Here’s information you should have about the 10 percent minimum remainder interest (MRI) requirement for charitable remainder unitrusts (CRUTs) and charitable remainder annuity trusts (CRATs). Historically low Internal Revenue Code Section 7520 rates can be dangerous to your client’s wealth.
Background
For CRUTs and CRATs, the minimum payout is 5 percent, the maximum payout is 50 percent and the MRI is 10 percent. And CRATs must meet the 5 percent probability test of Revenue Ruling 77-374. Caution for CRATs: The 10 percent MRI requirement can be met by a mile, but the CRAT can flunk the 5 percent probability test of Rev. Rul. 77-374.
Valuing CRUT and CRAT Remainder Interests
The value is determined under IRC Section 7520. That section provides for valuing both charitable and non-charitable split-interest trusts and other arrangements. Those interests are determined under tables prescribed by the Treasury using an interest rate (rounded to the nearest 2/10ths of 1 percent) equal to 120 percent of the federal midterm rate in effect under IRC Section 1274(d)(1) for the month in which the valuation date falls. The rate so determined is the applicable federal rate (AFR). Section 7520 goes on to provide that if an income, estate or gift tax charitable contribution deduction is allowed for any part of the property, the taxpayer, instead of valuing the interest for the month of the creation of the interest, may elect to use the AFR for either of the two preceding months.
Ten Percent MRI Requirement for CRUTs
For each contribution to the trust, the value (determined under Section 7520) of the remainder interest must be at least 10 percent of the net fair market value of the property as of the date the property is contributed to the trust.1 The 10 percent MRI requirement is effective for transfers to trusts after July 28, 1997.
Caution: Low Section 7520 rates (currently 1.8 percent) may result in not meeting the 10 percent MRI requirement for CRUTs and CRATs.
Can the 10 percent MRI requirement be met by using the AFR for either of the two months preceding the month the CRAT or CRUT is created, or must the valuation be made using the AFR for the month the trust is created? Section 7520 says you can use either of the two preceding months for computing any income, estate or gift tax charitable deduction. It doesn’t say you can use either of those two months for determining whether the 10 percent MRI requirement is met. Yet, IRC Section 664(d)(1)(D) and Section 664(d)(2)(D) say the values for meeting the 10 percent MRI requirement shall be “determined under section 7520,” and those IRC sections don’t carve out the “either-of-the-two-preceding months” election. Also, Section 664(d)(2)(D) provides: “with respect to each contribution of property to the trust, the value (determined under section 7520) of such remainder interest in such property is at least 10 percent of the net fair market value of such property as of the date such property is contributed to the trust.” (emphasis added.)
A splendid argument can be made that for purposes of meeting the 10 percent MRI requirement, the remainder can be valued using the AFR for either of the two preceding months or the month of the transfer. But do you want to have to make that argument to the IRS or to a court?
The words of Justice Oliver Wendell Holmes, Jr., in U.S. v. Wurzbach, are instructive: “Whenever the law draws a line there will be cases very near each other on opposite sides. The precise course of the line may be uncertain, but no one can come near it without knowing that he does so, if he thinks.” 2 So, unless clarification comes from IRS, cautious individuals will make sure the 10 percent MRI requirement is met for the month of the transfer.
The 10 percent MRI requirement must be met for “each contribution of property to the trust,”3 and the value is to be determined under Section 7520. Again, make sure the 10 percent MRI requirement is met for the month of the additional contribution.
CRUTs and CRATs That Flunk the 10 percent MRI Requirement
An otherwise qualified charitable remainder trust (or one that could be reformed to qualify) that fails to meet the 10 percent MRI requirement may be declared null and void ab initio (from the beginning) or changed by reformation, amendment or otherwise to meet the 10 percent MRI requirement by reducing the payout rate and/or the duration of any non-charitable beneficiary’s interest to the extent necessary to satisfy that requirement.4
Practice Pointers: Be sure to meet the 10 percent MRI requirement when creating the trust. But suppose the requirement isn’t met (someone else was involved with the drafting and the funding of the trust). Who decides whether the trust is declared void from the beginning or is to be reformed or amended to comply? That the IRC states those two options doesn’t necessarily give the grantor, the trustee, the beneficiary or the charitable remainder organization (CRO) the power to choose. State law and a state of uncertainty govern unless the trust instrument gives direction. A trip to the courthouse is likely.
Many CRUT and CRAT governing instruments traditionally have given the trustee the power to amend the trust for the sole purpose of complying with the requirements of Section 664, Treasury regulations under that section and any other Treasury or Internal Revenue Service requirements for CRUTS or CRATs. That language would likely give the trustee the power to fix up the trust to meet the 10 percent MRI requirement. But does it give the trustee the power to declare the trust void?
Suppose the trust had sold highly appreciated property before being declared void. The capital gain would be taxable to the donor. Had the trust been amended or reformed to meet the 10 percent MRI requirement, the gain wouldn’t be taxable. The CRO won’t be enthusiastic about a trust being declared void. But the donor or other beneficiaries might not have wanted the trust to be created if the payout has to be lower or the term shorter (or both).
What to Do?
Ah, that, of course, depends on the facts of each situation. Consider giving the trustee the power to declare the trust void ab initio or to amend it to qualify. Will the donor retaining that power create any tax problems? That should be explored.
A blanket trust provision providing that if the 10 percent MRI requirement isn’t met, the trust shall be deemed void ab initio could come back to haunt a donor if it wasn’t discovered until after the trust sold highly appreciated property that the 10 percent MRI requirement wasn’t met. If the trust is deemed void, the donor will be taxable on the gain. But if the trust can be and is amended, the gain won’t be taxed to the trust and will be taxable to the trust beneficiary only to the extent that it flows through under category two of the four-category taxation provision.
