933 / How are annuity, unitrust, and income (or use) interests retained by a grantor in a trust valued for estate tax purposes?

If a grantor retains an annuity, unitrust, or income (or use) interest in an irrevocable trust and dies before such retained interest terminates, the retained interest is includable in the decedent’s gross estate for estate tax purposes. While a retained annuity or unitrust (which is a variable annuity) interest in a trust could be included in the estate under either IRC Section 2036 as a retained life estate or under IRC Section 2039 as an annuity, regulations state that IRC Section 2036, rather than IRC Section 2039, will be applied to such interests.¹ A retained income (or use) interest in an irrevocable trust would be includable under IRC Section 2036. A revocable trust is includable in a grantor’s estate under IRC Section 2038. A gift within three years of death of an IRC Section 2036, 2038, or 2039 interest is includable in the estate under IRC Section 2035.

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Planning Point: If the grantor dies after the retained interest terminates, the interest is generally not includable in the grantor’s estate. Setting the trust term can be a balancing act. If the trust with a retained interest is for life, it will be includable in the grantor’s estate. In general, the longer the term of years the grantor retains the interest, the lower is the value of gifts to others; but longer terms increase the risk that the grantor with a retained interest will die during the trust term and that the trust will be includable in the grantor’s estate.

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Such retained annuity, unitrust, and income (or use) interests are generally found in GRITs, GRATs, GRUTs, PRTs, QPRTs, CRATs, and CRUTs, but can be found in other trusts as well. The valuation rules discussed below apply only to valuing the retained interest includable in the grantor’s estate. The regular rules under IRC Section 2702 (see Q 938) and IRC Section 7520 apply for valuing gifts in such trusts and for determining charitable deductions (see Q 8098). In general, the rules below include an amount in the gross estate that represents the amount of trust assets needed to yield the payments to the grantor from the trust.

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Planning Point: The IRS is required by IRC Section 7520 (c)(3) to update the actuarial tables to reflect the new mortality data produced by each U.S. census. In that regard, the IRS has produced tables to reflect the 2000 census and regulations under Section 7520 reflecting the data. The data reflects an increased life expectancy for all persons under age 95. The result is that Table 2000 C.M. increases the value of lifetime interests and decreases the value of remainders or reversions following lifetime interests. This makes CRTs and QPRTs slightly less desirable while CLTs, private annuities and self-cancelling installment notes (SCINs) are slightly more desirable. Generally, the new tables apply to transfers for which the valuation date is on or after May 1, 2009.

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An includable retained income interest would be valued based on the percentage of income retained by the grantor. The right to use trust property is valued similarly to an income
interest.

Example 1: If the grantor retained the right to all the trust income, 100 percent of the trust corpus would be includable. If the grantor retained the right to 60 percent of the income, 60 percent would be includable. If the grantor retained the right to 50 percent of the income, which increased to 100 percent when the other income beneficiary died before the grantor, 100 percent would be includable. If a grantor retained use of a personal residence in a QPRT, 100 percent of the QPRT is includable.²

An includable retained annuity interest would be valued by dividing the annual annuity (adjusted for frequency of payment and whether payments are made at the beginning or the end of each period) by the IRC Section 7520 rate at the date of death (or alternate valuation date).³ For this purpose, Annuity Adjustment Factors Table A is used for payments made at the end of each period, and Annuity Adjustment Factors Table B is used for payments made at the beginning of each period. Presumably, if the value of the annuity calculated in this fashion exceeds the value of the trust assets, the amount includable would be limited to the value of the trust assets.

Example 2: Grantor created a GRAT with an annuity of $1,000 ($12,000 annual) payable at the end of each month to Grantor for 10 years, with remainder to Grantor’s child. Grantor died during the 10 year term. At grantor’s death, the value of the GRAT assets was $300,000 and the Section 7520 interest rate was 6 percent. The annuity adjustment factor (monthly, payments at the end of each period, 6 percent) is 1.0272 (from Annuity Adjustment Factors Table A). The amount of property includable under IRC Section 2036 is $205,440 [($12,000 × 1.0272) / 6%].

An includable retained unitrust interest would be valued by multiplying the value of the trust assets by an inclusion ratio. The inclusion ratio is determined by dividing the trust’s equivalent income interest rate by the IRC Section 7520 rate at the date of death (or alternate valuation date). The equivalent income interest rate is determined by dividing the trust’s adjusted payout rate by the excess of 1 over the adjusted payout rate. The adjusted payout rate is determined by multiplying the payout rate by the Unitrust Payout Adjustment Factor. If the inclusion ratio is greater than 100 percent, it is reduced to 100 percent.⁴

Example 3: Grantor created a CRUT with a 6 percent unitrust payout rate payable (in equal installments at the end of each quarter) to Grantor for life, then to Grantor’s child for life, with remainder to charity. At grantor’s death, the value of the CRUT assets was $300,000, the Section 7520 interest rate was 6 percent, and Grantor’s child was age 55. The unitrust payout adjustment factor (6 percent Section 7520 rate, quarterly, three months to payout) is 0.964365. The adjusted payout rate equals 5.786 percent [6% payout rate × 0.964365]. The equivalent income interest rate equals 6.141 percent [5.786% / (1 – 5.786%)]. The inclusion ratio equals 102.35 percent [6.141% / 6% Section 7520 rate]. Since the inclusion ratio exceeds 100 percent, it is reduced to 100 percent. The amount includable under IRC Section 2036 is $300,000 [$300,000 × 100%]. The charitable deduction for the estate would be calculated under the regular rules for CRUTs (see Q 8098), as a CRUT with a unitrust payable to Grantor’s child for life, and would be $84,759.

