ABA Members Agree With Proposed Technical Changes To Qualified Interest Rules.

Max Gutierrez Jr., Lloyd Leva Plaine, Pam H. Schneider, Carol A. Harrington, Carlyn S. McCaffrey, and Steve R. Akers of the American Bar Association (ABA) Real Property, Probate and Trust Law Section have expressed agreement with certain changes to regulation section 25.2702-3 that were proposed by the American College of Trust and Estate Counsel. Those changes include: (1) revising example 5 in regulation section 25.2702-3(e) to eliminate the suggestion that a portion of an annuity amount payable after the annuitant's death is not a qualified interest; (2) revising regulation sections 25.2702- 3(b)(1)(i) and (c)(1)(i) to permit annuity or unitrust payments that are to be made to persons designated by the transferor in the future to be treated as a qualified interest; (3) revising regulation sections 25.2702-3(b)(1)(ii) and (c)(1)(ii) to permit the portion of an annuity amount or of a unitrust amount payable in one year that exceeds the amount payable in the prior year by more than 120 percent to be treated as a qualified interest; (4) revising regulation sections 25.2702-3(b)(1)(i) and (c)(1)(i) to delete the requirement that the trust's governing instrument must require that the annuity or unitrust amount be payable at least once in each tax year of the trust; (5) revising regulation section 25.2702-3(b)(4) to delete the requirement that the governing instrument of a trust that provides a qualified annuity interest contain a prohibition against additions; and (6) revising regulation section 25.2702-3(d)(2) to permit the trust's governing instrument to allow required payments to more than one person if the required payments would otherwise have been treated as qualified annuity or unitrust interests.

In addition, the ABA members ask that the Service issue a technical correction to the final regulations confirming that a remainder interest in a personal residence that is not transferred in trust can meet the regulatory requirements of a personal residence trust or a qualified personal residence trust, through a joint purchase or joint ownership agreement that contains the governing instrument requirements.

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December 15, 1993

Honorable Leslie B. Samuels

Honorable Margaret Milner Richardson

Honorable David L. Jordan

Re: Final Regulations Under Chapter 14 of

Dear Sirs and Madam:

We are writing with respect to the final regulations under Chapter 14 of the internal Revenue Code. In response to the proposed 1993 IRS Business Plan, we are working on comments to be submitted to you later proposing certain technical corrections to those regulations.

Although each of us holds officer, council or committee positions in the Real Property, Probate and Trust Law Section of the American Bar Association, we are writing in our individual capacities. The views expressed in this letter have not been approved by the Council of that Section, the House of Delegates or the Board of Governors of the American Bar Association and accordingly should not be construed as representing the policy of the American Bar Association or of the Real Property, Probate and Trust Law Section.

We are enclosing a set of comments with respect to a portion of those regulations, Treas. Reg. section 25.2702-3, prepared by the American College of Trust and Estate Counsel and, we believe, previously submitted to you. Some of us, as members of the American College of Trust and Estate Counsel, were involved in the preparation of the enclosed. All of us nave carefully reviewed it, concur in the views expressed in it and urge you to carefully consider it.

In addition, there is an additional item that we would urge you to consider at this time:

Some practitioners have expressed the concern that it is unclear whether a remainder interest in a personal residence that is not transferred in trust, can meet the regulatory requirements of a personal residence trust or a qualified personal residence trust. Others believe that as there is no requirement in the statute or the regulation that a state law trust be created, the regulatory requirement can be met in a Joint Purchase or Joins Ownership Agreement that contains the governing instrument requirements. We agree with this latter position and request that it be confirmed in a technical correction to the final regulations.

If you would like to discuss the matters raised in this letter, the enclosure, or any other aspect of the Chapter 14 regulations, please feel free to contact any of the undersigned. Thank you for considering these views.

Very truly yours,

Max Gutierrez, Jr.

Enclosure

cc: Richard Grosgebauer, Esq.,

RESOLUTION

RESOLVED, that the Board of Regents of the American College of Trust and Estate Counsel authorizes the President of the College (or his designee) to send to appropriate officials of the Treasury the attached report recommending certain technical changes to Treas. Reg. section 25.2702-3.

