SCHOTT v. COMMISSIONER

MEMORANDUM OPINION

COHEN, JUDGE: Respondent determined Federal gift tax deficiencies for 1994 in docket No. 469-00 in the amount of $ 126,080 and in docket No. 470-00 in the amount of $ 137,953.

The issue for decision in these consolidated cases is whether a successor annuity interest of a spouse in a retained two- life annuity is a qualified interest that is subject to valuation pursuant to section 2702. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect on the date of the transfers, and all Rule references are to the Tax Court Rules of Practice and Procedure.

BACKGROUND

The parties submitted these cases fully stipulated pursuant to Rule 122. The stipulated facts are incorporated by this reference. At the time of the filing of the petitions in these cases, petitioners resided in Los Altos, California. Petitioners owned 90 percent of the outstanding stock of SCS Development Company (company), a closely held corporation that develops, constructs, *138 and sells single-family houses.

On May 31, 1994, Stephen C. Schott (Mr. Schott) created the Stephen C. Schott 1994 Qualified Annuity Trust, a grantor retained annuity trust (GRAT) in which Mr. Schott was both the grantor and trustee. On that same day, Patricia A. Schott (Mrs. Schott) created the Patricia A. Schott 1994 Qualified Annuity Trust, a GRAT in which Mrs. Schott was both the grantor and trustee. Each GRAT was funded by 11,400 shares of stock in the company that were valued at $ 5,394,929.50.

Each GRAT provided for fixed annual annuity payments in an amount equal to 11.54 percent of the initial fair market value of the assets that were contributed. The annuity was to be paid to the grantor commencing on May 31, 1994, and ending on the date that was 15 years after the commencement date or, if sooner, on the date of death of the grantor. If the grantor died prior to the end of the 15- year term, the annuity was to be paid to the spouse for the balance of the term, unless this right had been previously revoked by the grantor. If the grantor died prior to the end of the 15-year term, and if the spouse did not survive the grantor or if the grantor had revoked the interest of the*139 spouse, the annuity payments would cease, and the remaining GRAT property would be held in trust for the surviving spouse or for the descendants of the grantor. For the Stephen C. Schott 1994 Qualified Annuity Trust, if the grantor survived the 15-year term, the assets remaining in the GRAT would be held in trust for the grantor's spouse, if then living, or otherwise for the grantor's descendants. For the Patricia A. Schott 1994 Qualified Annuity Trust, if the grantor survived the 15-year term, the assets remaining in the GRAT would be held in trust for the grantor's descendants.

During the annuity term, distribution of trust income or principal could not be made to any person other than the grantor during the life of the grantor. In the event that the grantor died and the spouse received the annuity, distribution of income or principal could not be made to any person other than the spouse during the life of the spouse. Each GRAT was irrevocable except that the grantor retained the right to revoke the successor interest of his or her spouse in the annuity.

Each GRAT provided that the grantor intended to create a "qualified interest", as defined in section 2702(b)(1), and that the*140 provisions of the GRAT document were to be construed in accord with that intent. Each GRAT document further provided that, if the initial fair market value of the assets that were contributed was incorrectly determined, the trustee would either pay to or recover from the grantor or his or her spouse the amount necessary to account for the undervaluation or overvaluation of the assets within a reasonable period after the final Federal tax determination of the correct value. Each GRAT document also prohibited commutation of the annuity interest and additional contributions to the GRAT's, after the initial funding.

DISCUSSION

Petitioners assert that the interests in the annuities that were given to each spouse are qualified interests under section 2702 and that the retained interests are single annuities based on two lives, referred to as dual-life annuities. Petitioners contend that the retained interests in the annuities should be valued as interests for the term of 15 years or for the lives of the grantor and spouse, whichever is shorter. Respondent asserts that the interests in the annuities that were given to each spouse are not qualified interests and that the retained interests*141 are single-life annuities. Respondent contends that the retained interests in the annuities should be valued as interests for the term of 15 years or for the life of the grantor, whichever is shorter. Valuation of a retained interest as a dual-life annuity produces a greater retained value than valuation as a single-life annuity and, correspondingly, reduces the amount of the taxable gift of the remainder.

Section 2501 imposes a tax for each calendar year on the transfer of property by gift. A gift of property is valued as of the date of the transfer. See sec. 2512(a). Generally, where property is transferred in trust but the donor retains an interest in such property, the value of the gift is the value of the property that is transferred, less the value of the donor's retained interest. See sec. 25.2512-5A(e), Gift Tax Regs. However, if the gift in trust is to a family member (as defined in section 2704(c)(2)), the value of the gift is determined subject to the limitations of section 2702.

Section 2702 provides:

   SEC. 2702. SPECIAL VALUATION RULES IN CASE OF TRANSFERS OF

INTERESTS IN TRUSTS.

