Before delving into IRC Sec. 2702, the latest final word involving the use of trusts in estate planning, a basic understanding of its evolution, is necessary. In its formative years, the estate freeze was a collection of various concepts. The buy-sell agreement, private annuities, and installment sales involving family members were some of the methods implemented with success. From these theories, it was a natural lead to corporate reorganizations, partnerships using multiple tiers, and Crown loans. With these as a base and creativity as their guide, estate planners developed the self canceling installment note (SCIN), remainder interest purchases, and the private lead trust.

The Private Lead Trust

The private lead trust, also referred to as the grantor annuity trust, was, as its name suggests, a trust where the settlor retained a lead interest. The trust was typically structured for a given term of years, and assuming the grantor lived out the term, it terminated in favor of the grantor's heirs free and clear of estate and gift taxes. The advantages were numerous, especially during periods of inflation. Back in those golden pre-IRC Sec. 7520 days, the IRS used valuation tables whose interest rates were significantly lower than those of which any good money manager was capable of achieving. During the 1970s and early 1980s, the IRS valued annuity interests under the assumption that the trust would only yield 6% a year. Accordingly, given the correct annuity term and amount, by the time the trust terminated, the principle would be assumed to have been entirely consumed. This would, of course, mean that there was nothing to pass to the grantor's heirs, and accordingly there was no transfer tax to pay. (See Rev. Rul. 77-454, 1977-2 CB.)

For example, a trust for a term of 12 cars, with an annuity of 11.92% would have produced the desired "zero-out" trust, i.e., no gift tax. Thus, the grantor could transfer securities yielding 12% sufficient to pay the annuity and within 12 years would be able to transfer the principal amount without any gift tax. Variations of the term and the annuity interest were structured around the unified credit. Furthermore, if the grantor died within the term, only the present value of the remaining interest would be included in the state. Reg. Sec. 20.2031- 10(a)(1).

Next Came GRITs

The next technique involving the use of the "trust freeze" was the GRIT, or grantor retained income trust. The primary distinction between the grantor annuity trust and the GRIT was that in a GRIT the grantor was entitled to all of the income or use of the property rather than a fixed and determined amount of income. Secondly, a GRIT could not reduce the value of the remainder interest down to zero for gift tax purposes. Therefore, inherent in a GRIT was some valued gift of the remainder interest, though no tax would have to be paid if the unified credit were properly utilized. However, if the grantor survived the term, the original trust corpus and all of the built-up appreciation would have passed to the grantor's heirs free of tax, once again dependent on the unified credit used. If the grantor died during the term, the property would be included in his estate IRC Sec. 2036(a)(1), however, his unified credit would be restored. As such, a GRIT was virtually risk- free save the fees incurred in implementing the trust.

RA 87 attempted to eliminate estate freezes by enacting Sec 2036(c). In a nutshell, Sec. 2036(c) was overly broad and generally unfair and as such was repealed retroactively. The section attempted to forbid any appreciation from passing to the donee if any "string" was retained by the donor. The section also lacked definitional guidelines as to its scope and nature.

Along came IRS Notice 89-99, which purported to give guidelines and examples as to transactions which would be included within the reach of Sec. 2036(c). The notice provided a safe harbor for reversionary interests if the actuarial value of the reversion is less than 25% of the value of the income interest.

Finally, after endless complaints and testimony, Congress added new Chapter 14, which like Sec. 2036(c) is very complex and its scope and application still need much refining. However, the Treasury moved swiftly to provide guidance by drafting substantial regulations for the new chapter with a promise that more will be forthcoming.

Chapter 14 is based on a closed transaction theory, which values a transfer for gift tax purposes when the gift is made. The chapter is divided into Secs. 2701 to 2704, and covers corporate, partnership, and trust freeze methods, as well as buy-sell agreements, options, voting rights, liquidation rights, and lapsed rights.

Valuation of Lifetime Transfers

Sec. 2702 deals specifically with valuations of lifetime transfers in trusts - particularly valuation rules to apply to interests in trusts for certain family members. The section is divided into five subsections: 1) the valuation rules: 2) the definition of a qualified interest: 3) transactions that will be treated as being held in trust; 4) the divisibility of a transaction: and 5) the definition of a family member. The regulations contain six sections:

1. Valuation rules; 2. Definitions; 3. Qualified interests; 4. Transactions that will be treated as being held in trust; 5. Personal residence GRITs; and 6. Reg. Sec. 25.2702-6, reduction in taxable gifts has been reserved.