October 18, 1993

COMMENTS CONCERNING TREAS. REG. SECTION 25.2702-3

Prepared by:

AMERICAN COLLEGE OF TRUST AND ESTATE COUNSEL

I.R.C. section 2702(a)(2)(B) excludes retained qualified interests from the zero valuation rule that applies generally to retained interests in trusts. Qualified interests are to be valued under I.R.C. section 7520.

The term "qualified interest" is defined simply in I.R.C. section 2702(b) as --

"(1) any interest which consists of the right to receive fixed

(2) any interest which consists of the right to receive amounts

(3) any noncontingent remainder interest if all of the other

Treas. Reg. section 25.2702-3 superimposes a number of additional requirements (the so-called "governing instrument" requirements) and, in addition concludes that certain payments, despite the fact that the governing instrument requirements have been satisfied, will not be treated as qualified interests.

We believe that most of the conclusions reflected in Treas. Reg. section 25.2702-3 are reasonable and satisfy legitimate governmental concerns as to possible abusive use of qualified interests. There are, however, six significant issues that we believe were incorrectly decided. One of these six (and the first issue discussed below) involves a misinterpretation of the statute. The other five are inconsistent with the statement in the preamble to the proposed regulations that these requirements "generally look to the rules governing charitable led annuity and unitrust interests." For the most part, the positions taken in the regulations on these issues are inconsistent with the position taken on identical issues that arise in connection with the definition of charitable lead annuity trusts and charitable lead unitrusts (Treas. Reg. section 25.2522(c)- 3(c)(2)(vi) and (vii)). To correct the regulations, we suggest the following six revisions, each of which is discussed more fully below.

1. Treas. Reg. section 25.2702-3(e) Ex. 5 should be revised to

2. Treas. Reg. section 25.2702-3(b)(1)(i) and (c)(1)(i) should

3. Treas. Reg. section 25.2702-3(b)(1)(ii) and (c)(1)(ii) should

4. Treas. Reg. section 25.2702-3(b)(1)(i) and (c)(1)(i) should

5. Treas. Reg. section 25.2702-3(b)(4) should be revised to

6. Treas. Reg. section 25.2702-3(d)(2) should be revised to

* * * * *

DISCUSSION

A. DEFINITION OF QUALIFIED INTEREST

1. Treas. Reg. section 25.2702-3(e) Ex. 5 should be revised to

We believe the most significant error in the regulations dealing with qualified interests is the suggestion in Treas. Reg. section 25.2702-3(e) Ex. 5 that the portion of an annuity amount payable after the annuitant's death is not a qualified interest.

Treas. Reg. section 25.2702-2(a)(6) and (7) define a qualified annuity interest and a qualified unitrust interest as interests that meet the requirements of Treas. Reg. section 25.2702-3(b) and (d) and Treas. Reg. section 25.2702-3(c) and (d), respectively. Treas. Reg. section 25.2702-2(b)(2) requires that the value of a qualified annuity interest or a qualified unitrust interest be valued under I.R.C. section 7520 and I.R.C. section 664, respectively. Treas. Reg. section 25.2702-3(d)(3) requires that the term of the qualified annuity or unitrust interest be payable over one of three different terms -- (1) for the life of the term-holder, (2) for a specified term of years, or (3) for the shorter of these two periods.

Thus, an annuity or unitrust interest that is payable for a specified term of years is a qualified interest in its entirety if the other requirements set forth in Treas. Reg. section 25.2702-3 are satisfied.

Examples 2 and 3 in Treas. Reg. section 25.27.2702-3(e) confirm this conclusion. Both examples describe annuity payments to be made over a specified period of time. In each case, the example concludes that the annuity is a qualified annuity interest to the extent of the term-holder's right to receive a particular amount in each year that an amount is required to be paid.

Treas. Reg. section 25.2702-3(e) Ex. 5, however, casts some doubt on this conclusion. Example 5 describes a unitrust interest payable to the grantor on the grantor's estate for a 10-year term. The example concludes, without explanation, that the unitrust interest is qualified only "to the extent of the right to receive the unitrust payment for 10 years or until A's [the grantor's] prior death.

Example 5's failure to ascribe qualified interest treatment to that portion of an annuity or unitrust interest payable after the term-holder's death is inconsistent with I.R.C. section 2702, with the general descriptions of qualified interests contained in Treas. Reg. section 27.2702-2(a)(6) and (7), with the explicit description of the terms permitted for qualified interests contained in Treas. Reg. section 25.2702-3(d)(3), and with Examples 2 and 3. We believe that Treasury lacks the authority to deny qualified interest treatment to post-death annuity or unitrust payments.

