulations): On November 1, year N, D transfers assets valued at $2,000,000 to a GRAT. Under the terms of the GRAT, the trustee is to pay to D a qualified annuity for a 5-year term. The annuity amount is to be paid annually at the end of each trust year, on October 31st. The first annual payment is to be $100,000. Each succeeding payment is to be 120 percent of the amount paid in the preceding year.  If D dies during the 5-year term, the payments are to be made to D's estate for the balance of the GRAT term. At the end of the 5-year term, the trust is to terminate and the corpus is to be distributed to C, D's child. D dies on January 31st of the third year of the GRAT term. On the date of D's death, the value of the trust corpus is $3,200,000 and the §7520 interest rate is 6.8 percent.

The amount includible in D's gross estate under §2036(a)(1) is determined and illustrated as follows:

A

B

C

D

E

F

G

GRAT Year

Annual Annuity Payment

Periodic Addition

Required Principal X Adj. Factor (0.068)

Deferral Period: Death to GRAT year

Present Value Factor 1/(1+.068)^E

Corpus Amount at Death (D X F)

3

$144,000

n/a

$2,117,647

n/a

n/a

$2,117,647

4

$172,800

$28,800

$423,529

0.747945

0.951985

$403,193

5

$207,360

$34,560

$508,235

1.747945

0.891372

$453,026

 

 

 

 

 

Total

$2,973,866

A total corpus amount of $2,973,866 constitutes the principal required as of D's date of death to produce (without reducing or invading principal) the annual payments that D would have received if D had survived and continued to receive the retained annuity.  Therefore, $2,973,866 of the trust corpus is includible in D's gross estate under §2036(a)(1). The remaining $226,134 of the trust corpus is not includible in D's gross estate under §2036(a)(1) (or, in this case, §2039). The result would be the same if D's retained annuity instead had been payable to D for a term of 5 years, or until D's prior death, at which time the GRAT would have terminated and the trust corpus would have become payable to another.

Relationship to §2033.  In response to comments, the regulations clarify the interaction of §§2033 and 2036 in a situation where the decedent establishes a GRAT or GRUT under the terms of which the retained interest is paid to the decedent for a specified term of years and, if the decedent dies prior to the expiration of that term, the retained annuity or other payment is to be paid to the decedent's estate for the balance of the term.3

The IRS agrees that, because all or a portion of the trust corpus is includible in the decedent's gross estate under §2036, the annuity or other payments that become payable after the decedent's death and are required to be paid to the estate for the remainder of the trust term are reflected in the amount includible under §2036, and therefore should not also be includible under §2033. Therefore, to prevent double inclusion of such amounts, the final regulations4 provide specifically that payments that become payable to the decedent's estate after the decedent's death are not subject to inclusion under §2033, if §2036 is applied to include all or a portion of the trust corpus in the gross estate.

However, annuity or other payments payable to the decedent prior to the decedent's date of death, but that are not paid until after death. Such payments are includible in the decedent's gross estate under §2033 as a separate receivable. Thus, such an amount payable by the trust reduces the fair market value of the trust as of the date of death, but is included in the decedent's gross estate under §2033 as a receivable amount.

Amount Includible Where Decedent's Interest Is Preceded by Another's.  The final regulations essentially adopt the position of the proposed regulations in describing the method required to compute the amount includible in the decedent's gross estate under §2036 in a situation where the decedent is to receive a payment (or an increased payment) after the death of another beneficiary who is receiving an annuity or other payment at the time of the decedent's death.

This method provides that, if the beneficiary predeceases another beneficiary, the amount includible is the greater of: (1) the amount of corpus required to generate sufficient income to pay the annuity payable to the decedent as of the date of death; or (2) the amount of corpus required to produce sufficient income to satisfy the annuity or other payment the decedent would have been entitled to receive if the decedent had survived the other beneficiary, reduced by the present value of the other beneficiary's interest. The amount includible, however, cannot exceed the fair market value of the trust corpus on the date of death.

The IRS rejected comments that this method attributes to the decedent a greater portion of a trust's value than is appropriate, because the method does not take into account any depletion of trust principal that is assumed if the annuity payable to the current recipient is a greater percentage of the trust corpus than the assumed rate of return based on the applicable §7520 rate. The IRS countered that the regulations under §2036 historically have provided that if the decedent retained or reserved an interest or right with respect to all or a portion of the property transferred, then the amount includible under §2036 is the value of the property with respect to which the decedent retained the interest less the value of any outstanding income interest that is not subject to the decedent's retained interest and that is being enjoyed by another person at the time of decedent's death.

