Recent IRS Challenges to Grantor Retained Annuity Trusts (GRAT)

Jun 6, 2023 | General Estate Planning, IRS / Tax Guidance, Podcasts

“Recent IRS Challenges to Grantor Retained Annuity Trusts,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Travis Hayes, ACTEC Fellow from Naples, Florida. Grantor Retained Annuity Trusts, also known as GRATs, are commonly used to potentially minimize taxes on large financial gifts to family members. There are two separate significant IRS challenges to GRATs in the context of ongoing merger negotiations that have garnered considerable attention going back to 2019. ACTEC Fellow Kevin Matz of New York City will explain the significance of these cases and the IRS rulings. Welcome, Kevin.

Kevin Matz:  Thank you, Travis. So, we have essentially here a tale of two GRATs in the context of ongoing merger negotiations. As Travis has mentioned, there are right now bubbling up two separate significant IRS challenges to GRATs in the context of ongoing merger negotiations that have generated considerable attention. This is going back to 2019.

Case Introductions: Valuations of Securities Funded GRATs

First, in a case that is now settled favorably to the taxpayer, we have a case in which the IRS withdrew its previous position in Chief Counsel Advice 201939002, 201939002, that rejected the use of the standard methodology in valuing publicly traded stock transferred to a GRAT that failed to take into account pending merger discussions. The resolution that was in Baty v. Commissioner, that is a stipulated decision that was entered June 17, 2022.

However, against that, we still have present bubbling up in the tax court. We don’t know exactly where it is these days, but we’ll probably hear from it before too long, a separate resolution of a CCA or possible resolution of a CCA that applies the so-called “Atkinson Rationale”, which is another way for saying blowing up the GRAT as not qualifying –being disqualified. That also involved evaluation in connection with an anticipated merger, and that was in CCA 202152018. And as mentioned, that is now a pending case.

2019 Chief Counsel Advice on Publicly Traded Securities Funded GRAT

So, turning to the first one, the 2019 CCA that is now settled, we’re going back to 201939002. The Chief Counsel Office of the IRS considered a situation in which a co-founder and chairman of a company whose stock was traded on the New York Stock Exchange contributed shares to the company’s common stock to a two-year zeroed out GRAT. Now, what that means is essentially, the GRAT annuity was set to roughly equal the value of the shares transferred to the GRAT, taking into account the Section 7520 rate in effect at the time of the GRAT’s inception.

So, the donor’s gift tax return valued the shares based on the mean between the high and low New York Stock Exchange prices on the date of contribution. These prices did not take into account ongoing merger negotiations, which did ultimately come to fruition about seven months later. Very significantly, however, it would have been a violation of the federal securities laws for the donor to sell the stock at that time.

IRS Position on Appraisal and Valuation

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, the delta, approximately $18 million, should be considered a taxable gift notwithstanding that the GRAT trust instrument contains standard provisions for a formal reevaluation of the annuity amount based on amounts as filed for federal gift tax purposes.

Now, this matter as I mentioned, was litigated in the tax court in Baty v. Commissioner. And the crux of the taxpayer’s argument was, as you would suspect, that the GRAT valuation adjustment clause applies with any gift tax whatsoever. Now, as set forth in the taxpayer’s brief, with respect to the willing buyer-willing seller analysis, the IRS provided no explanation whatsoever of how the hypothetical buyer might learn of a closely guarded merger negotiation nor did the IRS address the fact that to trade non-public information received from insiders would be illegal.

Now, the IRS’s CCA here cited an exception to the mean between the high and low method of valuing publicly traded securities that’s set forth in Regulation 25.2512-2(e). That 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.”

Now, the CCA cited this regulation in concluding that a reasonably informed hypothetical buyer would have knowledge of the pending merger and that to ignore the circumstances of the pending merger would undermine the basic tenants of fair market value and yield a baseless valuation.

IRS Determines Regulations and Exceptions Support Taxpayer

If you look at the regulation, however, it doesn’t say that. The regulation mentions several situations in which exceptions 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 the controlling interest. None of these situations described in the regulations apply to the Baty facts.

In addition, the merger 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. According to the IRS’ attempt to rely on that CCA on the Ferguson v. Commissioner case, which incidentally is an anticipatory assignment of income case, was factually misplaced. Moreover, the taxpayer’s brief on its memorandum moving for summary judgment 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 as unworkable for a gift by an insider under the federal securities laws.

Now, in Baty, the IRS’s primary position was not the draconian position of that later 2021 CCA that we’ll talk about in a second of disqualification. Rather, the IRS’s Notice of Deficiency took the position that the annuity payments would not be adjusted, notwithstanding the GRAT trust instrument requirements calling for such adjustments, so that the difference between the IRS’s determined value of contributed stock and the value of the contribution reported on the gift tax return was a gift.

