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IRS Offers an Alternative to the Portability-of-Exhaustion Test for CRATs

The recently issued Revenue Procedure 2016-42 helps solve a common problem

In recent years, many charitably motivated donors who’ve been drawn to the fixed-payment charitable remainder annuity trusts (CRATs) have found it impossible to do what they want.  Reason: In this era of low Internal Revenue Service discount rates, it’s impossible for many proposed CRATs to pass the 5 percent probability test. But with the issuance of Revenue Procedure 2016-42 on Aug. 8, the IRS offers taxpayers an alternative that helps solve this problem.

Background

For some years, a CRAT for a life or lives has had to satisfy two up-front tests. First, the initial present value of the charitable remainder must be at least 10 percent of the initial value of trust assets. Second, on the date the trust is created, there must be no more than a 5 percent probability the trust will be exhausted before it terminates.

Both tests are carried out using the IRS discount rate applicable to the trust. In practice, the 10 percent minimum charitable remainder test has tended not to be a problem in the prevailing low interest rate environment. The 5 percent probability test has proved to be a major problem, however.

For example, given a 1.8 percent IRS discount rate, a 70-year-old who tries to set up 5 percent payout CRAT easily clears the 10 percent minimum charitable remainder hurdle (39.2 percent remainder value) but fails badly to clear the 5 percent probability hurdle (9.2 percent probability of exhaustion). The 5 percent probability test in practice has been throwing out a lot of wheat with the chaff.

Another Option

In Rev. Proc. 2016-42, issued Aug. 8, 2016, the IRS offers an optional sample CRAT provision that, if inserted into a CRAT instrument, makes the 5 percent probability test inapplicable to the CRAT. The new provision instead requires the CRAT trustee to pass a new 10 percent test before making each annuity payment. If the CRAT would fail the test on making an annuity payment, the CRAT terminates the day before the annuity payment is made. The IRS characterizes the new provision as a qualified contingency for purposes of Internal Revenue Code Section 664(f).

How New Provision Works

Before making an annuity payment “A,” the trustee subtracts A from the current value of trust assets “V”. The trustee gets V - A. This is a key number.

Next, the trustee computes a “discount factor” (DF). DF is equal to:

1/(1 + i)t, where

“i” is the IRS discount rate used to calculate the donor’s up-front charitable contribution, and “t” is the number of years (whole years and fraction of a year) that have elapsed since the CRAT was created.

Next, the trustee multiplies DF by (V - A). If DF x (V - A) is at least 10 percent of the amount used to fund the CRAT, the CRAT passes the test, and the trustee makes the annuity payment of A. If DF x (V - A) is less than 10 percent of the amount used to fund the trust, the CRAT fails the test and terminates the day before the trustee would otherwise make the annuity payment of A, in which case the charitable remainder beneficiary gets at least something.

Example

Joan, aged 70, sets up a 5 percent CRAT having the new optional provision on a day when the applicable IRS discount rate is 1.8 percent. Joan funds the CRAT with $200,000.

Exactly 12 years later, the CRAT has assets of $152,500, and the trustee is getting ready to make a $2,500 annuity payment to Joan: A = 2,500, V = 152,500 and V - A = 150,000.

The trustee computes DF: DF = 1/(1 + 0.018)12 = 0.807.

Multiplying 0.807 (DF) by 150,000 (V - A) yields 121,093 (rounded). This far exceeds 10 percent of the funding amount, $20,000, which means the CRAT passes the new 10 percent test with flying colors, and the trustee will make the scheduled $2,500 annuity payment.

A Blessing or a Curse?

Rev. Proc. 2016-42 is a blessing to many potential CRAT donors in today's low interest rate environment. Should interest rates rise, however, the blessing will fade, and CRAT drafters will need to consider carefully whether the blessing might be a curse.

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