A charitable remainder trust is a trust that provides for a specified distribution, at least annually, to at least one noncharitable income recipient for a period specified in the trust instrument, with the remainder interest paid to at least one charitable beneficiary. This 285-page, fully annotated text, by Marc D. Hoffman, provides a complete technical overview of CRTs, charitable contribution deductions, transfer tax considerations, operational and investment considerations, and cash Flow planning.
Editor's Note: This Technical Report is currently being revised. A news alert will be issued when the revised edition is published.
A charitable remainder trust is a trust that provides for a specified distribution, at least annually, to one or more beneficiaries, at least one of which is not a charity. The distribution must be paid at least annually for life or for a term of years, with an irrevocable remainder interest to be held for the benefit of, or paid over to, one or more qualified charities. The specified distribution must be either a sum certain, which is not less than five percent and not more than fifty percent of the initial net fair market value of all property placed in trust (a charitable remainder annuity trust), or a fixed percentage, which is not less than five percent and not more than fifty percent, of the net fair market value of the trust assets, valued annually (a charitable remainder unitrust).
In order to qualify as a charitable remainder trust, the trust must meet all of the requirements set forth in IRC §664, the regulations promulgated thereunder, Revenue Rulings, and Procedures.1
In Rev. Proc. 91-3 and subsequent rulings the IRS announced that it will no longer issue advance rulings regarding whether a transfer to a charitable remainder trust described in section 664 of the Code that provides for annuity or unitrust payments for one or two measuring lives qualifies for a charitable income, gift or estate tax deductions under sections 170(f)(2)(A), 2522(c)(2)(A) or 2055(e)(2)(A). The Service will, however, continue to rule regarding provisions that deviate from those found in the sample documents published in the Revenue Procedures.2
Caution: A trust that does not contain a required governing provision or otherwise fails to qualify as a charitable remainder trust will cause the loss of the trustor's income tax deduction, will cause all transactions within the trust to be taxable, and may also subject the transfer to gift tax even though made to charity. Further, it may be impossible to amend or reform a defective trust.3
A charitable remainder trust is exempt from all taxes unless it has unrelated business taxable income within the meaning of IRC §512. In any year in which a charitable remainder trust has one penny of UBTI, the trust is subject to tax as if it was a complex trust. A charitable remainder trust that sells appreciated property within two years of the date the property is contributed to the trust is exempt from the requirement of IRC §644 that it compute the gain on the sale at the transferor's tax rate. Further, the grantor trust rules of IRC §?671 - 678 and the throwback rules of IRC §?665 - 668 are not applicable to a qualified charitable remainder trust.4
The trust assumes the trustor's adjusted cost basis and holding period in the transferred property based on the carryover basis provisions of the Code. If the trust sells the property, it will realize the same amount of gain as the trustor would have realized if he or she had sold the property. The trust is tax-exempt and, therefore, will not pay any tax.5
In practice, this feature makes charitable remainder trusts ideal for use by individuals who desire to dispose of highly appreciated, low yielding property free of capital gains tax exposure in favor of assets that will produce higher amounts of cash flow and appreciation. It is important to note the double tax leverage that can be accomplished by avoiding recognition of capital gain and creating an immediate income tax deduction.
Anyone who wishes to create a charitable remainder trust must choose between the annuity trust and unitrust formats. A trust is a charitable remainder trust only if it is either a charitable remainder annuity trust or a charitable remainder unitrust in every respect.6 No blending is allowed. The principle difference between the two is the way in which income distributions are determined.
A charitable remainder annuity trust is a trust from which a sum certain (which is not less than 5 percent of the initial fair market value of all property placed in trust) is to be paid, not less often than annually, to one or more persons7 (at least one of which is not an organization described in IRC §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 twenty years) or for the life or lives of such individual or individuals.8
The annuity amount may be stated as a fixed percentage of the initial net fair market value, or it may be stated as a fixed sum. The annuity percentage or amount that is fixed cannot be changed regardless of fluctuations in portfolio value. For this reason, additional contributions to annuity trust are prohibited.9
| Payout rate | 7% | ||
| Yr. | Earnings Rate |
Trust Value |
Annuity Amount |
| 1 | 8% | $1,000,000 | $ 70,000 |
| 2 | 6% | $1,010,000 | $ 70,000 |
| 3 | 10% | $1,000,600 | $ 70,000 |
| 4 | 8% | $1,030,660 | $ 70,000 |
| 5 | 4% | $1,043,113 | $ 70,000 |
| 6 | 12% | $1,014,837 | $ 70,000 |
| 7 | 6% | $1,066,618 | $ 70,000 |
| 8 | 7% | $1,060,615 | $ 70,000 |
| 9 | 3% | $1,064,858 | $ 70,000 |
| 10 | $1,026,804 | $ 70,000 | |
Figure 4 These charts illustrate the level income stream that flows from a charitable remainder annuity trust. Annuity payments are level regardless of the trust's fair market value. Annuity payments are NOT guaranteed, however. If the trust's asset value falls to zero, the annuity payments cease.
A charitable remainder unitrust is a trust from which a fixed percentage (which is not less than 5 percent) of the net fair market value of its assets, valued annually, 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 IRC §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 twenty years) or for the life or lives of such individual or individuals.
Unlike the charitable remainder annuity trust, additional contributions to unitrusts are permitted.
| Payout rate | 7% | ||
|
Yr. |
Earnings Rate |
Trust Value |
Unitrust Amount |
| 1 | 8% | $1,000,000 | $ 70,000 |
| 2 | 6% | $1,010,000 | $ 70,700 |
| 3 | 10% | $ 999,900 | $ 69,993 |
| 4 | 8% | $1,029,897 | $ 72,093 |
| 5 | 4% | $1,040,196 | $ 72,814 |
| 6 | 12% | $1,008,990 | $ 70,629 |
| 7 | 6% | $1,059,440 | $ 74,161 |
| 8 | 7% | $1,048,845 | $ 73,419 |
| 9 | 3% | $1,048,845 | $ 73,419 |
| 10 | $1,006,891 | $ 70,482 | |
Figure 5 This table and chart illustrate the direct relationship between the value of a charitable remainder unitrust's assets and the unitrust amount it distributes.
The net fair market value of the trust assets may be determined on any one date during the taxable year of the trust. It also may be determined by taking the average of valuations made on more than one date during the taxable year of the trust, so long as the same valuation date or dates and valuation methods are used each year.10
Multiple valuation dates, while helping to balance payout fluctuations, are usually impractical from an administrative standpoint. Therefore, the majority of unitrust instruments provide for one valuation date. However, if an additional contribution is made on a non-valuation date, the property is valued on the date of contribution and the unitrust amount is adjusted to reflect the unitrust amount attributable to the additional contribution for the balance of the trust's taxable (calendar) year.11
To enable the trustee to plan for required distributions and to easily determine the value of publicly traded securities held by the trust, most trust instruments designate the first business day of each calendar year as the annual valuation date. Designating an annual valuation date after a required payment date requires the trustee to estimate the future value of trust assets in order to determine the unitrust amount and, therefore, is not generally recommended.
A unitrust is required to distribute, at least annually, an amount equal to at least 5 percent of the annual value of trust assets. This is referred to as the unitrust amount. In the event income and gain are not sufficient to make the required distribution, the trustee is required to distribute corpus. This type of format is commonly referred to as a standard or Type I payout option.
The previous illustration and chart demonstrate a standard unitrust bearing a 7 percent payout rate. There is no statutory maximum payout rate.
Notwithstanding the 5 percent minimum distribution rule applicable to a standard unitrust, a unitrust instrument may include an optional provision that requires the trustee to pay, for any year, the lesser of the full unitrust amount and trust income (as defined in section 643(b) and the regulations thereunder). This provision is commonly referred to as a net income, income only, or Type II option.12
As originally envisioned by Congress, the net income option was intended to relieve trustees from having to distribute trust corpus in years in which trust income was insufficient to satisfy the unitrust amount.
