By Christopher P. Cline
Few estate planning devices have proven as useful as the charitable remainder trust (CRT). Lawyers have touted CRTs as the estate planning jack-of-all-trades: charitable giving vehicle, installment sale substitute, nonqualified retirement plan and life insurance funding source. Over the past few years, the IRS, concerned that lawyers and others have sold CRTs as devices to defer or avoid taxes, has closely scrutinized the uses of CRTs. In some cases the IRS has even denied the tax-exempt status of CRTs when it disagreed with the use of the CRTs. Critics argued that these pronouncements had no basis in law and were unenforceable. On April 17, 1997, the IRS took a new tack by issuing proposed regulations concerning CRTs under Code 664 and 2702 (CRT Regulations). The CRT Regulations, if issued in final form, will officially promulgate many of the IRS' previously informally stated positions on CRTs and will allow donors and their lawyers more flexibility in the creation and operation of CRTs.
This article discusses various uses for CRTs invented by lawyers and other professionals, the IRS response to those uses and the effect that the CRT Regulations will have on both existing and future CRTs. After briefly describing the way CRTs work, the article looks at a variety of creative CRT planning techniques and some of the IRS attacks and restrictions on those techniques. Finally, the article describes the operation of the CRT Regulations, along with some planning ideas to consider in light of the regulations.
CRTsA CRT pays a specified amount to one or more individuals (noncharitable beneficiaries) either for their lives or for a fixed term not exceeding 20 years. A charitable remainder annuity trust (CRAT) pays a fixed amount equal to at least 5% of the trust assets on the creation of the trust to the noncharitable beneficiary each year. For instance, a 6% CRAT funded with $1 million will pay $60,000 to the noncharitable beneficiary per year, regardless of the increase or decrease in the value of the trust assets over time.
A charitable remainder unitrust (CRUT) pays to the noncharitable beneficiary a fixed percentage (unitrust amount) of the trust assets revalued each year. For example, a 6% CRUT funded with $1 million will pay $60,000 to the noncharitable beneficiary in the first year of the trust. If, however, the trust assets appreciate in value to $1,100,000 in the second year, the noncharitable beneficiary will receive 6% of that amount, or $66,000.
The net income with makeup CRT (NIMCRUT) is a variant of the CRUT. The noncharitable beneficiary of a NIMCRUT receives the lesser of the specified unitrust amount or the trust's net accounting income. Any deficiency between the amount of net income paid and the unitrust amount in any year is paid in a future year when the trust income exceeds the unitrust amount. For example, assume a donor creates a 6% NIMCRUT with assets worth $1 million. If the trust has $50,000 of income in the first year, the noncharitable beneficiary will receive $50,000, which is the lesser of income or the unitrust amount ($60,000).
Assume in its second year that the trust again has $1 million of assets but now has $80,000 of income. The noncharitable beneficiary will receive $60,000 (the lesser of the unitrust amount or trust income) plus $10,000 from the excess income to make up for the deficiency between the unitrust amount and actual income paid to the noncharitable beneficiary in year one. The remaining $10,000 of excess income is added to principal.
A significant benefit of a CRT is that the donor receives a current income tax charitable deduction equal to the actuarially determined present value of the remainder interest passing to charity on the date the donor makes the gift to the CRT. Calculation of the deduction depends on the type of CRT, the percentage payment, the term of the CRT (either the term of years or the life expectancies of the noncharitable beneficiaries if the CRT runs for their lifetimes) and the Code 7520 interest rate published for either the month in which the CRT is created or one of the two months before the creation. Choosing the highest of those rates maximizes the amount of the deduction. For example, if a 60 year old donor funds a 6% CRUT with $1 million and retains an interest in the trust for his or her lifetime and the Code 7520 rate is 8.2%, then the donor will receive a $362,000 charitable income deduction.
Another benefit of a CRT is that it is not subject to federal and state income tax unless it has unrelated business taxable income under Code 512. The noncharitable beneficiary, however, is subject to income tax on payments he or she receives under a four-tier system. Payments are treated first as ordinary income to the extent the trust has ordinary income in the current year or undistributed ordinary income from prior years, second as capital gains in the same manner, third as other income in the same manner and finally as trust principal.
CRTs are also subject, through Code 4947, to certain penalty taxes and restrictions applicable to private foundations. Most significantly, Code 4941 imposes a penalty tax on a disqualified person (defined in Code 4946 but typically the donor) for any act of "self-dealing" between the trust and the disqualified person. The penalty tax initially equals 5% of the amount involved and 200% if the act is not corrected within the taxable period.
