The Internal Revenue Service has issued important new guidance that can allow a charitable remainder annuity trust (CRAT) to qualify under Internal Revenue Code section 664 in a low-interest environment.
Section 664 confers substantial tax benefits on charitable remainder trusts that meet its requirements. These are irrevocable trusts that during their term distribute a formula amount to one or more non-charitable beneficiaries, with the remainder distributed to charity upon termination of the trusts. There are two allowable formulas. A charitable remainder unitrust (CRUT) distributes a fixed percentage of the value of trust assets determined every year. There are some allowable variations for CRUT distributions, but in general this means that distributions from a CRUT can go up or down from year to year, depending on increases or decreases in the value of trust assets. While CRUTs are by far the more popular of the two main varieties, some clients and donors prefer the CRAT, which distributes the same amount every year during its term, which is fixed at the time the trust is created and which must be at least 5% of the value of assets contributed to the trust.
The problem with CRATs is that these fixed payments might exhaust all of the assets of the trust, meaning that nothing would be left in the trust for charity, even though the trust and the taxpayer that funded it enjoyed favorable tax treatment based on the assumption that at least a portion of the trust assets would eventually go to charity. To address this problem, the IRS issued Revenue Ruling 77-374, which applies a probability-of-exhaustion test to CRATs at the time they are created. The test created by the ruling applies the IRS §7520 assumed rate of return on CRAT assets against the amount of the trust distributions provided in the trust instrument, to determine when the assets of the CRAT would be exhausted. A mortality table is then consulted to determine the probability that the income beneficiary of the CRAT would outlive the exhaustion of trust assets. If that probability exceeds five percent, the trust will not qualify as a CRAT for tax purposes.
Impact of Low Interest Rates
Applying this test will never disqualify a CRAT if the §7520 rate is equal to or greater than the percentage used to calculate the payments to the income beneficiary. The problem is that this percentage must be at least 5% of the value of assets contributed to the trust, and the §7520 rate has not been more than 5% since 2007. (The §7520 rate for September, 2016 is 1.4%. A trust created in September may use the rate for July or August, but the highest rate of the three months was July, at 1.8%.). For example, a trust that will pay 5% of the value of assets contributed to the trust each year to an income beneficiary who is 70 years old at the time the trust is created cannot qualify as a CRAT under IRC §664, since under the probability-of-exhaustion test in Revenue Ruling 77-374 there is a greater than five percent probability that the income beneficiary will outlive the exhaustion of trust assets, leaving the charity with nothing. (This is the case even though the trust easily satisfies the requirement under §664(d)(1)(D) that the present value of the remainder be at least 10% of the value of the property transferred to the trust.) The result of the probability-of-exhaustion test is to effectively eliminate a CRAT for the life of an individual as a charitable gift planning vehicle during a period of low interest rates.
Many planners consider this a harsh result, since it assumes the trust will earn only the §7520 rate during its entire term – a very conservative assumption, since the trust in our example would pass the probability-of-exhaustion test if an annual total return on trust assets of only 2.5% is assumed.
New Revenue Procedure
Revenue Procedure 2016-42 provides a remedy through the device of a qualified contingency. Section 664(f)(1) provides that if a trust would, but for a qualified contingency, meet the requirements of §664(d)(1), the trust will be a qualified CRAT and the possibility of early termination based on the contingency will be ignored for purposes of determining its initial qualification. A qualified contingency is a provision in the trust that provides that payments to the income beneficiary will terminate, and the remaining trust assets will be distributed to the charitable remainder beneficiary, upon the happening of the contingency. Note the qualified contingency is also ignored for purposes of calculating the charitable deduction at the time the trust is created. The Revenue Procedure contains sample language for a qualified contingency that would cause the trust to terminate early, and provides that any CRAT containing this provision will not be subject to the probability-of-exhaustion test of Revenue Procedure 77-374.
To bring the trust within the very helpful provisions of the Revenue Procedure, the trust document must contain the following exactly:
“The first day of the annuity period shall be the date the property is transferred to the trust and the last day of the annuity period shall be the date of the Recipient’s death or, if earlier, the date of the contingent termination. The date of the contingent termination is the date immediately preceding the payment date of any annuity payment if, after making that payment, the value of the trust corpus, when multiplied by the specified discount factor, would be less than 10 percent of the value of the initial trust corpus. The specified discount factor is equal to [1/(1+i)]t, where t is the time from inception of the trust to the date of the annuity payment, expressed in years and fractions of a year, and i is the interest rate determined by Internal Revenue Service for purposes of section 7520 of the Internal Revenue Code of 1986, as amended (section 7520 rate), that was used to determine the value of the charitable remainder at the inception of the trust. The section 7520 rate used to determine the value of the value of the charitable remainder at the inception of the trust is the section 7520 rate in effect for [insert the month and year], which is [insert the applicable section 7520 rate].”
Using this qualified contingency in the trust document will prevent the 5% CRAT for a 70 year old beneficiary in our example from being disqualified, since the Revenue Procedure provides that a trust with this language will not be subject to the probability-of-exhaustion test. And assuming the trust assets earn an average annual total return of 2.5% or more, the provision should not result in early termination of the trust.
New Life for CRATs
It is unlikely that CRATs will ever be as popular as CRUTs, since there is no possibility that distributions to the income beneficiary will increase over time based on the investment performance of trust assets, and amounts paid to the CRAT beneficiary will therefore lose purchasing power over time as a result of inflation. But for those donors whose first priority is the certainty of knowing how much the trust will distribute each year, this very helpful Revenue Procedure resurrects the CRAT as a viable charitable gift planning alternative.