April 2001

GRATs with No Taxable Gift: Results of the Walton Case

A recently decided tax court case (A.J. Walton v. Comm’r, 12/22/00) has cleared the way for grantor retained annuity trusts (GRATs) to be designed with no gift tax consequences.

The GRAT is an estate-planning technique that may allow a taxpayer to transfer an asset at a reduced value for gift tax purposes. The creation of a GRAT has generally resulted in at least a small gift taxable to the grantor.

In a GRAT, the grantor transfers assets to a trust but retains the right to receive a stream of income from the trust for a fixed number of years (the retained annuity). After the term of the trust, all remaining assets are transferred to the trust beneficiaries. For gift tax purposes, the retained annuity is valued when the GRAT is funded. The grantor has a taxable gift, on that date, of the fair market value of the assets used to fund the GRAT less the value of the retained annuity.

The annuity is often designed to exhaust all, or virtually all, of the initial value of the assets used to fund the GRAT, permitting all appreciation in the asset value during the GRAT term to pass to the beneficiary without creating a taxable gift.

That was the intent of Sam Walton’s widow, Audrey, when she set up two GRATs, each funded with approximately $100 million of Wal-Mart stock. Each GRAT had a two-year term and provided for Mrs. Walton to receive 49.35 percent of the initial value in the first year and 59.22 percent in the second.

Although the combined percentages exceeded 100 percent, Mrs. Walton hoped the value of the stock would increase enough to pay the annuities and, after the GRAT term, pass to the beneficiaries, her daughters, gift-tax free. The stock actually decreased in value over the two-year term, and nothing remained for the beneficiaries. Gift tax valuations are performed when the GRAT is funded, without benefit of hindsight.

The IRS contended that there was a chance that Mrs. Walton would die during the two-year term and, if this occurred, the remaining portion of the annuity would be paid to her estate. The IRS took the position that this “contingent” interest of her estate was not a qualified remainder interest under IRC section 2702. Therefore, it could not be included in the value of the annuity to be subtracted from the entire value of the Wal-Mart stock to calculate the taxable gift. The IRS relied heavily on Example 5 of section 25.2702-3(e) of the Gift Tax Regulations to support its position.

The tax court, however, refused to draw a distinction between the annuity to be paid to Mrs. Walton and that which would be paid to her estate if she died. The court noted that a person cannot make a gift to his or her own estate, and any such transfers are regarded under law as retained by the donor. Noting that an interpretative regulation such as section 25.2702-3(e) must implement the intent of Congress, the court said that Congress’ intent was for the IRS to use the existing rules governing charitable remainder annuity trusts (CRATs) as guidance when creating regulations for valuing GRATs.

The court found it “incongruous” that, with regard to contingent payments to an estate, the regulations take opposite positions when valuing GRATs (where the IRS’s interest lies in minimizing the annuity value) and charitable trusts (where it seeks to maximize the annuity).

As a result, the tax court threw out Example 5 of the regulation as “an unreasonable interpretation and an invalid extension of section 2702.” No reduction in the retained annuity was required for the possibility that Mrs. Walton could die during the GRAT term. The annuity value could equal or exceed the value of the stock, resulting in an insignificant taxable gift to Mrs. Walton. (For a reason not explained in the opinion, the grantor conceded that each GRAT created a gift of approximately $6,200, a fraction of the initial GRAT value. The IRS alleged a gift of close to $4 million from each GRAT.) The case can be appealed to the Court of Appeals for the Eighth Circuit.