According to IRC §643(b), the term income, when not preceded by the words taxable, distributable, undistributed net, or gross, means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local (state) law. For purposes of determining the unitrust amount for a net income unitrust, many states provide that expenses incurred in the administration, management or preservation of trust property, and all expenses reasonably incurred by the trustee are charges against trust income. Regular trustee's compensation is generally charged in equal portions against income and principal.
The Revised Uniform Income and Principal Act adopted by most states defines income to include interest, dividends, rents, royalties, and the discount element of original issue discount obligations. Unless otherwise defined, and subject to state law, income does not include capital gains. Furthermore, a net income unitrust is never permitted to distribute corpus.
Reg. §1.643(b)-1 adds: Any trust provisions which depart fundamentally from concepts of local law in the determination of what constitutes income are not recognized for these (federal tax) purposes. The draftsman should always, therefore, conform to local law.
| Payout rate | 7% | ||||
| Yr. | Income Rate |
Trust Value |
Unitrust Amount |
Trust Income |
Actual Payment |
| 1 | 8% | 1,000,000 | 70,000 | 80,000 | 70,000 |
| 2 | 6% | 1,010,000 | 70,700 | 60,600 | 60,600 |
| 3 | 10% | 1,010,000 | 70,700 | 101,000 | 70,700 |
| 4 | 8% | 1,040,300 | 72,821 | 83,224 | 72,821 |
| 5 | 4% | 1,050,703 | 73,549 | 42,028 | 42,028 |
| 6 | 12% | 1,050,703 | 73,549 | 126,084 | 73,549 |
| 7 | 6% | 1,103,238 | 77,227 | 66,194 | 66,194 |
| 8 | 7% | 1,103,238 | 77,227 | 77,227 | 77,227 |
| 9 | 3% | 1,103,238 | 77,227 | 33,097 | 33,097 |
| 10 | 10% | 1,103,238 | 77,227 | 110,324 | 77,227 |
Figure 6 This illustration compares the unitrust amount that should be paid to the amount that can be paid based on the distributable net income of the trust. The shaded areas illustrate years in which the trust income is insufficient to satisfy the unitrust amount. Because this trust does not contain a make-up option, there is no opportunity for any income deficiencies to be recovered by the income recipient(s) in future years.
If a net income option is adopted, the trust will pay income in excess of the full unitrust amount to the extent the aggregate of amounts paid in prior years were (by reason of the income only exception) less than the aggregate of the fixed percentage amounts for such prior years. The trust can, in other words, make-up past deficiencies from prior years by paying out excess income earned in the current year.13 The concept is somewhat analogous to a cumulative dividend feature on preferred stock and is referred to as a net income with make-up or Type III unitrust.
Net income and make-up options are available only to charitable remainder unitrusts. They are not available to charitable remainder annuity trusts or to charitable income (lead) unitrusts. Furthermore, excess income from a prior year cannot be used to satisfy a deficiency amount arising in a later year.
Planning Note: The net income and net income with make-up unitrusts can solve the problem of funding a trust with a non-income producing asset by limiting the requirement for income distributions to times when the trustee has the capacity to make them. Further, as will be discussed, net income unitrusts provide planning opportunities for those income recipients who wish to defer income distributions.
| Payout rate | 7% | ||||||
| Yr. | Income Rate |
Trust Value |
Unitrust Amount |
Trust Income |
Actual Payment |
Annual Deficit |
Amount of Make-up Payment |
| 1 | 8% | 1,000,000 | 70,000 | 80,000 | 70,000 | 0 | 0 |
| 2 | 6% | 1,010,000 | 70,700 | 60,600 | 60,600 | 10,100 | 0 |
| 3 | 10% | 1,010,000 | 70,700 | 101,000 | 80,800 | 0 | 10,100 |
| 4 | 8% | 1,030,200 | 72,114 | 82,416 | 72,114 | 0 | 0 |
| 5 | 4% | 1,040,502 | 72,835 | 41,620 | 41,620 | 31,215 | 0 |
| 6 | 12% | 1,040,502 | 72,835 | 124,860 | 104,050 | 0 | 31,215 |
| 7 | 6% | 1,061,312 | 74,292 | 63,679 | 63,679 | 10,613 | 0 |
| 8 | 7% | 1,061,312 | 74,292 | 74,292 | 74,292 | 0 | 0 |
| 9 | 3% | 1,061,312 | 74,292 | 31,839 | 31,839 | 42,452 | 0 |
| 10 | 10% | 1,061,312 | 74,292 | 106,131 | 106,131 | 0 | 31,839 |
| 94,381 | 73,154 | ||||||
|
Remaining Makeup |
21,226 | ||||||
Can a unitrust instrument be drafted to permit the trust to switch or flip from having a net income option to a standard income provision? Under proposed regulations it can. The legislative history explains the rationale and applications of the flip unitrust.
In a 1987 letter ruling, the Service approved an arrangement whereby a unitrust was funded with restricted securities that could not be traded until the applicable holding period expired. The trust provided that if the shares were ineligible for sale to the public, the trustee would pay only trust income (as defined under IRC §643(b)) for such period during which the restriction or inability to sell the shares existed; provided that such income would not exceed the 10 percent unitrust amount. The trust also contained a make-up option.14
In 1995, the Service reversed itself.15 In an independent case, two individuals had transferred real property to an 8 percent net income unitrust with make-up option. The taxpayers later realized that they had intended to include language that converted the trust to a standard payout format upon sale of the property. The taxpayers petitioned the Circuit Court to reform the trust agreement to include such language.
The Service ruled that pursuant to section 664(d) of the Code, the amount payable to noncharitable recipients from a qualified charitable remainder unitrust must be computed using one of three methods as selected by the terms of the trust's governing instrument, and that such method must be used during the entire term of the trust. In addition, the method of computing the unitrust amount may not be reformed to provide for a change in the method of computation of the unitrust amount without adversely affecting the qualification of the trust under section 664.
On April 18, 1997, Treasury issued proposed amendments to the regulations that would permit the use of a flip provision under certain circumstances.16
a. General Explanation of Proposed Regulations.
In its general explanation of proposed rule making, Treasury stated:
The governing instrument of a CRUT must specify the method of computing the unitrust payments. Section 664(d)(3) provides that the income exception methods (either the net income method or the NIMCRUT method) may be used to pay the unitrust amount "for any year." The legislative history, however, provides that the method used to determine the unitrust amount may not be discretionary with the trustee. H.R. Conf. Rep. No. 782, 91st Cong., 1st Sess. 296 (1969), 1969-3 C.B. 644, 655.
Some donors may fund a CRUT with unmarketable assets that produce little or no income. These donors often want the income beneficiary or beneficiaries of the CRUT to receive a steady stream of payments based on the total return available from the value of the assets. The donors recognize, however, that the CRUT cannot make these payments until it can convert the unmarketable assets into liquid assets that can be used to pay the fixed percentage amount. These donors establish CRUTs that use one of the income exception methods to calculate the unitrust amount until the unmarketable assets are sold. Following the sale, the donors may prefer that the CRUT use the fixed percentage method to calculate the unitrust amount. A trust using such a combination of methods would be a "flip unitrust."
The proposed regulations provide that a donor may establish a flip unitrust that qualifies as a CRUT if the following conditions are satisfied. First, to ensure that the CRUT has substantially all unmarketable assets prior to the switch in methods, at least 90 percent of the fair market value of the assets held in the trust immediately after the initial contribution or any subsequent contribution (prior to the switch in methods) must consist of unmarketable assets. Unmarketable assets are assets that are not cash, cash equivalents, or marketable securities (within the meaning of section 731(c)).
Second, because the legislative history indicates that a trustee should not have discretion to change the method used to calculate the unitrust amount, the governing instrument must provide that the CRUT will use an income exception method until the earlier of (a) the sale of a specified unmarketable asset or group of unmarketable assets contributed at the time the trust was created or (b) the sale of unmarketable assets such that immediately following the sale, any remaining unmarketable assets total 50 percent or less of the fair market value of the trust's assets. For making this determination, the remaining unmarketable assets are valued as of the most recent valuation date.
