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Many people still believe that Jacqueline Kennedy Onassis created a charitable lead annuity trust in her will. Why? The New York Times and other newspapers obtained a copy of her will from the New York Surrogates Court and reported the terms that spelled out her lead trust. So, how could it be that the CLAT wasn’t created?
First, I’ll tell you about the CLAT as it appeared in her will. (You’ll see how beneficial CLATs can be.) Then, I’ll report on recent CLAT Treasury regulations and a recent letter ruling. At the end of this article, I’ll tell you how it came to pass that Mrs. Onassis’s CLAT was never created.
MRS. ONASSIS’S NOT-CREATED CLAT
Payments to charity. The C & J Foundation would have paid to charities for 24 years "an annuity amount" equal to "eight percent (8%) of the initial net fair market value of the assets of the Foundation as finally determined for federal estate tax purposes."
Selecting the charities. The payments would have been to qualified charitable organizations (described in Sections 170(c) and 2055(a) of the Code), selected by her trustees in their absolute discretion:
"It is my wish, however, that in selecting the particular qualified charitable beneficiaries which shall be the recipients of benefits from the Foundation the independent Trustees give preferential consideration to such eligible organization or organizations the purposes and endeavors of which the independent Trustees feel are committed to making a significant difference in the cultural or social betterment of mankind or the relief of human suffering."
Remainder to family members. At the end of the Foundation's 24-year term, the assets would have been distributed to family members. A number of contingencies were covered, but, basically, the assets would have gone to the descendants of her children.
What's in a name? Mrs. Onassis's will called the just-described arrangement a Foundation, but it was really a CLAT. Call it what her will wills, it still smelled sweet for the charities that would have benefitted handsomely for 24 years. And, the estate tax and generation-skipping transfer (GST) tax savings would have been fragrant too.
The trustees. Mrs. Onassis's daughter, Caroline B. Kennedy, her son, John F. Kennedy, Jr., Alexander D. Forger and Maurice Tempelsman would have been the trustees.
The Foundation administrator. The will provided:
"To assist the independent Trustees I authorize, but do not direct, that they retain my close friend and confidante Nancy L. Tuckerman to assist them in the administration of the Foundation. Should the independent Trustees deem it advisable to retain Nancy L. Tuckerman, they shall pay to her from the assets of the Foundation reasonable compensation for the services she shall render. But such compensation shall not be charged against the annuity amount in any full taxable year of the Foundation nor against the appropriate fraction of said amount, determined as herein provided, payable to the qualified charitable beneficiaries in any short taxable year of the Foundation but shall rather be paid from the assets of the Foundation at large."
The would-have been estate tax charitable deduction. I don't know the value of Mrs. Onassis's residuary estate that would have funded the CLAT. Based on press reports, let's assume a $100 million residuary estate (a nice round number).
Mrs. Onassis died in May of 1994. When computing the estate tax charitable deduction for the value of the charitable lead interest, her estate could have used 120 percent of the Treasury's mid-term federal rate for split-interest gifts for the month of her death or the rate for either of the two preceding months. Using the March Internal Revenue Code Section 7520 rate (the lowest rate and thus the largest estate tax charitable deduction for charitable lead trusts) the estate tax charitable deduction for a $100 million charitable lead trust paying charities $8 million a year for 24 years would have been approximately $96.8 million. So, only $3.2 million of the $100 million trust would have been subject to estate tax. Again, the value of the residuary estate is assumed. Whatever the value, however, the estate tax charitable deduction would have equaled approximately 96.8 percent of the amount funding the charitable lead trust.
Which generation has a rendezvous with Treasury? Looking down the road, the GST tax would have been payable at the end of the 24-year term. The amount would have depended on the value of the trust at that time and the then-effective interest assumptions.
Assuming: (1) the trust would have been funded with $100 million; (2) it would have used the lowest allowable monthly discount rate — the IRC Section 7520 rate for March 1994 — 6.4 percent; (3) it would have earned 8 percent each year and appreciated 2 percent annually; and (4) it would have made annual end-of-year payments to charity, the value of the assets after 24 years would have been approximately $213.76 million. The GST tax at that time (assuming that the GST is still in existence) would have been approximately $115.13 million, leaving roughly $98.63 million for the family. (Note, with historically low IRC Section 7520 rates, CLATs are now better than ever.)
