Prior to the Tax Reform Act of 1969 (the 1969 Act), there was limited guidance in the federal Tax Code for those contemplating the terms of charitable remainder trusts (CRTs), charitable lead trusts and other charitable gifts with retained interests. The 1969 Act laid down a set of rules to aid advisors seeking to draft trusts that would qualify for available income, capital gains and estate tax savings. Subsequent revenue rulings, private letter rulings and revenue procedures have continued to refine the permissible terms of these gift vehicles.
For example, statutory and regulatory rules have evolved to address minimum and maximum payout rates, how the income from trusts is taxed, what assets can be held, who can be trustee and many other aspects that must be considered when drafting such trusts. There are also “saving provisions” to allow trusts to be modified when drafters unintentionally run afoul of the law and regulations.
One of the concerns reflected in the federal Tax Code and regulations is the desire to prevent payment rates and/or time periods that make it highly unlikely that there’ll be anything left for charitable use. Congress and regulators have taken pains to make certain that when federal revenue is foregone in favor of voluntary gifts for charitable purposes, there will, in fact, be assets remaining for charitable use.
Under the terms of Rev. Rul. 70-452, a charitable remainder annuity trust (CRAT) may not make annual fixed payments when there’s more than a 5 percent probability that the trust will be exhausted. The formula used to estimate that probability assumes the life expectancy of the individual or individuals receiving payments and further assumes the trust corpus will earn the applicable federal midterm rate (AFMR) as determined under Internal Revenue Code Section 7520. That rate has ranged from 11.6 percent in May 1989 to as low as 1 percent in January 2013. The rate as of September 2016 is 1.4 percent.
Many planners have been surprised to learn that under the September AFMR rate of 1.4 percent, a CRAT making the minimum statutory payment of 5 percent won’t qualify if it’s for the life of a 76-year-old couple, because the formulas used by the Treasury project a greater than 5 percent probability the corpus will be exhausted given the couple’s approximately 16-year life expectancy. The same is true in the case of a single-life CRAT for a 74 year old with a 13-year life expectancy.
This reality has created a situation in which relatively older charitably minded individuals aren’t able to make significant gifts they would otherwise make. These donors and their advisors in many cases believe the probability of their trust actually experiencing the impact of historically low interest rates underlying the AFMR over an extended period is low enough that they’re willing to make the gifts despite the “warning” that the trust is very likely to be exhausted prior to the end of their lifetimes.
Revenue Procedure 2016-42
Fortunately, the Internal Revenue Service has addressed this issue in Rev. Proc. 2016-42, effective Aug. 8, 2016. Under its terms, the IRS has agreed to allow a trust to qualify as a CRT even if it fails the 5 percent probability test.
The trust will now qualify so long as it includes language set out in the revenue procedure that states that the trust will terminate prior to the death of the beneficiaries and distribute remaining corpus, should the value of the trust assets as determined under a formula outlined in the revenue procedure drop to less than 10 percent of the amount originally contributed to the trust.
To illustrate how this would work, let’s first assume the impact of the law as it stood prior to the announcement of Rev. Proc. 2016-42.
Take the case of Virginia, age 74. If she wished to fund a $1 million CRAT paying 5 percent for her lifetime, it wouldn’t qualify under an AFMR rate of 1.4 percent, as the formula used to determine the 5 percent probability of exhaustion would disqualify the trust.
Under the terms of the new revenue procedure, the trust can go forward as Virginia wishes. If the trust earns an average of 4 percent, there would be $834,000 remaining at the end of her life expectancy of 13 years. Even if she lives to be 100 years old, the trust would still distribute $557,000 at her death. As a result, she isn’t overly worried about the trust exhausting over her life expectancy and has little hesitation in including a provision that would terminate the trust if the value determined under the revenue procedure fell to less than 10 percent of the original value.
Considerations for Younger Donors
The IRS has reported that the average length of time for the existence of a CRT is 15 years. This would roughly translate into a life expectancy of a man in his late 60s or a woman in her early 70s.
Prior to Rev. Proc. 2016-42, the individuals on the younger end of the age spectrum for CRATs would be excluded from the advantages of CRATs in times of low interest rates that serve to drive down AFMR rates and thereby restrict the use of CRATs.
While this vehicle is now restored as an option if a donor is willing to risk ending the trust if it shrinks by more than 90 percent from its original value, donors in their 50s and early 60s may wish to carefully consider the impact on their future income should the trust terminate prematurely.
All things considered, however, this action by the IRS should be welcomed as a positive development for those who wish to incorporate philanthropy as a part of their long-range financial and estate planning.