Recent IRS Challenges to Grantor Retained Annuity Trusts (GRATs)

*The article was originally published by Tax Stringer.
There are two separate significant IRS challenges to grantor retained annuity trusts (GRATs) in the context of ongoing merger negotiations that have garnered considerable attention going back to 2019.

  • First, in a case that has now settled very favorably for the taxpayer, the IRS withdrew its previous position in Chief Counsel Advice (CCA) 201939002 (the “2019 CCA”) that had rejected the use of standard methodology in valuing publicly traded stock transferred to a GRAT that did not take into account pending merger discussions. Baty v. Commissioner, Tax Court Docket No. 12216-21 (stipulated decision entered June 17, 2022).
  • Second, however, the IRS applied the draconian “Atkinson rationale” (in effect, blowing up the GRAT as disqualified) to another GRAT with a valuation issue in connection with an anticipated merger in CCA 202152018 (the “2021 CCA”), which is now a pending case.

Some Background—What Is a GRAT?

By way of background, the estate planning concept behind a GRAT is relatively straightforward: the grantor (also referred to as the “donor”) transfers property to an irrevocable trust (the GRAT) for a specified number of years, retaining the right to receive an annuity (a fixed amount payable not less frequently than annually). Upon termination of the GRAT, the trust assets are paid to the remaindermen named by the grantor, typically his or her children, or to a trust of which the grantor’s spouse and descendants are beneficiaries.

In essence, the grantor creates a GRAT to transfer its remainder at termination.

This transfer is a taxable gift that is deemed to occur upon creation of the GRAT. The remainder is valued for federal gift tax purposes by subtracting the interest retained by the grantor—the annuity—from the value of the initial transfer into the GRAT. The IRS requires that the value of the retained annuity be calculated on an actuarial basis using an assumed interest rate published by the IRS that is in effect for the month that the GRAT is funded (the “Section 7520 rate”).

The tax benefit of the GRAT therefore arises if the investments held in the GRAT outperform the assumed interest rate used in the gift tax calculations. In this event, there is a tax-free transfer to the extent of that extra performance from grantor to remaindermen because the actual value of the remainder at termination will be greater than the value that was calculated for federal gift tax purposes. It should be noted, however, that there are limitations on a GRAT’s usefulness in planning for transfers to grandchildren and more remote descendants due to certain rules pertaining to an “estate tax inclusion period” that apply for purposes of the generation-skipping transfer tax.

What if the investments held in the GRAT underperform the assumed interest rate? This will cause the actual value of the remainder at termination to be less than the value used for gift tax purposes. The common way to address this risk is to minimize the taxable gift at the creation of the GRAT. By adjusting the duration of the GRAT, the payout of the annuity and other provisions (for example, the annuity can increase by up to 20% from year to year), the grantor may be able to create a GRAT where the gift tax value of the retained annuity interest is almost equal to the initial value of the GRAT. In this manner, the grantor makes only a very small gift upon creation of the GRAT. If the investments held in the GRAT prove disappointing, the grantor will have lost little.

The benefits of a GRAT can only be fully realized if the grantor survives the trust term. If the grantor dies during the term of the GRAT, the IRS takes the position that a portion of the GRAT will be included under Internal Revenue Code (“Code”) section 2036 in the grantor’s gross estate for federal estate tax purposes. Although the GRAT will not have achieved its purpose, the tax result will be no worse than had the grantor done nothing, provided that the GRAT contains appropriate contingent provisions to utilize fully the federal estate tax marital deduction, if applicable.

In sum, the main benefit of a GRAT hinges upon the investment performance of the trust assets and the assumed interest rate used in calculating the gift upon creation of the GRAT.  It all seems so straightforward and risk-free–but is that always the case?