     (a) Valuation Rules. --

 *142        (1) In general. -- Solely for purposes of determining

     -- whether a transfer of an interest in trust to (or for

     the benefit of) a member of the transferor's family is a

     gift (and the value of such transfer), the value of any

     interest in such trust retained by the transferor or any

     applicable family member * * * shall be determined as

     provided in paragraph (2).

        (2) Valuation of retained interests. --

          (A) In general. -- The value of any retained

        interest which is not a qualified interest shall be

        treated as being zero.

          (B) Valuation of qualified interest. -- The value

        of any retained interest which is a qualified interest

        shall be determined under section 7520 [providing for

        use of valuation table prescribed by the Secretary for

        annuities, life interests, etc.].

               * * * * * * *

   *143   (b) Qualified Interest. -- For purposes of this section,

   the term "qualified interest" means --

        (1) any interest which consists of the right to

     receive fixed amounts payable not less frequently than

     annually,

        (2) any interest which consists of the right to

     receive amounts which are payable not less frequently than

     annually and are a fixed percentage of the fair market

     value of the property in the trust (determined annually),

     and

        (3) any noncontingent remainder interest if all of the

     other interests in the trust consist of interests described

     in paragraph (1) or (2).

Regulations promulgated under section 2702 expand the definition of "qualified interest" in the following manner:

   Qualified interest means a qualified annuity interest, a

   qualified unitrust interest, or a qualified remainder interest.

RETENTION OF A POWER TO REVOKE A QUALIFIED ANNUITY INTEREST

* * * OF THE TRANSFEROR'S SPOUSE IS TREATED AS THE RETENTION OF

   A*144 QUALIFIED ANNUITY INTEREST * * *. [Sec. 25.2702-2(a)(5), Gift

   Tax Regs.; emphasis added.]

"A qualified annuity interest is an irrevocable right to receive a fixed amount * * * payable to (or for the benefit of) the holder of the annuity interest for each taxable year of the term." Sec. 25.2702-3(b)(1)(i), Gift Tax Regs. The term of a qualified annuity interest must be fixed and ascertainable at the creation of a GRAT. See Cook v. Commissioner, 115 T.C. 15, 23 (2000); sec. 25.2702- 3(e), Example (6), Gift Tax Regs. A qualified annuity interest cannot be a contingent interest that may in fact never take effect. See id. A fixed amount is either a stated dollar amount or a fixed fraction or percentage (not to exceed 120 percent of the fixed fraction or percentage payable in the preceding year) of the initial fair market value of the property that is being transferred to the trust as finally determined for Federal tax purposes. See sec. 25.2702- 3(b)(1)(ii), Gift Tax Regs. In either case, a fixed amount must be payable periodically but not less frequently than annually. See id.

The trust instrument must also prohibit distributions from the trust to or for the benefit*145 of any person other than the holder of the qualified annuity interest during the term of the qualified interest. See sec. 25.2702-3(d)(2), Gift Tax Regs. The term of the annuity interest must be fixed by the trust instrument "for the life of the term holder, for a specified term of years, or for the shorter (but not the longer) of those periods." Sec. 25.2702-3(d)(3), Gift Tax Regs.

For purposes of section 2702, a transfer of an interest in property with respect to which there are one or more term interests is treated as a transfer in trust. See sec. 2702(c)(1). "A term interest is one of a series of successive (as contrasted with concurrent) interests." Sec. 25.2702-4(a), Gift Tax Regs.

Petitioners' argument, that the retained interests in the annuities should be valued as interests for the term of 15 years or for the lives of the grantor and spouse, is essentially the same as the argument we rejected in Cook v. Commissioner, supra, a case with nearly identical facts to those of the cases at hand. In Cook, the taxpayers, husband and wife, each created two GRAT's. The grantor of each GRAT retained an annuity for a stated term of years. If the grantor died before the*146 expiration of the stated term of years and was survived by the spouse, the annuity continued for the spouse until the earlier of his or her death or the expiration of the stated term. If the grantor died before the expiration of the stated term of years and was not survived by the spouse, the term of the annuity ended upon the death of the grantor. In each trust, the grantor reserved the power to revoke the interest of the spouse. The taxpayers argued that the value of the remainder interest in each GRAT, of which the grantor made a taxable gift, was the value of the assets that were contributed to the trust, reduced by the value of a dual-life annuity. See 115 T.C. at 16-20.

In Cook, the Court decided that, because the spousal interest in each GRAT was not fixed and ascertainable at the inception of the GRAT, the spousal interest was contingent on the spouse's surviving the grantor. Furthermore, the Court held that each spousal interest was not a qualified interest, because the spousal interest was subject to revocation by the grantor, and, therefore, if treated as a retained interest of the grantor pursuant to section 25.2702-2(a)(5), Gift Tax Regs., the requirement of section*147 25.2702- 3(d)(3), Gift Tax Regs., would not be met. See Cook v. Commissioner, supra 115 T.C. at 23-26.

