[Federal Register Volume 64, Number 119 (Tuesday, June 22, 1999)]
[Proposed Rules]
[Pages 33235-33237]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-15524]


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DEPARTMENT OF TREASURY

Internal Revenue Service

26 CFR Part 25

[REG-108287-98]
RIN 1545-AW25


Definition of a Qualified Interest in a Grantor Retained Annuity 
Trust and a Grantor Retained Unitrust

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the 
definition of a qualified interest. The proposed regulations apply to a 
grantor retained annuity trust (GRAT) and a grantor retained unitrust 
(GRUT) in determining whether a retained interest is a ``qualified 
interest.'' The proposed regulations will affect individuals who have 
made a transfer in trust to a family member and have retained an 
interest in the trust. The proposed regulations clarify that a trust 
that uses a note, other debt instrument, option or similar financial 
arrangement to satisfy the annual payment obligation will not meet the 
requirements of section 2702(b) of the Internal Revenue Code. This 
document also provides notice of a public hearing on these proposed 
regulations.

DATES: Written comments must be received by September 20, 1999. 
Outlines of topics to be discussed at the public hearing scheduled for 
October 20, 1999, at 10 a.m., must be received by September 29, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-108287-98), room 
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may also be hand delivered Monday 
through Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R 
(REG-108287-98), Courier's Desk, Internal Revenue Service, 1111 
Constitution Avenue, NW., Washington, DC. Alternatively, taxpayers may 
submit comments electronically via the internet by selecting the ``Tax 
Regs'' option on the IRS Home Page, or by submitting comments directly 
to the IRS internet site at http://www.irs.gov/prod/tax__ regs/
regslist.html. The public hearing will be held in the IRS Auditorium, 
Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, 
DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, James F. 
Hogan, (202) 622-3090; concerning submissions of comments, the hearing, 
and/or to be placed on the building access list to attend the hearing, 
LaNita Van Dyke, (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    Sections 2701 through 2704 were added to the Internal Revenue Code 
in the Omnibus Budget and Reconciliation Act of 1990 (1990 Act), 1991-2 
C.B. 481, 524. Section 2702 applies to a transfer in trust that 
benefits a family member where the transferor retains an interest in 
the property subject to the transfer. If section 2702 applies to a 
transfer, the transferor's retained interest will be

[[Page 33236]]

valued at zero for gift tax purposes (and the transferor will be 
treated as making a gift of the entire value of the property), unless 
the interest is a ``qualified interest.'' The term ``qualified 
interest'' is defined in section 2702(b) and includes a right to 
receive, annually, fixed payments (a qualified annuity interest) and a 
right to receive, annually, a fixed percentage of the trust corpus 
determined annually (a qualified unitrust interest).
    Congress was particularly concerned about properly valuing gifts in 
trust with retained interests. The legislative history that accompanied 
the 1990 Act states:

[T]he committee is concerned about the undervaluation of gifts valued 
pursuant to Treasury tables. Based on average rates of return and life 
expectancy, those tables are seldom accurate in a particular case, and 
therefore, may be the subject of adverse selection. Because the 
taxpayer decides what property to give, when to give it, and often 
controls the return on the property, use of Treasury tables undervalues 
the transferred interests in the aggregate, more often than not.
    Therefore, the committee determines that the valuation problems 
inherent in trusts and term interests in property are best addressed by 
valuing retained interests at zero unless they take an easily valued 
form--as an annuity or unitrust interest. By doing so, the bill draws 
upon present law rules valuing split interests in property for purposes 
of the charitable deduction.

