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IRS Sends a Shot Across the Bow to Taxpayers With Grantor-Retained Annuity Trusts

By Joel N. Crouch on February 25, 2022
An IRS legal memorandum involving a grantor-retained annuity trust (GRAT) released on December 30, 2021, should be a wake-up call to taxpayers and tax professionals. The memorandum blows up the taxpayer’s GRAT by determining that the business asset held in the taxpayer’s GRAT was egregiously undervalued allowing the IRS to disregard the GRAT and treat the entire transfer of assets to the trust as an outright gift. Not surprisingly, there are some unique and difficult facts regarding the GRAT and asset at issue, but it is a reminder of the importance of a good valuation and dotting all the I’s and crossing all the T’s when doing complex tax planning.

A GRAT is a widely used planning technique that leverages asset transfers to maximize the benefit to a taxpayer, the taxpayer’s family and/or a charity. For example, a business owner can transfer a minority interest in the business to a trust which ultimately passes to his or her children after the expiration of an initial term. During this initial term, however, the business owner retains the right to an annuity payment equal in value to the value of the interest that was transferred. An actuarially-determined value of the remainder is a gift to the children, but the annuity can be structured so that the remainder interest is worth zero. As a result, if properly restructured, no taxable gift occurs. If the business is sold during the initial term, the GRAT is entitled to its share of the sale proceeds. The value of these sale proceeds will almost always be worth more than the initial value for several reasons. First, the initial value was reduced by lack of control and lack of marketability discounts. Second, GRATS will be “grantor trusts” for income tax purposes meaning that the grantor/business owner will pay the income tax liability on behalf of the GRAT so that it will retain the pre-tax proceeds. A significant amount of family wealth may be transferred with no transfer taxes if correctly implemented in front of a liquidation event such as the sale of a business.

The taxpayer in the IRS legal memorandum was trying to do exactly that. The taxpayer had a “multi-billion dollar” business and had moved shares in the business to a GRAT setting the required annuity payments based on a seven month old appraisal of the company’s value, which was initially obtained for other purposes. So far so good, but that is where things started to go wrong. Six months after the GRAT’s two-year term concluded, the shares in the company were sold for almost three times the value used for the GRAT. In addition, just before the sale of the business, the taxpayer transferred shares of the business to a charitable remainder trust using an appraisal that valued the business at the sale price, substantially boosting the donor’s charitable deduction.

The IRS’ typical modus operandi is to retroactively increase the GRAT payments, sometimes with interest. However, even though the taxpayer had set up a standard zeroed-out GRAT, the IRS was much more aggressive in response by disregarding the GRAT and treating the entire transfer to the trust as an outright gift. If the IRS ultimately prevails, the taxpayer could be facing a very large gift tax bill. To add insult to injury, the IRS could propose up to a 40% undervaluation penalty. Based on the facts, it is likely the IRS’ response was more aggressive because someone thought the taxpayer was “gaming” the tax system, but it may be a signal that the IRS is considering more aggressive scrutiny of complex planning techniques.

For questions regarding this blog post or any other civil or criminal tax related matter, please feel free to contact Joel Crouch at (214) 749-2456 or jcrouch@meadowscollier.com.