Third, to ensure that the CRUT will use the fixed percentage method after the unmarketable assets are sold, the CRUT must switch exclusively to the fixed percentage method for calculating all remaining unitrust amounts payable to any income beneficiary at the beginning of the first taxable year following the year in which the earlier of the above events occurs.
Finally, because the fixed percentage method does not provide for a makeup amount, any makeup amount described in section 664(d)(3)(B) is forfeited when the trust switches to the fixed percentage method.
Final Regulations Regarding Flip Unitrusts
On December 10, 1998, Treasury published final regulations regarding flip unitrusts.17 In response to public commentary, the final regulations expand the availability of the flip unitrust to certain other situations that are described as follows:
The final regulations allow the governing instrument of a CRUT to provide that the CRUT will convert once from one of the income exception methods to the fixed percentage method for calculating the unitrust amount if the date or event triggering the conversion is outside the control of the trustees or any other persons. The final regulations include examples of permissible and impermissible triggering events.
For example, permissible triggering events with respect to any individual include marriage, divorce, death, or birth of a child. Also, the sale of an unmarketable asset such as real estate is a permissible triggering event. Examples of impermissible triggering events include the sale of marketable assets and a request from the unitrust recipient or the unitrust recipient's financial advisor that the trust convert to the fixed percentage method.
The final regulations also provide that the conversion to the fixed percentage method occurs at the beginning of the taxable year that immediately follows the taxable year in which the triggering date or event occurs. Any make-up amount described in section 664(d)(3)(B) is forfeited when the trust converts to the fixed percentage method.
The proposed regulations define unmarketable assets as assets other than cash, cash equivalents, or marketable securities (within the meaning of section 731(c)). Commentators asked for clarification of the term unmarketable assets and recommended changing the scope of this class of assets. In response, the final regulations define unmarketable assets as assets other than cash, cash equivalents, or assets that can be readily sold or exchanged for cash or cash equivalents. For example, unmarketable assets include real property, closely-held stock, and unregistered securities for which there is no available exemption permitting public sale.
Commentators requested that the final regulations permit conversions from the fixed percentage method to one of the income exception methods and conversions from a CRAT to a CRUT. The flip unitrust allowed in the final regulations is the only type of permissible conversion. Thus, a CRAT cannot convert to a CRUT without losing its status as a CRT. Similarly, a CRUT using the fixed percentage method cannot convert to an income exception method without losing its status as a CRT.
Proposed Effective Date and Transitional Rules
The final rules for flip unitrusts are effective for CRUTs created on or after December 10, 1998. The proposed regulations allowed reformations in limited circumstances. In response to comments, the final regulations expand the circumstances in which reformation is available. The final regulations allow income exception CRUTs to be reformed to add provisions allowing a conversion to the fixed percentage method provided the triggering event does not occur in a year prior to the year in which the court issues the order reforming the trust. Adding the conversion provisions will not cause the CRUT to fail to function exclusively as a CRT and will not be an act of self-dealing under section 4941 if the trustee initiates legal proceedings to reform the trust by June 8, 1999. In Notice 99-31, the Service subsequently extended the reformation window until June 30, 2000.
The concept of the make-up option is simple unless the definition of income within the trust instrument is modified. For example, in Ltr. Rul. 9511007, a taxpayer proposed to create a 10 percent net income unitrust with make-up option. The trust instrument directed the trustee to allocate to trust income all gains that are realized on trust assets after contribution to the trust (whether attributable to appreciation occurring before or after contribution). The trust further stated, "the liability to the income recipient resulting from any income shortfall (i.e., the deficiency account balance) shall be taken into account in determining the annual unitrust amount." The trust provided specifically that the net fair market value of trust assets as of the valuation date would be determined by first subtracting the amount of the shortfall as of that date, provided the reduction is no more than the amount of the unrealized gain then inherent in trust assets.
In its analysis the Service stated,
The income exception provision of section 664(d)(3) was enacted by Congress to permit greater flexibility for certain charitable remainder gifts, but it was crafted in such a manner as to prevent the manipulation of the trust assets to the detriment of the charitable remainder interest. If the income exception provision is included in the trust's governing instrument, this provision prevents the trust from having to invade corpus when income for the year is below what was originally contemplated. For purposes of this provision, the determination of what constitutes trust income is to be made under the applicable local law and, thus, is not to include items such as capital gains which must be allocated to the trust principal.
As envisioned by Congress, the trust income used to pay the unitrust amount would never include amounts that in prior years had been included in the fair market value of the trust assets on which the fixed amount had been based. The allocation of capital gains to trust income creates the potential to manipulate the trust assets to the detriment of the charitable remainder interest. Year after year, the trustee naturally includes any unrealized appreciation in determining the fair market value of the trust's assets on which the unitrust amount is based. Then when the trustee chooses to realize the appreciation by selling the assets, the realized appreciation is taken out of the base. The realized appreciation becomes trust income that will be paid to the noncharitable recipient to the extent of the current year's unitrust amount and any deficiency in the unitrust amounts from prior years. The trustee has, thus, inflated the unitrust amount each year by amounts that will be payable to the noncharitable recipient upon the sale of the assets. Under these circumstances, the amount that will be paid to the charitable organization at the termination of the trust may well be less than the amount that would be paid to the charitable organization if the fixed unitrust amount had been paid each year pursuant to section 664(d)(2)(A) of the Code (i.e., a standard trust).
The Service ruled,
In determining the fair market value of the assets on the annual valuation date, the governing instrument must require the trustee to treat as a liability the amount of any deficiency for prior years computed under section 664(d)(3)(B). The amount treated as a liability need not exceed the trust's unrealized appreciation that would be trust income under the terms of the governing instrument and applicable local law if the trustee sold all the assets in the trust on the valuation date. This trust provision will ensure that the timing of the realization of the gain by the trustee cannot be manipulated to the detriment of the charitable remainder interest.
The key to this ruling rests in the fact that the trust instrument defined distributable net income to include all gains realized on trust assets after contribution to the trust (whether attributable to appreciation occurring before or after contribution). In theory, if the contributed assets have a zero cost basis, the entire amount of the trust can be used to satisfy a deficiency payment, thereby exhausting the trust! If, however, the trust instrument limits the definition of income to gains that occur only after the contribution of assets to the trust (i.e., the contribution value is the basis for purposes of determining subsequent gain or loss), it becomes mathematically impossible, given identical investment assumptions, for a net income unitrust to produce a smaller remainder interest than a standard unitrust bearing the same payout rate. In fact, there is a possibility the net income unitrust will terminate prior to gains being realized and distributed. In such case, the remainder interest could be greater than from a standard unitrust. Thus, the formula called for in the ruling should not, in the opinion of some practitioners, logically apply.
In a subsequent letter ruling, a similar fact pattern was presented. In this case the trustee was instructed to allocate gains to income only upon receipt of cash or other property, by reason of sale or distribution.18 In addition, a portion of the net proceeds of dispositions of underproductive property was to be allocated to income. In both cases, however, how capital gains were to be determined (i.e., whether based on the donor's basis or the contribution value as basis) or what portion of the proceeds from underproductive property was to be considered income was not addressed. In the absence of a clear definition, and relying on the logic presented in the first ruling, the Service required the same formula to be used in determining the annual unitrust amount.19
a. Regulations Amended to Eliminate Allocation of Pre-Contribution Gains to Trust Income
On April 18, 1997, Treasury issued proposed amendments to the regulations that would prohibit the allocation of pre-gift gain to trust income.20 In response to public comments, The National Committee on Planned Giving supported this proposal and further requested that Treasury and IRS revoke the positions held in Ltr. Ruls. 9511007 and 9511029 (and other subsequent PLRs) that require charitable remainder unitrust governing instruments to treat the deficiency account as a liability in calculating the fair market value for purposes of determining the annual unitrust amount.
b. Final Regulations
On December 10, 1998, Treasury issued final regulations that maintain the prohibition on allocating pre-contribution gain to trust income for an income exception CRUT.21 However, the governing instrument, if permitted under applicable local law, may allow the allocation of post-contribution capital gains to trust income. Most importantly, Treasury stated specifically that taxpayers do not have to treat the make-up amount as a liability when valuing the assets of a NIMCRUT.
