A recent Tax Court case, Estate of Block v. Commissioner, T.C.M. (RIA) 2023-030 (T.C. 2023), examined whether a Connecticut estate could claim a charitable deduction under Internal Revenue Code Section 2055(a) from the value of the gross estate for the transfer of the remainder interest in a trust. After a thorough examination of the requirements for charitable remainder annuity trusts (CRATs) and qualified reformations, the court denied the charitable deduction. The court explained that the trust at issue didn’t qualify as a CRAT, and therefore, required a qualified judicial reformation. Strictly construing the exception for judicial reformations, the court further determined that the trustees didn’t properly effect such a reformation.
At the time of her death on Oct. 21, 2015, and at all relevant times, Susan Block was a resident of Connecticut. She had established a revocable trust on Sept. 2, 1997. Years later in 2015, she executed a will, which transferred her residuary estate to the trust. She also amended and restated the trust at that time. On Susan’s death, a subtrust (the Katz Trust) was created for the benefit of Susan’s sister, Harriet, and then for Harriet’s spouse, if he survived Harriet. On the death of the survivor of them, any remaining assets were to be distributed to the Jewish Community Foundation of Greater Hartford, Inc.
The trust provided that Susan intended the Katz Trust to be a CRAT and directed that the terms be construed accordingly. Article 4.1(A) of the trust instructed the trustees to pay Harriet (or her spouse, as the case may be) an annuity of the greater of all net income or $50,000, at least annually. In August 2017, after the Internal Revenue Service initiated an audit of the estate tax return, the trustees of the trust executed an amendment, which revised Article 4.1(A) to say that Harriet or her spouse should receive an annuity amount equal to $50,000. The amendment purported to be effective as of Susan’s date of death. At the conclusion of its audit, the IRS disallowed the entire charitable deduction ($352,085) with respect to the Katz Trust.
Charitable Deduction for Split-Interest Transfers
IRC Section 2055(a), for federal estate tax purposes, allows a deduction from the value of a decedent’s gross estate for transfers to charity. When split-interest transfers (that is, those that involve conveying an interest in property to both charitable and non-charitable beneficiaries for less than full and adequate consideration) are involved, however, Congress includes limitations to avoid potential abuse. Manipulating how the trust assets are invested could have a detrimental effect on the charitable beneficiary. Section 2055(e)(2)(A) only allows a deduction for the charitable remainder portion of a split-interest transfer when the remainder passes in trust and the trust is either a CRAT, charitable remainder unitrust (CRUT) or a pooled income fund (PIF).
Requirements for Qualified Reformation
Section 2055(e)(3)(A) goes on to provide that a qualified reformation can save an estate’s charitable deduction if a trust initially failed to qualify as a CRAT or a CRUT. A qualified reformation can only happen if the remainder interest is a reformable interest under Section 2055(e)(3)(B). This means that: (1) all payments to the noncharitable beneficiaries under the terms of the original trust must have been either a specific dollar amount or a fixed percentage of the fair market value of the property; and (2) the remainder interest must have been exclusively charitable. There’s even an exception to the specific dollar amount or fixed percentage rule. A judicial proceeding brought within 90 days of the due date for the estate tax return that qualified the trust as either a CRAT or a CRUT, retroactive to the decedent’s date of death, can cure an initially nonfixed interest.
The court explained that the trust provisions, as they were at Susan’s death, weren’t limited to a specific dollar amount and therefore didn’t qualify as a CRAT. Under the default rules, the Katz Trust charitable remainder wasn’t a reformable interest. The estate’s only option was a judicial reformation, but the court quickly dismissed the estate’s argument that the amendment effected a qualified reformation. It was executed long after the 90-day period following the estate tax return due date and wasn’t instituted by a court. The court also declined to accept the estate’s substantial compliance argument.
In an effort to bind the IRS to its prior decisions, the estate argued that Revenue Procedure 2003-57, and Rev. Proc. 2003-59 allow trustees to act without court involvement to amend the terms of a trust to ensure it qualifies as a CRAT and retroactively qualifies for an estate tax deduction. The court wasn’t convinced. It pointed out that major defects, like an income interest not expressed as an annuity interest, require a judicial proceeding to commence before an IRS audit is initiated. Because the original Katz Trust violated the CRAT rules, it didn’t fall within the reasoning of the two revenue procedures discussed above. Ultimately, the court disallowed the entire charitable deduction.
A Cautionary Tale
Estate of Block certainly serves as a cautionary tale to trust drafters. The rules allowing and disallowing charitable deductions can be complex at times, but it’s critical for attorneys and tax professionals to understand them and how they’re applied. A bungled interpretation could lead to significant unintended tax consequences, as it did here. Like a skilled craftsman who measures twice and cuts once, a skilled draftsman should check and re-check how their provisions measure up against the rules before the trust is executed.