Badgley v. United States - Entire Value of GRAT Includible in Grantor’s Estate

The U.S. Court of Appeals for the Ninth Circuit recently held that the full value of a grantor retained annuity trust (GRAT) was properly included in the grantor’s gross estate under Internal Revenue Code Section 2036(a)(1). That section provides for inclusion of transferred property if the grantor retains “the possession or enjoyment of, or the right to the income from, the property” for life or “for any period not ascertainable without reference to his death or for any period which does not in fact end before his death.”

Strings Attached

A GRAT is a popular estate planning tool that families can use to transfer wealth in a tax-efficient manner while maintaining some control over the assets. Typically, a GRAT is structured to pay a fixed annuity to the grantor for a specific term. After the end of the trust’s term, the assets remaining in the GRAT are transferred to the beneficiaries. One potential risk is that the grantor will die before the end of the trust term, and then the GRAT assets will be pulled back into his or her estate.

In this case, the decedent (“grantor”) transferred a 50% partnership interest — valued at $2.4 million — to a GRAT established for the benefit of her two daughters. The mother retained the right to a $300,000 annuity (12.5% of the initial value of the assets in the trust) for 15 years. At the end of the term, the remaining assets would transfer to the beneficiaries.

The grantor died shortly before the 15-year period expired, and her estate tax return reported a gross estate that included the GRAT’s assets. Later, one of grantor’s daughters, acting in her capacity as executor, sought a partial refund. She argued that the gross estate should have included only the net present value of the unpaid annuity payments, rather than the GRAT’s entire date-of-death value.

The IRS failed to act on the refund claim in a timely fashion, so the executor filed a refund action in federal district court. The court granted the government’s motion for summary judgment, ruling that grantor’s retained annuity interest constituted both a right to substantial income from and continued enjoyment of the property.

Substance Over Form

On appeal, the Ninth Circuit explained that to avoid inclusion under Sec. 2036(a)(1), one must “absolutely, unequivocally, without reservations part with all of his title and all of his possession and all of his enjoyment of the transferred property,” and the transfer “must be unaffected by whether the grantor lives or dies.”

The second requirement means the beneficiaries must receive their interests before the grantor’s death. The court held that the grantor retained enjoyment of the property for purposes of Sec. 2036(a)(1) because her retained annuity was a “substantial present economic benefit.”

The estate made several arguments for why Sec. 2036(a)(1) didn’t apply, but it failed to convince the court. One argument was that the provision is inapplicable because it doesn’t expressly refer to annuities. The court rejected this “form over substance” argument, noting that other courts had applied Sec. 2036(a)(1) to a variety of interests that aren’t expressly listed.

The estate also argued that the GRAT’s principal exceeded the annuity for much of the 15-year term. That means that the annuity could have been drawn from prior year partnership distributions and the interest earned on them. The court declined to speculate on the annuity’s source, but it found the inquiry to be irrelevant. It noted that the partnership interest was the only property in the GRAT. Because the annuity was drawn from the GRAT, the court concluded that the payments received by the grantor “came from the partnership interest.”

No Surprise

Notably, the court commented that its decision should come as no surprise. The risks associated with GRATs are well known. However, if the grantor survives the trust’s term, the potential benefits — which include transferring property to beneficiaries free of estate tax and with low or no gift tax — can be substantial.