Using CRTs in Estate Planning In its simplest form, a CRT can provide a cash stream to the donor or another beneficiary and serve as a deferred charitable giving vehicle. The CRT can also provide other benefits. Because the trustee of a CRT can sell assets without incurring income tax, a donor can use a CRT to defer the tax liability on appreciated assets (often real property or a closely-held business), thereby allowing the CRT to act as an installment sales substitute. If a donor transfers appreciated assets to a CRT, the donor can obtain a return of a fixed percentage of the full value of the assets over time, rather than immediately losing a significant portion of that value to capital gains tax. The donor pays income tax at his or her marginal rate on CRT distributions to the extent the CRT has income and at capital gains rates to the extent of the balance of the payment.
The donor who intends to sell a business or other asset through a CRT will, however, face an unpleasant choice. Either the donor can use a CRUT and take the chance that the trust will not sell the asset immediately, which will require the trust to satisfy its distribution requirement through a piece of the asset, or the donor can use a NIMCRUT and take the chance that the trust's income will never equal the unitrust amount, thereby reducing the amount the donor receives from the trust. To solve this dilemma, lawyers have suggested using a CRT that begins life as a NIMCRUT but that converts to a straight CRUT after the trust sells certain assets_a flip unitrust. A flip unitrust has the advantage over a straight CRUT of not requiring the trustee to distribute trust assets until the CRT sells the business or other asset. After the sale, the CRT would convert to a straight CRUT and the CRUT would pay the noncharitable beneficiary the original unitrust amount.
A CRT also can provide a non- charitable beneficiary with an income stream, the source of which probably is protected from the beneficiary's creditors. The degree of protection afforded depends on the state law under which the CRT is governed and is not uniform, but an irrevocable trust that has a charity as a remainder beneficiary probably is an unattractive asset to creditors. If the donor has appreciated assets, the donor also can take advantage of the installment sale characteristics of a CRT in this situation. Many lawyers and insurance professionals have also marketed CRTs as an alternative to a qualified retirement plan. In this situation, the donor creates a NIMCRUT that invests only in high-growth, low-income assets during its early years. Because the trust has little or no accounting income, the actual distributions from the trust are low, thereby increasing the amount of future makeup payments. When the noncharitable beneficiary retires, the NIMCRUT trustee shifts the trust's investments to income producing assets and, by using a combination of the unitrust amount and the makeup payments, replaces the income lost on retirement. The problem with using a CRT in this manner is finding investments that generate income sufficient not only to meet the unitrust amount but also to exceed it so that the makeup payments can be made.
Lawyers came up with two solutions to this problem. The first was to include a provision in the trust instrument deeming capital gains to be accounting income. This provision allowed the trustee time for the sale of trust assets to generate income at the time when the noncharitable beneficiary needed it. The second was to advise the trustee to invest in partnerships, life insurance or deferred annuities and have the trust administered under the law of a state (such as Indiana or Delaware) that deems distributions to the trustee from those investments to be accounting income. This allowed the trustee to time distributions from the investments, which would be deemed trust accounting income when distributed to the trustees and thus distributable to the noncharitable beneficiary.
Finally, lawyers and clients came up with a way to use CRTs to make gifts to a client's children at a small gift tax cost, known as a "near zero CRUT." Under this plan, a donor would establish a NIMCRUT, usually with a capital-gains-as-income provision that named the donor as a noncharitable beneficiary for a term of years, after which the donor's children succeeded the donor as the noncharitable beneficiaries.
During the term of years in which the donor was the noncharitable beneficiary, the trustee would invest trust assets in high-growth, low-income assets. The donor would accordingly receive few, if any, trust distributions, causing a significant buildup in the makeup account. After the term ended and the children became noncharitable beneficiaries, the trustee would switch investment strategies and sell appreciated assets to produce greater income. The trustee would then distribute both the unitrust amount and the makeup account to the children. The gift of the interest to the children, however, would be valued at the time the donor created the trust under the IRS tables, with the assumption that the donor would actually receive the unitrust amount each year. This valuation technique greatly reduced the amount of gift tax due on the gift of the unitrust interest to the children.