As a retained interest of the grantor, the possibility existed that each retained annuity would extend for the life of the spouse, which could be beyond the life of the term holder, i.e., the grantor, but less than a specified term of years. Thus, each retained interest violated section 25.2702-3(d)(3), Gift Tax Regs., which provides that the term of the annuity interest must be fixed by the trust instrument for one of three terms: (1) The life of the term holder, (2) a specified term of years, or (3) the shorter (but not the longer) of those periods. For these reasons, the spousal interests were valued at zero under section 2702(a)(2)(A). See id. at 24-25. Petitioners acknowledge that Cook is applicable to this issue but argue that Cook was incorrectly decided. However, we find no reason to reach a result that is different from the result in Cook.

As part of the analysis in Cook, the Court relied on section 25.2702-2(d)(1), Examples (6) and (7), Gift Tax Regs. Examples (6) and (7) are as follows:

     Example 6. A transfers property to an irrevocable*148 trust,

   retaining the right to receive the income for 10 years. Upon

   expiration of 10 years, the income of the trust is payable to

   A's spouse for 10 years if living. Upon expiration of the

   spouse's interest, the trust terminates and the trust corpus is

   payable to A's child. A retains the right to revoke the spouse's

   interest. Because the transfer of property to the trust is not

   incomplete as to all interests in the property (i.e., A has made

   a completed gift of the remainder interest), section 2702

   applies. A's power to revoke the spouse's term interest is

   treated as a retained interest for purposes of section 2702.

   Because no interest retained by A is a qualified interest, the

   amount of the gift is the fair market value of the property

   transferred to the trust.

     Example 7. The facts are the same as in Example 6, except

   that both the term interest retained by A and the interest

   transferred to A's spouse (subject to A's right of revocation)

   are qualified annuity or unitrust interests. The amount of the

   gift is the fair market value*149 of the property transferred to the

   trust reduced by the value of both A's qualified interest and

   the value of the qualified interest transferred to A's spouse

   (subject to A's power to revoke).

The Court noted that, in Example (7), the revocable spousal interest is treated as an interest retained by A and that A's direct interest and the revocable spousal interest are both qualified interests pursuant to section 2702(b). The interests of both A and his or her spouse, at the creation of the trust, are fixed and ascertainable for specified 10-year terms and are not contingent upon A's death or the spouse's death. Furthermore, the Court noted that, because the interests were for a collective 20-year specified term, Example (7) was an illustration of how a grantor could retain a power of revocation over a spousal interest that did not extend beyond the life of the term holder, a specified term of years, or the shorter (but not the longer) of those periods. See Cook v. Commissioner, supra 115 T.C. at 25-26.

Petitioners claim that the holding in Cook is inconsistent with Example (7). Petitioners argue that Example (7) provides that the spouse's receipt of payments*150 from the trust is contingent upon the spouse's living beyond the 10-year period of A's interest, i.e., the grantor's interest. Petitioners contend that there is a possibility that the spouse in Example (7) will receive nothing, and, yet, Example (7) holds that the interest of the spouse is a qualified interest. Thus, petitioners claim that the requirement in section 25.2702-3(b)(1)(i), Gift Tax Regs., that an interest be fixed was only intended to prevent interests such as the interest in section 25.2702-3(e), Example (6), Gift Tax Regs., from satisfying the definition of a qualified interest. Section 25.2702-3(e), Examples (5) and (6), Gift Tax Regs., incorporates the same factual scenario:

     Example 5. A transfers property to an irrevocable trust,

   retaining the right to receive 5 percent of the net fair market

   value of the trust property, valued annually, for 10 years. If A

   dies within the 10-year term, the unitrust amount is to be paid

   to A's estate for the balance of the term. A's interest is a

   qualified unitrust interest to the extent of the right to

   receive the unitrust payment for 10 years or until A's prior

*151    death.

     Example 6. The facts are the same as Example 5, except that

   if A dies within the 10-year term the unitrust amount will be

   paid to A's estate for an additional 35 years. The result is the

   same as in Example 5, because the 10-year term is the only term

   that is fixed and ascertainable at the creation of the interest.

Reliance by petitioners on section 25.2702-2(d)(1), Example (7), Gift Tax Regs., for the proposition that a contingent interest can be a qualified interest under section 2702(b) is misplaced. Petitioners misread Example (7) to include a nonfixed, contingent spousal interest, on the premise that the trust will only make payments to the spouse if the spouse is living at the end of the grantor's 10-year term interest. Petitioners' interpretation of the example concentrates on the language that reads: "Upon expiration of [A's] 10 years, the income of the trust is payable to A's spouse for 10 years IF LIVING." Sec. 25.2702-2(d), Example (6), Gift Tax Regs. (Emphasis added.) However, the spousal interest in Examples (6) and (7) is a fixed, noncontingent spousal interest for a term of 10 years, and the spouse or*152 the estate of the spouse will receive payments from the GRAT whether or not the spouse is living at the end of the 10-year term of the grantor.

