In Private Letter Ruling 201422021 (released Aug. 15, 2014), the Internal Revenue Service addressed five issues posed by a private foundation (PF). Specifically, the IRS ruled that a surviving spouse’s estate could claim a charitable deduction for assets passing to three charitable lead annuity trusts (CLAT 1, CLAT 2 and CLAT 3). The CLATs, created under the surviving spouse’s revocable trust, included assets passing from a marital trust created under a revocable trust of the predeceased spouse. The IRS also considered which players are “disqualified persons” and whether the PFs are subject to the excess business holdings tax.
The PFs
A couple (Founder A and Founder B) had two children, a son and a daughter. The son had one child (GC 1) and the daughter had two children (GC 2 and GC 3). The son created PF 1 through a trust agreement. The daughter created two PFs, PF 2 and PF 3, through trust agreements. A bank was appointed trustee for each of the three PFs. Before the trustee could transfer any stock in a certain corporation, the trustee was required to obtain consent of the daughter or the adult owners of 55 percent of the beneficial interests of any trusts that held stock in that corporation.
When each grandchild (GC 1, GC 2 and GC 3) turns 35 years old, he would become the foundation advisor for his respective PF. The main responsibilities of a foundation advisor were to appoint a philanthropy committee to designate charitable distributions and remove and appoint corporate trustees. Until GC 2 and GC 3 turned 35, their mother would have the authority to remove and appoint trustees for their respective PFs.
The CLATs
Founder A and Founder B left their residuary estates to their own revocable trusts. The couple created three CLATs (CLAT 1, CLAT 2 and CLAT 3) out of the two revocable trusts, which would come into existence on the death of Founder A or Founder B—whomever was the last to die. Under the revocable trusts, the residue of the estate of the first to die would pass to a marital trust for the surviving spouse. On the surviving spouse’s death, 55 percent of the marital trust assets and 55 percent of the surviving spouse’s residue would be distributed equally to the three CLATs.
The CLATs were irrevocable, and no additional contributions could be made to the CLATs after the initial contributions. The trustee of each CLAT, however, has the power to amend a CLAT in any manner to ensure that any annuities passing to a PF is a guaranteed annuity interest, and the payment of the annuity to a PF would be deductible from the CLAT’s gross income under Internal Revenue Code Section 642(c)(1).
The Annuities
CLAT 1 would pay an annuity to PF 1; the son and GC 1 would be the remainder beneficiaries through a trust established under CLAT 1. CLAT 2 would pay an annuity to PF 2; the daughter and GC 3 would be remainder beneficiaries through a trust established under CLAT 2. CLAT 3 would pay an annuity to PF 3; the daughter and GC 2 would be remainder beneficiaries through a trust established under CLAT 3. Prior to receiving any annuity payments, the PFs wouldn’t own any stock in the corporation that would give rise to an excess business holding tax under IRC Section 4943.
The terms of each CLAT provide that for 20 years, the trustee is to pay to each PF, an annual annuity at the end of each taxable year. The trustee is to pay the annuity from income, and if the income is insufficient, from principal. If a CLAT’s income is in excess of the annuity amount in a taxable year, that excess income is to be distributed to the PF. Payment of the annuity may be deferred until the end of the taxable year in which a CLAT is completely funded. Within a reasonable time after the end of the taxable year in which a CLAT is completely funded, the trustee must pay to the PF the difference between the annuity amount actually paid and the annuity amount payable, plus interest. Interest is to be compounded annually and computed at the IRC Section 7520 rate. The last day of the annuity period is the day preceding the 20th anniversary of the surviving spouse’s death.
The IRS Rulings
The PFs requested the IRS to rule on five issues:
Issue 1: Is the estate of the surviving spouse entitled to a charitable deduction under IRC Section 2055(e)(2) for assets passing to the three CLATs created under the surviving spouse’s revocable trust, including the assets passing from the marital trust created under the first spouse to die’s revocable trust? After citing several sections of the IRC, the IRS said “yes.” Section 2055(e)(2)(b) provides that no deduction is allowed when the lead interest in property passes to a charitable organization and the remainder interest passes to a non-charitable beneficiary, unless the lead interest is in the form of a guaranteed annuity or is a fixed percentage of the fair market value of all of the property and distributed annually. In this instance, the formula set forth by each revocable trust to determine the annuity from each CLAT resulted in a determinable amount that was ascertainable as of the valuation date of the surviving spouse’s estate. This formula resulted in a guaranteed annuity within the meaning of the relevant IRC section. Additionally, the surviving spouse’s estate would be entitled to a deduction under Section 2055(a) for the present value of the annuity from each CLAT if: 1) the marital trust’s terms satisfied IRC Section 2056(b)(7), and the election was properly made for the assets of the marital trust that actually passed to each CLAT; 2) the assets that passed from the marital trust to each CLAT aren’t subject to liabilities of the surviving spouse’s estate; 3) the CLAT’s terms satisfied the successor guidance requirements of Revenue Procedure 2007-26; and 4) the recipient of the annuity from each CLAT is a PF.
