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Reproduced with permission from CCH's Estate Planning Review published and copyrighted by CCH INCORPORATED, 2700 Lake Cook Road, Riverwoods, IL 60015
THE WALTON GRAT--A PLANNING TOOL
FOR THE 21st CENTURY ESTATE
The Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16)(2001 Act) has created a strange new world for estate planners. It is a world in which the estate tax is scheduled to be repealed, but not until 2010 and, even then, only for one year. It is also a world in which the gift tax will continue to exist, but with a different exclusion amount from the estate tax after 2003. Accordingly, in this new world, strategies that involve making a taxable gift would appear to make little sense, at least for those individuals who have a reasonable expectation of surviving until the repeal of the estate tax is scheduled to occur. At the same time, however, the Tax Court has effectively sanctioned a technique that may prove invaluable to estate planners in the foreseeable future. In the following interview, attorney Richard A. Oshins provides us with his views on how this planning idea can work for you and your clients. Mr. Oshins is senior partner with the Law Offices of Oshins & Associates, Las Vegas, Nevada (www.oshins.com), a nationally recognized firm specializing in estate planning, business planning, and probate.
CCH: The grantor retained annuity trust (GRAT) is a concept that has proved popular since GRATs were sanctioned by the rules of Code Sec. 2702. Could you give us a brief synopsis of how and why GRATs work as an estate planning tool?
Mr. Oshins: Basically, a GRAT is an irrevocable trust in which the grantor retains a right to receive an annuity payable at least annually for a term of years (term). At the end of the term, the remaining trust corpus is paid to certain designated beneficiaries, including trusts. If the GRAT is properly designed and implemented, an estate owner has an opportunity to transfer significant amounts of property from his or her taxable estate with little or, as a result of the recent Walton decision (A. Walton, 115 T.C. No. 41), no gift tax exposure, provided he or she survives the term. This lack of gift tax exposure is a point that will become increasingly important as we go forward after passage of the 2001 Act.
As long as the grantor survives the trust term, the assets remaining in the trust after the term are removed from his or her estate with no additional gift tax implications. If the trust assets appreciate at a rate in excess of the applicable federal rate (AFR) under Code Sec. 7520, the appreciation will pass free of gift tax. If the growth does not exceed the AFR, nothing will pass to the remainder beneficiaries. Because the GRAT can be designed to zero out the gift, the grantor is in a no lose position except for the costs of doing the transaction and perhaps the lost opportunity of implementing another wealth shifting device. GRATS are often formed with assets that are entitled to a valuation discount for transfer tax purposes and, thus, reduce the value of the gift to the trust. On the other hand, where assets having a cash flow are transferred, the cash flow is not reduced, enhancing the GRAT’s ability to pay the annuity. In addition, the discounted assets will pass to the remainder beneficiaries without further gift tax implications at the end of the term.
CCH: Is there a potential downside to using a GRAT?
Mr. Oshins: The biggest risk in using the GRAT technique is the possibility that the grantor will not survive the term. If the grantor does not survive the annuity term, there is possible inclusion of all or part of the GRAT property in the grantor’s estate. Many practitioners and commentators believe that the inclusion portion should be limited to a formula amount of the trust property that would produce the specified annuity for the grantor. The IRS’s position, however, is that the entire amount is includible under Code Sec. 2039 (see IRS Letter Rulings 9345035, 9451056, and 200036012).
The difference in the amount of inclusion is generally not believed to be relatively meaningful because, "[t]his particular advantage is of modest value with the market interest rates imposed under Section 7520. The annuities selected for Grantor Annuity Trusts are normally very high, so that the trust corpus will have to increase in value substantially to produce the annuity without invading principal." [Zaritsky and Aucutt, Structuring Estate Freezes Under Chapter 14, ¶11.02(2), p. 11-5].
CCH: How does one value the gift element in a GRAT?
Mr. Oshins: In general, there is a taxable gift of the remainder interest. The remainder interest is computed by subtracting the value of the retained annuity interest from the value of the property transferred to the trust. The value of the retained annuity interest is the present value of the grantor’s right to receive the prescribed annuity calculated with reference to the AFR under Code Sec.7520.
CCH: What is the significance of the recent Walton case with respect to the issue of gift tax exposure?