In my sister's house are many lead trusts. Each of Lee B. Radziwill's children would have been remainderpersons of separate 10 percent lead annuity trusts—each to be funded with $500,000. Each trust would have paid $50,000 annually for ten years to charities selected by the trustees.
Why was the CLAT called the C & J Foundation? When Abe Lincoln was asked how many legs a sheep would have if its tail were counted as a leg, he responded: "Four. No matter what you call a tail, it's still a tail." But, it's OK to have a lead trust in foundation clothing—especially where the trustees have discretion to select the charities. Actually, you could say that Mrs. Onassis would have created a term-of-years foundation.
What is a foundation anyway? A large body of money surrounded by those who want some.
“ORDERING” RULES FOR CHARITABLE LEAD TRUST PAYMENTS DISREGARDED . . . FINAL REGULATIONS
Bottom line on the top. Treasury regulations (effective April 4, 2012) adopt, with one insignificant change, the June 2008 proposed regulations. A CLT provision (or local law) that specifies the source of income from which amounts are to be paid to the charity has no economic effect independent of income tax consequences and will be disregarded. T.D. 9582, 2012-18 IRB 868 (April 30, 2012).
Thus, payments to a charity will consist of the same proportion of each class of the items of income of the trust as the total of each class bears to the total of all classes. The regulations apply to charitable lead trusts and other trusts making payments or permanently setting aside amounts for a charitable purpose.
Why is Treasury concerned about an ordering (rather than a pro rata) payment provision? My opinion: The Treasury and the IRS want to maximize taxes. Income ordering provisions in lead trusts are designed to minimize them and to maximize the charity’s benefits. Charitable lead trusts (as differentiated from charitable remainder trusts) aren’t tax exempt and are subject to the complex trust rules (unless drafted as a grantor trust).
Charitable deductions for lead trusts. A lead trust itself is allowed a charitable deduction for gross income (the annuity or unitrust amount) paid to the charity. Income above the required payment is taxable to the trust. However, a charitable deduction isn’t available to a lead trust for tax-exempt income because it isn’t includable in the trust’s gross income. And, a lead trust’s IRC Section 642(c) charitable deduction is disallowed for unrelated business taxable income (UBTI) paid to charity. Thus, a CLT has to pay tax on the UBTI. But the trust can qualify for a charitable deduction under IRC Section 512(b)(1) if the UBTI is paid to a public charity during the taxable year. Reg Section 1.642(c)-3(d). However, the deduction is limited to the 50 percent ceiling for individuals. Who says this stuff is complicated?
As noted, ordering provisions are designed to minimize taxes to the lead trust and to maximize the charity’s benefits. They do so by providing that income that won’t qualify for a charitable deduction be paid out last.
Here’s a seven-tier ordering provision—given as an example in the final regulations—on which Treasury has put the kibosh.
Example 1. A CLAT has the calendar year as its taxable year and is to pay an annuity of $10,000 annually to an organization described in Section 1170(c). A provision in the trust governing instrument provides that the $10,000 annuity should be deemed to come first from ordinary income, second from short-term capital gain, third from 50 percent of the unrelated business taxable income, fourth from long-term capital gain, fifth from the balance of unrelated business taxable income, sixth from tax-exempt income and seventh from principal. This provision in the governing instrument does not have economic effect independent of income tax consequences, because the amount to be paid to the charity is not dependent upon the type of income from which it is to be paid. Accordingly, the amount to which Section 642(c) applies is deemed to consist of the same proportion of each class of the items of income of the trust as the total of each class bears to the total of all classes.
The Final Regulations’s Preamble Summarizes the Public Comments on the Proposed Regulations and the Treasury’s Response.
Commentators said: Treasury’s proposed regulations are contrary to the clear language of IRC Sections 642(c) and 643(a)(5) and the existing regulations.