To the extent that Example 5 was adopted because of a concern over the apparent inconsistency between the statute's treatment of post-death annuity payments and post-death contingent reversion payable if the term-holder dies within the specified term of the trust, that concern is misplaced. The statute prohibits assigning value to contingent reversions. But, there is nothing contingent about an annuity interest that requires payments after death. Such annuity payments to be paid whether or no the term-holder is alive. If the term-holder dies before all of the payments to which he or she is entitled have been received. I.R.C. section 2033 will require the inclusion his or her estate of the remaining annuity payments.

During the period permitted for comments on the proposed regulations, some expressed concern about an apparent inconsistency between valuing annuity payments payable to the estate of a deceased annuitant and refusing to value that portion of the contingent revision that represents the annuity that would have been payable to the annuitant had he or she not died within the term.

As a matter of substance, an inconsistency does exist. A strong case can be made that, despite the form of the transfer, the portion of the reversion that represents the annuity that would have bean paid to the annuitant had he or she lived is not really contingent and should be given value.

However, it is well within Treasury's regulatory power for it to refuse to look beyond the form prescribed by the taxpayer (i.e., an annuity payable until the earlier of a stated term or the annuitant's death coupled with a contingent reversion if the annuitant dies within the term) to recognize that the stated contingent reversion is not contingent at all to the extent it represents annuity payments that would have been made had the annuitant lived. Such a refusal is consistent with Treasury's position in other transfer tax areas.

Nevertheless, the substantive inconsistency created by Treasury's refusal to look beyond form to substance is not a basis for treating a transfer that is in both FORM AND SUBSTANCE noncontingent (an annuity payable for a stated term of years in all events) as if it were contingent.

We suggest that Example 5 be revised to read as follows:

"A transfers property to an irrevocable trust, retaining

2. Treas. Reg. section 25.2702-3(b)(1)(i) and (c)(1)(i) should

Treas. Reg. section 25.2702-3(b)(1)(i) and (c)(1)(i) define a qualified annuity or unitrust interest as the right to receive a fixed amount or a unitrust amount and provide that it must be payable to or for the benefit of the term-holder. This regulation denies qualified interest treatment to an annuity that is not payable to a particular, designated person, but, instead, is payable as directed by the transferor.

For example, suppose G creates a trust to pay a charity to be selected by G each year, $10,000 per year for 10 years, remainder to G's child C. /1/ Alternatively, suppose G creates a trust to pay a to a descendent of G's to be selected by G each year, $10,000 per year for 10 years. In each case, G's retained power to designate the recipient of the annuity is a retained interest within the meaning of I.R.C. section 2702. Treas. Reg. section 25.2702(a)(4) specifically defined the term "interest" to include such a power. Accordingly, unless the power is eligible far qualified interest treatment, it will be valued at zero. As a result, the full value of the property transferred to the trust will be a taxable gift.

Since G's retained power is treated as a retained interest for I.R.C. section 2702 purposes, it ought to have the opportunity to qualify as a qualified annuity or unitrust interest even though it is not actually payable to or for the benefit of a particular individual. No revenue would be lost by permitting this opportunity since the trust creator would be treated as making a gift each time that he or she exercises the retained power of designation.

We suggest than the first two sentences of Treas. Reg. section 25.2702-3(b)(1)(i) be revised to read as follows and that a new third sentence as set forth below be inserted in this regulation: /2/

"(i) In general. A qualified annuity interest is an

We suggest that the first three sentences of Treas. Reg. section 25.2702-3(c)(1)(i) be revised to read as follows and that a new third sentence as set forth below be inserted in this regulation /3/:

"(i) In general. A qualified unitrust interest is an

3. Treas. Reg. section 25.2702-3(b)(1)(ii) and (c)(1)(ii) should

Treas. Reg. section 25.2702-3(b)(ii) provides that that portion of an annuity amount payable in one year that exceeds the amount payable in the prior year by more than 120 percent is not treated as a qualified interest. Treas. Reg. section 25.2702-3(c)(ii) contains a similar restriction applicable to unitrust interests.

