Qualified Interests, 9222-9224 [05-3589]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 70, Number 37 (Friday, February 25, 2005)]
[Rules and Regulations]
[Pages 9222-9224]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-3589]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 25

[TD 9181]
RIN 1545-BB72


Qualified Interests

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations amending the 
regulations under the gift tax special valuation rules to provide that 
a unitrust or annuity interest payable for a specified term of years to 
the grantor, or to the grantor's estate if the grantor dies prior to 
the expiration of the term, is a qualified interest for the specified 
term. The final regulations also clarify that the exception treating a 
spouse's revocable successor interest as a retained qualified interest 
applies only if the spouse's annuity or unitrust interest, standing 
alone, would constitute a qualified interest that meets the 
requirements of Sec.  25.2702-3(d)(3), but for the grantor's revocation 
power.

DATES: The regulations are effective July 26, 2004.

FOR FURTHER INFORMATION CONTACT: Juli Ro Kim (202) 622-3090 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On July 26, 2004, the IRS published in the Federal Register (69 FR 
44476) a notice of proposed rulemaking (REG-163679-02) conforming the 
gift tax regulations defining a qualified interest for purposes of 
section 2702 to the Tax Court's decision in Walton v. Commissioner, 115 
T.C. 589 (2000), acq. in result, Notice 2003-72, 2003-2 C.B. 964. In 
Walton, the court declared Example 5 of Sec.  25.2702-3(e) to be 
invalid. The notice of proposed rulemaking also clarifies those parts 
of the regulations under section 2702 addressing revocable spousal 
interests that were at issue in Schott v. Commissioner, 319 F.3d 1203 
(9th Cir. 2003), rev'g and remanding T.C.M. 2001-110, and Cook v. 
Commissioner, 269 F.3d 854 (7th Cir. 2001), aff'g 115 T.C. 15 (2000).
    No public hearing was requested or held, but one written comment 
and some telephone comments were received. After consideration of all 
the comments, the proposed regulations are adopted as amended by this 
Treasury decision, and the corresponding proposed regulations are 
removed. The comments and revisions to the proposed regulations are 
discussed below.

Summary of Comments

    Generally, the commentators agreed with the amendments conforming 
the regulations to the Walton decision. Several commentators requested 
that the regulations address the amount includible in the grantor's 
gross estate with respect to a Walton-type grantor retained annuity 
trust (GRAT), if the grantor dies during the GRAT term, including the 
application of Rev. Rul. 82-105 (1982-1 C.B. 133). In addition, several 
commentators requested guidance regarding the application of section 
2035 if the grantor dies within three years after termination of the 
term of the GRAT (or grantor retained unitrust (GRUT)). These 
suggestions were not adopted. The determination of the amount 
includable in the grantor's gross estate is an issue different from and 
governed by different Code sections than the definition of a qualified 
interest for purposes of section 2702, and is thus beyond the scope of 
this project. However, Treasury and IRS will consider addressing that 
issue in future guidance.
    Regarding the proposed regulations addressing revocable spousal 
interests, commentators suggested that section 2702 was enacted to 
avoid valuation problems and that, because the value of the contingent 
revocable spousal interest at issue in Schott v. Commissioner is 
readily determinable using actuarial tables, such an interest should be 
a qualified interest (as the Ninth Circuit concluded in Schott).
    Treasury and the IRS continue to believe that the proposed 
regulations properly implement section 2702 and the policy underlying 
the statute. Uncertainty in valuation is not the only valuation 
inaccuracy that the statute was intended to correct. A valuation 
inaccuracy is also present when the value of a retained interest is 
increased through the use of a joint and survivor (or two-life) annuity 
or unitrust interest if there is no certainty that the survivorship 
interest will ever be paid. The revocable spousal interest involved in 
Schott may best be described as speculative, because it takes effect, 
if at all, only if the grantor fails to survive the term of the trust, 
and the duration of the interest, if it takes effect at all, is 
dependent on the portion of the term remaining at the grantor's death. 
The existing regulations make it clear that the ability to actuarially 
determine an interest is not sufficient to secure recognition of that 
interest as a qualified interest for purposes of section 2702.

