[Federal Register Volume 65, Number 172 (Tuesday, September 5, 2000)]
[Rules and Regulations]
[Pages 53587-53589]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-22544]


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DEPARTMENT OF TREASURY

Internal Revenue Service

26 CFR Part 25

[TD 8899]
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: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
definition of a qualified interest under section 2702 of the Internal 
Revenue Code. The final 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. These final 
regulations affect individuals who make a transfer in trust to a family 
member and retain an interest in the trust. These final regulations 
clarify that a trust that uses a note, other debt instrument, option, 
or similar financial arrangement to satisfy the annual payment 
obligation does not meet the requirements of section 2702(b).

DATES: Effective Date: These regulations are effective September 5, 
2000.

FOR FURTHER INFORMATION CONTACT: James F. Hogan, (202) 622-3090 (not a 
toll-free number).

[[Page 53588]]


SUPPLEMENTARY INFORMATION:

Background

    On June 22, 1999, the IRS published in the Federal Register (64 FR 
33235) a notice of proposed rulemaking (REG-108287-98) relating to the 
definition of a qualified interest under section 2702. The IRS received 
comments on the notice of proposed rulemaking; however, no request for 
a public hearing was received so no public hearing was held. This 
document adopts final regulations with respect to the notice of 
proposed rulemaking. A summary of the principal comments received is 
provided below.
    In addition, the final regulations clarify the regulatory rule 
regarding the payment period of the annuity or unitrust amount and the 
proration of payments for periods of less than 12 months.

Comments on Notice of Proposed Rulemaking

    Under the proposed regulations, the use of a note, other debt 
instrument, option, or similar financial arrangement does not 
constitute a payment of the annuity or unitrust amount to the grantor 
as required by section 2702. Further, the proposed regulations provide 
that 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.
    Commentators suggested that the regulations should permit the use 
of short-term notes or notes that bear interest at the section 7520 
rate. This suggestion was not adopted. A note issued by the trust, 
regardless of the term or the interest rate, effectively defers the 
required payment. Thus, the issuance of a note is not the current 
payment of the annuity or unitrust amount not less frequently than 
annually as required by the statute. Under these provisions, in order 
to satisfy the annuity or unitrust payment obligation under section 
2702(b), the annuity or unitrust amount must be paid with either cash 
or other assets held by the trust.
    Commentators also questioned whether the prohibition on the use of 
notes to make the annuity or unitrust payment applies if the trustee 
borrows the required funds from an unrelated party. The Treasury 
Department and the IRS acknowledge that a trustee may borrow from an 
unrelated party to make the payment. However, the step transaction 
doctrine will be applied where a series of transactions is used to 
achieve a result that is inconsistent with the regulations. For 
example, suppose that the trustee borrows cash from a bank to make the 
required annuity payment and then borrows cash from the grantor to 
repay the bank. Similarly, suppose the grantor requests that a bank 
make a loan to the trust, but as a prerequisite for making the loan, 
the bank requires the grantor to deposit with the bank an amount equal 
to the loan. There is no substantive difference between these series of 
transactions and the situation in which a trustee issues a note for the 
annuity amount directly to the grantor. The final regulations have 
added the words ``directly or indirectly'' to clarify this point.
    In response to a comment, the final regulations clarify that a 
trust instrument provision expressly prohibiting the use of notes to 
satisfy the annual payments is not required for trusts established 
before September 20, 1999. However, as provided in the regulations, a 
retained interest in a trust established before September 20, 1999, 
will not be treated as a qualified interest if notes are used after 
September 20, 1999, to satisfy the payment obligation, or any notes 
issued to satisfy the annual payment obligation on or prior to 
September 20, 1999, are not paid in full by December 31, 1999.

Proration of First Year's Payment

    In response to comments, the regulations clarify the rules covering 
the period on which the annual payment must be based and the proration 
of the annuity or unitrust amount in the case of short periods. The 
final regulations make it clear that the annuity or unitrust amount 
need not be payable based on the taxable year of the trust. Rather, the 
annuity or unitrust amount may be payable annually or more frequently, 
(for example, monthly, quarterly, or semi-annually) based on the 
anniversary date of the creation of the trust. Thus, a trust providing 
for an annuity interest created on May 1st need not require that the 
trustee make payments based on the taxable year of the trust. Instead, 
the entire annual payment may be made by April 30th of each succeeding 
year of the trust term. If payment is based on the anniversary date of 
the trust, proration of the annuity or unitrust amount will be required 
only if the last period during which such amount is payable to the 
grantor is a short period. On the other hand, if payment is based on 
the taxable year of the trust, proration is required for each short 
taxable year of the trust during the grantor's term.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 
6) do not apply to these regulations, and therefore, a Regulatory 
Flexibility Analysis is not required. Pursuant to section 7805(f) of 
the Internal Revenue Code, the notice of proposed rulemaking preceding 
these regulations was submitted to the Small Business Administration 
for comment on its impact on small business.