In response to congressional concern that some charitable remainder trusts have been established with combined measuring terms and payout/annuity rates that will result in only a de minimis remainder interest passing to charity, the Taxpayer Relief Act of 1997 imposes two new requirements for all charitable remainder trusts:
Since their inception, charitable remainder trusts have been subject to a minimum payout, or annuity rate, of 5 percent; however, there has been no maximum rate. The new law imposes a maximum annuity, or payout rate, of 50 percent.
In application, this new rule will have little effect on most charitable remainder trust planning because it was intended to curtail the use of accelerated charitable remainder unitrusts as described in Notice 94-78. The trust cited in the notice carried a payout rate of 80 percent and a measuring term of two years. Conversely, the majority of traditionally designed charitable remainder trusts carry single digit payout or annuity rates and terms measured by the life of each income recipient.
With respect to charitable remainder annuity trusts, when such trusts are measured by the life of an individual, they are subject to the 5 percent probability test.22 This test effectively limits the maximum annuity rate for a qualifying trust to between approximately 7 and 15 percent.
In addition to establishing a 50 percent maximum annuity, or payout rate, the law also requires the present value of the charitable remainder interest to be at least 10 percent of the net fair market value of such property transferred in trust on the date of transfer. A charitable remainder trust that satisfies the 10 percent test on the date of transfer will not fail to qualify if the present value of the remainder interest subsequently falls below the minimum original qualifying amount. Similarly, where a charitable remainder trust is created for the joint lives of two individuals, the trust will not cease to qualify because the value of the charitable remainder is less than 10 percent of the trust's assets at the first death of those two individuals.
The conference agreement provides several additional rules in order to provide relief for trusts that do not meet the 10 percent rule:
First, when a transfer is made after July 28, 1997 to a charitable remainder trust that fails the 10 percent test, the trust is treated as meeting the 10 percent requirement if the governing instrument is changed by reformation, amendment, construction, or otherwise to meet such requirement. This is accomplished by reducing the payout rate or measuring term (individually or in combination) of any noncharitable income recipient's interest to the extent necessary to satisfy such requirement. The reformation must be commenced within the period permitted for reformations of charitable remainder trusts under section 2055(e)(3). The statute of limitations applicable to a deficiency of any tax resulting from reformation of the trust shall not expire before the date one year after the Treasury Department is notified that the trust has been reformed. In substance, this rule relaxes the requirements of section 2055(e)(3)(B) to the extent necessary for the reformation of the trust to meet the 10 percent requirement.
Second, a transfer to a trust will be treated as if it had never been made where a court having jurisdiction over the trust subsequently declares the trust void (because, for example, the application of the 10 percent rule frustrates the purposes for which the trust was created) and judicial proceedings to revoke the trust are commenced within the period permitted for reformations of charitable remainder trusts under section 2055(e)(3). Under this provision, the effect of "unwinding" the trust is that any transactions made by the trust with respect to the property transferred (e.g., income earned on the assets transferred to the trust and capital gains generated by the sales of the property transferred) would be income and capital gain of the donor (or the donor's estate if the trust was testamentary), and the donor (or the donor's estate if the trust was testamentary) would not be permitted a charitable deduction with respect to the transfer. The statute of limitations applicable to a deficiency of any tax resulting from "unwinding" the trust shall not expire before the date one year after the Treasury Department is notified that the trust has been revoked.
Third, where an additional contribution is made after July 28, 1997 to a charitable remainder unitrust created before July 29, 1997, and that unitrust would not meet the 10 percent requirement with respect to the additional contribution, the conference agreement provides that the additional contribution will be treated, under regulations to be issued by the Secretary of the Treasury, as if it had been made to a new trust that does not meet the 10 percent requirement. The failure of the new trust to qualify will not adversely affect the status of the original unitrust as a charitable remainder trust.
The requirement that the present value of the charitable remainder, with respect to any transfer to a qualified remainder trust, be at least 10 percent of the fair market value of the assets transferred in trust applies to transfers to a trust made after July 28, 1997. However, the 10 percent requirement does not apply to charitable remainder trusts created by a testamentary instrument executed before July 29, 1997, if the instrument is not modified after that date and the settlor dies before January 1, 1999, or could not be modified after July 28, 1997 because the settlor was under a mental disability on that date (i.e., July 28, 1997) and at all times thereafter.
The effect of the new 10 percent qualification floor is more far reaching than the 50 percent annuity/payout rate maximum and has been the topic of intense public debate. Proponents of the new rule argue that in order for donors to enjoy the tax benefits that accompany the use of a charitable remainder trust, such as complete avoidance of capital gains tax on the transfer and sale of contributed assets, there should be a minimum charitable component. Those who oppose the new rule have suggested the new rule discriminates against younger donors by preventing them from creating charitable remainder trusts with measuring terms based on their lives. Others argue the new floor prevents the use of more creative trust designs that are based on the unique circumstances of each donor.
Although the 10 percent qualification floor will discourage the creation of some charitable remainder trusts, it will also serve to remind planners that the primary purpose of the charitable remainder trust is to be charitable. As an alternative, younger donors may consider a contribution to a pooled income fund or to the charitable gift annuity, which are not subject to the 10 percent minimum present value floor.
A unitrust can make distributions annually, semi-annually, quarterly, or monthly, at the beginning or end of the payment period prescribed in the trust instrument. In addition, an annuity trust can make distributions on a weekly basis if desired.
The majority of charitable remainder trusts make distributions at the end of each calendar quarter. This format offers a practical balance between the income recipient's desire to receive regular payments and the trustee's desire to manage the administrative burden of such distributions.
Although all charitable remainder trusts are required to make distributions at least annually, the regulations have permitted the trustee to make actual payment of the annuity or unitrust amount within a reasonable time after the close of the trust's taxable year. A reasonable time would not ordinarily extend beyond the date by which the trustee would be required to file Form 1041-A (including extensions) for such year.23 Since 1987, all charitable remainder trusts have been required to operate on a calendar tax year.
1. Proposed Regulations
On April 18, 1997, the Treasury issued proposed amendments to the regulations to require that all annuity trusts and standard payout format unitrusts distribute the full annuity or unitrust amount by the close of the taxable year in which it is due.24 Unitrusts that use a net income format will be permitted to continue to make payment within a reasonable amount of time after the close of the trust's taxable year.
These changes were initiated solely by the Treasury's desire to curtail the use of accelerated charitable remainder trusts as described in Notice 94-78. Accelerated CRTs exploit legal fictions involving trust accounting income for the purpose of enabling trustees to convert trust distributions from taxable capital gains into a tax-free return of principal.
In response to numerous objections that such a requirement would place undue hardship on trustees of conforming trusts, the IRS issued Notice 97-68 that exempts some charitable remainder trusts from the year-end payment requirement. Specifically, trusts created before January 1, 1998 may pay the annuity or unitrust amount for the 1997 tax year within a reasonable period following the close of the tax year, provided (1) the payout rate or annuity rate of the trust does not exceed 15 percent, and (2) that all distributions received by the income recipient for 1997 are characterized for income tax purposes as described in IRC 664(b)(1), (2), and (3), and not as trust corpus.
In the case of a testamentary charitable remainder trust, the obligation to pay the unitrust or annuity amount commences with the date of the testator's death. Actual payment can, however, be deferred (with accrued interest) until a reasonable time after the taxable year in which complete funding of the trust occurs.25 These rules are unaffected by the proposed regulations.
