In Badgley v. United States, the 9th Circuit upheld summary judgment in favor of the IRS in a case regarding the legality of including the entire grantor-retained annuity trust (GRAT) value in a decedent’s estate for purposes of the estate tax under 26 U.S.C. § 2036(a)(1).
A GRAT is an irrevocable trust that meets the requirements of 26 U.S. Code § 2702. A GRAT is usually used to transfer appreciating assets to the next generation with minimal taxes due. When property is transferred to the GRAT, then such property is subject to gift taxes on the present value of the GRAT’s remainder interest, in accordance with 26 U.S. Code § 7520. A reduction in the gift value of trust property is permitted if the grantor retains an annuity interest in the trust. However, if the beneficiary is a family member, then the annuity interest must be a qualified interest under §2702. Trust property can be transferred to the beneficiary without gift tax implications by modifying the trust term and annuity amount in a way as to zero out any remainder. But what about estate taxes if the grantor dies during the annuity payout period?
In this case, the decedent created a GRAT to transfer her partnership interest in a family-run company to her daughters, while retaining a right to an annuity paid from it for 15 years. The decedent died before the end of the 15-year period, and the estate tax return included the GRAT’s assets as part of the gross total estate. The executor of the estate filed a tax refund action, arguing that the inclusion of the entire date-of-death value of the GRAT led to an overpayment and that only the net present value of the unpaid annuity payments should have been included. The district court held that the decedent’s annuity interest was both a right to income from and continued enjoyment of the property, and that thus the entire date-of-death value of the GRAT should be included in the gross estate.
The court here agreed and ruled that the IRS properly included the entire date-of-death value of the GRAT in the gross estate. The court stated, “At the most colloquial level, § 2036(a) stands for the proposition that if the taxpayer does not let property go, neither will the taxman.” While 26 U.S.C. § 2036(a)(1) does not expressly mention annuities, in that section Congress established three ways of tying a grantor to property, a string, that would require the possessor to include the property interest in the grantor’s gross estate for estate tax purposes: possession, enjoyment, or a right to income therefrom. The form of that string is not what matters – just that the string exists from one type of property to the grantor.
In addition, the court ruled that the annuity from a GRAT should be treated as a substitute for wills under § 2036(a), because the grantor did not fail to completely divest herself of possession, enjoyment, and income from the property, and the beneficiaries’ interest did not take effect prior to the grantor’s death. Here, the grantor derived substantial present economic benefit from the property, meaning she retained enjoyment of the property for the purposes of § 2036(a)(1).
The executor argues that the right to income string means a distinction should be made whether the grantor had a right to trust income or trust principal. The court here was not convinced, saying that the analysis depends on substance rather than formalities. The court declined to speculate about which part of the of trust property the annuity was drawn from. The business interest was the only property funded into the GRAT, and so the annuity stemmed from that property interest. The grantor “died before the termination of the GRAT, the property was not transferred to its beneficiaries before her death—and remained tied to her by the string she created.”
Because the grantor retained strings to the property used to fund the GRAT, the Court determined that it should be included in the gross estate. Accordingly, the Circuit Court upheld the district court’s grant of summary judgment in favor of the IRS in Badgley v. United States.
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