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Tax Court Chimes In on Annuity Trusts

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A Grantor Retained Annuity Trust (GRAT) is an estate planning technique whereby an individual makes an irrevocable gift of assets to a trust, and at the same time the grantor retains an income stream from the trust for either an established term of years, or the shorter of the term of years or life. This arrangement is sometimes called a “split interest” trust, referring to the two types of interests that comprise a GRAT: a retained interest, which the grantor receives from the trust in the form of an annuity; and a remainder interest, which the named beneficiary receives at the termination of the trust. The annuity is a fixed amount determined at the inception of the trust and paid out to the grantor at least annually. This is a common estate planning tool for the removal of S-Corporations from a taxable estate.

In the case of The Estate of Trombetta vs. Commissioner, the Tax Court held that the value of rental properties transferred to the decedent's annuity trust was includable in her gross estate under IRC §§ 2036(a) and 2035(a).

In 1993, at age 72, Trombetta, the decedent, executed a Will and created an annuity trust to which she transferred her two rental properties. These rental properties value, as determined by the Tax Court later, was $14,177,325. The decedent was the sole beneficiary of the annuity trust and retained 50 percent of its voting rights. The trust provided for an annuity term of 180 months. As part of the contract the decedent had the power to reduce the term the trust. During the annuity's term, the trustees would distribute to the decedent, at quarterly or more frequent intervals, an annual sum of $75,000. This amount increased yearly by 4% at the beginning of each successive 12-month period. At the later of the end of the trust term or date of the decedent's death, the annuity trust property would pass to the decedent's surviving children or grandchildren. The decedent reported the transfers of the properties to the annuity trust on her federal gift tax return for 1993. She reported that the properties had a net value of $1,425,802, that she had a retained interest of $921,809, and that she made a gift of $503,993 (the remaining value). Tragically, in 2005, the decedent was diagnosed with cancer. Because she believed she would not live until the termination of the annuity trust terms, she reduced used her powers of reduction to 156 months. In doing this the date that the trust would terminate was July 31, 2006.

On its federal estate tax return, the decedent's estate reported a total value for the gross estate of $1,814,423. The IRS disagreed with this calculation, and issued a notice of deficiency. The IRS determined that the estate had failed to report transfers of $14,365,823 during the decedent's life. It determined that the fair market value of the rental properties to be $14,177,325 as of the date of the decedent's death. The IRS asserted that, pursuant to IRC § 2036(a), the decedent's gross estate must include the values of the rental properties. IRC § 2036(a) includes the value of assets in a decedent's gross estate when (1) the decedent made an inter vivos transfer of property, (2) the decedent's transfer was not a bona fide sale for adequate and full consideration, and (3) the decedent retained an interest or right in the transferred property that he or she did not relinquish before death. In the pleading to the court, the estate did not contest that the decedent made inter vivos transfers of property to the annuity trust. Instead it argued that (1) the decedent's transfers of the rental properties were bona fide sales for adequate and full consideration, and (2) she did not retain during her life an interest in the transferred properties.

The Tax Court held that the estate did not qualify for the bona fide sale exception. In order to support the assertion that the eventual sale to the GRAT was a bona-fide sale, most estate planning commentators suggest that the trust should initially be funded with assets equal to at least ten percent (10%) of the face amount of the promissory note (because an independent third party would not sell assets to a trust in return for a promissory note if the trust only had nominal assets). The conventional wisdom is that assets equal to ten percent (10%) of the face amount of the note should provide the trust with the financial means to pay off the note if there is an unexpected decline in the value of the trust assets.

Using this assertion, the Court pointed out that the decedent did not receive full and adequate consideration for the transfers of the rental properties. She received an interest reducible to the present value of the periodic payments. However, the annuity trust was structured as a grantor trust, and the decedent reported the difference between the then present value of the periodic payments and the fair market value of the properties as a gift. The court said that the structure of the annuity trust and the subsequent tax reporting supported a finding that she did not transfer the properties to the trust in exchange for full and adequate consideration.

In the second assertion, the court pointed out that no bona fide sale, in the sense of an arm's-length transaction, occurred in connection with the decedent's transfers of the properties to the trust. The decedent, as the sole beneficiary and the sole transferor, formed the transaction, fully funded the annuity trust, and basically stood on both sides of the transaction.

So basically the IRS stated that the sale that was done was only done to avoid the Estate tax on $14 million, and disallowed the transfer. Now a GRAT, which has failed to terminate at death is added to the estate of a decedent. This is why Mrs. Trombetta, sped up the terms whereby the GRAT terminated.

In contrast of the determination of the IRS, the estate asserted that the decedent's transfers of the properties to the trust satisfied the bona fide sale exception because she had clear nontax reasons for the transfers. Just a case in point, the transactions that you set up to avoid taxation have to have a non-tax reason. In this case the Estate argued that the decedent was trying to relieve herself of managing the properties and to receive an assured income.

The court rejected this argument, issuing TC Memo 2013-234. The memo pointed out that all cases that have applied the "significant tax reasons" standard to determine whether a bona fide sale exception was satisfied did so in the context of a transfer to a family limited partnership. In this case, the decedent transferred the rental properties to a grantor trust, not to a family limited partnership. There was no case law on this topic. According to the court, the decedent's transfers to a grantor trust were not comparable to transfers to a family limited partnership, especially since no other individual received a present interest in the trust. When you transfer your assets to a family limited partnership, each limited partner receives a present interest, which is subject to gift tax.

The court stated that even if the "significant tax reasons" standard was applicable, there was no evidence that the taxpayer had substantial non-tax reasons for transferring the properties to the trust. So basically, the court rejected the basic argument from the Estate. The court pointed out that the taxpayer continued to participate in managing the properties, even after the annuity trust was established. Additionally, the annuity trust was structured to provide periodic payments to the decedent at least in part because of the beneficial tax treatment of such arrangement as compared to an alternative arrangement, such as the sale or transfer of the properties.

The court went on to say that given the decedent's continued control over the transferred properties, her right to the excess income from the properties, and the use of income from the properties to discharge the taxpayer's personal legal obligations, the court found that the taxpayer retained an interest in the transferred properties. Even though the GRAT had terminated before death. The estate argued that the decedent did not have a retained interest in the properties because Mrs. Trombetta received only the right to specific periodic payments, computed without regard to the annuity trust income. It characterized the decedent's transfer of the properties as a sale in exchange for an annuity rather than a transfer with a retained interest.

There were more assertions made by the court, but you get the point. GRATs need to carefully be used in Estate Planning. They can easily trigger gift tax, and will be subject to the estate tax if not carefully structured by the estate planner. Be careful who you choose to structure your estate. You should choose someone that is not only familiar with estate planning, but is familiar with the taxation consequences of what you are doing.

If you need help with your estate, you can send us an email at: info@estate-taxexpert.com, you can phone us at (407) 926-4124, or you can visit us on the web at www.estate-taxexpert.com

Craig W. Smalley, E.A., C.E.P.®

Admitted to Practice Before the Internal Revenue Service

Certified Estate Planner®

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