The IRS Office of Chief Counsel recently issued CCA 202152018 (“CCA”), in which the IRS is attacking yet another business valuation. The IRS takes the position in the CCA that because the valuation used failed to account for a potential acquisition, the grantor retained annuity trust (“GRAT”) failed to properly qualify as a GRAT even though the GRAT otherwise met the statutory and regulatory requirements. This opinion is very similar to CCA 201939002 from 2019, where the IRS took the position that the pending merger of a publicly traded company should be taken into account for valuation purposes because a hypothetical buyer would know about it and would do so.
GRATs and CRTs
A GRAT is a trust whereby the grantor transfers property to the trust and takes back an annuity. The value of assets remaining in trust at the end of the annuity term, which may be a term of years or lifetime, passes as a gift to the remainder beneficiaries. The value of the retained annuity reduces or offsets the value of the gift to the remainder beneficiaries. The annuity can be structured in a variety of ways and the gift tax consequences of the GRAT will be based on the value of assets transferred to the trust and the structure of the annuity, which in turn determines the value of the annuity for offsetting purposes. One key structure for GRATs is the so called “zeroed out” GRAT, whereby a grantor structures the annuity to equal the value of the property transferred to the GRAT thereby avoiding a gift when the GRAT is formed (although there have been a number of recent proposals to eliminate the ability to use zeroed out GRAT’s and to require a minimum term). The effect is that the remainder interest is valued at zero based on the IRS actuarial tables, meaning that any assets passing to the remainder beneficiaries are free of any gift tax consequences.
A charitable remainder trust (“CRT”) also involves a transfer of property by the grantor to a trust and includes payments for a specified term (not to exceed 20 years) or for the life (or lives) of a specific beneficiary (or beneficiaries). At the termination of the term interest (death of all term beneficiaries or the designated term or years), the trustee distributes the remaining trust assets to certain charitable organizations. At the creation of the CRT, the grantor receives an income tax deduction for the present value of the future gift the charities will receive when the trust terminates. That value is calculated based on actuarial tables, taking into account the value of the property transferred to the trust, interest rates, the age of each beneficiary, or the term of the trust if it is for a specific number of years.
When the IRS issues guidance with taxpayer information in it, such as private letter rulings or chief counsel advice memorandums, it replaces much of the information with placeholders and variables to protect the taxpayer’s information. I do not know about you, but I often end up reading such guidance multiple times before I get a handle on the timeline and figures discussed. For ease of readability, I have therefore replaced the placeholder dates and numbers in the CCA with my own approximations for such, based on information provided in the CCA.
Taxpayer was the founder of a successful company (“Company”). At the end of Year 1, Taxpayer contacted two investment advisors to explore the possibility of finding a buyer for the Company. Taxpayer obtained an appraisal for the Company dated December 31, Year 1, which valued the shares of the Company at $10 per share (“First Valuation”). The First Valuation was obtained to satisfy the reporting requirements for nonqualified deferred compensation plans under Section 409A.
Approximately six months later, on June 1, Year 2, the investment advisors presented Taxpayer with initial offers from several potential buyers. Three days later, on June 4, Year 2, Taxpayer created a GRAT with a two-year annuity term, the terms of which appeared to satisfy the requirements for a qualified interest under Section 2702 and the corresponding regulations. Under the terms of the GRAT, the trustee was to base the amount of the annuity payment on a fixed percentage of the initial fair market value of the trust property. Taxpayer funded the GRAT with shares of the Company and used the $10 per share valuation from the First Valuation in calculating the initial fair market value of the trust property.
The potential buyers submitted final offers by September 1, Year 2, almost three months after they made initial offers. On November 1, Year 2, Taxpayer gifted Company shares to a CRT and valued those shares at $30 per share, pursuant to a qualified appraisal, presumably dated the same date (“Second Valuation”). The Second Valuation was prepared by a qualified appraiser as required by Section 170(f)(11).