Treasury’s response. The IRS and Treasury have carefully considered these arguments and the analyses suggested by the commentators. We continue to believe that the position clarified in the proposed regulations, requiring that a specific provision of the governing instrument or a provision under local law have economic effect independent of income tax consequences in order to be respected for Federal tax purposes, is the proper interpretation of the relevant Code provisions and is a principle that applies throughout Subchapter J.
One commentator said: Income ordering provisions in CLTs have economic effect independent of income tax consequences, because disregarding an income ordering provision could increase a CLT's tax liability, thereby reducing the value of the trust and, in turn, reducing the annual lead unitrust payments to the charitable beneficiaries and increasing the risk that the trust's assets in lead unitrusts and annuity trusts will be depleted before the end of the trust term.
Treasury’s response. Although the general pro rata allocation rule may increase a trust's tax liability and, thereby, reduce the value of the trust's corpus, the effect of the payment of the trust's income tax liability is not an economic effect independent of income tax consequences as described in these regulations. Any possible reduction in the unitrust amount subsequently paid to the charitable beneficiary would be the direct result of the payment of income taxes by the unitrust. The use of an income ordering rule in a CLT directing the tax characteristics of the unitrust or annuity payments to the charity is primarily, if not exclusively, an attempt to minimize the tax liabilities of the trust and its remainder beneficiaries. The only effects of the use of an ordering rule are, in fact, dependent solely upon tax consequences: specifically, the reduced amount of tax paid and the trust's retention of the income tax savings.
Ordering provisions in CLTs will never have economic effect independent of their tax consequences, because the amount paid to the charity is not dependent upon the type of income it's allocated. An annuity payment is a fixed amount from year to year, and although a unitrust amount may fluctuate annually, the amount is based upon a predetermined percentage of the trust's value.
Permitting an ordering rule with no economic effect independent of income tax consequences to supersede the pro rata allocation rule generally applicable under Subchapter J would, in effect, permit taxpayers to deviate at will from the general rule imposed throughout Subchapter J in the case of all kinds of complex trusts.
One commentator said. The proposed regulations are contrary to the Federal government's long-standing policy to encourage charitable gifts and to benefit and protect charities.
Treasury’s response. The IRS and Treasury have carefully considered the merits and implications of this suggestion. We believe, however, that the proper interpretation of the relevant Code sections does not permit the creation of a special rule for CLTs. A CLT is treated and taxed in the same way as any other complex trust under Subchapter J. Subchapter J does not differentiate between CLTs and other types of complex trust, and there is no provision of Subchapter J that applies exclusively and expressly to CLTs. Thus, any income tax rule applicable to a CLT will apply in the same way to every other complex trust.
The Treasury obliges. One commentator requested an example of a provision in a governing instrument that would have economic effect independent of income tax consequences. Thus, the final regulation gives an additional example. Reg. Section 1.642(c)-3(b)(2).
Example 2. A trust instrument provides that 100 percent of the trust's ordinary income must be distributed currently to an organization described in Section 170(c) and that all remaining items of income must be distributed currently to B, a noncharitable beneficiary. This income ordering provision has economic effect independent of income tax consequences because the amount to be paid to the charitable organization each year is dependent upon the amount of ordinary income the trust earns within that taxable year. Accordingly, for purposes of Section 642(c), the full amount distributed to charity is deemed to consist of ordinary income.
I submitted comments to the Treasury in 2008 on the proposed regulations on behalf of the American Council on Gift Annuities and the National Committee on Planned Giving (now the Partnership for Philanthropic Planning). If you would like a copy of those comments, e-mail me at: [email protected]
Hard to believe. The Treasury didn’t change its position based on my comments.
If one were to do battle with the IRS in court over this issue (and I’m not suggesting doing so), perhaps my comments would be helpful in writing the brief for the taxpayer. Again, I’m not suggesting that a taxpayer go to court on this issue, but if the decision is made to do so, consideration should be given to litigating in a federal district court rather than in the U.S. Tax Court.
Every client is entitled to his decade in court—keeping in mind that it’s a long way to certiorari.