If you’re dealing with a testamentary CRUT or CRAT and the trust hasn’t been funded, consider giving the executor the power to decide whether to declare the trust void ab initio or to amend or reform it to comply with the 10 percent MRI requirement. If it’s been funded, consider giving the power to the trustee alone (or together with the executor). Explore, however, whether giving the fiduciaries this power could endanger the estate tax charitable deduction. Alternatively, the testator might direct that if the trust won’t meet the 10 percent MRI requirement it shall not be created, or he could direct that it be amended to comply. In all cases, if the trust is declared void or isn’t to be funded, provide for an alternative disposition (for example, add to my residuary estate). Take into account whether the trustee and executor are family members, trust beneficiaries or both. So you see, it depends on the facts of each situation.
Deadline for Reforming or Amending
A “proceeding” must be commenced within the period required in IRC Section 2055(e)(3)(C)(iii). That section provides that a proceeding must begin within 90 days after the filing date (including extensions) of the estate tax return.5 If no estate tax return is required (the estate isn’t large enough to require the filing of a return, or the trust is created during the donor’s lifetime), reformation must begin within 90 days after the due date (including extensions) for the trust’s first income tax return.6 Does a “proceeding” mean a court reformation exclusively or can the trustee correct by “amendment or otherwise” without going to court? The statute isn’t clear.
Consequence of Declaring a Trust Void Ab Initio.
No deduction will be allowed for any transfer to the trust, and any transactions entered into by the trust before being declared void will be treated as entered into by the donor.7
Additional Contributions To Existing Qualified CRUT
If the remainder value of the additional contribution isn’t at least 10 percent, that addition would result in the trust ceasing to be a qualified CRUT except for this saving provision: The additional contribution “shall be treated as a transfer to a separate trust under regulations [to be] prescribed by the Secretary [of the Treasury].”8 Can that separate trust then be amended or reformed to qualify as a CRUT? The IRC and the Conference Report are silent.
Practice Pointer: Again, you’ll want to be sure that the 10 percent MRI requirement will be met before making additional transfers to CRUTs. But suppose there’s a snafu. The IRC says that the transfer “shall be treated as a transfer to a separate trust.”9 That the IRC says so doesn’t necessarily mean that the CRUT’s trustee has the power to put the additional contribution in a separate trust. So consider providing for such a contingency: “If any additional contribution [to this trust] shall not have a remainder interest of at least 10 percent at the time of transfer to the trust, that additional contribution shall be treated as a transfer to a separate trust under regulations to be prescribed by the Secretary of the Treasury.” I hope all the beneficiaries will live long enough to see those regulations. So, again, make sure the 10 percent MRI requirement is met for additional contributions.
Private Letter Ruling 200022014
A created a 5 percent CRUT (before the 10 percent MRI requirement took effect), paying him for life, then to B, C, D and E and the survivor of them; the remainder was to go to charity. In 1999, A made an additional contribution to the CRUT, and the remainder interest flunked the 10 percent MRI test. The trustee petitioned a state court to sever an amount representing the additional contribution from the trust and transfer it equally to four separate trusts. Each new trust was to make unitrust payments to A for life, and then to only one beneficiary for life, with remainder to charity. Thus, Trust 1 would pay A for life and then B for life, with remainder to charity. C, D and E were each successor beneficiaries to A in Trusts 2, 3 and 4, respectively. Each of the new trusts passed the 10 percent MRI test.
In the PLR, the IRS ruled that an amount representing the additional contribution to the initial trust may be severed without disqualifying that trust. By creating four new trusts (each with only one successor beneficiary), the duration of the non-charity beneficiaries’ interests would be reduced (as authorized by the IRC), and thus, the 10 percent MRI requirement would be met. In all other respects, (other than the number of non-charity beneficiaries), the four separate trusts were identical to the original trust. Each of the four trusts were qualified CRUTs, and contributions to them qualified for the income tax charitable deduction.10
Caution Re: Charitable Gift Annuities
The charitable gift portion of a charitable gift annuity (CGA) (the value of the amount transferred minus the “investment in the contract”) must be more than 10 percent. Note the difference between at least 10 percent MRI for CRUTs and CRATs and more than 10 percent for CGAs.
CRUTs and CRATs aren’t qualified if the 10 percent MRI requirement isn’t met. But for CGAs, if the more than 10 percent requirement isn’t met, the donor still has a darn good gift annuity. (The usual charitable deduction, exclusion ratio and capital gains rules apply.)
If the four requirements of IRC Sections 514(c)(5) and 501(m) aren’t met, the charity will be taxed on debt-financed income, as an insurance company, and in extreme cases can lose its tax exemption. (Not a good thing):
1. The gift portion is more than 10 percent;
2. The annuity is payable over the lives of one or two individuals (no annuities for a term of years);
3. The annuity doesn’t guarantee a minimum amount of payments or specify a maximum amount of payments; and
4. The annuity doesn’t provide for any adjustment of the annuity payment by reference to the amount received from the transferred property or any other property.
Endnotes
- Internal Revenue Code Section 664(d)(2)(D).
- U.S. v. Wurzbach, 280 U.S. 396, 399 (1930).
- IRC Section 664(d)(2)(D).
- IRC Section 2055(e)(3).
- Section 2055(e)(3)(C)(iii)(I).
- Section 2055 (e)(3)(C)(iii)(II).
- Section 2055(e)(3)(J).
- Section 664(d)(4).
- Ibid.
- Private Letter Ruling 200022014 (Feb. 29, 2000).
© Conrad Teitell 2016