2. Final Regulations
On December 10, 1998, the Treasury issued final regulations on the issue of the timing the CRT payments.26 Treasury commented --
Although recent legislative changes have reduced the potential tax benefits of accelerated CRTs, the IRS and Treasury continue to be concerned about the potential abuse of the post-year-end grace period to produce a tax-free return of appreciation in the assets contributed to a CRAT or a fixed percentage CRUT. Therefore, the final regulations adopt rules similar to those in Notice 97-68 with certain modifications. The rules are effective for taxable years ending after April 18, 1997.
For CRATs and fixed percentage CRUTs, the annuity or unitrust amount may be paid within a reasonable time after the close of the year for which it is due if (a) the character of the annuity or unitrust amount in the recipient's hands is income under section 664(b)(1), (2), or (3); and/or (b) the trust distributes property (other than cash) that it owned as of the close of the taxable year to pay the annuity or unitrust amount and the trustee elects on Form 5227, "Split-Interest Trust Information Return," to treat any income generated by the distribution as occurring on the last day of the taxable year for which the amount is due. In addition, for CRATs and fixed percentage CRUTs that were created before December 10, 1998, the annuity or unitrust amount may be paid within a reasonable time after the close of the taxable year for which it is due if the percentage used to calculate the annuity or unitrust amount is 15 percent or less.
One the first decisions that must be made in the design of a charitable remainder trust is the trust's payout format. Will the trust be an annuity trust or unitrust? If it is a unitrust, will it be standard, or include a net income or net income with makeup provision? If it is a net income unitrust, how will income be defined? These choices of annuity or unitrust depend on a thorough analysis of a number of factors, including:
One of the first steps a planner can take in choosing a payment format is to examine the compatibility of contributed assets with various format options. The marketability, liquidity, and cash flow producing capability of contributed assets are an excellent starting point.
Suppose a trustor funds a charitable remainder annuity trust with an apartment complex and with the intent of an immediate sale. Suppose also that the current net rents are sufficient to make the annuity payments. However, what if unforeseen additional cash requirements arise prior to the sale? What if the owner is required to make unanticipated capital improvements prior to the sale? What if one or more major tenants move out, severely reducing net operating income below that of the trust's payout requirement? Can the trustor of an annuity trust make additional contributions to the trust? No. Additional contributions to annuity trusts are prohibited. Further, a net income provision is unavailable to an annuity trust.27
Can a trustee borrow money? Yes. However, the trust might have acquisition indebtedness / unrelated debt-financed income and lose its tax-exempt status for that year. Accordingly, all income (including capital gain upon the sale of trust assets) could be taxable.28
The consequences of not making a distribution may, however, be more severe. The regulations provide that the unitrust or annuity amount is includible in the gross income to the recipient in the year it is required to be distributed even though no distribution is made until after the close of the tax year of the trust.29 Such a deemed distribution results in phantom income to the income recipient. As mentioned earlier, the trust is required to make the distribution no later than when the tax return is filed for the year in which the distribution is due. A failure to make such a distribution may result in the disqualification of the trust.
Illiquid, non-income-producing, or potentially non-income-producing property is most suitably transferred to a charitable remainder unitrust for two reasons. First, the unitrust can receive additional contributions if necessary. Second, the unitrust can include a net income provision that can relieve the trustee of the obligation to make distributions during periods when net cash flow does not satisfy the unitrust amount.
Should a trustor automatically select a net income unitrust over a standard unitrust when illiquid or low-income-producing contribution assets are contemplated? No, not without (a) considering the effect that selecting the net income format will have on the investment management of the trust's ability to produce adequate net income to satisfy the unitrust amount, and (b) understanding the alternatives.30
Because high returns and low risk are mutually exclusive, the choice of payment format is most greatly influenced by the income recipient's investment horizon, risk tolerance, and prevailing investment market conditions. The investment horizon of a charitable remainder trust is its measuring life, usually represented by the actuarial life expectancies of income recipients. Risk tolerance can be defined as the amount of fluctuation in asset value an investor is willing to accept.
Charitable remainder trusts have risk tolerances as well. A charitable remainder annuity trust, with its fixed distribution requirement, may have difficulty in recovering from a loss of capital because, when principal value is reduced, the relative annuity amount is increased. On the other hand, a unitrust is more risk tolerant because, in the event of a loss of capital, the payout is adjusted downward.
The annuity format is usually selected by individuals who are averse to risk or have short investment horizons. Upside potential is deliberately sacrificed in exchange for the assurance of a fixed income stream regardless of investment performance or fluctuations in trust value. For example, a seventy-five year old income recipient may prefer an annuity trust invested in U.S. Treasury bonds, purchased at par or a discount, thereby locking in and guaranteeing the rate of return.
On the other hand, the unitrust is most often selected by those with higher risk tolerances or who otherwise desire to protect the purchasing power of their income distributions over longer investment horizons. In times of inflation or economic prosperity, a unitrust format may be preferable because the income recipient's return varies with in direct proportion to the annual fair market value of trust assets.
The most significant design consideration regarding a charitable remainder trust is the choice of the annuity or payout rate. Not only will this choice affect the amount of income distributions, it will also affect the amount of the charitable remainder interest and the trustor's charitable contribution deduction. Further, the rate will influence the selection of investment strategies for the trust.
With respect to charitable remainder annuity trusts, the annuity amount will remain static for the life of the trust. This, however, assumes the trust does not deplete its assets in the meantime. Therefore, the choice of annuity rate must take into account the income recipient's income needs, prevailing investment markets, and the amount of risk the trustee is willing to bear in meeting the annuity amount. An annuity trust bearing a high rate (relative to prevailing market returns) not only runs the risk of depleting principal (which can be exacerbated if principal falls below the initial funding amount), but the contribution may not qualify for a charitable contribution deduction.
The unitrust, with its variable payout format and more-flexible drafting options provides an opportunity for more-creative cash flow planning. A unitrust bearing a payout rate that is less than its return on investment will grow from year to year and, with it, the amounts distributed to income recipients. The concept of tax-free compounding and its effect on future income distributions adds another element to the payout rate design equation.
The following illustration shows the annual net cash flow and tax savings produced by two standard unitrusts bearing payout rates of 5 percent and 10 percent. The assumed rate of return on investment within the trusts is 10 percent. The term of the analysis is forty years.
Comparison of Income
5 and 10% Standard Unitrusts
| Yr. | 5%Std. CRUT | 10% Std. CRUT | ||
| 1 | 50,000 | 100,000 | ||
| 5 | 63,814 | 100,000 | ||
| 10 | 81,445 | 100,000 | ||
| 15 | 103,946 | 100,000 | ||
| 20 | 132,665 | 100,000 | ||
| 25 | 169,318 | 100,000 | ||
| 30 | 216,097 | 100,000 | ||
| 35 | 275,801 | 100,000 | ||
| 40 | 351,999 | 100,000 | ||
| Totals | 6,391,988 | 4,100,000 | ||
Figure 8 Although the unitrust bearing the 5 percent payout rate pays less initially than the unitrust bearing the 10 percent rate, the income from the 5 percent unitrust passes the income from the 10 percent unitrust in year fifteen.
As demonstrated, crossover points occur as the unitrust amounts of the trusts reach equilibrium with one another. Which trust produces the greatest aggregate cash flow over the period? The trust with the 5 percent payout rate. However, should a 5 percent payout be selected?
Variable cash flows are most accurately compared by discounted cash flow analysis. The following analysis illustrates the cumulative net present value of cash flows and tax savings, along with the net present value of the future charitable gifts. Trust assets are to be invested at an assumed rate of 10 percent. The discount rate is 6 percent. In this case, a 6 percent discount rate is used to simulate the after-tax opportunity cost of reinvestment (i.e., 10 percent taxable rate of return less 40 percent income tax).
