Take-Away: The administration a trust, either a charitable remainder trust or a grantor retained annuity trust, after it is created is equally as important as complying with the required technical terms of the trust, when the goal is to either obtain an income tax deduction or avoid the imposition of a taxable gift.

Background: The Tax Code often provides estate planning techniques that are expressly created to enable an individual to possibly achieve income and estate tax benefits. Yet those opportunities usually come with rules and conditions. A couple of well-known planning opportunities endorsed in the Tax Code are the charitable remainder annuity trust (CRAT) and the grantor retained annuity trust (GRAT.) Unlike ‘horseshoes and hand grenades,’ getting close to satisfying the technical requirements of those Tax Code sections may not be enough. While at times the Court will find that substantial compliance with tax rules is sufficient to enable the individual to achieve their tax objectives when implementing an estate planning strategy, at other times substantial compliance with the Tax Code’s requirements is not enough. Then enters the Atkinson Rationale, which is taken from the case in Atkinson v. Commissioner, 115 Tax Court 26 (2000), affirmed 11th Circuit Court of Appeals, No 01-16536 (2002).

Atkinson v. Commissioner

Facts: Mrs. Atkinson created a CRAT for selected beneficiaries for their lifetimes with the remainder then passing to several charities. Her CRAT was funded with $4 million. The CRAT provided annuity payments to Mrs. Atkinson for her lifetime; on her death, the annuity was then divided among four individual beneficiaries for their lifetimes, but subject to the condition that those individuals agree to pay their share of any estate tax due on Mrs. Atkinson’s death. When the last successor beneficiary died, any amount remaining in the CRAT would be distributed to certain charitable groups. No annuity payments were ever actually made to Mrs. Atkinson from the CRAT; while checks were mailed to her by the CRAT trustee, she never cashed the checks, since she apparently had no need for the cash. In all respects, the CRAT instrument fully complied with and contained all of the provisions required by IRC 664. When Mrs. Atkinson died two years after the CRAT was created. The successor CRAT beneficiaries then had to make an election, either accept their share of the annuity payment and also pay their share of Mrs. Atkinson’s estate tax, or they could refuse the ‘gift.’ None of the individuals elected to receive the gift. However, one of these successor beneficiaries claimed that a promise had been made to her by Mrs. Atkinson, not reflected in the CRAT’s terms, that entitled her to receive her share of the annuity payment but without being liable for her share of the federal estate tax. Eventually this beneficiary’s claim was resolved and she was paid $667,000 to end the dispute. The claim was paid by the trustee using the CRAT’s assets.

Dispute: Mrs. Atkinson’s estate claimed an estate tax charitable deduction of $3.894 million representing the CRAT’s remainder interest. [IRC 2055(a)(2).] The IRS disallowed the charitable deduction. It asserted that the CRAT failed to comply with certain statutory procedures applicable to the deductibility of charitable remainders. The estate challenged the IRS’s position in the Tax Court.

Tax Court: The Tax Court held for the IRS.  To claim a charitable deduction for a remainder interest in property, the trust must not only be set up as a CRAT, but it must also comply with the CRAT statutory requirements from its formation to its final disposition of the trust’s assets. Mrs. Atkinson failed to cash the two annual annuity checks which was required to be paid to her under the CRAT Regulations.

Appeals Court: The denial of Mrs. Atkinson’s estate’s claim for a charitable deduction was sustained on appeal. This Court held: “The documents that established the Atkinson annuity trust track the CRAT requirements to the letter. However, the Atkinson annuity trust failed to comply with the CRAT rules throughout its existence. Yearly annuity payments to Atkinson were not made during her lifetime. Accordingly , since the CRAT regulations were not scrupulously followed through the life of the trust, a charitable deduction is not appropriate. … It is not sufficient to establish a trust under the CRAT rules, then completely ignore the rules during the trust’s administration, thereby defeating the policy interests advanced by Congress in enacting the rules. Despite the certain charitable donation in this case, the countervailing Congressional concerns surrounding the deductibility of charitable remainders in general counsel strict adherence to the Code, and, barring such adherence, mandate a complete denial of the charitable deduction.”

In sum, the Atkinsons Rationale is that the trust failed to function as a charitable remainder trust; its administration caused the trust to be disqualified as a charitable remainder trust from its inception. Recently, the Atkinson Rationale was used to disqualify a GRAT from its inception.

Chief Counsel Advice 202152018

This CCA dealt with funding a GRAT with privately owned shares of stock. The donor was the founder of a very successful company who hired an investment advisory firm to solicit offers for a merger. 5 offers were received. Three days after the 5 offers were received, the donor created a 2-year GRAT, the terms of which trust instrument satisfied the GRAT rules under the Regulations. [IRC 2702.] The donor then funded his GRAT with his closely held stock. However, the appraisal used for that stock was performed 7 months earlier- moreover, that appraisal was obtained to satisfy the requirements for the corporation’s non-qualified deferred compensation plan. In reality, this appraisal valued the shares at a very low price that was much, much lower than the prices reflected in the 5 merger offers.

To make matters worse, the donor then funded a CRT also using his closely held stock, but this time he used an updated appraisal for the stock transferred to the CRT with a value three times the value used to fund the GRAT (reflecting, in part, the 5 merger offer prices per share.)

In short, the value of a share transferred to the GRAT was about one-third of the value of the 5 merger offer prices. The cascading effect of using this ‘low-ball’ appraised value was intended to produce a windfall to the GRAT’s remainder beneficiaries.

While the CCA initially focused on the value of the shares transferred to the GRAT, compared to the new appraisal that had to be obtained and used to value the transfer of shares to the CRT, the IRS found that the 6-month old appraisal was stale and that the company’s business operations had not materially changed in the intervening 6 months. The IRS started with the conventional ‘willing buyer-willing seller’ test to determine value, but then surprisingly it turned to whether the trust was even a valid GRAT.

Specifically,  the IRS looked at the definition of a qualified annuity interest [Regulation 25.2702-3(d)(1)], which provides that to be a qualified annuity interest the interest must meet the definition of and function exclusively as a qualified interest from the creation of the GRAT. Then, relying on the Atkinson Rationale, the CCA found that the same reasoning was analogous and the GRAT was disqualified due to the trust’s perceived failure to function as a GRAT from its inception.

Basically, it came down to the IRS being highly agitated by the donor’s failure to consider the facts and circumstances of the pending merger in valuing the closely held shares that he transferred to the GRAT. The fact that the GRAT trust instrument, in accordance with the Treasury Regulations applicable to GRATs, included a built-in revaluation clause to revalue the qualified annuity interest in the event of the IRS adjustment was not enough according to the IRS to ‘save the day’ and find that the trust did not qualify as a GRAT. The IRS observed:

“indeed ignoring the facts and circumstances of the pending merger undermines the basic tenants of fair market value, and yields a baseless valuation, and thereby casts more than just doubt upon the bona fides of the transfers to the GRAT….the operational effect of deliberately using an undervalued appraisal is to artificially depress the required annual annuity.”

Conclusion: In order to achieve intended tax results with a CRAT or a GRAT, the trust instruments must do more than just track the requirements of the Tax Code sections. These trusts must actually be administered as the Regulations require, something that can be lost if the individual who creates a CRAT or a GRAT forgets once they have left their estate planning attorney’s office. Substantial compliance with the Regulations may not be enough. The need to annually monitor how these unique trusts are administered, and promptly correcting mistakes and omissions, will go a long way to assure that the intended tax benefits are achieved.