Now, the IRS did say in the alternative – they said, “Well, maybe you don’t have a qualified interest.” But they didn’t focus on that. That was a backup argument. The service apparently saw the taxpayer’s very strong brief and ultimately conceded. They fully conceded, and a stipulated decision was entered in the Baty case in the taxpayer’s favor. Taxpayer victory.

That’s GRAT No. 1, but I said a tale of two GRATs, right? So, what about the second one? And that’s that 2021 CCA, CCA 202152018 again CCA 202152018. The facts there – the facts were not good for the taxpayer.

2021 Chief Counsel Advise on Privately Owned Shares Funded GRAT

The donor was a founder of a very successful company that through an investment advisory firm solicited an office for a merger and received five such offers. Three days after receiving the five separate offers for merger, the donor then created a two-year grantor retained annuity trust. A two-year GRAT.  The terms of which satisfied Section 2702 in the treasury regulations. The donor went ahead and funded the GRAT with shares of the company.

However, the value of the shares – we’re not talking publicly traded stock here, we’re talking about privately owned stock — the value of the shares is determined based upon an appraisal of the company as of the date which was approximately seven months prior to the transfer to the GRAT. The appraisal which was obtained in order to satisfy the requirements for non-qualified deferred compensation plans under Section 409(a) of the Internal Revenue Code valued the shares at a very low price that was much, much lower than the prices reflected in the merger offers.

So, stopping right there, the facts are not good. They get worse. So subsequently, very soon thereafter, the donor gifted company shares to a separate charitable remainder trust, and in contrast, valued those shares for charitable deduction purposes at a subsequent tender offer price that was approximately three times greater than the Section 409(a) appraisal of the price from the prior year that was used to establish the value of the GRAT, even though it was roughly the same timeframe.

Difference of Appraisal Values Causes Concern

Now, when asked to explain the use of the outdated appraisal as of December 31 of the prior year to value the transfer of the shares to the GRAT compared to the use of the new appraisal to value the transfer to charity, the company that conducted the appraisal stated only that, “Well, the appraisal used for the GRAT transfer was about six months old — six, seven months old. And business operations had not materially changed in the six-to-seven-month period.”

However, for the charitable gift, under the rules of 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 the company to the various charities.”

Well, the IRS was not amused, needless to say. And its analysis, the IRS started with a willing buyer-willing seller test but, then turned rapidly to consider: do you have a valid GRAT at all? They considered: what’s the meaning of a qualified annuity interest in a GRAT for purposes of Treasury Regulation Section 25.2702 and noted that Section 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.

Then, the IRS cited the case of Atkinson v. Commissioner, which is a tax court decision from 2000, affirmed by the 11th Circuit Court of Appeals in 2002. For the proposition that in a somewhat parallel context of a charitable remainder trust – granted, we’re dealing with a GRAT here, not a charitable remainder trust- but the IRS is importing analysis to stand for the proposition that in the failure of the trust in Atkinson to function as a charitable remainder trust, the administration caused that trust to be disqualified as a charitable remainder trust from the get-go, from inception.

Now, in that Atkinson case, the donor had created a charitable remainder annuity trust, but no payments were actually made from that trust to the donor during the two-year period between the creation of the trust and the donor’s death. The IRS here, the CCA argued that this caused the charitable remainder trust in Atkinson – or actually, the IRS backing Atkinson argued that it just caused it to be an invalid charitable remainder trust from its creation. And the court agreed with it. The tax court agreed with it because the trust failed to operate in accordance with its terms.

Court Upholds IRS Disqualification of GRAT

Now, applying this analysis, importing this analysis to the facts before the IRS in the CCA, found the reasoning of the Atkinson case to be analogous and disqualified the GRAT due to the trust’s perceived failure to function as a GRAT from inception. Basically, it comes down to the IRS being 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.

According to the IRS in the CCA, “…indeed ignoring the facts and circumstances of the pending merger undermines the basic tenants of fair market value, and yields a baseless valuation, and thereby casts more than just doubt upon the bona fides of the transfers to the GRAT.” The fact that the GRAT trust instrument, in accordance with the treasury regulations applicable to GRATs, included a built-in revaluation clause to revalue the qualified annuity interest in the event of the IRS adjustment was not enough, according to the service, to save the day.

To quote the service (they really let off steam at the end), “…the operational effect of deliberately using an undervalued appraisal is to artificially depress the required annual annuity.” Thus, in the present case, according to the IRS in the CCA, the artificial annuity to be paid was less than $0.34 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 remainder.

Accordingly, because of this operational failure, donor did not retain a qualified annuity interest under Section 2702. See Atkinson. Big thud. Ouch. That really is painful for the taxpayer.

Well, there you have it. A tale of two GRATs with securities in the merger context. And this second case, the second CCA is still unresolved. Thank you.

Thank you, Kevin, for updating us on recent developments regarding IRS challenges to GRATs.

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