To hold that Examples (6) and (7) contain a contingent spousal interest would ignore other language in the examples that states: "UPON EXPIRATION OF THE SPOUSE'S INTEREST, the trust terminates and the trust corpus is payable to A's child." Sec. 25.2702-2(d), Example (6), Gift Tax Regs. (Emphasis added.) This sentence reflects that the remainder interest of the child will vest only after the expiration of the 10-year term of the spouse. The "if living" language in Example (6), relied on by petitioners, should be interpreted to read that, if the spouse is living at the end of the grantor's 10-year term, annuity payments shall be payable to the spouse, but, if the spouse is not living at the end of the grantor's 10-year term, the spouse's 10-year term interest is payable to the estate of the spouse.

Petitioners also argue that dual-life annuities should be treated as qualified interests in valuing remainder interests in GRAT's because dual-life annuities are respected in valuing charitable remainder trusts. Petitioners rely on the legislative*153 history of section 2702, which states that qualified interests under section 2702 "are similar to those permitted in charitable split interest trusts under section 664." 136 Cong. Rec. S15629, S15682 n.30 (daily ed. Oct. 18, 1990) (Explanatory Material Concerning Committee on Finance 1990 Reconciliation Submission Pursuant to House Concurrent Resolution 310).

Section 664(d) defines a charitable remainder annuity trust as follows:

     (d) Definitions. --

        (1) Charitable remainder annuity trust. -- For

     purposes of this section, a charitable remainder annuity

     trust is a trust --

          (A) from which a sum certain (which is not less

        than 5 percent of the initial net fair market value of

        all property placed in trust) is to be paid, not less

        often than annually, to one or more persons (at least

        one of which is not an organization described in

        section 170(c) and, in the case of individuals, only

        to an individual who is living at the time of the

  *154       creation of the trust) for a term of years (not in

        excess of 20 years) or for the LIFE OR LIVES of such

        individual or individuals * * *. [Emphasis added.]

If Congress intended to include dual-life annuities in the definition of a qualified interest for valuing the remainder interests of GRAT's, Congress could have included similar "life or lives" language in section 2702. Instead, section 2702 is silent as to what constitutes an acceptable term for a qualified interest. However, the regulations under section 2702 state that the term of a qualified annuity "must be for the LIFE OF THE TERM HOLDER, for a specified term of years, or for the shorter (but not the longer) of those periods." Sec. 25.2702-3(d)(3), Gift Tax Regs. (Emphasis added.) The term restrictions that are found in the regulations are consistent with the purpose of section 2702, which is to deter the potential valuation abuse that is inherent in using actuarial tables by making unfavorable assumptions regarding certain retained rights. See 136 Cong. Rec. S15629, S15680-S15681 (daily ed. Oct. 18, 1990); Cook v. Commissioner, supra at 24. Thus, *155 the general intent of Congress to conform qualified interests in valuing GRAT's with charitable split interest trusts did not include dual-life annuities.

Our holding, that the spousal interest in each GRAT that was created by petitioners is not a qualified interest under section 2702(b), is distinguishable from the previous decision of the Court in Walton v. Commissioner, 115 T.C. 589 (2000). In Walton, the taxpayer established two GRAT's in which the taxpayer retained annuity rights. In the event that the taxpayer died prior to the expiration of the annuity term, the remaining scheduled annuity payments were to be made to the estate of the taxpayer. The balance of the GRAT property would then be paid to the remainder beneficiaries at the expiration of the annuity term. See id. at 590- 591.

As part of the analysis, the Court in Walton found that the interest of the estate could not be bifurcated from the retained interest of the taxpayer. See id. at 602. The Court noted that an individual cannot make a gift to himself or to his or her own estate. See id. at 595. Therefore, the Court held that, for purposes of determining the value*156 under section 2702, the taxpayer's retained interest should be valued as an annuity for a specified term of years, rather than as an annuity for the shorter of a term certain or for the period ending upon the taxpayer's death.

The dual-life annuity, in the cases at hand, differs from the annuity for a specified term of years in Walton, in that, with the dual-life annuity, the value of the remainder interest would be reduced for a contingent spousal interest that may in fact never take effect. Furthermore, the retained interests in Walton satisfied one of the three term requirements of section 25.2702-3(d)(3), Gift Tax Regs.

We have considered all remaining arguments made by petitioners for a result contrary to that expressed herein, and, to the extent not discussed above, they are irrelevant or without merit.

To reflect the foregoing and the concessions of the parties,

Decisions will be entered under Rule 155.