IRS Reactions to CRTs- Some Recent HistoryAlthough the IRS has continued to support the use of CRTs that it deems "legitimate," it has made several pronouncements condemning certain uses for CRTs that it deemed abusive or inconsistent with the purposes of CRTs. For instance, in 1994 the IRS issued Notice 94-78, 1994-2 C.B. 555, in which it stated that it would closely scrutinize "accelerated" CRTs. The example provided in the Notice is of a two year, 80% CRUT funded with a highly appreciated asset. By deferring the sale of the asset and the first year distribution from the CRUT into the early part of the second year, which was allowable under the regulations in effect at the time, no income tax liability would attach to the first year payment to the noncharitable beneficiary because the trust would have no income, the sale having taken place in the second year. This resulted in the noncharitable beneficiary paying $44,800 in income taxes during the two-year CRT term on an asset with $1 million of built-in gain. The IRS stated that it would not respect the form of this transaction, that gain from the sale might be attributable to the donor under the assignment of income doctrine, that the CRT might not qualify as a CRT under Code 664 and that the entire transaction might constitute self-dealing under Code 4941. In short, the IRS said that it did not know exactly what the accelerated CRT was but that it would fight it.
Also in 1994 the IRS issued PLR 9442017, in which it privately ruled that a provision in a CRT that allowed the trustee to deem a reasonable amount of capital gains from the sale of unproductive assets to be accounting income did not disqualify the CRT. Although this provision probably gave the trustee slightly greater authority than that provided under state law, the provision was not out of line with most states' principal and income acts. In 1995 the IRS again ruled that a capital-gains-as-income provision in a CRT would not disqualify the CRT. PLR 9511007. The IRS, however, noted that the provision worked only because the CRT also required that the trustee treat any shortfall between the unitrust amount and the amount actually distributed in any year as a liability in determining the unitrust amount for future years. The provisions in the CRT described in PLR 9442017 and those in the CRT de-scribed in 9511007 differed in that the former dealt only with gains from unproductive assets, whereas the latter dealt with all gains. Also in 1995 the IRS determined that flip unitrusts were contrary to the legislative intent behind Code 664 and therefore ruled that a court reformation to convert a NIMCRUT to a straight CRUT would disqualify the trust as a CRT. PLR 9506015. The IRS later ruled that such a reformation would be self-dealing. PLR 9522021. Neither ruling, however, considered a CRT that included a conversion provision in the trust agreement.
In 1996 the IRS made three sig- nificant pronouncements regarding CRTs. In PLR 9609009, the IRS approved a CRT with a capital- gains-as-income provision, following the rationale of PLR 9511007. The trust agreement involved in PLR 9609009, however, provided that only post- contribution capital gains were deemed to be income. Second, in PLR 9643014, the IRS again approved a NIMCRUT that deemed post-contribution capital gains to be income and included the "liability" provisions, although the IRS "express[ed] no opinion on whether the trustee's control over the timing and amount of realized income from the sale of trust assets would constitute an act of 'self-dealing.'" Third, and most important, the IRS told its agents in its training manual that use of NIMCRUTs to defer payouts to noncharitable beneficiaries in years when a beneficiary is in a lower tax bracket, which the IRS referred to as "income deferral NIMCRUTs," constituted self-dealing under Code 4941. This mandate is Topic K of the 1996 (for FY 1997) Exempt Organizations CPE Technical Instruction Program Textbook and is quoted in full in the October 1996 issue of Taxwise Giving. This approach is consistent with PLR 9643014 and explains why the IRS refused to express an opinion on the self-dealing issue.
In 1997, in addition to issuing the CRT Regulations, the IRS issued Rev. Proc. 97-23, 1997 I.R.B. 17, in which it provided that it would not privately rule on whether a trust qualifies as a CRT if it is a NIMCRUT and a grantor, trustee, beneficiary or a person related or subordinate to any of those parties could control the timing of the trust's receipt of income from a partnership or deferred annuity contract. This is an area currently under study by the IRS. This Revenue Procedure appears to be a further step toward eliminating the use of retirement plan CRTs.
The CRT RegulationsThe CRT Regulations attempt to make fast some of these recent informal IRS positions. The CRT Regulations, if made final, will do the following:
- allow donors to create flip unitrusts under certain circumstances;
- eliminate the ability of a trustee of a CRUT or CRAT, but not of a NIMCRUT, to make the payment to a noncharitable beneficiary for a given year within a reasonable time after the end of that year;
- impose appraisal requirements on CRT donors or related or subordinate parties serving as trustees of CRTs holding hard-to-value assets;
- eliminate the use of near-zero CRTs; and
- require the allocation of the proceeds of sale of any trust asset to trust principal to the extent those proceeds represent the fair market value of the asset at the time the donor contributed the asset to the trust.
Flip UnitrustsThe CRT Regulations state that a CRUT agreement may provide that the trust will pay the lesser of income or the unitrust amount during the "initial period" of the CRUT and will pay the unitrust amount for the remaining period of the CRUT if four conditions are met.