Graduated Retained Interests

A graduated retained interest is an annuity, unitrust, or other payment, payable at least annually, that increases at a regular rate over time, but not more often than annually. If the grantor dies during the trust term with a graduated retained interest, the amount includable in the gross estate for estate tax purposes includes the sum of the following: (1) the amount of corpus needed to generate the annuity, unitrust, or other payment for the year of the grantor’s death (the base amount); and (2) the discounted value of the amounts of corpus needed to generate the periodic additions starting in each of the remaining years of the trust term.⁵

Example 4: Grantor created a five-year grantor retained annuity trust (GRAT). The GRAT pays Grantor an annual annuity at the end of each trust year, on October 31st. The first annuity payment equals $100,000 and the annuity payment increases by 20 percent each year. If Grantor dies during the trust term, payments continue to Grantor’s estate. At the end of the trust term, the corpus is to be distributed to Grantor’s child.

Grantor dies on January 31 of the third year of the GRAT term. The value of the trust corpus is $3,200,000 on the date of death. The Section 7520 interest rate for the month of death equals 6.8 percent. The alternate valuation date is not elected. The table shows calculation of the $2,973,868 includable in Grantor’s gross estate as a graduated retained interest.⁶

A	B	C	D	E	F	G
GRAT	Annual	Periodic	Required	Deferral	PV	Corpus
Year	Annuity	Addition	Principal	Period	Factor	Amount
1	100,000
2	120,000	20,000
3	144,000	24,000	2,117,647			2,117,647
4	172,800	28,800	423,529	0.747945	0.951985	403,194
5	207,360	34,560	508,235	1.747945	0.891372	453,027
Total						2,973,868
D = (B or C × Ann. Adj. Factor) ÷ Sec. 7520 Rate E = 273 {days from January 31 to October 31} ÷ 365 [for year 4] F = 1 ÷ (1 + Sec. 7520 Rate)E G = D × F

Contingent Retained Interests

If the grantor retained the right to receive an annuity, unitrust, or other payment from transferred property after the death of another person who was enjoying the annuity, unitrust, or other payment at the time of grantor’s death, then the amount includable in grantor’s gross estate is the amount of trust assets needed to yield the payments to the grantor from the trust. But this amount is reduced by the present value of the other person’s interest. However, the amount includable cannot be less than the amount of trust assets needed to yield the trust payments the grantor was entitled to at grantor’s death. In any event, however, the amount includable cannot exceed the fair market value of the trust corpus on the date of grantor’s death.⁷

Example 5: Grantor created an irrevocable trust. The trust provides that 50 percent of trust income is to be paid each to Grantor and Grantor’s child during their joint lives. On the death of the first to die of Grantor or Grantor’s child, 100 percent of trust income is to be paid to the survivor for life. On the death of the survivor, the remainder is to be paid to a third person.

Grantor dies survived by child. Fifty percent of the trust corpus is includable in Grantor’s gross estate because Grantor retained the right to 50 percent of trust income for life. In addition, the value of the remaining 50 percent of trust corpus, less the present value of the child’s life estate, is includable in Grantor’s estate because Grantor retained the right to 100 percent of trust income if Grantor survived child. [If child had predeceased Grantor, 100 percent of trust corpus would be includable in Grantor’s gross estate.]⁸

Example 6: Grantor created an irrevocable trust. The trust provides that an annuity of $5,000 is to be paid each to Grantor and Grantor’s child during their joint lives. On the death of the first to die of Grantor or Grantor’s child, an annuity of $10,000 is to be paid to the survivor for life. On the death of the survivor, the remainder is to be paid to a third person.

Grantor dies survived by child. The value of the trust corpus is $120,000 on the date of death. The Section 7520 interest rate for the month of death equals 7.0 percent. Assume the present value of child’s $5,000 annuity for life is $40,000. The table shows calculation of the $102,857 includable in Grantor’s gross estate. [If child had predeceased Grantor, $120,000 would be includable in Grantor’s gross estate (Step 4 would be $0, and $120,000 is less than $142,857).]⁹

Step 1: Fair market value of corpus	$120,000
Step 2: Corpus needed to produce Grantor’s annuity ($5,000 ÷ 7%)	$71,429
Step 3: Corpus needed to produce survivor’s annuity ($10,000 ÷ 7%)	$142,857
Step 4: Present value of child’s annuity	$40,000
Step 5: Step 3 minus Step 4 (but not less than Step 2)	$102,857
Step 6: Lesser of Step 1 or Step 5	$102,857