IRS Section 2702: Valuation Rules for Family Trusts

Internal Revenue Code Section 2702 is a component of the federal tax law that addresses how transfers of assets to family members through trusts are valued for gift tax purposes. Its function is to ensure that the value of a gifted asset is not artificially minimized to reduce gift tax liability by establishing specific valuation rules when the grantor retains an interest in the trust.

The rules were introduced to prevent valuation strategies the IRS deemed abusive. Before its enactment in 1990, grantors could often assign a high value to their retained interest, which lowered the calculated value of the gift made to the family member. This practice was common with assets that did not produce steady income, making the valuation of the retained interest subjective.

The Zero Valuation Rule

Before Section 2702, a Grantor Retained Income Trust (GRIT) was a popular estate planning tool. A grantor would place assets into a trust, retain the right to all income for a set number of years, and name a family member as the beneficiary. The taxable gift was the asset’s fair market value minus the present value of the grantor’s retained income interest.

This created a valuation problem when the trust was funded with non-income-producing property, like high-growth stock with low dividends. The retained income stream had little actual value but could be assigned a substantial theoretical value, artificially reducing the taxable gift. To address this, Section 2702 introduced the “zero valuation rule.”

This rule dictates that when an individual transfers property into a trust for a family member and retains an interest, that retained interest is valued at zero for gift tax purposes. A “retained interest” is any interest held by the transferor or an applicable family member that is not a “qualified interest.” The consequence is that the value of the taxable gift becomes the entire fair market value of the property transferred into the trust.

The zero valuation rule effectively serves as a default measure. It shifts the burden onto the taxpayer to structure the transaction to meet the law’s strict requirements and ensures the gift tax is based on a more realistic valuation.

Transactions Subject to Section 2702

For Section 2702 to govern a transaction, three conditions must be satisfied. The first is that there must be a transfer of an interest in property to a trust. This includes funding a new trust or contributing to an existing one.

The second condition is that the transfer must be for the benefit of a “member of the family” of the transferor. The Internal Revenue Code defines this term to include the transferor’s spouse, any ancestor or lineal descendant of the transferor or their spouse, any sibling of the transferor, and the spouse of any of these individuals. This definition covers immediate relatives and in-laws but excludes more distant relations like nieces or nephews.

The final condition is that the transferor or an “applicable family member” must retain an interest in the trust. An “applicable family member” is defined more narrowly than a “member of the family” and includes the transferor’s spouse and any ancestor of either the transferor or the transferor’s spouse. This means if a grandparent transfers property to a trust for a grandchild and the grandparent’s spouse retains an interest, the rules of Section 2702 are triggered.

The Qualified Interest Exception

The zero valuation rule does not apply if the interest retained by the grantor is a “qualified interest.” This exception provides a pathway to avoid the zero valuation. If the retained interest is qualified, its value can be calculated using standard actuarial methods and subtracted from the property’s value to determine the taxable gift.

The tax code defines three types of qualified interests. The first is a “qualified annuity interest,” which is the right to receive fixed annual payments from the trust. The amount is specified at the trust’s creation and does not change, regardless of the trust’s performance. This predictability is why it is considered “qualified,” as its value can be ascertained with a high degree of accuracy.

The second type is a “qualified unitrust interest.” This is the right to receive annual payments equal to a fixed percentage of the trust’s assets, which are revalued annually. The payment amount can fluctuate each year depending on the investment performance of the trust’s assets.

The third type is a “qualified remainder interest.” This is the right to receive the entire trust property upon the termination of all other interests in the trust. For a remainder interest to be “qualified,” all other interests in the trust must be either qualified annuity or unitrust interests.

Common Compliant Trust Structures

Grantor Retained Annuity Trust (GRAT)

A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust where the grantor transfers assets while retaining the right to a fixed annual payment, or annuity, for a specified term. This retained right is a qualified annuity interest. The term of the annuity payments can be for the life of the holder, a set number of years, or the shorter of the two.

The taxable gift to the beneficiaries is the fair market value of the assets minus the present value of the grantor’s annuity, calculated using the Section 7520 interest rate. If the GRAT’s assets appreciate faster than this rate, the excess growth passes to the beneficiaries free of additional gift tax. GRATs are often structured so the annuity’s value nearly equals the transferred property’s value, creating a “zeroed-out” GRAT with a minimal taxable gift. If the grantor survives the trust term, the remaining assets are transferred to the beneficiaries and are not part of the grantor’s taxable estate.

Grantor Retained Unitrust (GRUT)

A Grantor Retained Unitrust (GRUT) operates on a similar principle to a GRAT. The grantor transfers assets to a trust and retains the right to receive annual payments equal to a fixed percentage of the trust’s assets, which are revalued each year. This retained right constitutes a qualified unitrust interest.

The annual payment from a GRUT fluctuates with the value of the trust’s assets. This structure can be advantageous if the trust assets are expected to appreciate significantly, as the grantor shares in that appreciation through larger payments. The gift to the remainder beneficiaries is the fair market value of the property minus the present value of the grantor’s retained unitrust interest, also based on the Section 7520 rate. GRUTs are less common than GRATs, partly because the annual revaluation can be administratively burdensome for hard-to-value assets.

Qualified Personal Residence Trust (QPRT)

A Qualified Personal Residence Trust (QPRT) is a statutory exception to Section 2702. It allows a grantor to transfer a personal residence into a trust for family members while retaining the right to live in it for a specified term. This retained right to use the property is exempt from the zero valuation rule.

The trust’s main asset must be the grantor’s principal residence or one other residence, such as a vacation home. The trust is generally prohibited from holding other assets, with limited exceptions for cash to cover expenses. The taxable gift is the home’s fair market value minus the present value of the grantor’s right to live there. If the grantor outlives the term, the residence passes to the beneficiaries and is excluded from the grantor’s taxable estate; if the grantor dies during the term, the home’s value is included in their estate.