Drafting Information

    The principal author of these 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.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 25 is 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 revising the second and fourth 
sentences, and removing the last sentence.
    2. Paragraph (b)(3) is revised.
    3. Paragraph (b)(4) is redesignated as paragraph (b)(5).
    4. A new paragraph (b)(4) is added.
    5. Paragraph (c)(1)(i) is amended by revising the third and fifth 
sentences and removing the last sentence.
    6. Paragraph (c)(3) is revised.
    7. Paragraphs (c)(4) and (d)(5) are added.
    The revisions and additions read as follows:


Sec. 25.2702-3  Qualified interests.

* * * * *
    (b) * * *
    (1) * * * (i) * * * The annuity amount must be payable to (or for 
the benefit of) the holder of the annuity

[[Page 53589]]

interest at least annually. * * * Issuance of a note, other debt 
instrument, option, or other similar financial arrangement, directly or 
indirectly, in satisfaction of the annuity amount does not constitute 
payment of the annuity amount.
* * * * *
    (3) Payment of annuity amount. The annuity amount may be payable 
based on either the anniversary date of the creation of the trust or 
the taxable year of the trust. In either situation, the annuity amount 
may be paid annually or more frequently, such as semi-annually, 
quarterly, or monthly. If the payment is made based on the anniversary 
date, proration of the annuity amount is required only if the last 
period during which the annuity is payable to the grantor is a period 
of less than 12 months. If the payment is made based on the taxable 
year, proration of the annuity amount is required for each short 
taxable year of the trust during the grantor's term. The prorated 
amount is the annual annuity amount multiplied by a fraction, the 
numerator of which is the number of days in the short period and the 
denominator of which is 365 (366 if February 29 is a day included in 
the numerator).
    (4) Payment of the annuity amount in certain circumstances. An 
annuity amount payable based on the anniversary date of the creation of 
the trust must be paid by the anniversary date. An annuity amount 
payable based on the taxable year of the trust may be paid after the 
close of the taxable year, provided the payment is made no later than 
the date by which the trustee is required to file the Federal income 
tax return of the trust for the taxable year (without regard to 
extensions). If the trustee reports for the taxable year pursuant to 
Sec. 1.671-4(b) of this chapter, the annuity payment must be made no 
later than the date by which the trustee would have been required to 
file the Federal income tax return of the trust for the taxable year 
(without regard to extensions) had the trustee reported pursuant to 
Sec. 1.671-4(a) of this chapter.
* * * * *
    (c) * * *
    (1) * * * (i) * * * The unitrust amount must be payable to (or for 
the benefit of) the holder of the unitrust interest at least annually. 
* * * Issuance of a note, other debt instrument, option, or other 
similar financial arrangement, directly or indirectly, in satisfaction 
of the unitrust amount does not constitute payment of the unitrust 
amount.
* * * * *
    (3) Payment of unitrust amount. The unitrust amount may be payable 
based on either the anniversary date of the creation of the trust or 
the taxable year of the trust. In either situation, the unitrust amount 
may be paid annually or more frequently, such as semi-annually, 
quarterly, or monthly. If the payment is made based on the anniversary 
date, proration of the unitrust amount is required only if the last 
period during which the annuity is payable to the grantor is a period 
of less than 12 months. If the payment is made based on the taxable 
year, proration of the unitrust amount is required for each short 
taxable year of the trust during the grantor's term. The prorated 
amount is the annual unitrust amount multiplied by a fraction, the 
numerator of which is the number of days in the short period and the 
denominator of which is 365 (366 if February 29 is a day included in 
the numerator).
    (4) Payment of the unitrust amount in certain circumstances. A 
unitrust amount payable based on the anniversary date of the creation 
of the trust must be paid by the anniversary date. A unitrust amount 
payable based on the taxable year of the trust may be paid after the 
close of the taxable year, provided the payment is made no later than 
the date by which the trustee is required to file the Federal income 
tax return of the trust for the taxable year (without regard to 
extensions). If the trustee reports for the taxable year pursuant to 
Sec. 1.671-4(b) of this chapter, the unitrust payment must be made no 
later than the date by which the trustee would have been required to 
file the Federal income tax return of the trust for the taxable year 
(without regard to extensions) had the trustee reported pursuant to 
Sec. 1.671-4(a) of this chapter.
    (d) * * *
    (5) Use of debt obligations to satisfy the annuity or unitrust 
payment obligation--(i) In general. In the case of a trust created on 
or after September 20, 1999, 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 issued after September 20, 1999, to satisfy the 
annuity or unitrust payment obligation; and
    (B) Any notes or any other debt instruments that were 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 Internal 
Revenue Code, or the fair market value of the option.
* * * * *

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: August 10, 2000.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 00-22544 Filed 9-1-00; 8:45 am]
BILLING CODE 4830-01-P