This analysis presents a completely different result. As can be seen, the present values of cash flows are similar. What payout rate should be selected? The rate the trustor selects after seeing this type of analysis and making an informed decision.
Cumulative Income at 6% NPV
5 and 10% Standard Unitrusts
| Yr. | 5%Std. CRUT | 10% Std. CRUT | ||
| 1 | 46,296 | 92,593 | ||
| 5 | 259,187 | 462,288 | ||
| 10 | 444,108 | 713,896 | ||
| 15 | 604,733 | 885,137 | ||
| 20 | 744,254 | 1,001,680 | ||
| 25 | 865,444 | 1,080,998 | ||
| 30 | 970,712 | 1,134,980 | ||
| 35 | 1,062,150 | 1,171,719 | ||
| 40 | 1,141,574 | 1,196,723 | ||
Figure 9 Based on a discount rate of 6 percent (the projected after-tax investment opportunity cost), the cumulative net present value income from 5 percent unitrust does not catch the cumulative net present value of income from the 10 percent unitrust until year forty. While the 5 percent unitrust produces less cumulative benefit in most years, the decision regarding payout rate selection is not as simple or obvious as this NPV analysis suggests. The donor also must examine the impact of payout rate selection higher upon the projected charitable remainder interest.
Figure 10 This chart shows the cumulative net present value of income provided by the 5 percent and 10 percent payout rate unitrusts in the fortieth year and the net present value of each trust's charitable remainder interest.
Even though the difference in the cumulative net present value of the two income streams is negligible, the difference in the value of the gift to charity is significant. The analysis demonstrates, given an adequate length of time, a donor can maximize the total benefit (i.e., the combination of the net present value of the income and remainder interests) by selecting the lowest possible payout rate.
If the projected measuring term of the trust is less than the period illustrated in this analysis (as would be the case with older life income recipients), the payout rate will need to be increased in order to maximize the total benefit of the trust.
Even though a charitable remainder trust can distribute only the annuity or unitrust amount to a noncharitable income recipient, the regulations do permit the transfer of trust principal or excess income to the charitable remainderman prior to the conclusion of the measuring term of the trust.
Regarding the deductibility of advance payments, Rev. Rul. 86-60 provides that an income recipient's contribution of their entire annuity or unitrust income interest to charity qualifies for income and gift tax deductions.31
In Ltr. Rul. 8805024, an individual created a charitable remainder unitrust from which a 5 percent unitrust amount was payable for his life and thereafter for the life of his spouse. The trustor reserved the right, exercisable by will, to revoke his spouse's income interest. It was trustor's original intent to keep the trust in operation throughout his lifetime; however, during the initial years following its creation, the trust appreciated greatly in value. The trustor then decided to accelerate a portion of the remainder interest to the charitable remainderman. In his request for ruling, the trustor asked (a) Will the transfer of a portion of the trustor's entire interest and a portion of the contingent recipient's entire interest in the trust qualify for a charitable contribution deduction? (b) Will the proposed transaction cause a merger of the income and remainder interests thereby disqualifying the trust? (c) How will the charitable contribution deduction, if allowed, be calculated?
In response to the first question, the Service ruled that a deduction would be allowable only for the trustor's component of the transfer. A deduction for the portion of the transfer attributable to the spouse's contingent interest was disallowed because the trustor's reserved right of revocation could be exercised, leaving the surviving spouse with nothing to give. With respect to the second question, in interpreting state law, the Service ruled that, although a merger would exist on the accelerated portion, the trust would not be disqualified provided it continued to pay the 5 percent unitrust amount to the noncharitable income recipient from the remaining trust assets. Finally, the amount of the income tax charitable deduction would be calculated by multiplying the amount being transferred by the quantity 1.00000 minus the present value of remainder interest factor based on the trustor's age (on the date of transfer).32
Another trustor approached this issue differently. Through a reformation, the trustor divided one unitrust and its assets into two separate (but identical) unitrusts. The trustor then contributed his retained unitrust income interest in the newly formed trust to charity while retaining the income interest from the original trust.33
In a 1994 letter ruling, the IRS approved an arrangement whereby a special independent trustee of a 10 percent charitable remainder unitrust was given the discretionary power to distribute income that exceeded the 5 percent unitrust amount to the charitable remainderman. The trustors also retained the right to transfer all or a portion of trust corpus to the remainderman at any time during the measuring term of the trust. Although the issue was not specifically addressed, it is assumed that no income or gift tax deduction accompanied the contributions of the excess income. Likewise, it is assumed that payments to the charitable remainderman are not considered to be taxable to the grantors.34 The ruling also provided that, in the case of distributions in kind, the adjusted basis of the property distributed would be fairly representative of the adjusted basis of the property available for payment on the date of payment.
The Service approved a provision in a charitable remainder unitrust that granted authority to the trustees to pledge, with the consent of the income recipients, trust assets as collateral to third party lenders for loans made to the charitable remaindermen of the trust.35 Note that a unitrust was the subject of the ruling. The Service has not ruled on the application of this type of provision to an annuity trust.
The rules concerning the payment period or measuring term of a charitable remainder trust offer great theoretical flexibility in designing a trust's operational life. However, flexibility often breeds complexity and the possibility of producing undesired tax consequences. Therefore, this section should be read with consideration to the marital deduction, gift tax, and estate tax consequences of various measuring term formats.36
Following is an overview of measuring term rules as described in Reg. §?1.664-2(a)(5) and 1.664-3(a)(5):
The following are common forms of measuring terms:
A study conducted by the National Committee on Planned Giving reported that 94 percent of charitable remainder trusts are measured by the life of the last surviving income recipient; 4 percent provide payments for a fixed term of years; and only 2 percent include a combination of the two.39
The Service approved a structure whereby a husband and wife established a trust that would pay a unitrust amount to them for their joint lifetimes, then for the life of the survivor. Upon the survivor's death, the trust would pay the unitrust amount to their two children in equal amounts for their joint lifetimes, and then pay all income to the survivor.40
Comment: While this format was allowed as a qualified charitable remainder trust, the ruling did not consider the loss of the marital deduction on the income interest passing to the surviving spouse.
A trustor established a charitable remainder trust with income payable to himself for life, then to his sister for her life (if she survives him), then to his wife for her life (if she survives them both). The trustor proposed to change the order of income distributions by changing positions with his sister. The change was to be made with the consent of the income recipients and the charitable remainderman.
Section 1.664-3(a)(4) of the regulations provides, "The trust may not be subject to a power to invade, alter, amend, or revoke for the beneficial use of a person other than an organization described in section 170(c)." The Service considered the proposed change a prohibited power that would disqualify the trust under IRC §664(d)(2).41
Can a trustor retain the right to terminate an income recipient's interest prior to the term stated within the trust? Yes, in two ways.
First, the regulations permit a trustor to reserve a power to revoke non-trustor income recipient's interest. This power must be included within the trust instrument and is exercisable solely by the trustor's will.42 A retained power of revocation can provide gift and estate planning opportunities.
The second method in which a trustor can terminate an income recipient's interest is the qualified contingency. Reg. §1.664-3(a)(5)(i) requires that a trust that is measured by life must be measured solely by the life of the income recipient(s). However, IRC §664(f) allows a trustor to terminate a charitable remainder trust prior to its stated measuring life based on the happening of a qualified contingency. IRC §664(f)(3) defines a qualified contingency as, "any provision of a trust which provides that, upon the happening of a contingency, the unitrust or annuity trust payments will terminate no later than such payments would otherwise terminate under the trust." This language grants great latitude in defining the contingency.
A established a testamentary charitable remainder unitrust that named B as the sole income recipient. A's will provided the trust term would end upon the death of B or C, whichever occurred sooner. The Service concluded that the death of C was a qualified contingency that met the requirements of a qualified charitable remainder trust.43
Can a trustor, who establishes a charitable remainder trust naming a non-spouse as the sole income recipient of the trust, retain the power to revoke the recipient's income interest by will or through use of a qualified contingency?
