“Penny wise but pound foolish” first appeared in writing over 500 years ago. This idiom captures the wisdom of human experience in just five words: shortcuts that appear to save money are more expensive in the long run. Sometimes much more. Further proof of this eternal truth - and one taxpayer’s failure to appreciate it - is evidenced in IRS Chief Counsel Memorandum 202152018, released on December 30, 2021. The IRS takes a particularly hard line in connection with the tax consequence to the owner of a closely held business who undertook estate tax planning with what is otherwise a relatively benign tool – the grantor retained annuity trust (or “GRAT”), using an appraisal to value the business that was, as the IRS characterizes, “outdated and misleading.”
For gift tax purposes, when an interest in a closely held business is gifted, its value must be determined at the time of the gift, generally by an independent appraiser. Appraisals can be expensive, so clients often try to avoid the cost of a new appraisal if an appraisal was prepared prior to the gift. Closely held businesses often need appraisals for purposes such as non‑qualified deferred compensation or employee stock ownership plans. That is why a business may already have an existing appraisal when a business owner makes a gift of an interest in the business.
In IRS Chief Counsel Memorandum 202152018 (the “Memo”), the taxpayer was a business owner who transferred an interest in his business to a two-year grantor retained annuity trust (a “GRAT”), a tool used to freeze the value of the asset, so that all appreciation of the asset after the GRAT is funded escapes gift and estate tax. A GRAT is often designed so that the present value of the stream of payments to the taxpayer equals the value of the gift upon funding. This results in no taxable gift, and is a very common tool in estate planning. That was the type of GRAT the taxpayer used in the Memo. Click here to read the Memo.
Approximately six months before funding the GRAT, the business had an appraisal prepared for qualified deferred compensation purposes under Code Section 409A. Between the effective date of the appraisal and the date the taxpayer made his gift to the GRAT, the taxpayer began to solicit offers to sell the business. The offers were significantly higher (about 3x) than the value determined under the 409A appraisal. This information did not exist and thus was not reflected in the value of the business determined in the appraisal. Nevertheless, the taxpayer used the 409A appraisal to value the gift to the GRAT.
By law, a GRAT must contain a “self-adjusting” clause, which allows an automatic adjustment to the calculation of the amount payable to the taxpayer. If the value of the gift turns out to be higher than reported, the GRAT pays more to the taxpayer. If the value of the gift turns out to be lower than reported, the taxpayer returns funds to the GRAT. This self-adjusting clause is generally thought to mean that a GRAT avoids the risk that an audit could result in a change to the value of the gift tax aspect when funding the GRAT. But not so.
The taxpayer in the Memo thought that his taxable gift when funding the GRAT was zero. But the IRS concludes that the entire value of the business interest was a taxable gift, undoubtedly a nasty surprise. The IRS stated the annuity as calculated by the appraisal was an “operational failure” because the calculation of value “had no relation” to the actual value at the time of the gift. The self-adjusting clause apparently cannot correct this as the value was based on an “outdated and misleading appraisal.” The IRS concluded, “[t]he operational effect of deliberately using an undervalued appraisal is to artificially depress the required annuity. Thus, in the present case, the artificial annuity to be paid was less than 34 cents on the dollar instead of the required amount, allowing the trustee to hold back tens of millions of dollars. The cascading effect produced a windfall to the remaindermen.”
The self-adjusting clause could not save the taxpayer’s intentional disregard for actual events known that affected the value of the business. In the end, the full value of the business interest that funded the GRAT a taxable gift and likely causes a significant gift tax due now. This may be a double whammy when the taxpayer dies: Not only is the full value of the business interest that funded the GRAT added to the taxpayer’s estate when calculating the estate tax at his death, but it is likely that the GRAT payments to the taxpayer are also includible in his estate for estate tax purposes – the same property is taxed twice, once under the gift tax and again under the estate tax, without any credit or deduction.
This debacle could have been avoided if the taxpayer had obtained an updated appraisal at the time the GRAT was funded, to reflect the value at that time. Although the taxpayer may have been penny wise, he was undoubtedly pound foolish. He may have saved a few bucks by not obtaining an updated appraisal when needed, but this savings will be more than offset by the much larger price in gift and estate tax.