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Ninth Circuit Holds Annuities from a GRAT Were Includible in the Taxable Estate under Section 2036(a)(1) By: CORY STIGILE and TENZING TUNDEN

In Badgley v. U.S, 957 F.3d 969 (9th Cir. 2020), the9th Circuit addressed the unfortunate fact pattern when a taxpayer dies prior to the termination of a lengthy (15-year) grantor-retained annuity trust (“GRAT”). 

As background, GRATs allow a grantor to transfer property to a beneficiary in trust while retaining the right to an annuity for a specified term of years.  In the year of the transfer, the grantor is taxed on a gift for the difference between the transferred property and the value of the annuity retained, as computed under the regulations.  At the end of the term, the GRAT dissolves and the property is transferred to the beneficiaries.  Id. at 972. This transfer can be free of estate tax, and with a gift tax that is diminished or even eliminated. Id.  This works to effectively transfer any appreciation of the underlying property in the GRAT if the assets sufficiently appreciate.  This estate and gift planning approach can be attractive at times, such as now, when the interest rates are very low, thereby permitting lower annuity payments, or when assets are either depressed or may significantly appreciate in the future.  The grantor, however, risks that either the property does not appreciate, or that the grantor dies.  Here, the grantor died and the executor of her estate sought to not be taxable on a retained interest. 

The 9th Circuit reviewed the District Court’s holding that a decedent’s retained annuity interest from the GRAT both retained a right to income from and permitted continued enjoyment of the property.  Id. at 974.   The 9thCircuit reviewed the lower court decision de novo and held that the government correctly included the entire date-of-death value of the GRAT in the decedent’s gross estate.   Id. at 972.

The Court addressed the taxpayer’s primary argument that the annuity flowing from the GRAT operated as a substitute for a will to relinquish possession and enjoyment of the property, thereby avoiding the force of § 2036(a).  To relinquish the property, the grantor must “absolutely, unequivocally, and without possible 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.” Commissioner v. Church’s Estate, 335 U.S. 632 at 645–46.  Accordingly, § 2036(a)(1) focuses on both the grantor, who must completely divest herself of possession, enjoyment, and income, and the beneficiaries, whose interest must “take effect” prior to the grantor’s death. See id. at 637.

Ultimately, the decedent’s annuity was a substantial present economic benefit, requiring inclusion of the GRATs date-of-death value in her estate.  The Court noted that the partnership interest was the only property in the GRAT, and the annuity stemmed from that property interest.  Since decedent died before the termination of the GRAT, the property was not transferred to its beneficiaries before her death thus it remained tied to her by the string she created.  Id. at 973.  Query whether the result may have been different if the asset was transferred for an arms-length note that constituted bona fide indebtedness.  Various other arguments, such as the formula in Treasury Regulation §20.2036-1(c)(2) to calculate the portion of property includable under §2036(a), were rejected by the Court.

While GRATs present potential estate planning benefits (particularly in light of the low §7520 interest rate), the benefits and consequences under the Internal Revenue Code provisions and related regulations hinge on the value of the assets put in trust, the value of the retained annuity interests, and the life expectancy.  While it was possible to have a shorter trust, the taxpayer opted for a longer trust period and arguably retained interests in the property.  Ultimately, the decedent’s remaining strings to the property in the GRAT resulted in the property not being transferred to the beneficiaries, thus remaining in her estate.

Cory Stigile – For more information please contact Cory Stigile – stigile@taxlitigator.com  Mr. Stigile is a principal at Hochman Salkin Toscher Perez P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state controversy matters and tax litigation, including sensitive tax-related examinations and investigations for individuals, business enterprises, partnerships, limited liability companies, and corporations. His practice also includes complex civil tax examinations. Additional information is available at www.taxlitigator.com

Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C. Mr. Tunden recently graduated from the Graduate Tax Program at NYU School of Law and the J.D. Program at UC Davis School of Law. During law school, Mr. Tunden served as an intern at the Franchise Tax Board Legal Division and at the Tax Division of the U.S. Attorney’s Office (N.D. Cal).

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