The value of a gift in trust to a family member, while the grantor or any applicable family member retains a qualified interest, is determined the value of the property at the time of the gift less the value of the retained interest Reg. Sec. 25.2702-1(b). The retained interest will be assigned a value of zero unless it is a qualified interest (QI). Herein lies a significant difference with its predecessor. Under Sec. 2036(c), if the grantor retains the safe harbor reversion, a zero-value interest for Sec. 2702 purposes, the safe harbor reversion reduced the property's gift tax value. However, under Sec. 2702 a reversion will not reduce the value of the gift. Therefore, Sec. 2702 forces higher gift tax values and eliminates the added leverage that a reversionary interest produced.

There are a few exceptions to the valuation rules, and the regulations either exclude these trusts completely or force a different valuation method. Incomplete gifts are excluded, thus allowing revocable trusts to work Reg. Sec. 25.2702-1(c)(3). Charitable-remainder trusts are similarly excluded. A transfer to a pooled income trust is wholly excluded and should be valued under conventional gift and estate valuation rules Reg. Sec. 25.2702-1(c)(4).

Personal Interest Trust is an Exception

The most interesting exception is the transfer in trust of the grantor's personal residence. The narrow definition of a personal residence trust (PRT) prohibits a great deal of latitude, but there is room for planning. A PRT is a trust whose governing instrument forbids the trust from holding any asset other than one residence that is to be used as a personal residence by the term holder Reg. Sec. 25.2702-5(d). As strict as this definition is, the Treasury allows a safe harbor for a "Qualified Personal Residence Trust" (QPRT).

A QPRT is wholly excludable from Sec. 2702 if all of the provisions are met. First, any and all distributions must only be made to the trust's term holder Reg. Sec. 25.2702-5(e)(2). Second, a QPRT can hold cash for up to three months if it is to pay expenses incurred or reasonably expected to be incurred for improvements expected to be made and to purchase a personal residence at the trust's inception Reg. Sec. 25.2702-5(e)(3)(11).

Furthermore, the residence may be sold and the cash held for a period of up to two years if the trustee intends to purchase a replacement residence. The same is true for cash received from insurance proceeds paid as a result of damage or destruction of the residence Reg. Sec. 25.2702-5(e)(3) (IV). Any excess cash other than that described must be distributed.

If these requirements are met, a grantor can freeze the value of his or her personal residence while continuing to live there. Planning possibilities exist to sell the house if less than two years remain in the term. The grantor may set up two QPRTs. It may be either a personal residence and/or a "home office" home, or an undivided fractional share in either. Reasonable adjacent land and other structures are permissible QPRT property. Consideration must be given to IRC Secs. 1034 and 121 prior to implementing a QPRT. Furthermore, the freeze can be extended, even if the residence is sold, if the trust is subsequently converted into a qualifying GRAT or GRUT (see below) Reg. Sec. 25.2702-5(c).

However, save these exceptions, a transfer in trust to a member of the family will be valued at the fair market value of the property at the time of transfer, regardless of the grantor's or applicable family member's retained interest, unless his or her retained interest is a qualified interest IRC Sec. 2702(a)(1). This is the heart of Sec. 2702. What this means is that if not properly structured with a qualified interest, the discount element of the future interest is lost. Without this discount, the grantor may as well hold the property and gift it 10 years in the future, keeping full control, and pay no gift tax currently.

As concisely structured as the qualifying trust must be, exact definitions are essential. A member of the family - the remainderman of these trusts - is defined as the individual's spouse, any ancestor or lineal descendant of the individual or the individual's spouse, any brother or sister of the individual, and any spouse of the foregoing. Thus, if a niece or nephew is to be a recipient, then a common law GRIT is fine, and there is no need to structure a qualified interest.

An applicable family member is someone who must hold a qualified interest in order for that interest not to be valued at zero. Applicable family members are defined as the transferor spouse, any ancestor of the grantor or of the grantor's spouse and the spouse of any ancestor Reg. Sec. 25.2701(d)(2).

A "transfer in trust" is defined as a transfer to a new or existing trust, or an assignment of an interest in an existing trust. The regulations, though, specifically exclude from this definition the exercise of a limited power of appointment or the execution of a qualified disclaimer. This leads to interesting possibilities. If property were left to a beneficiary, income only until attaining a certain age and remainder to the same beneficiary, and if such beneficiary disclaimed only his or her income interest to an applicable family member, then the trust would need not be structured with a qualified interest Reg. Sec. 25.2702-(a)(2). However, beware of local laws.

A Qualified Interest is...

A qualified interest (QI) is one of three things: 1) a qualified annuity interest; 2) a qualified unitrust interest; or 3) a qualified remainder interest Reg. Sec. 25.2702-2(a)(4). Most practitioners are familiar with an annuity or unitrust as it relates to a charitable remainder trust. They are precisely the same thing. In fact, the regulations define these interests with reference to the charitable remainder provisions. Whether these GRATs (grantor retained annuity trust) and GRUTs (grantor retained unitrusts) need be drafted with the same conciseness to qualify, remains to be seen. Suffice to say that the qualifications are stringent as is. For instance, the trust must be either a GRAT or a GRUT. If the trust is structured to pay the larger of the unitrust or annuity amount, the payment fails to qualify as a QI Reg. Sec. 25.2702-3(?)(1). Thus, the retained interest in this instance is valued at zero for subtraction purposes.