[[Page 9223]]

Under Example 1 of Sec.  25.2702-2(d)(1), neither a retained income 
interest for life nor a contingent reversionary interest in trust 
corpus payable to the grantor's estate if the grantor dies prior to the 
expiration of the trust term is a qualified interest, notwithstanding 
that the present value of both the income interest and the contingent 
reversion is readily determinable actuarially. Just as the contingent 
reversion in Example 1 would increase the value of the retained 
interest without any certainty that the reversion would ever be paid, a 
revocable spousal interest of the kind at issue in Schott would 
similarly increase the value of the retained interest without any 
certainty that the spouse's survivorship interest would ever be paid.
    Some commentators requested that the regulations also confirm the 
gift tax consequences of the lapse of the grantor's retained right to 
revoke the spouse's successor interest, for example when that 
revocation right lapses at the end of the GRAT term and the spouse's 
successor interest becomes operative. In response, language has been 
added to Sec.  25.2702-3(e), Example 8, to clarify that the grantor 
makes a completed gift to the spouse when the revocation right lapses 
on the expiration of the grantor's retained term (the grantor having 
survived the term and not having exercised the revocation right). See 
Sec.  25.2511-2(f).
    Other commentators suggested that the regulations also address the 
treatment of a revocable spousal interest in a Walton-type GRAT when 
the grantor's spouse is given a revocable survivor interest in the 
annuity payments to be made during the balance of the fixed term of the 
GRAT remaining after the grantor's death. Specifically, if the grantor 
dies prior to the expiration of the fixed GRAT term, the annuity 
interest is payable to the spouse for the balance of that term, subject 
to the grantor's power to revoke the spousal interest or, if the 
spousal interest is revoked, then to the grantor's estate for the 
balance of the fixed term. The commentators suggested that regardless 
of whether the grantor dies during the stated term or survives, the 
annuity or unitrust interest will be paid for a fixed term of years 
either to the grantor, the surviving spouse, or the grantor's estate. 
Accordingly, the commentators suggested that the interest is payable in 
all events for a fixed term, and is therefore a qualified interest. The 
commentators' suggestion would extend the concept espoused by the Tax 
Court in Walton of an ``undifferentiated unit'' consisting of the 
grantor and the grantor's estate (see 115 T.C. at 603) to include the 
grantor, the grantor's estate, and the grantor's spouse. Treasury and 
the IRS do not believe that the Tax Court opinion supports this 
extension. The spouse's revocable successor interest is an interest 
separate and distinct from the interest of the grantor and the 
grantor's estate. Further, the use of the spouse's life expectancy in 
valuing the retained interest would increase the value of that interest 
without any guarantee that the spouse would actually receive any part 
of that interest. For these reasons, the spouse's revocable successor 
interest described above does not satisfy the requirements of a 
qualified interest. Accordingly, this suggestion was not adopted.

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 also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations, and, because 
these regulations do not impose on small entities a collection of 
information requirement, the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) does not apply. 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 their impact on small business.

Drafting Information

    The principal author of these regulations is Juli Ro Kim, Office of 
the Associate Chief Counsel (Passthroughs and Special Industries), 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

0
Accordingly, 26 CFR part 25 is amended as follows:

PART 25--GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954

0
Paragraph 1. The authority citation for part 25 continues to read, in 
part, as follows:

    Authority: 25 U.S.C. 7805 * * *


0
Par. 2. In Sec.  25.2702-0, the table is amended as follows:
0
1. The entries for Sec.  25.2702-2(a)(5) through Sec.  25.2702-2(a)(9) 
are redesignated as Sec.  25.2702-2(a)(6) through Sec.  25.2702-
2(a)(10), respectively.
0
2. A new entry for Sec.  25.2702-2(a)(5) is added.
0
3. The entries for Sec.  25.2702-3(d)(2) through Sec.  25.2702-3(d)(4) 
are redesignated as Sec.  25.2702-3(d)(3) through Sec.  25.2702-
3(d)(5), respectively.
0
4. A new entry for Sec.  25.2702-3(d)(2) is added.
0
5. An entry for Sec.  25.2702-3(d)(6) is added.
    The additions read as follows:


Sec.  25.2702-0  Table of contents.

* * * * *

Sec.  25.2702-2 Definitions and valuation rules.

    (a) * * *
    (5) Holder.
* * * * *

Sec.  25.2702-3 Qualified interests.