The answer seems to be yes on both counts. It is clear that a power of revocation can be used in the case where the trustor is a life income recipient. Further, the IRS has allowed a right of revocation exercisable by will for a charitable remainder trust measured by a term of years in which the trustor was not an income recipient.44 In the case where the trust is measured by the life of the non-trustor recipient, however, a question arises. The regulations require a trust that is measured by life to be measured solely by the life of the income recipient(s).45 Although this requirement seems to prevent a non-income recipient trustor from terminating the trust by will, IRC §664(f) allows a trustor to terminate a charitable remainder trust prior to its stated measuring life for virtually any reason.46
The annuity or unitrust amount must be payable to or for the use of a person or persons, at least one of which is not an organization described in IRC §170(c). The term person includes:
If the annuity or unitrust amount is to be paid to an individual or individuals for their lifetime, they must be living at the time of creation of the trust. A named person or persons may include members of a named class provided that, in the case of a class which includes any individual, all such individuals must be living and ascertainable at the time of the creation of the trust unless the annuity or unitrust amount is to be paid to such class consists solely of a term of years. For example, in the case of a testamentary trust, the testator's will can provide that an amount shall be paid to his children who are living at the time of his death.48
Can a noncharitable trust be named as the income recipient of a charitable remainder trust that is measured by the life of an individual?
In Rev. Rul. 76-270, a charitable remainder trust was established for the lifetime of an individual who was incompetent.49 Because of the income recipient's incompetence, the unitrust paid the unitrust amount over to a second trust, which provided for payments of a designated portion of the unitrust amount to the income recipient for his lifetime. The trustee of the second trust could pay additional amounts for the care, support, and maintenance of the income recipient, if the amounts provided were insufficient. Any amounts remaining in the second trust at the income recipient's death would be payable to his estate. The Service ruled the arrangement would qualify and would be treated as though the unitrust payments were made directly to the income recipient of the second trust.
In a similar ruling, the IRS allowed a provision that enabled the trustee of a charitable remainder trust, in its sole discretion, to make payments for the benefit of the recipient if, in the opinion of the trustee, the recipient was without legal capacity. Payments were to be deposited in a bank account in the name of the recipient, or to a legal guardian or conservator for the recipient.50
It is important to note that these two rulings dealt with income recipients who lacked the legal capacity to accept payments from a charitable remainder trust. What if the income recipient is competent? Can payments still be made to a trust for his or her benefit?
Two grantors proposed to create three residuary charitable remainder trusts from their estates.51 Upon the death of the surviving grantor, the trustee would create two separate charitable remainder annuity trusts and one charitable remainder unitrust. The payments from all three trusts would be made to a fourth (noncharitable) trust established for the purpose of making distributions to separate trusts for the benefit of the grantors' relatives. The measuring terms of the charitable remainder trusts ranged from five to twenty years.52 The Service approved the arrangements.
In a subsequent and unrelated request for ruling, a parent proposed to establish a charitable remainder unitrust that named a noncharitable trust as its sole income recipient. The charitable remainder trust was measured by the life of the grantor's son. The son was the sole beneficiary of the noncharitable trust and had the absolute and unqualified right to withdraw, except in the case of disability or incapacity, all or any part of the trust account. Further, the son had a general power of appointment, exercisable by will, over the trust account.
The Service approved the proposed arrangements based on the facts the son would retain a power to withdraw principal and income from the noncharitable trust under IRC §678(a) and, further, would be treated as the owner of the noncharitable trust for income tax purposes under IRC §671.53 However, the Service subsequently had a change of heart and has revoked this ruling.
In a telephone call to the grantor's authorized representative, the Service stated that it was revoking Ltr. Rul. 9619044 because, "it is not in accord with the current views of the Service." In response, the grantor requested that the transaction subject to the original ruling be excluded from the retroactive revocation. In subsequent rulings, the Service permitted the grantor to rely on the holdings of the original ruling.54
In Ltr. Rul. 9718030, the Service announced that it is revoking Ltr. Rul. 9101010 in which it had ruled that a charitable remainder unitrust could distribute the unitrust payments to a trust established to benefit the donor's daughter. The trustee of the noncharitable trust could in its sole discretion distribute principal and income to the daughter. On the daughter's death, the remaining principal and income would be distributed to her estate.
The Service stated, "Under section 664(d)(2), an otherwise qualifying charitable remainder trust that makes distributions for the life of a named individual to a second trust (whose only function is to receive and administer those distributions for the benefit of the named individual beneficiary) will not qualify as a charitable remainder unitrust, unless the named individual is incompetent."55
The key to the Service's current position on this issue seems to be the measuring term of the trust. If the charitable remainder trust is measured by a term of years, it can make distributions to a trust without restriction. If, however, the charitable remainder trust is measured by the life of an individual, payments to a trust on that individual's behalf will be allowed only when that individual is incompetent.
In a private ruling, the beneficiary of a living trust held a lifetime limited power to appoint any part or all of the trust principal to or for the benefit of his heirs or charitable organizations. The beneficiary proposed to appoint the trust principal to a charitable remainder unitrust with the unitrust amount payable to the living trust for a term of twenty years. The Service approved the arrangement stating, "There is nothing in section 664 or the applicable regulations that prohibits a trust from being a permissible donor to an otherwise qualified charitable remainder trust."56 Again, the key to this ruling most likely rests in the fixed measuring term. A life measuring term might have produced a different result.
There is no limit to the number of income recipients a charitable remainder trust can have. However, there may be a limit to the number of trustors if they are also the income recipients. In Ltr. Rul. 9547004 a husband, wife, and their six grandchildren proposed to make contributions to one charitable remainder unitrust. Under the terms of the trust instrument, the husband and wife would be entitled to the entire unitrust amount during their lives, after which, the grandchildren, as a class, would receive the unitrust amount.
In determining whether the trust was a qualified charitable remainder trust, the Service first address whether the trust was classified as a trust for federal income tax purposes.
Procedure and Administration Regulation §301.7701-2(a)(1) sets forth six characteristics to be considered in determining whether an organization is properly classified as an association taxable as a corporation, a partnership, or a trust:
Reg. §301.7701-2(a)(2) provides that characteristics common to trusts and corporations are not material in attempting to distinguish between a trust and an association.
If an entity, the Service said, has both associates and a business purpose, it cannot be classified as a trust for federal income tax purposes. In the present situation, eight individuals will each contribute their own funds to the proposed trust. As the recipients of the unitrust amount, the grantors will share in the profits derived from the joint investment of their assets held by the proposed trust. Thus, the grantors are associates and have pooled their assets with an object to carry on business and divide the gains from it. The arrangement, the Service concluded, is not a trust for federal income tax purposes. Therefore, it is not a qualified charitable remainder trust.
Notwithstanding this issue, as will be discussed, the presence of additional income recipients (other than the trustor's or spouse) may also cause adverse income, gift, and estate tax consequences.
Many people consider their pets to be more human than some people they know. Charitable remainder trusts that name animals as income recipients may, depending on local law, be deemed valid and enforceable, valid but unenforceable, or void from inception.
Not only is a charitable income tax deduction unavailable in all three cases, but the transfer may also be subject to gift or estate tax.57 After all, there are no valuation tables based on the nine lives of a cat!