CLAT’S ASCENDING ANNUITY PAYMENTS—OK (Letter Ruling 201216045)
Quick background. Treasury regulations (above) specify how payments from charitable lead annuity and lead trusts are taxable. CLT income payments consist of a pro-rata share of each item of trust income. Any trust provisions (or state law) directing payments under an ordering provision will be disregarded. Treas. Regs. Sec tion 1.642(c)-3(b)(2).
Time now for a different CLT issue. Most charitable lead trusts are lead annuity trusts, few are lead unitrusts.
Now that we know how the payments are deemed taxable (pro-rata rule, not ordering rule), how is the payment itself set? Generally, it's specifically set in the trust instrument.
Example. Charitable lead annuity trust is funded with $1 million and the annual payment is set at $30,000 for the ten-year term. Then the trust assets go to the family members.
Example. Charitable lead unitrust is funded with $1 million and the annual payment is to be 3 percent multiplied by the net fair market value of the trust’s assets, as revalued each year, for the ten-year term. Then the trust assets go to family members.
Unlike charitable remainder trusts, lead trusts have no 5 percent minimum and no 50 percent maximum payment requirements. And there is no 10 percent minimum remainder interest requirement. In fact, CLTs are often drafted with as small a remainder as possible in order to avoid making gifts to the family remainder takers. This is especially so when the IRC Section 7520 rate is low—the current case.
The mechanism to try to achieve as small a remainder interest as possible is using a formula for setting the annual payout. Read on, and you’ll learn about that in the following letter ruling.
Facts. A CLAT created at the donor’s death is to make payments to a private foundation (or its successor in interest) for 10 years. Then the trust corpus will be distributed per stirpes to trusts for the benefit of the donor’s descendants. If there are no remaining descendants, the trust corpus will be distributed to the Foundation or a similar qualified organization.
The trust states that it is the donor’s intent that the CLAT “qualify as a charitable lead [trust] so that the value of the interest passing to charity is deductible as a charitable lead interest under Sections 2055 (e)(2)(B) and 2522(e)(2)(B) of the Code, and so that the payments of the amount to charity will be deductible from the gross income of the trust to the extent provided by Section 642(c).”
The trust uses this formula to determine the annual annuity amount:
Accounting from the beginning date, the annual annuity amount shall be an amount that will produce a present value under §7520 of the Code for the non-charitable remainder interest equal to zero or as close to zero as possible without exceeding zero.
The trustee is prohibited from exercising any power or discretion granted by state law that would be inconsistent with the CLAT’s qualification as a charitable lead trust under IRC Section 2055(e)(2).
The donor’s United States Estate (and Generation-Skipping Transfer) Tax Return, Form 706, was timely filed. On Schedule O of Form 706, the estate claimed a charitable deduction under IRC Section 2055(a) for the present value of the property passing to the CLAT. The estate received a closing letter from the IRS accepting the estate tax return as filed.
The CLAT trustees, with the consent of the Foundation and the remainder beneficiaries, and with notice to the state attorney general’s office, filed a complaint with the state probate court requesting that the court construe the formula for determining the annuity amount to permit variable ascending annuity payments, commencing on the donor’s date of death and continuing for the 10-year annuity term, with the annuity payments made to ascend each year by 120 percent of the prior year’s payment over the annuity term, rather than a straight-line annuity payment over the 10-year term.
The complaint explained that construing the formula as a straight-line annuity would make it unlikely that the trustees could make the annuity payments over the entire term. Therefore, the trustees would be unable to satisfy the donor’s intentions regarding the gift of the lead annuity interest to the charitable beneficiary. According to the letter ruling, the court was given schedules showing a comparison to the straight-line method that demonstrated that a variable ascending annuity payment method would result in a higher total payout to the Foundation.
The state probate court found the material allegations to be true and the relief requested to be in the best interests of the beneficiaries. Further, the variable ascending method conforms to the terms of the trust and meets the donor’s intent and tax objective. The court issued an order construing that both straight line and variable ascending annuity payment formulas are actuarial equivalents (based on the IRC Section 7520 rate applicable at the donor’s death) and either form of payment is permitted under the CLAT agreement.
