IRS ATTACKS GRITS WHICH USE DEBT TO DEFER ANNUITY PAYMENTS

The most common type of GRIT (Grantor Retained Interest Trust) is the qualified personal residence trust or QPRT. Here is how a QPRT works. Parent who has a federal taxable estate wants to take steps to reduce the size of the estate. Parent has been told that if parent transfers her residence to a QPRT having a term of say 10 years (Parent must outlive the term of the trust if this strategy is to work), the value of the residence gifted to the QPRT is reduced by the value of Parent's right to use the residence while in the trust for the term of the trust, to wit, 10 years. The children who are the beneficiaries of the trust will receive the residence once the trust terminates at the end of the 10 year period but they must wait for 10 years. Thus, the value of the gift is reduced for gift tax purposes to about 50% of the full value of the property. Thus if the property is valued at $500,000, the gift will be treated as having a value of, say, $250,000. Thus $250,000 will not be subject to gift or estate taxes.

Not a bad idea. The problem comes up when the residence is sold. If the proceeds are not entirely invested in a new residence, the excess must be used to pay Parent an annuity for the balance of the 10 year term of the trust. Rather than pay cash, why not just give Parent a promissory note? This way the cash can be invested in investments producing a return higher than the current market. This is a great little idea and the IRS would agree. The problem is that its so good that the IRS doesn't like it. Thus the IRS has new proposed regulations which require GRITS including QPRTS executed after September 20, 1999 to contain provisions which specifically prohibit the use of notes, other debt instruments, options or similar financial arrangements as a method of satisfying what would otherwise be the need to make a cash payment. Now for trusts which are created prior to September 20, 1999 and which do not contain prohibitions against using notes or other debt instruments, those QPRTS will qualify if no such note or similar arrangement is in fact used. Now in the situation where a trust has already issued a note or debt instrument, that obligation must be paid by December 31, 1999 in order for the GRIT to work.

Note that the proposed regulation is not limited to promissory notes. It also applies to any debt arrangement, option or similar arrangement seeking defer a cash payment. See 64 Federal Register 33,235 (June 22, 1999).