The trustee of a charitable remainder trust may be given the power to allocate or sprinkle income among named recipients or a named class of recipients. Because an individual cannot receive an income interest measured by the life of another, trusts containing sprinkling powers must either have a measuring term that ends with the death of the last surviving income recipient or one that is based on a term not to exceed twenty years. As previously stated, in the event the measuring term is based on the life of an individual or individuals, the individuals must be alive when the trust is created. Alternatively, a trust that is established based solely on a term of years can provide for distributions to be made to a named class of individuals not yet in being (e.g., the children of the trustor).58
In order to avoid treatment as a grantor trust, a trustee that is granted sprinkling powers must be independent as described in Reg. §1.674(c)-1.59
The regulations provide that when a decedent establishes a testamentary charitable remainder trust, the trust is deemed created on the date of death of the decedent (even though the trust is not funded until the end of a reasonable period of administration or settlement).60
The obligation to pay the annuity or unitrust amount must commence with the date of death. If permitted by applicable local law or authorized by the provisions of the governing instrument, payment of the annuity or unitrust amount may be deferred from the date of death until the end of the taxable year of the trust in which complete funding of the trust occurs.61
Because the regulation includes the phrase, "may be deferred," in reference to the payment of the annuity or unitrust amount, the decedent's estate can make distributions to the income recipients during the course of estate administration or settlement and in advance of the funding of the trust. These advance payments are, therefore, estimates which may differ from the amounts that are ultimately determined when actual funding of the trust occurs.
Within a reasonable time after the end of the taxable year in which the complete funding of the trust occurs, the trustee must pay to the recipient (in the case of an underpayment) or must receive from the recipient (in the case of an overpayment) the difference between:
(a) any annuity or unitrust amounts actually paid, plus interest on such amounts, computed at the rate of interest specified in Reg. §1.664-1(a)(5)(iv), compounded annually,62 and
(b) the unitrust amounts payable, plus interest on such amounts, computed at the rate of interest specified in Reg. §1.664-1(a)(5)(iv), compounded annually.
The amounts payable are retroactively determined by using the taxable year, valuation method, and valuation dates ultimately adopted by the charitable remainder trust.63 In the case of a unitrust (funded by residuary bequest, for example), it may be difficult to determine the amount the income recipient would have received, plus interest, had the trust been funded and operational on the date of the decedent's death. An alternative method of determining the amount is, accordingly, provided in Reg. §1.664-1(a)(5)(ii).
Revenue Rulings 88-81 and 82-165 erroneously indicate that interest should be added to the amount determined under the formula in Reg. §1.664-1(a)(5)(ii). Revenue Ruling 92-57 properly interprets the regulation stating the interest component is included in the computation; thus, no additional interest is required.64
The sample provisions in Rev. Proc. 90-30 and 90-31 correctly apply section 1.664-1(a)(5)(ii) and may be used.65
Following the termination of payments to the income recipient(s), the remainder interest in the trust must be transferred to, or for the use of, an organization described in IRC §170(c) or can be retained by the trust for such use.66 In the latter case, in the absence of a noncharitable income recipient, the trust is treated as a private non-operating foundation.
As discussed in the next chapter, the choice of charitable remainderman may adversely affect the grantor's charitable contribution income tax deduction. For example, the selection of a private non-operating foundation as remainderman might cause the deduction to be computed based on the lesser of (a) the fair market value, and (b) the adjusted cost basis of the contributed assets, whereas the choice of a public charity as remainderman will enable the deduction to be computed based on the possibly higher fair market value. In contrast, the selection of the charitable remainderman will have no effect on deductions for gift and estate tax purposes.
The trust agreement may include multiple remaindermen by fractional interest or by a combination of a fractional interest, fixed amount, or residuary interest.
The trust instrument must contain a provision that, in the event a named charity does not exist or is not qualified at the time the interest is to be transferred to the charity, the trustor or trustee must select an alternate qualified organization. Caution must be taken in drafting this provision to ensure that the alternate organization is of the same tax-exempt status. For example, if the originally named organization is a 50 percent-type public charity, but the document allows the trustee to select any organization as described under section 170(c), the possibility exists that the trustee could select a 30 percent-type private foundation as an alternate remainderman. The IRS would then base the trustor's income tax deduction on the assumption that the 30 percent-type organization would be the recipient.
In Rev. Rul. 76-8 the Service considered the case of a charitable remainder trust in which the governing instrument permitted the grantor to, at any time, designate, in lieu of the charitable organization named in the trust instrument as remainderman, another organization satisfying the requirements of sections 170(c), 2055(a), and 2522(a) of the Code.67 The ruling concluded that such a reserved power will not disqualify the trust. The power of substitution is accomplished by written notice delivered to the trustee on an inter vivos or testamentary basis. The Service subsequently issued letter rulings granting non-trustor and successor income recipients the power to substitute the charitable remaindermen.68
A trustor can designate the specific use to which the charitable remaindermen places the remainder interest. Examples typically include maintaining the remainder interest in an endowment for a general or specific purpose or limiting the use of the funds for a specific purpose within the organization. If such a restriction is desired, it can be accomplished by including a provision in the governing instrument. In the absence of such a provision, the use of the proceeds is unrestricted.
A recent letter ruling permitted the estate of a decedent trustor to claim a charitable contribution estate tax deduction for a charitable remainder trust that restricted the use of the trust proceeds to funding scholarships for students with specific surnames.69
See Rev. Rul. 72-395, 1972-2 C.B. 340 as modified by Rev. Rul. 80-123, 1980-1 C.B. 205, and Rev. Rul. 82-128, 1982-2 C.B. 71; Rev. Proc. 89-19, 1989-1 C.B. 841; Rev. Proc. 89-20, 1989-1 C.B. 841; Rev. Proc. 89-21, 1989-1 C.B. 842; Rev. Proc. 90-30, 1990-1 C.B. 534; Rev. Proc. 90-31, 1990-1 C.B. 539; Rev. Proc. 90-32, 1990-1 C.B. 546back
IRC §2055(e)(2)back
Reg. §1.664-1(c)back
IRC §?1015; 664(c)back
Reg. §1.664-2back
Under IRC §7701(a)(1), the term "person" includes an individual, trust or estate, partnership, association, company, or corporation.back
IRC §664(d)(1)back
Reg. §1.664-2(b)back
Reg. §1.664-3(a)(1)(iv)back
Reg. §1.664-3(b)back
Reg. §1.664-3(a)(1)(i)(b)back
Reg. §1.664-3(a)(1)(i)(b)(2)back
Reg-209823-96back
63 Fed. Reg. 68188 (December 10, 1998)back
Ltr. Rul. 9609009, See also Ltr. Ruls. 9511029; 9609009; 9643014; and 9711013
back
Reg-209823-96back
63 Fed. Reg. 68188 (December 10, 1998)back
The five-percent probability test is discussed in greater detail supra.back
Reg. §?1.664-2(a)(1); 1.664-3(a)(1)(i)(a). Form 1041-B was discontinued for 1981 and tax years thereafter.back
Notice 94-78, 1994-2 C.B. 555. Accelerated CRTs are discussed in detail supra.back
63 Fed. Reg. 68188 (December 10, 1998)back
Reg. §1.664-2(b)back
IRC §?514(c)(1)(A); 664(c)back
Reg. §1.664-1(d)(4)(i)back
For complete discussions of these issues, refer to "Effect of Net Income Provision Upon Investment Policy" and "Taxation of In-Kind Distributions," supra.back
See also Ltr. Rul. 9721014back
Ltr. Rul. 9529039 held that, under a similar fact pattern, a charitable contribution gift tax deduction was allowed. See also Ltr. Rul. 9550026back
Ltr. Rul. 9423020; Reg. §1.664-2(a)(4); See also Ltr. Rul. 9323039back
See also Gift and Estate Tax Considerations.back
Reg. §?1.664-2(a)(5); 1.664-3(a)(5)back
Charitable Remainder Trusts: Characteristics of Selected CRTs Established in 1992. National Committee on Planned Giving.back
Reg. §?1.664-2(a)(4); 1.664-3(a)(4)back
Reg. §1.664-3(a)(5)(i)back
See Ltr. Rul. 9322031; Ltr. Rul. 9829017 terminates an individual's income interest upon her remarriage.back
IRC §7701(a)(1)back
Reg. §?1.664-2(a)(3)(i); 1.664-3(a)(3)(i)back
See also Ltr. Rul. 9253055back
Ltr. Ruls. 9619042; 9619043; and 9619044back
Ltr. Ruls. 9710008, 9710009, and 9710010back
TAM 9831004 also conf