136 Cong. Rec. S15681 (daily ed. Oct. 18, 1990) (Informal Senate Report 
on S. 3209).
    The provisions of section 2702 and the regulations thereunder are 
intended to ensure that, when a donor transfers property and retains an 
interest in the property, the value of the retained interest is readily 
ascertainable. Thus, the value of the gift, that is, the value of the 
transferred property less the value of the retained interest, can be 
accurately determined. Section 25.2702-3(b)(1) of the Gift Tax 
Regulations implements this principle by requiring that for a qualified 
annuity interest: (1) The annuity must be a fixed amount; (2) the 
annuity must be payable at least annually; and (3) the yearly amount 
must be paid by a specified date each year, that is, the annuity 
payment may be paid after the close of the taxable year, but no later 
than the due date of the trust's income tax return. The annuity payment 
must be payable to (or for the benefit of) the holder of the annuity 
interest for each taxable year of the trust term. A right of 
withdrawal, whether or not cumulative, is not a qualified annuity 
interest. Section 25.2702-3(c) provides comparable rules applicable in 
the case of a qualified unitrust interest.
    To avoid making a cash or an in-kind payment, some GRATs have 
issued notes to the transferor in satisfaction of the obligation to 
make the annual payment. In certain cases, the trust instrument 
specifically authorizes the trustee to satisfy the annual payment 
obligation with notes. The notes provide for actual payment at a date 
some time in the future.
    Thus far, the transactions that have come to the Service's 
attention have involved the use of notes. However, the Service is also 
concerned about other financial arrangements that have the effect of 
delaying payment from the trust to the grantor and thus may alter the 
value of the transferor's retained interest. These techniques include 
the grant of an option to purchase trust property in the future.
    Issuing a note is not payment of a fixed amount not less frequently 
than annually, nor is it payment of a fixed percentage of the trust 
assets determined annually, as required by the statute and regulations. 
A note is merely a promise to pay in the future. Delaying payment by 
the use of a note to satisfy the annual payment obligation alters the 
true value of the transferor's retained interest, contrary to 
Congressional intent in requiring provisions ensuring an accurate 
valuation of the interest. This position is consistent with case law 
and rulings concluding that the use of a note to satisfy an obligation 
does not constitute payment of the obligation for tax purposes. Don E. 
Williams Company v. Commissioner, 429 U.S. 569 (1977); Helvering v. 
Price, 309 U.S. 409 (1940); Eckert v. Burnet; 283 U.S. 140 (1931); 
Maddrix v. Commissioner, 780 F.2d 946 (11th Cir. 1986); Battelstein v. 
Internal Revenue Service, 631 F.2d 1182 (5th Cir. 1980); Rev. Rul. 76-
135, 1976-1 C.B. 114.
    Furthermore, under Secs. 25.2702-(3)(b)(1)(i) and 25.2702-
(3)(c)(1)(i), a right of withdrawal is not a qualified annuity or 
unitrust interest. A right of withdrawal allows the payee to determine, 
in the payee's discretion, when the payment will be made, and thus, 
neither the timing nor the amount of each payment is fixed and 
determinable under the trust instrument. For similar reasons, the use 
of notes, other debt instruments, options or other similar financial 
arrangements that place the amount and timing of each payment at the 
discretion of the payee should not satisfy the annual payment 
obligation.
    Accordingly, these proposed regulations amend the regulations under 
section 2702 to provide that issuance of a note, other debt instrument, 
option or similar financial arrangement does not constitute payment for 
purposes of section 2702. A retained interest that can be satisfied 
with such instruments is not a qualified annuity interest or a 
qualified unitrust interest. In examining all of these transactions, 
the Service will apply the step transaction doctrine where more than 
one step is used to achieve similar results. In addition, a retained 
interest is not a qualified interest under section 2702, unless the 
trust instrument expressly prohibits the use of notes, other debt 
instruments, options or similar financial arrangements that effectively 
delay receipt by the grantor of the annual payment necessary to satisfy 
the annuity or unitrust interest amount. Under these provisions, in 
order to satisfy the annuity or unitrust payment obligation under 
section 2702(b), the annuity or unitrust payment must be made with 
either cash or other assets held by the trust.
    The proposed regulations provide a transition rule for trusts 
created before September 20, 1999. If a trust created before September 
20, 1999 does not prohibit a trustee from issuing a note, other debt 
instrument, option or other similar financial arrangement in 
satisfaction of the annuity or unitrust payment obligation, the 
interest will be treated as a qualified interest under section 2702(b) 
if notes, etc. are not used after September 20, 1999 to satisfy the 
obligation and any note or notes or other debt instruments issued on or 
prior to September 20, 1999 to satisfy the annual payment obligation 
are paid in full by December 31, 1999, and any option or similar 
financial arrangement is terminated by December 31, 1999, such that the 
grantor actually receives cash or other trust assets in satisfaction of 
the payment obligation. For purposes of this section, an option will be 
considered terminated if the grantor is paid the greater of the 
required annuity or unitrust payment plus interest computed under 
section 7520 of the Code, or the fair market value of the option.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It also has been determined 
that section 553(b) of the Administrative Procedures Act (5 U.S.C. 
chapter 5) does not apply to these regulations, and because these