The 2019 CCA

In the 2019 CCA, the Chief Counsel’s Office of the IRS considered a situation in which the co-founder and chairman of a company whose stock was traded on the New York Stock Exchange (NYSE) contributed shares of the company’s common stock to a two-year zeroed-out GRAT–which means that the GRAT annuity was set to roughly equal the value of the shares transferred to the GRAT taking into account the Section 7520 rate that was in effect at the GRAT’s inceptionThe donor’s gift tax return valued the shares based on the mean between the high and low NYSE prices on the date of contribution. These prices did not take into account ongoing merger negotiations (which ultimately came to fruition more than seven months later). Significantly, it would have been a violation of the federal securities laws for the donor to sell the stock at that time.

The IRS’s position was that the stock should have been valued roughly 50% higher than what was reported on the gift tax return, and that the difference (of approximately $18 MLN) should be considered a taxable gift notwithstanding that the GRAT trust instrument contained standard provisions for a formula revaluation of the annuity amount based on values as finally determined for federal gift tax purposes.

The matter was litigated in the Tax Court in Baty v. Commissioner. The crux of the taxpayer’s argument was (1) that no tax deficiency existed; (2) that the publicly traded price should control; (3) that, indeed, the stock was valued without considering transfer restrictions imposed by the federal securities laws; (4) that the GRAT valuation adjustment clause applies to prevent any gift tax; and (5) that penalties should not be imposed. As set forth in the taxpayer’s brief, with respect to the willing-buyer willing-seller analysis that applies to determine fair market value for federal gift tax purposes, the IRS provides no explanation of how the hypothetical buyer might learn of closely guarded merger negotiations; nor did the IRS address the fact that to trade on non-public information received from insiders would be illegal.

The 2019 CCA cited an exception to the mean between the high and low method of valuing publicly traded securities that is set forth in Treas. Reg. § 25.2512-2(e).  The regulation begins as follows: “In cases in which it is established that the value per bond or share of any security determined on the basis of the selling or bid and asked prices  … does not represent the fair market value thereof, then some reasonable modification of the value determined on that basis or other relevant facts and elements of value shall be considered in determining fair market value.” The 2019 CCA cited this regulation in concluding that a reasonably informed hypothetical buyer would have knowledge of the pending merger, and to ignore the circumstances of the pending merger “would undermine the basic tenets of fair market value and yield a baseless valuation.”

The regulation, however, mentions several situations in which the exception might be applied, including few or sporadic sales, a very large block of stock being valued that could not be liquidated in a reasonable time without depressing the market, or a block representing a controlling interest. None of the situations described in the regulation applied to the Baty facts.

In addition, the merger at issue in Baty was not practically certain to occur (and in fact did not occur until more than seven months after the contribution of stock to the GRAT).  Moreover, the taxpayer’s brief in the Baty case pointed out that the IRS’s position that non-public information should be considered in valuing publicly traded stock “would create an administrative nightmare of epic proportions for both taxpayers and the IRS” and is unworkable for a gift by an insider under the federal securities laws.

In Baty, the IRS’s primary position was not the Draconian position in the 2021 CCA that the GRAT would not be a qualified GRAT so that the entire contribution to the GRAT would be a taxable gift. Instead, the IRS’s notice of deficiency took the position that the annuity payments would not be adjusted (notwithstanding the GRAT trust instrument requirements for such adjustments), so the difference between the IRS’s determined value of the contributed stock and the value of the contribution reported on the gift tax return was a gift. 

The IRS ultimately fully conceded, and a stipulated decision was entered in the Baty case.

The 2021 CCA

The favorable taxpayer settlement in the 2019 CCA is to be sharply contrasted with the 2021 CCA. 

In the 2021 CCA, thedonor was the founder of a very successful company (the “Company”), that through an investment advisory firm solicited offers for merger and received five such offers. Three days after receiving the five separate offers for merger, the donor created a two-year GRAT, the terms of which satisfied Code section 2702 and the accompanying Treasury Regulations. 

