SCHOTT v. COMMISSIONER

T.C. Memo. 2001-110

UNITED STATES TAX COURT

PATRICIA A. SCHOTT, Petitioner v. COMMISSIONER OF
INTERNAL REVENUE, Respondent

STEPHEN C. SCHOTT, Petitioner v. COMMISSIONER OF
INTERNAL REVENUE, Respondent

Docket Nos. 469-00, 470-00. Filed May 9, 2001.

Scott A. Bieber, for petitioners.

Catherine M. Thayer, James A. Whitten, and William E.

Bogner, for respondent.

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.
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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, 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.
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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

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
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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 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
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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 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.
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Section 2702 provides:

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

(a) Valuation Rules.--

(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.].

* * * * * * *

(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).
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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 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.
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The trust instrument must also prohibit distributions from

the trust to or for the benefit 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 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
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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 id. 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 25.2702-3(d)(3), Gift Tax Regs., would not

be met. See Cook v. Commissioner, supra 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),
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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
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 of the property transferred to
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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 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 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
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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 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
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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 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
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charitable remainder trusts. Petitioners rely on the legislative

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 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
 - 15 -

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, 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.
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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 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.