Definition of a Qualified Interest in a Grantor Retained Annuity Trust and a Grantor Retained Unitrust

DEPARTMENT OF TREASURY

Internal Revenue Service

26 CFR Part 25

[REG-108287-98]

RIN 1545-AW25

Definition of a Qualified Interest in a Grantor Retained Annuity

Trust and a Grantor Retained Unitrust

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the

definition of a qualified interest. The proposed regulations apply to a

grantor retained annuity trust (GRAT) and a grantor retained unitrust

(GRUT) in determining whether a retained interest is a ``qualified

interest.'' The proposed regulations will affect individuals who have

made a transfer in trust to a family member and have retained an

interest in the trust. The proposed regulations clarify that a trust

that uses a note, other debt instrument, option or similar financial

arrangement to satisfy the annual payment obligation will not meet the

requirements of section 2702(b) of the Internal Revenue Code. This

document also provides notice of a public hearing on these proposed

regulations.

DATES: Written comments must be received by September 20, 1999.

Outlines of topics to be discussed at the public hearing scheduled for

October 20, 1999, at 10 a.m., must be received by September 29, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-108287-98), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may also be hand delivered Monday

through Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R

(REG-108287-98), Courier's Desk, Internal Revenue Service, 1111

Constitution Avenue, NW., Washington, DC. Alternatively, taxpayers may

submit comments electronically via the internet by selecting the ``Tax

Regs'' option on the IRS Home Page, or by submitting comments directly

to the IRS internet site at http://www.irs.gov/prod/tax__ regs/

regslist.html. The public hearing will be held in the IRS Auditorium,

Internal Revenue Building, 1111 Constitution Avenue, NW., Washington,

DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, James F.

Hogan, (202) 622-3090; concerning submissions of comments, the hearing,

and/or to be placed on the building access list to attend the hearing,

LaNita Van Dyke, (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Sections 2701 through 2704 were added to the Internal Revenue Code

in the Omnibus Budget and Reconciliation Act of 1990 (1990 Act), 1991-2

C.B. 481, 524. Section 2702 applies to a transfer in trust that

benefits a family member where the transferor retains an interest in

the property subject to the transfer. If section 2702 applies to a

transfer, the transferor's retained interest will be

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valued at zero for gift tax purposes (and the transferor will be

treated as making a gift of the entire value of the property), unless

the interest is a ``qualified interest.'' The term ``qualified

interest'' is defined in section 2702(b) and includes a right to

receive, annually, fixed payments (a qualified annuity interest) and a

right to receive, annually, a fixed percentage of the trust corpus

determined annually (a qualified unitrust interest).

Congress was particularly concerned about properly valuing gifts in

trust with retained interests. The legislative history that accompanied

the 1990 Act states:

[T]he committee is concerned about the undervaluation of gifts valued

pursuant to Treasury tables. Based on average rates of return and life

expectancy, those tables are seldom accurate in a particular case, and

therefore, may be the subject of adverse selection. Because the

taxpayer decides what property to give, when to give it, and often

controls the return on the property, use of Treasury tables undervalues

the transferred interests in the aggregate, more often than not.

Therefore, the committee determines that the valuation problems

inherent in trusts and term interests in property are best addressed by

valuing retained interests at zero unless they take an easily valued

form--as an annuity or unitrust interest. By doing so, the bill draws

upon present law rules valuing split interests in property for purposes

of the charitable deduction.

136 Cong. Rec. S15681 (daily ed. Oct. 18, 1990) (Informal Senate Report

on S. 3209).

The provisions of section 2702 and the regulations thereunder are

intended to ensure that, when a donor transfers property and retains an

interest in the property, the value of the retained interest is readily

ascertainable. Thus, the value of the gift, that is, the value of the

transferred property less the value of the retained interest, can be

accurately determined. Section 25.2702-3(b)(1) of the Gift Tax

Regulations implements this principle by requiring that for a qualified

annuity interest: (1) The annuity must be a fixed amount; (2) the

annuity must be payable at least annually; and (3) the yearly amount

must be paid by a specified date each year, that is, the annuity

payment may be paid after the close of the taxable year, but no later

than the due date of the trust's income tax return. The annuity payment

must be payable to (or for the benefit of) the holder of the annuity

interest for each taxable year of the trust term. A right of

withdrawal, whether or not cumulative, is not a qualified annuity

interest. Section 25.2702-3(c) provides comparable rules applicable in

the case of a qualified unitrust interest.