Nevertheless, the final regulations provide, as in the preceding situations, that, once this computation has been completed, a ceiling on the amount includible in the gross estate under §2036 (specifically, the fair market value of the trust at death) is imposed.

The method in the proposed regulations also has been clarified by providing that, solely for the purpose of calculating the present value of the current recipient's interest in this computation, the "exhaustion of trust corpus test" described in Regs. §20.7520-3(b)(2) is not to be applied in cases where it otherwise would have been required to be applied.5

The procedure for computing the includible amount in this situation is illustrated by the following Example 1:Decedent (D) creates an irrevocable inter vivos trust. The terms of the trust provide that all of the trust income is to be paid to D and D's child, C, in equal shares during their joint lives and, on the death of the first to die of D and C, all of the trust income is to be paid to the survivor. On the death of the survivor of D and C, the remainder is to be paid to another individual, F. Subsequently, D dies survived by C. Fifty percent of the value of the trust corpus is includible in D's gross estate under §2036(a)(1) because, under the terms of the trust, D retained the right to receive one-half of the trust income for D's life. In addition, the excess (if any) of the value of the remaining 50 percent of the trust corpus, over the present value of C's outstanding life estate in that 50 percent of trust corpus, also is includible in D's gross estate under §2036(a)(1), because D retained the right to receive all of the trust income for such time as D survived C. If C had predeceased D, then 100 percent of the trust corpus would have been includible in D's gross estate.

The following steps - set forth in great detail in the final regulations - implement this computation:6

 Step 1: Determine the fair market value of the trust corpus on the decedent's date of death.

 Step 2: Determine the amount of corpus required to generate sufficient income to pay the annuity, unitrust, or other payment (determined on the date of the decedent's death) payable to the decedent for the trust year in which the decedent's death occurred.

 Step 3: Determine the amount of corpus required to generate sufficient income to pay the annuity, unitrust, or other payment that the decedent would have been entitled to receive for each trust year if the decedent had survived the current recipient.

 Step 4: Determine the present value of the current recipient's annuity, unitrust, or other payment (without applying the exhaustion test).

 

 Step 5: Reduce the amount determined in Step 3 by the amount determined in Step 4, but not to below the amount determined in Step 2.

 Step 6: The amount includible in the decedent's gross estate under this section is the lesser of the amounts determined in Step 5 and Step 1.

Effective Date.  The final regulations are generally effective November 8, 2011, which is the date they were published in the Federal Register.

Although not perfect, the final regulations provide needed clarity, particularly with respect to graduated GRATs, which are commonly used to augment the appreciation of the assets in the GRAT that eventually will be payable to the remainder beneficiaries by deferring the distribution of those assets to the grantor.

 For more information, in the Tax Management Portfolios, see Stoneman, 817 T.M., Gross Estate - Section 2033, Hood, 830 T.M., Valuation: General and Real Estate,  Blattmachr, Slade, and Zeydel, 836 T.M., Partial Interests: GRATs, GRTs, QPRTs (Section 2702), and in Tax Practice Series, see ¶6190, The Gross Estate - Section 2033, and ¶6290, Valuation - Generally.


 1 See Regs. §25.2702-3(b)(1)(ii)(A) or (b)(1)(ii)(B) or Regs. §25.2702-3(c)(1)(ii). 

 2 76 Fed. Reg. 69126-69131 (11/8/11). 

 3 See for example, Regs. §25.2702-3(e), Ex. 5 and Walton v. Comr., 115 T.C. 589 (2000), acq. Notice 2003-72, 2003-44 I.R.B. 964. 

 4 Regs. §20.2036-1(c)(2)(iv), Ex. 2 paragraph (ii) and Ex. 7, above. 

 5 For this purpose, it must be assumed that it is possible for each measuring life to survive until age 110. See Regs. §§1.7520-3(b)(2)(i), 20.7520-3(b)(2)(i), 25.7520-3(b)(2)(i). 

 6 See also Regs. §20.2036-1(c)(2)(iv), Ex. 8, illustrating the computation of the value of a decedent's interest in an annuity receivable concurrently with another person.