* * * * *
    (d) * * *
    (2) Contingencies.
* * * * *
    (6) Use of debt obligations to satisfy the annuity or unitrust 
payment obligation.
* * * * *


0
Par. 3. Section 25.2702-2 is amended as follows:
0
1. Paragraphs (a)(5) through (a)(9) are redesignated as paragraphs 
(a)(6) through (a)(10), respectively.
0
2. A new paragraph (a)(5) is added.
0
3. In newly designated paragraph (a)(6), the second sentence is removed 
and two sentences are added in its place.
0
4. In paragraph (d)(1), Example 6 and Example 7 are removed.
0
5. In paragraph (d)(2), introductory text, the language ``Examples 8-
10'' is revised to read ``Examples 6 through 8''.
0
6. In paragraph (d)(2), Examples 8, 9 and 10 are redesignated Examples 
6, 7 and 8, respectively.
    The additions read as follows:


Sec.  25.2702-2  Definitions and valuation rules.

    (a) * * *
    (5) Holder. The holder is the person to whom the annuity or 
unitrust interest is payable during the fixed term of that interest. 
References to holder shall also include the estate of that person.
    (6) * * * If a transferor retains a power to revoke a qualified 
annuity interest or qualified unitrust interest of the transferor's 
spouse, then the revocable qualified annuity or unitrust interest of 
the transferor's spouse is treated as a retained qualified interest of 
the transferor. In order for the transferor to be treated as having 
retained a qualified interest under the preceding sentence, the 
interest of the transferor's spouse (the successor holder) must be an

[[Page 9224]]

interest that meets the requirements of a qualified annuity interest in 
accordance with Sec.  25.2702-3(b) and (d), or a qualified unitrust 
interest in accordance with Sec.  25.2702-3(c) and (d), but for the 
transferor's retained power to revoke the interest. * * *
* * * * *

0
Par. 4. Section 25.2702-3 is amended as follows:
0
1. Paragraphs (d)(2) through (d)(5) are redesignated as paragraphs 
(d)(3) through (d)(6), respectively.
0
2. A new paragraph (d)(2) is added.
0
3. In newly designated paragraph (d)(4), the first two sentences are 
revised.
0
4. Newly designated paragraph (d)(5) is revised.
0
5. In paragraph (e), Example 5, the last sentence is revised.
0
6. In paragraph (e), Example 6, the last sentence is removed and two 
new sentences are added in its place.
0
7. In paragraph (e), new Example 8 and new Example 9 are added.
    The revisions and additions read as follows:


Sec.  25.2702-3  Qualified interests.

* * * * *
    (d) * * *
    (2) Contingencies. A holder's qualified interest must be payable in 
any event to or for the benefit of the holder for the fixed term of 
that interest. Thus, payment of the interest cannot be subject to any 
contingency other than either the survival of the holder until the 
commencement, or throughout the term, of that holder's interest, or, in 
the case of a revocable interest described in Sec.  25.2702-2(a)(6), 
the transferor's right to revoke the qualified interest of that 
transferor's spouse.
* * * * *
    (4) Term of the annuity or unitrust interest. The governing 
instrument must fix the term of the annuity or unitrust and the term of 
the interest must be fixed and ascertainable at the creation of the 
trust. The term must be for the life of the holder, for a specified 
term of years, or for the shorter (but not the longer) of those 
periods. * * *
    (5) Commutation. The governing instrument must prohibit commutation 
(prepayment) of the interest of the holder.
* * * * *
    (e) * * *