To avoid making a cash or an in-kind payment, some GRATs have

issued notes to the transferor in satisfaction of the obligation to

make the annual payment. In certain cases, the trust instrument

specifically authorizes the trustee to satisfy the annual payment

obligation with notes. The notes provide for actual payment at a date

some time in the future.

Thus far, the transactions that have come to the Service's

attention have involved the use of notes. However, the Service is also

concerned about other financial arrangements that have the effect of

delaying payment from the trust to the grantor and thus may alter the

value of the transferor's retained interest. These techniques include

the grant of an option to purchase trust property in the future.

Issuing a note is not payment of a fixed amount not less frequently

than annually, nor is it payment of a fixed percentage of the trust

assets determined annually, as required by the statute and regulations.

A note is merely a promise to pay in the future. Delaying payment by

the use of a note to satisfy the annual payment obligation alters the

true value of the transferor's retained interest, contrary to

Congressional intent in requiring provisions ensuring an accurate

valuation of the interest. This position is consistent with case law

and rulings concluding that the use of a note to satisfy an obligation

does not constitute payment of the obligation for tax purposes. Don E.

Williams Company v. Commissioner, 429 U.S. 569 (1977); Helvering v.

Price, 309 U.S. 409 (1940); Eckert v. Burnet; 283 U.S. 140 (1931);

Maddrix v. Commissioner, 780 F.2d 946 (11th Cir. 1986); Battelstein v.

Internal Revenue Service, 631 F.2d 1182 (5th Cir. 1980); Rev. Rul. 76-

135, 1976-1 C.B. 114.

Furthermore, under Secs. 25.2702-(3)(b)(1)(i) and 25.2702-

(3)(c)(1)(i), a right of withdrawal is not a qualified annuity or

unitrust interest. A right of withdrawal allows the payee to determine,

in the payee's discretion, when the payment will be made, and thus,

neither the timing nor the amount of each payment is fixed and

determinable under the trust instrument. For similar reasons, the use

of notes, other debt instruments, options or other similar financial

arrangements that place the amount and timing of each payment at the

discretion of the payee should not satisfy the annual payment

obligation.

Accordingly, these proposed regulations amend the regulations under

section 2702 to provide that issuance of a note, other debt instrument,

option or similar financial arrangement does not constitute payment for

purposes of section 2702. A retained interest that can be satisfied

with such instruments is not a qualified annuity interest or a

qualified unitrust interest. In examining all of these transactions,

the Service will apply the step transaction doctrine where more than

one step is used to achieve similar results. In addition, a retained

interest is not a qualified interest under section 2702, unless the

trust instrument expressly prohibits the use of notes, other debt

instruments, options or similar financial arrangements that effectively

delay receipt by the grantor of the annual payment necessary to satisfy

the annuity or unitrust interest amount. Under these provisions, in

order to satisfy the annuity or unitrust payment obligation under

section 2702(b), the annuity or unitrust payment must be made with

either cash or other assets held by the trust.

The proposed regulations provide a transition rule for trusts

created before September 20, 1999. If a trust created before September

20, 1999 does not prohibit a trustee from issuing a note, other debt

instrument, option or other similar financial arrangement in

satisfaction of the annuity or unitrust payment obligation, the

interest will be treated as a qualified interest under section 2702(b)

if notes, etc. are not used after September 20, 1999 to satisfy the

obligation and any note or notes or other debt instruments issued on or

prior to September 20, 1999 to satisfy the annual payment obligation

are paid in full by December 31, 1999, and any option or similar

financial arrangement is terminated by December 31, 1999, such that the

grantor actually receives cash or other trust assets in satisfaction of

the payment obligation. For purposes of this section, an option will be

considered terminated if the grantor is paid the greater of the

required annuity or unitrust payment plus interest computed under

section 7520 of the Code, or the fair market value of the option.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedures Act (5 U.S.C.

chapter 5) does not apply to these regulations, and because these

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regulations do not impose a collection of information on small

entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Therefore, a Regulatory Flexibility Analysis is not required.