First, 90% of CRUT assets, either immediately after the initial contri-bution of assets to the trust or after a subsequent contribution, must consist of "unmarketable assets" (90% Test).
Second, the CRUT instrument must trigger the change of payment method on the earlier of (1) the sale or exchange of a specified asset or group of assets that the donor contributed to the trust on its creation; or (2) the sale or exchange of "unmarketable assets" if, immediately afterward, the fair market value of the unmarketable assets in the trust equals 50% or less of the total fair market value of all trust assets. Third, the payment method must change at the beginning of the first calendar year following the sale or exchange that triggered the change.
Fourth, after the payment method has changed, the trustee must pay at least annually only the unitrust amount and not any makeup amount that accrued while the trust was a NIMCRUT. This fourth provision eliminates any benefit from the "makeup" feature, but most donors who create flip unitrusts will likely want to convert the trust to a straight CRUT soon after they fund the trust. For purposes of these provisions, "unmarketable assets" are any assets other than cash, cash equivalents or "marketable securities" as defined under Code 731(c) and the applicable regulations. Prop. Treas. Reg. 1.664-3(c). Lawyers should pay particular attention to the effective dates for flip unitrust provisions in the CRT Regulations. The provisions allowing a CRT to change payment methods apply to CRTs created on or after the date the IRS publishes the final regulations in the Federal Register. If a CRT created before that date has a defective "flip" provision in it, it may be reformed or amended to comply with the provisions of the CRT Regulations. A CRT created after that date with a defective "flip" provision, however, must be reformed or amended to require that its initial period payment method be used throughout the term of the trust or it will cease to qualify as a CRT. Finally, a CRT, whether created before or after the CRT Regulations become final, that is reformed or amended to add a "flip" provision will cease to qualify as a CRT. Prop. Treas. Reg. 1.664-3(f)(vi).
The rules governing flip unitrusts have several important ramifications. First, a flip unitrust created by a donor that converts to a straight unitrust following an asset sale before the date that the CRT Regulations become final presumably will be subject to the same scrutiny applied under PLRs 9505015 and 9522021, with the result that the CRT will not qualify as a CRT and may result in an excise tax under the self-dealing rules. Second, lawyers can probably begin drafting flip unitrusts for donors, so long as the "flip" provision does not become effective until after the CRT Regulations become final. Third, an improperly drafted flip unitrust created after the CRT Regulations become final cannot be amended to save the "flip" feature, but only to keep the CRT from becoming disqualified. Finally, a donor cannot use an existing CRT to jump on the "flip" bandwagon by simply amending or reforming the CRT to add a "flip" provision.
Lawyers also should be wary of the effects of the 90% Test. Because 90% of the trust assets must consist of unmarketable assets, which will be hard to value, it may be difficult to determine whether a CRT qualifies as "flippable." If the donor wishes to contribute both unmarketable assets and cash or publicly traded securities, the donor should consider creating two CRTs, one that will hold only the unmarketable assets and contain appropriate "flip" provisions, and the other that will hold the cash or publicly traded securities assets. Alternatively, the donor could contribute the cash or publicly traded securities to the CRT only after the trustee sells the unmarketable assets and the CRT has "flipped."
Timing of CRT PaymentsEffective for taxable years ending after April 18, 1997, the governing instrument of a CRT that pays a unitrust or annuity amount only must require that the trustee pay that amount to the noncharitable beneficiary for each taxable year "no later than the close of the taxable year for which the payment is due." Prop. Treas. Reg. 1.664-2(a)(1)(i) (for CRATs); Prop. Treas. Reg. 1.664-3(e) (for CRUTs). The CRT Regulations, however, allow NIMCRUT agreements to continue to give the trustee a reasonable time after the close of the year for payments to the noncharitable beneficiary. Inasmuch as the "reasonable time" provision for payment drove the accelerated CRT, this timing provision eliminates a donor's ability to create an accelerated CRT.
Although the IRS intended the timing-of-payment provision to correct a perceived abuse, it also is a trap for the unwary because it affects both the administration of existing CRTs and the preparation of new ones. Lawyers should consider making all of their clients who are acting as trustees of fixed percentage CRTs aware of this change and advise them to make distributions accordingly. Lawyers who draft fixed percentage CRTs to require distributions to noncharitable beneficiaries quarter-annually should consider providing the trustee with greater flexibility for the timing of payments, at least allowing the quarter-annual payments to be made before the end of the quarter.