In this respect, the requirements for a qualified annuity interest are different from the requirements for a qualified charitable lead annuity trust. (See Treas. Reg. section 25.2522(c)- 3(c)(2)(vi)(a)).

There is no reason for this deviation from the charitable lead trust mode. In many cases, grantors will want to provide for different amounts of annuity payments in different years to coincide with the expected cash flow from the transferred property. As the charitable lead trust regulations recognize so long as the divergent payments are valued using the I.R.C. section 7520 tables, the annuitant's rights will be correctly determined and no revenue will be lost.

For example suppose G creates a trust to pay G $10,000 for two years, then $30,000 per year for two years, then $50,000 for two years, and then to pay the remainder to G's child, C. Suppose further that the I.R.C. section 7520 rate in effect at the time of the trust's creation is 6% and that the trust property earns 6%. The present value of the right to receive these payments is $139,896. This amount is also equal to the present value of the right to receive $28,450 per year for six years. So long as G has the ability to reinvest the annuity payments received at 6%, G will have the same amount at the end of the six-year period regardless of which payment schedule is used.

The preamble to the final version of these regulations states that the Treasury Department and the Service were concerned that the ability to provide for unlimited annual increases in annuity payments would enable taxpayers to "zero out" a gift. In fact, the ability to create a stream of annuity payments with a value equal to the value of the property transferred to the trust is not prevented by the limitation imposed on annual increases. "Zeroing out" can be accomplished with a stream of constant annual payments as easily as it can be accomplished with a stream of increasing payments.

The possibility of "zeroing out" a grantor retained annuity trust or a charitable lead annuity true originates from the statutory definition of each. A "qualified interest" includes the right to receive fixed amounts payable annually. A deductible interest for purposes of I.R.C. section 2522 includes charity's right to receive a guaranteed annuity. Since in each case, the recipient's rights are valued under I.R.C. section 7520, the creator of the trust who wants to create a trust transfers to which will entail no gift tax liability has only to provide for a stream of payments (either of the same or different amounts) that, using the valuation assumptions of I.R.C. section 7520, will be predicted to exempt the trust fund by the end of the trust term.

We suggest that Treas. Reg. section 25.2702-3(b)(1)(ii) be revised to read as follows:

"(ii) Fixed amount. A filed amount means -- (A) A stated

(B) A fixed fraction or percentage OR FRACTIONS OR

SUCH AMOUNTS OR FRACTIONS OR PERCENTAGES MAY VARY FROM YEAR

We suggest that Treas. Reg. section 25.2702-3(c)(1)(ii) be revised to read as follows:

"(ii) Fixed percentage. A fixed percentage is a fraction or

B. GOVERNING INSTRUMENT REQUIREMENTS

1. Treas. Reg. section 25.2702-3(b)(1)(i) and (c)(1)(i) should

Treas. Reg. section 25.2702-3(b)(1)(i) and (c)(1)(i) provide that the trust's governing instrument must require that the annuity or unitrust amount be payable at least once in each taxable year of the trust. The taxable year of the trust will be either the calendar year or, if the trust is treated under I.R.C. section 671 as owned by its grantor the taxable year of the grantor. Unless a trust is created or January 1, if the trust's taxable year is a calendar year, this requirement forces the governing instrument to provide for at least one prorated annuity payment in its first year.

For example, suppose G creates a trust on December 1, 1993 to pay G $10,000 per year for 5 years. G would like to provide in the trust instrument that the $10,000 annuity be paid on each November 30th starting on November 30, 1994 and ending with a final $10,000 payment on November 30, 1998. The regulation will not permit this simple pattern of payments. Instead, if the trust is on a calendar year basis, the first payment must be due no later than December 31, 1993. If the trust accommodates this requirement by providing the first payment on December 31, 1993, successive annual payments on each of the next four December 31 dates, and a final payment on November 30, 1998, the payment schedule will be as follows:

          Date                       Payment

     December 31, 1993             $   833.33

This schedule of annuity payments is not only awkward but is also difficult to value, particularly if the annuity is payable for the life of the term-holder or for the lesser of a term of years or the life of the term-holder.

I.R.C. section 2702(b) does not require that payment be made each taxable year. It requires only that payments be made "annually." This requirement could be satisfied by requiring payment at least once during every 12-month period beginning with the date of the trust's creation.