Mr. Oshins: For many years, the IRS contended that it was impossible to "zero out" a GRAT. As illustrated in private letters rulings (e.g., 9239015) and, ultimately, in the language of Reg. §25.2702-3(e), Example 5, the IRS position had been that a GRAT must be valued by the "shorter-of-term-or- life method" using Table H in IRS Publication 1457 (Actuarial Values, Book Aleph (7-1999)). This was the case regardless of the fact that the trust did not provide that the retained interest would terminate upon the grantor’s earlier death. In other words, according to the IRS, one could not zero out the gift because there will always be some amount of gift to reflect the possibility that the grantor would die during the term. For older grantors, the possibility of not surviving the term, and thus the gift, was greater. (A sample computation using the IRS preferred method is illustrated in Example 1. A zeroed-out GRAT is illustrated in Example 2.)
Example 1.
Type of GRAT: Simple
Term: 10 years (shorter of term or life)
Grantor's age: 50
Code Sec. 7520 rate: 6.2%
Annuity payment rate: 10%
Property transferred: $1 million
Annuity factor: 7.0843
Retained (annuity) interest: $708,430
Remainder (gift) interest: $291,570
Example 2.
Type of GRAT: Zeroed-out
Term: 10 years (term)
Grantor's age: 50
Code Sec. 7520 rate: 6.2%
Annuity payment rate: 13.7159%
Property transferred: $1 million
Annuity factor: 7.2908
Retained (annuity) interest: $999,998.84
Remainder (gift) interest: $1.16
In Walton, the taxpayer owned approximately 7.2 million shares of Wal-Mart stock having an aggregate value of over $200 million (as of April 7, 1993). She proceeded to create two GRATs, funding each of them with one-half of her Wal-Mart shares. The GRATs were set up for a two-year term with the respective remainders to go to each of the grantor's daughters. Under the provisions of the GRATs, the grantor was to receive an annuity equal to 49.35 percent of the initial trust value for the first 12-month term and 59.22 percent of such value for the second term. In a gift tax return reporting the GRATs, the grantor claimed zero value for the gifts to her daughters based on the conclusion that the value of her retained interests in the GRATs was equal to 100 percent of the value of her Wal-Mart stock as of the date of the transfer. Although at trial, the grantor conceded that the gifts to each GRAT should have been valued at $6,195, this figure was still considerably lower than the $3,821,000 amount claimed by the IRS.
Many practitioners, including myself, believed that the IRS's position in Example 5 was without authority and in a 13-0 reviewed decision, the Tax Court agreed. Although in Walton the gift was not completely zeroed-out (a so-called "near-zero" GRAT is illustrated in Example 3), it is clear that the Tax Court’s position was that the retained annuity would be valued for the term of years unreduced by the possibility that the grantor would not survive the term. In light of Walton, taxpayers can now comfortably create a GRAT without any gift tax liability, thus, increasing the desirability of the GRAT as a wealth-shifting device of choice. The technique's desirability is enhanced by the presumptively reduced willingness of taxpayers to risk a possible gift tax after passage of the 2001 Act by using what is generally considered to be the primary GRAT alternative--an installment note sale to an income tax defective trust.
CCH: What exactly is a "defined value" sale and why would one use this technique?
Mr. Oshins: It is a technique which restricts the IRS’s ability to contest a good faith appraisal of the value of property being transferred. It is typically used with hard-to-value assets to finesse the potential undervaluation risk occurring in an installment sale as a result of the possibility that the transferred asset could be successfully revalued by the IRS. It typically involves a sale or gift of a non-controlling interest family controlled entity, such as a family limited partnership (FLP), to a dynastic defective trust (DDT) according to a formula clause allocating a fixed dollar value of the asset to be satisfied by an in kind distribution (e.g., $x of partnership units) with the residue going to a GRAT or to a charity.
In a case involving a charity, ideally the charity’s interests are purchased at some point in the near future by the DDT or redeemed by the family controlled entity for fair market value generally established by an independent appraisal. The technique’s overall impact is to limit the Service’s incentive to audit transfers which use a good faith appraisal, particularly where charity is the recipient of the remainder interest gift. In most instances, the charity would prefer to receive cash and the family would prefer to own a greater interest in the family controlled entity because the value of that interest is much less in the hands of a stranger, real or hypothetical, than it is to members of the control group. Thus, since it is in each party’s best economic interest to strike a deal, it is generally anticipated that after the gift is made, the parties, in an independent transaction, will negotiate a sale of the remainder interest to the family or entity. At the time of sale, it is anticipated that the sales price for the remainder interest in the split-interest transaction (as distinguished from the number of partnership units) will be derived by hiring an independent appraiser, and that the parties will obtain finality by following the normal business practice of each signing a mutual release. Thus, an adjustment on audit will not (and should not) affect the transaction between the parties. Indeed, a negotiated settlement with the IRS would include factors which are not relative as to fair market value of the remainder interest, such as the expense of litigation, the taxpayer’s personal audit tolerance, audit risk, etc. If at the conclusion of audit there is a reallocation in favor of the remainder interest, that means that the value of charitable gift was understated and the taxpayer should be entitled to amend his or her return to reflect this undervaluation.