The probate court ruled that its order is subject to the condition that the trustees request and receive a favorable private letter ruling from the IRS.
Key to all the favorable IRS rulings that follow: “We [the IRS] conclude that the construction of Trust’s formula for determining the Annuity Amount to permit variable ascending annuity payments resolves a genuine ambiguity in Trust and therefore the court order issued [Date] will be treated as the settlement of a bona fide contest. Payments of gross income made under that construction will be considered pursuant to the terms of the governing instrument within the meaning of [IRC] §642(c)(1).”
The IRS rules (Letter Ruling 201216045):
1. The CLAT’s terms, as construed by the state court’s order to permit variable ascending annuity payments, commencing on the decedent’s death and continuing for the 10-year annuity term, will satisfy the requirements of IRC Section 2055(e)(2) for a guaranteed annuity interest (for example, an arrangement under which a determinable amount is paid periodically, but not less often than annually, for a specified term of years) and, therefore, property of the taxable estate of the decedent passing to the charitable lead trust will qualify for a charitable deduction under IRC Section 2055(a).
2. The CLAT will be allowed a deduction under IRC Section 642(c) for each taxable year in an amount equal to the annuity amount paid from the charitable lead trust’s gross income during the taxable year in accordance with the CLAT’s terms, as construed by the state court’s order to permit variable ascending annuity payments, commencing on the donor’s death and continuing for the 10-year annuity term, except that no charitable deduction will be allowed for any amounts allocable to the trust’s unrelated business income for the taxable year.
3. The construction of the terms of the CLAT by the state court’s order, allowing ascending annuity payments over the 10-year annuity term, will not constitute a termination under IRC Section 507 of the CLAT’s private foundation status.
4. The construction of the terms of the CLAT by the state court’s order, allowing ascending annuity payments over the 10-year annuity term, will not be self-dealing under IRC Section 4941.
5. The construction of the terms of the CLAT by the state court’s order, allowing ascending annuity payments over a 10-year annuity term, will not subject the charitable lead trust to tax on the undistributed income of a private foundation under IRC Section 4942.
6. The construction of the terms of the CLAT by the state court’s order, allowing ascending annuity payments over a 10-year annuity term will not subject the charitable lead trust to tax on excess business holdings under IRC Section 4943.
7. The construction of the terms of the CLAT by the state court’s order, allowing ascending annuity payments over the 10-year annuity term, will not be an investment, which jeopardizes charitable purposes subject to tax under IRC Section 4944.
8. The construction of the terms of the CLAT by the state court’s order, allowing ascending annuity payments over a 10-year annuity term, will not be a taxable expenditure under IRC Section 4945.
9. To the extent that the construction of the terms of the CLAT by the state court’s order, allowing ascending annuity payments over the 10-year annuity term, is a transaction with respect to the CLAT’s interest or expectancy in property held by the estate, the living trust or the non-exempt marital trust such transaction will not be self-dealing under IRC Section 4941.
FINALLY, WATSON HERE’S THE SOLUTION TO THE CASE OF JACKIE O’S LEAD TRUST THAT NEVER WAS
Mrs. Onassis’s inter vivos revocable living trust gave almost her entire estate outright to her two children, Caroline and John. It provided that to the extent that her children disclaimed their inheritance, the disclaimed amounts would pour over to the C & J [CLAT] Foundation created by her will. Well, the kids didn’t disclaim.
This was savvy estate planning. She wanted her children to make the final decision whether a CLAT should be created.
Inter vivos trusts generally provide privacy—not available with wills. In this case, however, a New York Times investigative reporter working on a follow-up article on Mrs. Onassis’s CLAT, checked with the New York State Attorney General’s Charity Bureau. He learned that the C & J Foundation was not funded. This was reported in a Saturday edition ofThe New York Times and in hardly any other publications.
And that dear readers, is the news from Lake Taxbegone.
© Conrad Teitell 2012. This is not intended as legal, tax, financial or other advice. So, check with your adviser on how the rules apply to you.