[[Page 33237]]

regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Therefore, a Regulatory Flexibility Analysis is not required. 
Pursuant to section 7805(f) of the Internal Revenue Code, the 
regulations will be submitted to the Small Business Administration for 
comment on their impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) that are submitted timely to the IRS. The IRS and Treasury 
Department request comments on the clarity of the proposed rule and how 
it may be made easier to understand. All comments will be available for 
public inspection and copying.
    A public hearing has been scheduled for October 20, 1999, at 10 
a.m. in the IRS Auditorium, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the 10th Street entrance, located 
between Constitution and Pennsylvania Avenues, NW. In addition, all 
visitors must present photo identification to enter the building. 
Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance area more than 15 minutes before the hearing 
starts. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit comments by 
September 20, 1999, and submit an outline of the topics to be discussed 
and the time to be devoted to each topic (signed original and eight (8) 
copies) by September 29, 1999. A period of 10 minutes will be allotted 
to each person for making comments. An agenda showing the scheduling of 
the speakers will be prepared after the deadline for receiving outlines 
has passed. Copies of the agenda will be available free of charge at 
the hearing.

Drafting Information

    The principal author of these proposed regulations is James F. 
Hogan, Office of the Chief Counsel, IRS. Other personnel from the IRS 
and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 25

    Gift taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 25 is proposed to be amended as follows:

PART 25--GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954

    Paragraph 1. The authority citation for part 25 continues to read 
in part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 25.2702-3 is amended as follows:
    1. Paragraph (b)(1)(i) is amended by adding a new sentence after 
the third sentence.
    2. Paragraph (c)(1)(i) is amended by adding a new sentence after 
the fourth sentence.
    3. A new paragraph (d)(5) is added.
    The additions read as follows:


Sec. 25.2702-3  Qualified interests.

* * * * *
    (b) * * *
    (1) * * * (i) * *  * Issuance of a note, other debt instrument, 
option or other similar financial arrangement in satisfaction of the 
annuity amount does not constitute payment of the annuity amount. * * *
* * * * *
    (c) * * *
    (1) * * * (i) * * * Issuance of a note, other debt instrument, 
option or other similar financial arrangement in satisfaction of the 
unitrust amount does not constitute payment of the unitrust amount. * * 
*
* * * * *
    (d) * * *
    (5) Use of debt obligations to satisfy the annuity or unitrust 
payment obligation--(i) In general. The trust instrument must prohibit 
the trustee from issuing a note, other debt instrument, option or other 
similar financial arrangement in satisfaction of the annuity or 
unitrust payment obligation.
    (ii) Special rule in the case of a trust created prior to September 
20, 1999. In the case of a trust created prior to September 20, 1999, 
the interest will be treated as a qualified interest under section 
2702(b) if--
    (A) Notes, other debt instruments, options or similar financial 
arrangements are not used after September 20, 1999 to satisfy the 
annuity or unitrust payment obligation; and
    (B) Any note or notes or any other debt instruments issued to 
satisfy the annual payment obligation on or prior to September 20, 
1999, are paid in full by December 31, 1999, and, any option or similar 
financial arrangement issued to satisfy the annual payment obligation 
is terminated by December 31, 1999, such that the grantor receives cash 
or other trust assets in satisfaction of the payment obligation. For 
purposes of the preceding sentence, an option will be considered 
terminated only if the grantor receives cash or other trust assets 
equal in value to the greater of the required annuity or unitrust 
payment plus interest computed under section 7520 of the Code, or the 
fair market value of the option.
* * * * *
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 99-15524 Filed 6-21-99; 8:45 am]
BILLING CODE 4830-01-P