There is the concern that the IRS may attack this approach under the rationale of F. Proctor, CA-4, 44-1 ustc ¶10, 110, 142 F.2d 824, cert. denied 323 U.S. 756 (1944). Although distinguishable from Proctor, the defined value sales approach clearly cannot be considered to have the valuation certainty that can be incorporated in the GRAT. By expressing the annuity as a percentage of the initial value of the gift, the valuation issue is eliminated in a GRAT. Under Reg. §25.2702-3(b)(i)(ii), as a condition of qualification, the GRAT document must include a revaluation provision requiring any shortfall or over-payment to be paid back with interest.
CCH: Recently the IRS issued FSA Letter Ruling 200122011, which would seem to be the equivalent of a "warning shot'' with respect to the defined value sale concept since the IRS ruled that this type of formula clause should not be respected for federal tax purposes. As I understand it, this FSA is based on a case pending in the Tax Court (C. McCord, Dkt. No. 7048-00). Is that true and what, generally, is your reaction to this FSA?
Mr. Oshins: First of all, I would suggest that the facts of the FSA are distinguishable from those of the McCord case and, secondly, I do not agree with the IRS's conclusion in the FSA that a formula clause such as one used in a defined value sales agreement should not be respected for federal tax purposes. Moreover, as written, the FSA assumes that there was a prearranged understanding between the parties that effectively tainted the transaction. To my knowledge, there was no such an arrangement present in the McCord case nor would that be typical of a defined value sale that has been properly structured and implemented.
Although the FSA cites Proctor as authority for the proposition that any clause designed primarily to defeat the gift tax is void as against public policy, I would submit that there is a significant difference between a "value-definition clause" as in FSA 200122011 and a "value-adjustment clause," as found in Proctor. A value-adjustment clause provides for a post-transfer adjustment of the amount of the gift. Thus, it provides for an increase in the price of an asset or an adjustment in the amount of property transferred if the transferred asset is subsequently found to be greater than was anticipated at the time of the transfer. On the other hand, a value-definition clause simply defines the value of a gift or sale at the time of the transfer in terms of formula. The value definition approach is used in virtually all marital deduction funding formula clauses and has been sanctioned in the CRT regulations, the disclaimer regulations, the GST regulations, as well as the IRC §2702 regulations.
In addition, the FSA appears to take issue with the concept of redeeming the charity’s interest even though the price paid was the fair market value of the interest, based upon a second appraisal. In my opinion, the redemption should be considered as the functional equivalent of a charitable stock bailout. The fact that the charity winds up with an undesirable asset that it wishes to convert to cash may have an impact of the value of the charitable deduction, but it should not affect the legitimacy of the transaction as a whole. In the FSA the partnership agreement permitted the partnership to redeem the assignee interests held by the charities at fair market value. Although that should not be sufficient to infect the entire transaction, a safer course of action would be to not have such a call right but to leave it up in the air, recognizing that a redemption or sale to the DDT which received the front-end interest was economically preferable to both the family and the charity.
Finally, the execution of the release acknowledging payment in full appears to bother the Service since the charity would not participate if a readjustment occurred on audit. Common business practice is to obtain such a release so there is closure. Perhaps the charity could have insisted that it receive more if there was a readjustment in value for tax purposes but that is not normal in the typical business setting. The charity sold its interest for the then fair market value based upon the appraisal it obtained. Had the charity insisted on a revaluation clause, the taxpayer could have walked, leaving the charity holding an asset of little value in its hands. What if the valuation was wrong in the charity’s favor and the trust interest was undervalued? The release was meaningful to both parties. This concern of the IRS can be easily avoided by not using a call right in the partnership even though in my opinion the taxpayer’s course of action in McCord is sustainable. The FSA is instructive as to the fact that the conservative planner should go forward with the initial transfer, but leave it up to the parties to follow the normal behavioral pattern and to strike a deal on their own.