The corrective language we suggest appears at A.2. above. In addition, we suggest that Treas. Reg. section 25.2702-3(b)(3) and (c)(3) be deleted. These regulations require that pro rata annuity amounts be payable in short taxable years. The requirements contained in these regulations have no counterpart in the charitable lead trust regulations. No transfer tax advantage can be obtained by failing to provide for reduced payments in short taxable years, since the amount of each payment will be fixed at the inception of the trust and will be taken into account in valuing the qualified interest.

2. Treas. Reg. section 25.2702-3(b)(4) should be revised to

Treas. Reg. section 25.2702-3(b)(4) provides that the trust's governing instrument must prohibit additional contributions to the trust. No similar requirement applies to trusts that provide qualified unitrust interests. No sound tax policy is served by this prohibition. /4/ A post-creation transfer to a qualified grantor retained annuity trust could not create any transfer tax advantage that is inconsistent with the objectives of I.R.C. section 2702 since the addition itself would be subject to the I.R.C. section 2702 valuation rules.

For example, suppose G creates a trust to pay G $10,000 per year for 15 years and funds it with $100,000. Suppose further, that the I.R.C. section 7520 rate for the month of creation is 6%. The value of G's retained interest is $97,122 and the value of G's taxable gift should be $2,878. Suppose that five years after the trust's creation when the property held in the trust is worth [number illegible], G transfers an additional $100,000 to the trust. The value of G's interest in the trust immediately before the addition is $73,601. The addition would not increase the value of G's interest in the trust when that interest is valued under I.R.C. section 2702. As a result, the full amount of G's addition to the trust will be treated as a taxable gift. However, if the property in the trust was worth only $50,000 at the time of the addition, the addition would appear to increase the value of G's interest in the trust by the excess of the value of G's remaining annuity (valued using the I.R.C. section 7520 rate and assuming that the trust contained sufficient funds to pay it) over $50,000, $23,601. As a result, the gift would be only $76,399.

We suggest that Treas. Reg. section 25.2702-3(b)(4) be revised to read as follows:

"Additional contributions PERMITTED. AN ANNUITY INTEREST

If this approach is used, a similar provision should be added to Treas. Reg. section 25.2702-3(c). Alternatively, we suggest the deletion of Treas. Reg. section 25.2702-3(b)(4).

3. Treas. Reg. section 25.2702-3(d)(2) should be revised to

Treas. Reg. section 25.2702-3(d)(2) provides that the trust's governing instrument must prohibit distributions from the trust before the expiration of the qualified interest to or for the benefit of any person other than the person holding the qualified interest. This provision could be interpreted to prohibit payments of successive or concurrent annuities to different beneficiaries.

For example, suppose G creates a trust to pay G's child C $10,000 per year for 5 years, then $10,000 per year for 5 years to G, then remainder to C. Under Treas. Regs. section 25.2702-3(d)(2), C's annuity interest could result in loss of qualification for G's interest because C's interest requires payment to a person other than G before the end of G's interest.

A similar regulation affecting charitable lead trusts was held invalid by the Tax Court in Estate of Minnie L. Boeshore, 78 T.C. 523 (1982), acq. 1987-1 C.B. 1.

We suggest that Treas. Reg. section 25.2702-3(d)(2) be revised to read as follows:

"(2) Amounts payable to other persons. The governing

In addition, we suggest that conforming changes be made to Treas. Reg. section 25.2702-3(b)(1)(iii) and (c)(1)(iii), which permit income in excess of the annuity or unitrust amounts to be paid to the holder of the qualified annuity or unitrust interest or that these provisions be deleted.

FOOTNOTES

/1/ No deduction is permitted for the charitable interest under I.R.C. 2522 because the transfer of the annuity interest is incomplete for gift tax purposes. Treas. Reg. section 25.2511-2(b).

/2/ This proposed language also incorporates the suggestions made in B.1. below.

/3/ This proposed language also incorporates the suggestions made in B.1. below.

/4/ This requirement may have been modeled after the charitable remainder annuity trust's governing instrument requirements. Treas. Reg. section 1.664-2(b) prohibits additions to a charitable remainder annuity trust after its creation. The purpose for this requirement, however, was most likely to prevent the use of post-creation additions to avoid section 644(d)(1)'s requirement that the annuity be equal to at least 5% of the initial value of the trust. There is no corresponding requirement in the statutory definition of qualified interest.

END OF FOOTNOTES