On December 1, Year 2, Taxpayer accepted one of the final offers, which included an initial cash tender offer of $30 per share. Taxpayer and the CRT sold shares to the buyer at the price of $30 per share.
On December 31, Year 2, and again on December 31, Year 3, Taxpayer obtained new appraisals for the Company (collectively, “Later Valuations”). Like the First Valuation, the Later Valuations were obtained for nonqualified deferred compensation plan purposes, but they valued the Company at $20 per share. The Later Valuations both included the following language: “according to management, there have been no other recent offers or closed transactions in Company shares as of the Valuation Date.” There was no such declaration in the First Valuation.
On December 4, Year 4, approximately six months after termination of the GRAT’s two-year annuity term, the purchaser bought the balance of the Company shares for $40 per share.
The CCA claims that the facts support the proposition that, as of June 1, Year 2, a hypothetical willing buyer of the Company stock could have reasonably foreseen the merger and anticipated that the price of Company stock would trade at a substantial premium over the $10 per share value.
When asked to explain the use of the First Valuation to value the transfer to the GRAT, as well as the use of the Second Valuation to value the transfers to the CRT, the company that conducted the appraisal stated only that “[t]he appraisal used for the GRAT transfer was only six months old, and business operations had not materially changed during the 6‐month period . . . For the charitable gifts, under the rules for Form 8283, in order to substantiate a charitable deduction greater than $5,000, a qualified appraisal must be completed. Because of this requirement an appraisal was completed for the donations of [Company] stock to various charities on [Date 4].”
Key to the IRS’s position is the concept of a willing buyer and willing seller provided in Section 25.2512-1 of the Gift Tax Regulations and further developed in several cases cited in the CCA. Section 25.2512-1 provides that the value of a gift is the “price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts.” The IRS then cites cases which provide that generally valuations happen as of the date of the gift, with no regard for later events, however in certain circumstances post-valuation date events can be probative of the earlier valuation.
The IRS also cites to the Ferguson case, which held that certain charitable transfers of shares had “ripened from an interest in a viable corporation into a fixed right to receive cash” because a pending merger was “practically certain” to occur. Consequently, the assignment of income doctrine applied and the taxpayers in Ferguson realized gain when the shares were disposed of by the charities.
Finally, the IRS cites to Atkinson, as its authority for how an “operational failure” of a trust can cause it to fail to properly meet certain statutory requirements, even though the trust would otherwise meet those requirements. The taxpayer in Atkinson created a charitable remainder annuity trust (similar, but not to be confused with a CRT), but the trust never made any actual payments during the two-year period between formation and the grantor’s death. The IRS was successful in arguing that the trust was not a valid a charitable remainder annuity trust because it did not make the required annual annuity payments.
In the CCA, the IRS concludes that the acquisition was practically certain to go through as of the date the GRAT was established. Therefore, the Taxpayer’s reliance on the First Valuation for the transfer to the GRAT was not justified because that valuation did not adequately incorporate the acquisition. The IRS then concludes that the use of such an understated valuation caused an operational failure, because any payments made would have no relation to the initial fair market value of property transferred to the trust. Therefore, the Taxpayer did not retain a qualified annuity interest under Section 2702.
The IRS seemed to find it probative that the Taxpayer used the First Valuation for the transfer to the GRAT but then used the Second Valuation for the transfer to the CRT. Clearly, the difference in valuations was favorable to the Taxpayer. That is, the Taxpayer wanted a lower valuation for the transfer to the GRAT (because that was a non-charitable gift and therefore potentially subject to gift tax) and a higher valuation to the CRT (because that was a charitable gift resulting in a charitable deduction). However, the Taxpayer wasn’t allowed to use First Valuation for the charitable gift to the CRT. A “qualified appraisal” is an appraisal document that relates to an appraisal that isn’t made earlier than 60 days before the appraisal property’s contribution date and no later than the due date (including extensions) of the return on which the charitable contribution is first claimed for the donated property. Thus, the Taxpayer’s reason for getting an updated valuation for the CRT was because it was a statutory requirement to properly substantiate the charitable deduction. Additionally the taxpayer, or the appraiser, may have determined that the “practically certain” threshold was not met at the date the GRAT was formed, but that it had since ripened by the creation of the CRT.
