938 / What special valuation rules apply to the transfer of an interest in trust under the Chapter 14 special valuation rules?

Also, IRC Section 2702 does not apply to the following:

(1)     certain charitable remainder trusts;

(2)     pooled income funds;

(3)     charitable lead trusts in which the only interest in the trust other than the remainder interest or a qualified annuity or unitrust interest is the charitable lead interest;

(4)     the assignment of a remainder interest if the only interest retained by the transferor or an applicable family member is as a permissible recipient of income in the sole discretion of an independent trustee; and

(5)     a transfer in trust to a spouse for full and adequate consideration in connection with a divorce if any remaining interests in the trust are retained by the other spouse.²

For transfers to a trust made after May 17, 1997, regulations exempt charitable remainder unitrusts (CRUTs) from IRC Section 2702 only if the trust provides for simple unitrust payments, or in the case of a CRUT with a lesser of trust income or the unitrust amount provision, the grantor and/or the grantor’s spouse (who is a U.S. citizen) are the only noncharitable beneficiaries.³ Modified rules apply to certain qualified tangible property.

For these purposes, a transfer in trust does not include (1) the exercise, release, or lapse of a power of appointment over trust property that would not be a transfer for gift tax purposes, or (2) the exercise of a qualified disclaimer. An interest in trust includes a power with respect to a trust which would cause any portion of the transfer to be incomplete for gift tax purposes.⁴

Retained Interests

“Retained” is defined as the same person holding an interest both before and after the transfer in trust. Thus, a transfer of an income interest for life in trust to an applicable family member in conjunction with the transfer of a remainder interest in trust to a member of the transferor’s family is not subject to IRC Section 2702. However, with respect to the creation of a term interest (e.g., a joint purchase creating a term and remainder interest), any interest held by the transferor immediately after the transfer is treated as held both before and after the transfer.⁵ A negotiable note received in exchange for publicly traded stock sold to a trust was not treated as a retained interest in a trust.⁶

Qualified Interests

A “qualified interest” is an annuity or unitrust interest, or, if all other interests in the trust are annuity or unitrust interests, a noncontingent remainder interest. A qualified annuity interest means a right to receive fixed amounts (or a fixed fraction or percentage of the property transferred to the trust) not less frequently than annually. A qualified unitrust interest means a right to receive amounts which are payable not less frequently than annually and are a fixed percentage of the fair market value of the property in the trust (determined annually).⁷ A qualified annuity interest can provide for an annuity amount (or fixed fraction or percentage) which increases by not more than 120 percent of the stated dollar amount (or fixed fraction or percentage) payable in the preceding year.⁸ A qualified unitrust interest can provide for a unitrust percentage which increases by not more than 120 percent of the fixed percentage payable in the preceding year.⁹

The retention of a power to revoke a qualified annuity or unitrust interest of the transferor’s spouse is treated as retention of the qualified annuity or unitrust interest.¹⁰ Contingent annuity interests retained by the grantor or given to the grantor’s spouse were not qualified interests.¹¹ Regulations treat an interest with the following characteristics as a qualified interest retained by the grantor: an annuity or unitrust interest that is (1) given to the spouse of the grantor; and (2) contingent only on (a) the spouse surviving, or (b) that the grantor does not revoke the spouse’s interest.¹² The grantor makes an additional gift to the remainder person when the spouse’s interest is revoked or the grantor survives the trust term without having revoked the interest.

A right to receive each year the lesser of an annuity interest or a unitrust interest is not treated as a qualified interest. The right to receive each year the greater of an annuity interest or a unitrust interest is treated as a qualified interest. However, the qualified interest is valued at the greater of the two interests.¹³ A right of withdrawal, whether or not cumulative, is not a qualified annuity or unitrust interest.¹⁴

A qualified annuity or unitrust interest may permit the payment of income in excess of the annuity or unitrust amount to the transferor or applicable family member with the retained annuity or unitrust interest. However, the annuity or unitrust interest is valued without regard to the right to excess income (which is not a qualified annuity or unitrust interest).¹⁵ Also, a qualified annuity interest may permit the payment of an amount sufficient to reimburse the grantor for any income tax due on income in excess of the annuity amount; the annuity interest is valued without regard to such reimbursement right.¹⁶ Distributions from the trust cannot be made to anyone other than the transferor or applicable family member who holds the qualified annuity or unitrust interest.¹⁷

The term of the annuity or unitrust interest must be for the life of the transferor or applicable family member, for a specified term of years, or for the shorter of the two periods.¹⁸ There is a split of authority as to whether valuation may be based on two lives, or just one life.¹⁹ Regulations permit certain revocable spousal interests (see above), but value the retained grantor and spouse’s interests separately as for a single life.²⁰

An example in the regulations had provided that where a grantor retained the right to annuity payments for 10 years and the payments continued to his estate if he died during the 10-year term, the annuity was valued as for 10 years or until the grantor’s prior death (i.e., as a temporary annuity).²¹ The Tax Court ruled that the example was invalid, that the annuity should be valued as for 10 years (i.e., as a term annuity).²² The IRS has changed the regulations so as to follow Walton.²³ Note that if the trust property reverted to the grantor’s estate if the grantor died during the 10-year term, the annuity is valued as for 10 years or until the grantor’s prior death.²⁴ These results should apply likewise to unitrust payments.

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Planning Point: A grantor retained annuity trust (GRAT) can be zeroed out (i.e., the value of the gift of the remainder reduced to zero) using an annuity payable to the grantor for a term of years with payments continuing to the grantor’s estate for the balance of the term of years if the grantor dies during the term. In general, the GRAT is zeroed out if the annuity payment is made to equal the value of the property transferred to the trust divided by the appropriate annuity factor (including adjustments for frequency of payment).

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The IRS will not issue rulings or determination letters on whether annuity interests are qualified interests under IRC Section 2702 where (1) the amount of the annuity payable annually is more than 50 percent of the initial fair market value of the property transferred to trust, or (2) the value of the remainder interest is less than 10 percent of the initial fair market value of the property transferred to trust. For purposes of the 10 percent test, the value of the remainder interest is determined under IRC Section 7520 without regard to the possibility that the grantor might die during the trust term, or that the trust property might revert to the grantor or the grantor’s estate.²⁵

Commutation (generally, an actuarially based acceleration or substitution of benefits) of a qualified annuity or unitrust interest is not permitted.²⁶ Additional contributions are not permitted with qualified annuity interests.²⁷

The use of notes, other debt instruments, options or similar financial arrangements in satisfaction of the annuity or unitrust requirements under IRC Section 2702 is prohibited.²⁸

A remainder (or reversion) interest is treated as a qualified remainder interest if: (1) all interests in the trust (other than non-contingent remainder interests) are either qualified annuity interests or qualified unitrust interests (thus, an excess income provision is not permitted for this purpose); (2) each remainder interest is entitled to all or a fractional share of the trust property when all or a fractional share of the trust terminates (a transferor’s right to receive the original value of the trust property, or a fractional share, would not qualify); and (3) the remainder is payable to the beneficiary or the beneficiary’s estate in all events (i.e., it is non-contingent).²⁹

A qualified interest is to be valued using the valuation tables prescribed by IRC Section 7520.³⁰ For valuation rules for certain qualified tangible property, see Q 939.