CCH: Could you suggest other possible permutations of the GRAT strategy?
Mr. Oshins: One such possibility would involve life insurance. The common denominator of many of the advanced wealth-shifting strategies, such as the GRAT, is the survivorship feature. If the grantor survives the term, the technique works, and if the projected economics occur, considerable wealth can be transferred outside the purview of the transfer tax system. Other than the grantor’s inability to achieve the desired economic results, the sole risk is the grantor’s premature death. The estate owner can eliminate the primary disadvantage of the GRAT and hedge the downside risk of not surviving the term by the implementation of a well-conceived life insurance program.
The visceral reaction is that since the risk is for a term certain, the acquisition of term insurance for the annuity period should be the product of choice. In my experience, although the use of a permanent product is somewhat counterintuitive, it is typically preferable for longer term GRATs. Remember, the theoretical reason that there is little or no gift to the remainderman is that the value of the retained annuity is equal to the value of the property transferred. In fact, the IRS tables presume that the grantor will end up wealthier due to the interest assumption contained in the tables. Thus, the GRAT will not reduce the estate except if valuation adjustments are involved. It is merely an estate freeze and, to the extent of the interest factor, a "leaky freeze."
CCH: What about the case in which the estate owner is uninsurable or subject to relatively high rates?
Mr. Oshins: In such an instance, the inability to obtain adequate insurance coverage is indicative of the likelihood that the estate owner will not be able to survive the term, and should be a signal that the GRAT approach should be reevaluated and substitute planning that does not require survival techniques should be considered.
CCH: Is there also a possible place for the GRAT in generation-skipping transfer (GST) tax planning with dynasty trusts?
Mr. Oshins: One of the drawbacks associated with GRATs as compared to the installment note sale strategy is that GST tax exemption cannot be allocated to a GRAT until the grantor’s retained interest has ceased because of the estate tax inclusion period (ETIP) rules contained in Code Sec. 2642(f). That section prohibits allocation of GST tax exemption during the period that the property would be includible in the transferor’s estate if he or she died.
However, the ETIP rules should not apply if the remainderman were to sell or give his or her entire interest within a reasonable time after the GRAT was created to a GST exempt trust because the transferor would not retain an interest that would cause estate inclusion. Under the so-called "strings provisions" of the Code (Code Secs. 2036-2038), inclusion only occurs if the transferor makes (1) a gratuitous transfer and (2) retains an interest in the transferred property. Therefore, the ETIP rules should not apply because if the transferor/remainderman were to die, at that time the transferred property would not be includible in his or her estate since the transfer was of the entire interest of the transferor. This approach is, however, not without risk. It is reasonable to assume that the IRS would attack the transaction under a "substance over form" theory (i.e., that the spirit of Code Sec. 2642(f) should govern the result) or "step-transaction" approach. The IRS has indeed fired its first shot in an analogous instance where a taxpayer desired to use a charitable lead annuity trust (CLAT) to virtually zero-out a remainder interest that would be transferred at a negligible value to a grandchild. In a private letter ruling, the IRS indicated that it would treat the creator of the CLAT as the transferor for GST purposes because "[t]he series of transactions proposed in the ruling request have the effect of circumventing the rules of §2642(e) using the same type of leveraging that prompted Congress to enact §2642(e)" (IRS Letter Ruling 200107015). I am personally aware of several large CLATs that have been designed by other advisors in the manner rejected by the IRS in this letter ruling. Moreover, I have taken my own informal poll of several highly respected practitioners who believe the IRS’s position will not be sustained.
CCH: Finally, how would you evaluate the future of the Walton GRAT?
Mr. Oshins: The combination of the Walton decision enabling the GRAT to be zeroed-out, and Regulation §25.2702-3(b)(i)(ii) which permits the annuity to be expressed as a percentage of the initial value of the gift, means that the GRAT strategy can be implemented gift tax-free. Thus, it is a risk-free, potentially high reward opportunity to shift wealth and should be a viable strategy for all clients who are engaging in the estate planning process. For those clients who have the requisite risk tolerance, a Walton GRAT coupled with a remainder sale may achieve unparalleled results. As for the insurance element described above, I would suggest that, although the insurance advisor cannot control the ability to obtain the anticipated appreciation or the tax result with respect to the remainder interest transfer, he or she can resolve the survivorship contingency risk with the use of life insurance.
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