In December 2021, the IRS took a stringent stance on the effect of the valuation of assets contributed to a GRAT, resulting in a large taxable gift. Specifically, Office of Chief Counsel IRS memorandum 202152018 stated that an outdated appraisal that did not consider a pending sale was not sufficient for gift tax valuation purposes.
The taxpayer-funded a grantor retained annuity trust, or GRAT, with shares of their company in the same year the taxpayer commenced discussions with multiple buyers to sell the company. Three days after receiving multiple offers to purchase the company, the taxpayer transferred shares of the company to the GRAT.
Approximately six months after funding the GRAT, the taxpayer accepted one of the offers that was nearly three times greater than the value of the company used for gift tax purposes. Several weeks before that, the taxpayer obtained a new appraisal that considered the tender offer and made a gift to a charitable remainder trust.
The gift tax return reporting the transfer to the GRAT used an appraisal obtained seven months prior to the transfer. The appraisal did not account for the offers received from the potential buyers at the time of the transfer to the GRAT. Additionally, the appraisal was not obtained specifically for gift tax purposes; rather, the company obtained the appraisal to fulfill its reporting requirements for its nonqualified deferred compensation plans.
The IRS memorandum applied the fair market value standard, which depends on the price at which the asset would change hands between a hypothetical willing buyer and seller. The IRS stated that the hypothetical willing buyer would have been reasonably informed during the course of the negotiations of the pending purchase and sale of the shares and would have knowledge of all relevant facts in this case.1 Therefore, according to the IRS, the valuation the taxpayer used was severely undervalued for gift tax purposes.
Typically, a transfer of an asset to a GRAT results in a very low taxable gift. An asset is transferred to the trust in exchange for a retained annuity that has a present value equal or close to the value of the contributed asset, resulting in either no taxable gift or a small taxable gift.
The amount of the annuity payments is based on the initial fair market value of the trust, which, in this case, was the fair market value of the shares used to fund the trust.
The taxpayer was treated as making a gift equal to the higher value of the shares, which took into consideration the pending merger and all current offers. In the memorandum, the IRS valued the retained annuity payments at zero, resulting in a very large taxable gift and gift tax balance due for the taxpayer.
Valuing the retained annuity payments at zero was a surprising stance by the IRS, rather than adjusting the amount of the taxable gift based on the higher fair market value of the contributed shares. This result is quite severe, especially because it results in a taxable gift equal to the full value of the contributed shares, even though a significant portion of the contributed value will be paid back to the taxpayer.
Some takeaways from this example include: