The IRS is seeking about $736 million in gift tax and penalties from the Elcan family, which used GRATs to transfer wealth to its children.
The IRS is seeking about $736 million in gift tax and penalties from the Elcan family, which used GRATs to transfer wealth to its children.
Can a trust make its required payment to a parent by canceling the parent’s debt to the trust?
A grantor retained annuity trust starts with a parent putting assets into a trust and keeping the right to receive fixed payments for a period of years. The children receive what is left after those payments.
For gift-tax purposes, the value transferred is reduced by the value of the payments the parent will receive. Set those payments high enough, and the taxable gift can be close to zero. If the assets outperform the interest rate used in that calculation, value can remain for the children when the term ends.
Once the investments have appreciated, a family may want to preserve the gain already inside the GRAT. An equal-value swap lets the parent take those investments back. Using a note lets the parent do that without supplying cash at the time. The trust then depends on the parent’s promise to pay.
The Elcan trusts allowed the parent to exchange property of equal value with the trusts. The parent used that power to take investments back and replace them with her own promissory notes. The trusts then held her promises to pay instead of the investments.
When annuity payments came due, the trusts canceled portions of that debt. The parent owed less to the trusts, and the trusts treated that reduction as payment of the annuities they owed her.
The family says the trusts were distributing an asset they already owned. The trusts had not issued their own notes promising to pay the annuities later.
The IRS says the steps amount to an indirect payment by note. The regulation says that issuing a note, directly or indirectly, does not satisfy the annuity payment requirement.
The distinction is between the trust giving the parent its own promise to pay and the trust using the parent’s existing debt as payment. The IRS wants the asset swap and the later debt cancellation considered together.
The IRS also disputes whether the notes were genuine debt and equal in value to the assets exchanged.
According to the family’s lawyer, the third GRAT did not grow enough to leave anything for the daughters. The IRS nevertheless seeks to treat its original funding as a taxable gift.
Why does that matter so much? Section 2702 generally assigns a value of zero to a retained interest that does not qualify. If the parent’s annuity is valued at zero, it no longer reduces the gift-tax value of the original transfer.
The dispute therefore reaches back to the calculation that made the gift small in the first place. The court has not decided that issue.
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