    Example 5. * * * The interest of A (and A's estate) to receive 
the unitrust amount for the specified term of 10 years in all events 
is a qualified unitrust interest for a term of 10 years.
    Example 6. * * * As in Example 5, the interest of A (and A's 
estate) to receive the unitrust amount for a specified term of 10 
years in all events is a qualified unitrust interest for a term of 
10 years. However, the right of A's estate to continue to receive 
the unitrust amount after the expiration of the 10-year term if A 
dies within that 10-year period is not fixed and ascertainable at 
the creation of the interest and is not a qualified unitrust 
interest.
* * * * *
    Example 8. A transfers property to an irrevocable trust, 
retaining the right to receive an annuity equal to 6 percent of the 
initial net fair market value of the trust property for 10 years, or 
until A's prior death. At the expiration of the 10-year term, or on 
A's death prior to the expiration of the 10-year term, the annuity 
is to be paid to B, A's spouse, if then living, for 10 years or 
until B's prior death. A retains an inter vivos and testamentary 
power to revoke B's interest during the initial 10-year term. If not 
exercised by A during the initial 10-year term (whether during A's 
life or on A's death), A's right to revoke B's interest will lapse 
upon either A's death during the 10-year term, or the expiration of 
A's 10-year term (assuming A survives the term). Upon expiration of 
B's interest (or on the expiration of A's interest if A revokes B's 
interest or if B predeceases A), the trust terminates and the trust 
corpus is payable to A's child. Because A has made a completed gift 
of the remainder interest, the transfer of property to the trust is 
not incomplete as to all interests in the property and section 2702 
applies. A's annuity interest (A's right to receive the annuity for 
10 years, or until A's prior death) is a retained interest that is a 
qualified annuity interest under paragraphs (b) and (d) of this 
section. In addition, because A has retained the power to revoke B's 
interest, B's interest is treated as an interest retained by A for 
purposes of section 2702. B's successive annuity interest otherwise 
satisfies the requirements for a qualified interest contained in 
paragraph (d) of this section, but for A's power to revoke. The term 
of B's interest is specified in the governing instrument and is 
fixed and ascertainable at the creation of the trust, and B's right 
to receive the annuity is contingent only on B's survival, and A's 
power to revoke. Following the expiration of A's interest, the 
annuity is to be paid for a 10-year term or for B's (the successor 
holder's) life, whichever is shorter. Accordingly, A is treated as 
retaining B's revocable qualified annuity interest pursuant to Sec.  
25.2702-2(a)(6). Because both A's interest and B's interest are 
treated as qualified interests retained by A, the value of the gift 
is the value of the property transferred to the trust less the value 
of both A's qualified interest and B's qualified interest (subject 
to A's power to revoke), each valued as a single-life annuity. If A 
survives the 10-year term without having revoked B's interest, then 
A's power to revoke lapses and A will make a completed gift to B at 
that time. Further, if A revokes B's interest prior to the 
commencement of that interest, A is treated as making an additional 
completed gift at that time to A's child. In either case, the amount 
of the gift would be the present value of B's interest determined 
under section 7520 and the applicable regulations, as of the date 
the revocation power lapses or the interest is revoked. See Sec.  
25.2511-2(f).
    Example 9. (i) A transfers property to an irrevocable trust, 
retaining the right to receive 6 percent of the initial net fair 
market value of the trust property for 10 years, or until A's prior 
death. If A survives the 10-year term, the trust terminates and the 
trust corpus is payable to A's child. If A dies prior to the 
expiration of the 10-year term, the annuity is payable to B, A's 
spouse, if then living, for the balance of the 10-year term, or 
until B's prior death. A retains the right to revoke B's interest. 
Upon expiration of B's interest (or upon A's death if A revokes B's 
interest or if B predeceases A), the trust terminates and the trust 
corpus is payable to A's child. As is the case in Example 8, A's 
retained annuity interest (A's right to receive the annuity for 10 
years, or until A's prior death) is a qualified annuity interest 
under paragraphs (b) and (d) of this section. However, B's interest 
does not meet the requirements of paragraph (d) of this section. The 
term of B's annuity is not fixed and ascertainable at the creation 
of the trust, because it is not payable for the life of B, a 
specified term of years, or for the shorter of those periods. 
Rather, B's annuity is payable for an unspecified period that will 
depend upon the number of years left in the original term after A's 
death. Further, B's annuity is payable only if A dies prior to the 
expiration of the 10-year term. Thus, payment of B's annuity is not 
dependent solely on B's survival, but rather is dependent on A's 
failure to survive.
    (ii) Accordingly, the amount of the gift is the fair market 
value of the property transferred to the trust reduced by the value 
of A's qualified interest (A's right to receive the stated annuity 
for 10 years or until A's prior death). B's interest is not a 
qualified interest and is thus valued at zero under section 2702.
* * * * *

0
Par. 5. Section 25.2702-7 is amended by adding two sentences at the end 
of the section to read as follows:


Sec.  25.2702-7  Effective dates.

    * * * Section 25.2702-2(a)(5), the second and third sentences of 
Sec.  25.2702-2(a)(6), Sec.  25.2702-3(d)(2), the first two sentences 
of Sec.  25.2702-3(d)(4), the last sentence of Sec.  25.2702-3(e), 
Example 5, the last two sentences of Sec.  25.2702-3(e), Example 6, and 
Sec.  25.2702-3(e), Examples 8 and 9, apply for trusts created on or 
after July 26, 2004. However, the Internal Revenue Service will not 
challenge any prior application of the changes to Examples 5 and 6 in 
Sec.  25.2702-3(e).

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: February 15, 2005.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury.
[FR Doc. 05-3589 Filed 2-24-05; 8:45 am]
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