Assuming no other glaring issues, valuation is often the IRS’s best arguments for gift and estate tax cases. Taxpayers’ best defense to this is to not hide the ball from their appraiser, such that the appraisal that will be the backbone of the Taxpayer’s position, is accurate and up to date. Did the Taxpayer disclose the potential acquisition to the appraiser? Seems unlikely given that the appraiser didn’t incorporate the possibility at all in the First Valuation.
The Taxpayer probably should have gone ahead and gotten an updated valuation as of the date the GRAT was established (June 4, Year 2). Often the prior valuation can be updated for a fraction of the fees the taxpayer spent to get the prior valuation. At the very least they should have put the ball in the appraiser’s court and let them say that the First Valuation was still appropriate for the establishment of the GRAT.
Alternatively, Taxpayer could have used a formula clause for either or both of the transfers. For example, the Taxpayer might have specified that he was giving $10 million of Company stock, which based on the valuation, he expected to be equal to 1 million shares.
Taxpayer may have been relying on the automatic regulatory valuation adjustment for GRATs, and therefore believed that valuation differences would be taken care of. However, the IRS took the position that the valuation used was so inaccurate that the trust failed to qualify as a GRAT at all, therefore it was not eligible for the automatic self-adjusting. This is a bit of a bold argument on behalf of the IRS. Where do they draw the proverbial line in the sand? Undervaluing by 50%, 30%, 20%? Does the total value transferred matter? That is, would a 20% undervaluation of a $100 million transfer be considered egregious while a 25% undervaluation of a $1 million transfer might be considered acceptable? I think the Taxpayer will likely have some good arguments against the position taken by the IRS when this eventually goes before a court, even given the taxpayer favorable differences in the valuations.
 A full copy of CCA 202152018 can be found at https://www.irs.gov/pub/irs-wd/202152018.pdf.
 A full copy of CCA 201939002 can be found at https://www.irs.gov/pub/irs-wd/201939002.pdf
 DISCLAIMER: Such approximations are subject to my own misinterpretations of the CCA or other errors, and as such should not be relied upon as factual.
 $w per share in the CCA.
 Date 1 in the CCA.
 Date 2 in the CCA.
 Date 3 in the CCA.
 Date 4 in the CCA. The CCA provided less context for when Date 4 took place relative to any other dates, thus this date and the following date of December 21, Year 2 are likely to be the least accurate approximation.
 $x per share in the CCA.
 $y per share in the CCA.
 $z per share in the CCA.
 Ithaca Trust Co. v. United States, 279 U.S. 151 (1929); Estate of Noble v. Commissioner, T.C. Memo. 2005-2 n.3; Trust Services of America, Inc. v. U.S., 885 F.2d 561, 569 (9th Cir. 1989); Bank One Corp., 120 T.C. 174, 306; and Estate of Gilford v. Commissioner, 88 T.C. 38, 52-55 (1987). While not cited by the IRS, the recent case of Estate of Jackson v. Comm’r, T.C. Memo. 2021-48, also involved a discussion of when post death events should be considered for valuation purposes.
 Ferguson v. Commissioner, 174 F.3d 997 (9th Cir. 1999), aff’g 108 T.C. 244 (1997).
 While not cited by the IRS, See Jon Dickinson, et ux. v. Commissioner, TC Memo 2020-128, which also discussed the “practically certain” standard in which the taxpayer prevailed.
 Atkinson v. Commissioner, 115 T.C. 26, 32 (2000), aff’d, 309 F.3d 1290 (11th Cir. 2002).
 Reg. § 1.170A-13(c)(3)(i).
 Reg. §25.2702-3(b)(1)(ii)(B) & §25.2702-3(b)(2).