Pursuant to section 7805(f) of the Internal Revenue Code, the

regulations will be submitted to the Small Business Administration for

comment on their impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written (a signed original and eight

(8) copies) that are submitted timely to the IRS. The IRS and Treasury

Department request comments on the clarity of the proposed rule and how

it may be made easier to understand. All comments will be available for

public inspection and copying.

A public hearing has been scheduled for October 20, 1999, at 10

a.m. in the IRS Auditorium, Internal Revenue Building, 1111

Constitution Avenue, NW., Washington, DC. Due to building security

procedures, visitors must enter at the 10th Street entrance, located

between Constitution and Pennsylvania Avenues, NW. In addition, all

visitors must present photo identification to enter the building.

Because of access restrictions, visitors will not be admitted beyond

the immediate entrance area more than 15 minutes before the hearing

starts. For information about having your name placed on the building

access list to attend the hearing, see the FOR FURTHER INFORMATION

CONTACT section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who

wish to present oral comments at the hearing must submit comments by

September 20, 1999, and submit an outline of the topics to be discussed

and the time to be devoted to each topic (signed original and eight (8)

copies) by September 29, 1999. A period of 10 minutes will be allotted

to each person for making comments. An agenda showing the scheduling of

the speakers will be prepared after the deadline for receiving outlines

has passed. Copies of the agenda will be available free of charge at

the hearing.

Drafting Information

The principal author of these proposed regulations is James F.

Hogan, Office of the Chief Counsel, IRS. Other personnel from the IRS

and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 25

Gift taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 25 is proposed to be amended as follows:

PART 25--GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954

Paragraph 1. The authority citation for part 25 continues to read

in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 25.2702-3 is amended as follows:

1. Paragraph (b)(1)(i) is amended by adding a new sentence after

the third sentence.

2. Paragraph (c)(1)(i) is amended by adding a new sentence after

the fourth sentence.

3. A new paragraph (d)(5) is added.

The additions read as follows:

Sec. 25.2702-3 Qualified interests.

* * * * *

(b) * * *

(1) * * * (i) * * * Issuance of a note, other debt instrument,

option or other similar financial arrangement in satisfaction of the

annuity amount does not constitute payment of the annuity amount. * * *

* * * * *

(c) * * *

(1) * * * (i) * * * Issuance of a note, other debt instrument,

option or other similar financial arrangement in satisfaction of the

unitrust amount does not constitute payment of the unitrust amount. * *

*

* * * * *

(d) * * *

(5) Use of debt obligations to satisfy the annuity or unitrust

payment obligation--(i) In general. The trust instrument must prohibit

the trustee from issuing a note, other debt instrument, option or other

similar financial arrangement in satisfaction of the annuity or

unitrust payment obligation.

(ii) Special rule in the case of a trust created prior to September

20, 1999. In the case of a trust created prior to September 20, 1999,

the interest will be treated as a qualified interest under section

2702(b) if--

(A) Notes, other debt instruments, options or similar financial

arrangements are not used after September 20, 1999 to satisfy the

annuity or unitrust payment obligation; and

(B) Any note or notes or any other debt instruments issued to

satisfy the annual payment obligation on or prior to September 20,

1999, are paid in full by December 31, 1999, and, any option or similar

financial arrangement issued to satisfy the annual payment obligation

is terminated by December 31, 1999, such that the grantor receives cash

or other trust assets in satisfaction of the payment obligation. For

purposes of the preceding sentence, an option will be considered

terminated only if the grantor receives cash or other trust assets

equal in value to the greater of the required annuity or unitrust

payment plus interest computed under section 7520 of the Code, or the

fair market value of the option.

* * * * *

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

[FR Doc. 99-15524 Filed 6-21-99; 8:45 am]

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