A qualified annuity interest (QAI) and qualified unitrust interest (QUI) may be payable no less frequently than annually. They must actually be paid, though the payment can be made after the close of the taxable year, but prior to April 15 of the following year Reg. Sec. 25.2701-3(a) (1)(1) and 25.2701-3(c)(1)(i). An annual noncumulative right to withdraw a fixed percentage is not a QI. An interesting question covered by the regulations is whether an amount in excess of the annuity or unitrust retained would be eligible for valuation purposes. For example, if the grantor retained an income stream of 8% plus, if available, another $3,000, would the present value of that interest reduce the value of the gift? Taking the example to its highest degree would be to have an annuity or unitrust distribution plus all the remaining income as a retained interest. This, of course, is the same as retaining all of the income, or in other words, a GRIT. Surprisingly, the regulations do not value this interest at zero. Rather, the amount stipulated properly as a QI, the annuity or unitrust interest, is subtracted from the property for transfer tax purposes while the income in excess of that amount is ignored Reg. Sec. 25.2702-3(b)(1)(B)(iii). So a trust requiring an 8% annuity will have the same value as a trust requiring 8% and all of the remaining income to be distributed.

GRITs, GRATs, GRUTs: Distinction Without a Difference?

At first glance, the differences between a GRIT and a GRAT/GRUT seem small. The latter requires an ascertainable value, whereas the former may be influenced by the investment decision to minimize income. This seems to be in accord with the scope of the law. Forcing a fixed dollar amount out of the trust limits the potential appreciation and more justly values the gift.

The Treasury has forced an estate tax savings by requiring a QI. Under prior law, if a grantor died during the term of a GRIT, the full value of the trust would have to be included in the estate. A GRIT, after all, is a transfer in which the grantor retained for a period the right to "the income," which if held up to death causes full inclusion. This provision, however, is not a penalty, as any tax paid is credited or the unified credit used is restored. All of the appreciation which has accrued is forced back into the estate and, if not properly provided for with a reversionary clause, may cause unwarranted estate tax and liquidity problems.

It seems to follow that if the gift tax valuation of a QI is based on the charitable remainder sections, then the estate tax inclusion of the interest should be analogous. The amount includable in the grantor's estate is only that portion of the trust necessary to produce the annuity amount Rev.Rul. 82-105. This amount is determined using IRC Sec. 7520.

The qualifying GRAT GRUT will only permit the QI to be paid to the grantor or an applicable family member and may not be subsequently transferred to another Reg. Sec. 25.2702-3(d)(2). The term can be for life, or for a term of years or for the shorter of these periods Reg.Sec. 25.2702-3(d)(3). There may not be a provision to end the trust by paying off the remaining QI (a commutation power) Reg. Sec. 25.2702- 3(d)(4). A reversion may be included in the trust allowing for a marital or charitable deduction if the grantor dies in the interim. The reversion though has a zero value Reg. Sec. 25.2702-3(e) ex 1.

Another Option

There is yet another trust freeze, which, if properly implemented, can produce excellent transfer tax savings. Sec. 2702 carves out another exception that applies only to non-depreciable property having no extraneous rights attached to it Reg. Sec. 25.2702-2(c)(2). Furthermore, even this definition is not steadfast.

If there are depreciable improvements on land of 2% or less of the value of the property the exception still holds. The exception eliminates the Sec. 7520 valuation. Rather, if there is a transfer with a retained interest in land, the standard "willing buyer-willing seller" valuation method is used. This will prove very beneficial in periods of low interest rates. However, the IRS will be very wary of how the property is valued.

Actual sales or rentals of a comparable nature will be considered good evidence of value. Appraisals will be given little weight Reg. Sec.25.2702-2(C)(3). If the property is sold or converted into non- qualifying property, the conversion of the term interest Reg. Sec. 25.2702-2(c)(4). However, similar to the QPRT exception, if the term interest is converted into a QI, then no gift will be deemed. If any improvement is subsequently made that would have caused an original failure to qualify, then the entire property fails at the time of improvement.

In summation, though Sec. 2702 was brought to us by the same people who gave us Sec. 2036(c) and Notice 89-99, there seems to be some semblance of order and stability to their thinking. There is still plenty of room for improvement, as certain clauses still overlap and do not generally mesh. But overall, Sec. 2702 shows itself to be quite workable.