Issue 2: Is Founder A or Founder B a “substantial contributor” under IRC Section 507(d)(2) and therefore, a disqualified person under IRC Section 4946(a)(1) with respect to the PFs? “Yes,” said the IRS. Under Section 4946(a)(1)(A), a disqualified person includes a substantial contributor. A “substantial contributor” under IRC Section 507(d)(2)(A) is a person who contributes an aggregate amount of over $5,000 to a PF, if that amount is more than 2 percent of the total contributions and bequests received by the PF before the close of the taxable year. In this case, Founder A or Founder B will bequeath CLAT interests to the PFs. The annuity interests are guaranteed and deductible, and it’s assumed the value of each CLAT interest exceeds $5,000. Moreover, such bequests will constitute substantially all of the bequests to the PFs and will be more than the 2 percent minimum required under Section 507(d)(2). Thus, either Founder A or Founder B—whomever is the last to die—will be a “substantial contributor” to the PFs to which he bequeaths CLAT interests.
Issue 3: Shall stock owned by Founder A or Founder B before his death be included in determining whether the PFs are subject to the excise tax on excess business holdings under IRC Section 4943? “No,” said the IRS. Under Section 4943(c)(2), a PF is permitted to hold 20 percent of the voting stock of an incorporated business enterprise, reduced by the percentage of voting stock owned by disqualified persons. In this instance, proposed transfers of assets to the CLATs won’t occur until after Founder A and Founder B dies. The PFs won’t get any stock until the CLATs distribute it to them, when satisfying the PFs’ rights to receive annual annuity payments. And, under Treasury Regulations Section 53.4943, the computation of the tax will occur following the deaths of Founder A and Founder B, when they would no longer be shareholders in the corporation. As such, the stock owned by Founder A and Founder B before their deaths wouldn’t be included under Section 4943 to determine whether a PF is subject to the excise tax on business holdings.
Issue 4: Who will be the disqualified persons with respect to PF 1? The IRS ruled that the son, as PF 1’s creator, is a disqualified person because he’s the child of Founder A and Founder B—one of whom will be a substantial contributor to PF 1. Under Section 4946(a)(1)(D), the son is a family member of a substantial contributor and, under Section 4946(a)(1)(A), he’s the creator of a trust that’s a PF. Similarly, GC 1 is a disqualified person because she’s the child and grandchild of a disqualified person.
CLAT 1 is also a disqualified person with respect to PF 1. Under Section 4946(a)(1)(G), a trust is a disqualified person if more than 35 percent of the beneficial interest in the trust is owned, among others, by substantial contributors or 20 percent owners. In this instance, the beneficiaries are the remainder beneficiaries of CLAT 1 and are disqualified. They’re treated as owning no less than 40 percent of the total interest in the CLAT, because the annuity interest can’t exceed 60 percent. They thus exceed the 35 percent minimum requirement. Moreover, the voting stock that CLAT 1 owns is deemed owned by the remaindermen—that is, the trust for the benefit of the son and GC 1. Additionally, the family members of the son and GC 1 are also disqualified persons under Section 4946(a)(1)(D). The IRS, however, declined to rule on whether certain entities in which the son and GC1 have an interest, and certain entities in which their family members have an interest, are disqualified persons.
Issue 5: Are the PFs disqualified persons with respect to each other? Yes, under Section 4946(a)(1)(H). Under this section, if a PF is controlled by the same person or receives contributions, substantially all of which were made by substantial contributors, the PF is a disqualified person. In this instance, Founder A or Founder B will be substantial contributors to all three PFs. Accordingly, all three PFs are disqualified persons with respect to each other.