Appraisal Requirements for Hard-to-Value AssetsIf a CRT that holds assets other than cash, cash equivalents or marketable securities has as a trustee the grantor, a noncharitable beneficiary or a party that is related or subordinate to the grantor or noncharitable beneficiary, the trustee must use a current qualified appraisal (defined under Treas. Reg. 1.170A-13(c)(3)), from a "qualified appraiser" (defined in Treas. Reg. 1.170A-13(c)(5)), to value those assets. Prop. Treas. Reg. 1.664-1(a)(7). This provision addresses the portion of the legislative history of Code 664, in which Congress expressed concern that a trustee who is the grantor or a beneficiary of a CRT, or a party related or subordinate to either, should not have the power to independently value such assets for purposes of determining the unitrust amount. Before the issuance of the CRT Regulations, many lawyers appointed a special trustee, who was not the grantor, a beneficiary or a related or subordinate party to either, specifically to value such assets of a CRT, much to the chagrin of the donor. This new provision allows the donor to act as trustee in that situation_provided he or she obtains a qualified appraisal.
Elimination of Near-Zero CRTsUnder the CRT Regulations, for transfers made on or after May 19, 1997, a transfer to a CRT (other than a CRT that pays a fixed percentage only) or a pooled income fund is subject to the valuation rules under Code 2702. Prop. Treas. Reg. 25.2702-1(c)(3). This eliminates a donor's ability to derive benefit from a near-zero CRT because under Code 2702 the value of the interest retained by the donor or any applicable family member will be zero when someone other than the donor, his or her spouse or both the donor and spouse are noncharitable beneficiaries of the trust.
Allocation to Principal of Pre-Contribution GainsThe CRT Regulations state that, when determining "income" for purposes of NIMCRUT distributions, proceeds from the sale or exchange of any asset the donor contributes to the trust must be "allocated to principal and not to trust income at least to the extent of the fair market value of those assets on the date of contribution." Prop. Treas. Reg. 1.664-3(a)(1)(i)(b)(3). In other words, a NIMCRUT agreement can deem only post-contribution gains as accounting income. This provision, together with Rev. Proc. 97-23, under which the IRS announced its refusal to rule on whether NIMCRUTs holding certain partnership interests or deferred annuity products qualify as CRTs, appears to be part of the IRS attack on retirement plan CRTs.
The CRT Regulations formalize the requirement articulated by the IRS in PLRs 9609009 and 9643014 that pre-contribution capital gains cannot be allocated to principal, but the CRT Regulations are silent about the lia- bility account requirement. Because lawyers roundly criticized the liability account as unnecessary and unjustified, lawyers could read the CRT Regulations as an IRS retreat on the liability account requirement. The careful lawyer may, however, want to continue including liability account provisions until the IRS affirmatively states that they are no longer required.
Example for Computing IncomeFinally, the CRT Regulations contain an example of how a trustee should compute income distributable to a noncharitable beneficiary of a NIMCRUT. The example merely confirms that the trustee should make the computation in the same manner as in all other CRTs, i.e., a distribution is deemed first as ordinary income to the extent the CRT has such income, then as capital gains, then as other income and finally as a return of principal. This example answers the lawyers who wondered whether those computations should be different from those made for other CRTs. Prop. Treas. Reg. 1.664-1(d)(1)(iii). This example breaks no new ground.
Taxpayer Relief Act of 1997After this article was written, President Clinton signed into law the Taxpayer Relief Act of 1997 (TRA 97), which enacts several changes to the law regarding CRTs (none of which affect the CRT Regulations). TRA 97 is discussed in the article by Grace Allison and David Hirschey in this issue. Two aspects of TRA 97 should be noted, however. First, the percentage payment to the noncharitable beneficiary (of either a CRAT or a CRUT) cannot exceed 50% of the trust assets. Second, the value of the remainder interest passing to the charity must be at least 10% of the fair market value of the trust assets on the date of con-tribution to the CRT (TRA 97 also contains relief provisions if this requirement is violated).
ConclusionThe CRT Regulations, for the most part, are a welcome arrival. The flip unitrust should prove an effective tool for lawyers and donors interested in planned giving, and the ability of a donor to act as trustee of his or her own CRT, even if it holds hard-to-value assets, makes the lawyer's life much easier. There will be many, particularly those who have championed retirement plan CRTs and accelerated CRTs, who will find the CRT Regulations less helpful. Finally, as with all attempts by the IRS to correct behavior it perceives as abusive, the CRT Regulations present traps for inattentive lawyers. Those who recommend CRTs as a routine estate planning device for their clients should take a spin around the CRT Regulations to avoid skipping the grooves that the IRS has laid out in these pronouncements. Christopher P. Cline is an associate with Lane Powell Spears Lubersky LLP in Portland, Oregon.
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