Valuation Rule for Early Termination of Net-Income Charitable Remainder Unitrusts

By David Wheeler Newman

Under Internal Revenue Code § 664, a qualified charitable remainder unitrust each year during its term distributes to a non-charitable beneficiary a fixed percentage (5% or greater) of the value of trust assets, determined annually (the unitrust amount).  Assets remaining in the CRUT at the end of its term are distributed to charity.  Section 664(d) provides that a qualified CRUT may limit distributions to the non-charitable beneficiary to the lesser of the unitrust amount or trust income under fiduciary accounting principles (a net-income CRUT, or NICRUT), and may pay the non-charitable beneficiary any trust income in excess of the unitrust amount to the extent that aggregate distributions in prior years were less than the aggregate unitrust amounts as a result of the net-income limitation (a net-income with make-up CRUT, or NIMCRUT).

Section 664(e) has, since 1969, provided that for purposes of determining the amount of any charitable contribution the value of the charitable remainder is computed based on the assumption that the entire unitrust amount will be distributed to the non-charitable beneficiary each year, without taking into account any net-income limitation in the document.  This rule has always made sense to advisors who work with CRUTs since it precludes overvaluation of the charitable remainder of a NICRUT or NIMCRUT, for purposes of claiming a charitable deduction, by assuming that the trust income would be less than the unitrust amount.  Many of us assumed that the same rule should apply if a NICRUT or NIMCRUT was terminated early.  One type of early termination would be if the non-charitable and charitable beneficiaries agreed to terminate the trust and divide its assets,  the rule would be applied to apportion the assets between them. Another type would be the income beneficiary contributed her interest in the NICRUT or NIMCRUT to the charitable remainder beneficiary, and the rule would be applied to calculate her charitable deduction.

When we learned that Congress recently “clarified” this rule as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015, it was reasonable for people to ask why it needed clarification. It turns out that the IRS is to blame, or more precisely that private letter rulings (PLRs) issued by the agency created some uncertainty. PLR 200725044 and 201325018 both involved the first scenario – NIMCRUTs were terminated early by dividing assets between the non-charitable income beneficiary and the charitable remainder beneficiary, and in both cases the Service ruled that that in valuing these interests the parties must use the lower of the unitrust percentage or Code § 7520 rate, which would frequently reduce the value of assets received by the non-charitable income beneficiary upon termination of the trust. It didn’t help at all in the confusion department that the IRS had earlier ruled otherwise in the second scenario – trusts that were terminated early because the income beneficiary contributed her income interest to the remainder beneficiary. PLR 200124010 and PLR 200140027 did not require the donor to use the 7520 rate, if lower, to calculate the deduction.

The PATH Act expanded the language of section 664(e) to make it clear that the normal rule – the one many of us thought all along was the rule – applies in either early termination scenario.

A simple example illustrates what’s at stake. Suppose that in a month in which the 7520 rate is 2%, the income beneficiary (age 70) and charitable remainder beneficiary of a 5% NIMCRUT with assets of $1 million agree to terminate the trust and divide its assets.  If the parties use the 5% unitrust percentage to value their interests, the income beneficiary will receive approximately $478,000, while if they had been required to use the 2% 7520 rate she would have received only 239,000.

Caution:  The statute is only effective for CRTs terminated after the December 15, 2015 effective date of the PATH Act, which begs the question:  if this is simply a “clarification” as stated in legislative history, can the clarified rule be relied upon for earlier terminations?

More caution:  State law may prohibit early termination of a CRUT that has a spendthrift clause in its governing instrument.

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