The donor then funded the GRAT with shares of the Company. The value of the shares of the Company was determined based on an appraisal of the Company as of a date that was approximately seven months prior to the transfer to the GRAT trust. The appraisal, which was obtained in order to satisfy the reporting requirements for nonqualified deferred compensation plans under Code section 409A, valued the shares at a very low price that was much lower than the prices that were reflected in the merger offers.

Subsequently, the donor gifted Company shares to a separate charitable remainder trust and valued those shares (for charitable deduction purposes) at a subsequent tender offer price that was approximately three times greater than the section 409A appraisal from the prior year that was used to establish the value for the GRAT. When asked to explain the use of the outdated appraisal (as of December 31st of the prior year) to value the transfer to the GRAT, as well as the use of a new appraisal to value the transfers to charity, the company that conducted the appraisal stated only that “the appraisal used for the GRAT transfer was only 6 months old and business operations had not materially changed during the 6-month period. For the charitable gifts, under the rules for Form 8283, in order to substantiate a charitable deduction greater than $5,000, a qualified appraisal must be completed. Because of this requirement an appraisal was completed for the donations of Company stock to various charities.”

Simply put, the IRS was not amused at how it was essentially “whipsawed” by these inconsistent valuation approaches that were taken for gift tax and charitable deduction purposes respectively.

The IRS addressed what it means to have a “qualified annuity interest” in a GRAT for purposes of Treas. Reg. § 25.2702, and noted that § 25.2702-3(d)(1) provides that, to be a qualified annuity interest, the interest must meet the definition of and function exclusively as a qualified interest from the creation of the trust. The IRS then cited the case of Atkinson v. Commissioner, 115 T.C. 26, 32 (2000), aff’d, 309 F.3d 1290 (11th Cir. 2002), for the proposition that, in the parallel context of a charitable remainder trust, the failure of the trust to function as a charitable remainder trust in its administration caused the trust to be disqualified as a charitable remainder trust. In Atkinson, the donor created a charitable remainder annuity trust, but no payments were actually made from the trust to the donor during the two-year period between the creation of the trust and the donor’s death. The IRS argued that this caused the charitable remainder trust in Atkinson to be an invalid charitable remainder trust from its creation, and the court agreed because the trust failed to operate in accordance with its terms.

Applying this analysis to the facts before it, the IRS found the reasoning of Atkinson to be analogous and disqualified the GRAT due to the trust’s perceived failure to function as a GRAT. Basically, the IRS was extremely disturbed by the taxpayer’s failure to consider the facts and circumstances of the pending merger in valuing the corporate shares that were transferred to the GRAT.  As the 2021 CCA explained:  “Indeed, ignoring the facts and circumstances of the pending merger undermines the basic tenets of fair market value and yields a baseless valuation, and thereby casts more than just doubt upon the bona fides of the transfer to the GRAT.”  The fact that the GRAT trust instrument—in accordance with the Treasury Regulations applicable to GRATs—included a built-in re-valuation clause to re-value the qualified annuity interest in the event of the IRS adjustment was not enough to save the day.  According to the IRS: “[t]he operational effect of deliberately using an undervalued appraisal is to artificially depress the required annual annuity.  Thus, in the present case, the artificial annuity to be paid was less than 34 cents on the dollar instead of the required amount, allowing the trustee to hold back tens of millions of dollars. The cascading effect produced a windfall to the remaindermen. Accordingly, because of this operational failure, Donor did not retain a qualified annuity interest under § 2702. See Atkinson.”

So there you have it: a tale of two GRATs in the pre-merger context. Although the 2019 CCA was ultimately resolved favorably for the taxpayer in a settlement, the 2021 CCA continues to provide a cautionary tale for taxpayers proceeding with “bad facts” such as an outdated appraisal who are hoping to rely upon the GRAT trust instrument revaluation clause to bail them out from incurring adverse gift tax consequences. 

This article originally appeared in the Summer Issue of TaxStringer and is reprinted with permission from the New York State Society of Certified Public Accountants.


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