When it comes to transferring wealth, one of the biggest challenges is to minimize the amount of estate and gift taxes incurred by clients and their beneficiaries. In the past, one popular strategy was to use a “zeroed-out” grantor retained annuity trust (GRAT).
In 2000, the IRS challenged the validity of these trusts, putting their use in a state of limbo. However, many financial and tax advisors felt that the IRS’s stance was unreasonable and took the position for a number of years that “zeroed-out” GRATs are permissible and often the most optimal way to structure a GRAT. As it turns out, these advisors were correct. On October 15, 2003, the IRS announced that it will follow a 2000 decision of the Tax Court, Walton v. Commissioner, which approved of the concept of a “zeroed-out” GRAT.
What was the IRS’s justification for fighting “zeroed-out” GRATs? It all goes back to Example 5 under Treas. Reg. Sec. 25.2702-3(e). This example discussed a GRAT where the annuity was payable to the donor and, in the event of the donor’s death during the term of the GRAT, to the donor’s estate.
The example went on to imply that the annuity should be valued based on a term that was adjusted downward for the actuarial probability that the donor would die during this term. Thus, the value of the retained interest would be less, causing the value of the gift to be greater. The IRS called this an unavoidable mortality premium on any GRAT gift.
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The saga continued when the widow of Sam Walton (of Wal-Mart fame) contributed Wal-Mart stock worth approximately $100,000,000 to each of two GRATs for the benefit of her daughters. The GRATs were structured so that if Mrs. Walton were to die during the trust term, the annuity payments would continue to be paid out to the estate. Based on her tax advisor’s calculations, the value of her retained interest was 100% of the fair market value of the stock on the date of transfer and, therefore, there shouldn’t be any gift tax. As you might expect, the IRS did not agree. Based on Example 5 referenced above, it concluded that each GRAT in fact triggered a gift in excess of $3,800,000. Mrs. Walton then appealed the decision that was subsequently reviewed by the Tax Court.
An Invalid Interpretation
Ultimately, the court determined that Example 5 under IRC Reg. Sec.25.2702-3(e) was an invalid interpretation of Sec. 2702. The court concluded that the donor’s retained interest must be valued as an annuity for a specified term of years, thus making it possible to “zero out” a GRAT. The IRS chose not to appeal this decision, but it also decided not to officially announce its position on the issue.
Fortunately, the clouds have finally lifted. As previously mentioned, on October 15 of this year the IRS announced that it will follow a 2000 decision of the Tax Court that approved the concept of a “zeroed-out” GRAT. With the current low interest-rate environment and the fact that everyone is now in agreement, GRATs should be considered for your client’s wealth transfer needs.