Recent Developments Affecting Charitable Remainder Trusts

• Publication year: 1997
• Pages: 77

26 Colo.Law. 77 Colorado Lawyer 1997.

1997, November, Pg. 77. Recent Developments Affecting Charitable Remainder Trusts

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77

Vol.26, No. 11, Pg. 77

The Colorado Lawyer
November 1997
Vol. 26, No. 11 [Page 77]

Specialty Law Columns
Estate and Trust Forum
Recent Developments Affecting Charitable Remainder Trusts
by Kevin D. Millard

This article summarizes several recent developments that may affect the tax treatment or qualification of charitable remainder trusts ("CRTs"). Because some of the new developments affect only certain types of CRTs, it is first necessary to distinguish among the several types. This article discusses the types of CRTs affected and then examines the IRS, court, and legislative actions that will have an impact on them

Background

All CRTs provide for payments to be made to one or more noncharitable beneficiaries (usually, but not always, the grantor of the trust or the grantor and his or her spouse) either for the life or lives of the noncharitable beneficiaries, or for a fixed number of years. At the end of that time, any remaining trust assets are distributed to one or more charities

CRTs differ in how the amounts payable to the noncharitable beneficiaries are calculated. A charitable remainder annuity trust ("CRAT") provides for the payment of a fixed percentage (not less than 5 percent) of the initial fair market value of the trust assets.1 For example, a CRAT funded with $100,000, and using a 5 percent payout rate, will pay $5,000 each year, and this amount will not vary.

A "standard" charitable remainder unitrust ("STAN-CRUT") also provides for payments of a fixed percentage (not less than 5 percent), but the percentage is applied to the fair market value of the trust assets as redetermined each year.2 Therefore, a 5 percent STAN-CRUT funded with $100,000 will pay $5,000 the first year, but the payments in subsequent years will vary as the value of the trust assets increases or decreases.

A "net income with make-up" CRUT ("NIM-CRUT") is like a STAN-CRUT in that it provides for payment of a percentage of the value of the trust, as redetermined annually. However, in a NIM-CRUT, if the actual net income of the trust for a year is less than the percentage payout would be, the trust pays out only its net income for that year.3 The trustee keeps track of the deficiencies, and if, in a later year, the trust's net income is more than the percentage payout, then in that year the trustee pays both the percentage for that year, and the "excess" income for that year, up to the amount of accumulated deficiencies from prior years.4 There can also be a "net income" CRUT without any make-up provision, but this type of CRUT is rarely used.

IRS Training Manual And NIM-CRUTs

A NIM-CRUT is sometimes used for income deferral and retirement planning. A donor can establish a NIM-CRUT that, until the donor reaches retirement age, invests for growth, not income. During those years, the donor receives only the actual net income of the trust, which is little or nothing. However, the trustee keeps track of the deficiencies for possible payment in the future. When the donor reaches retirement age, the trustee changes the investment philosophy, to invest for high income, and pays out both the current percentage payout and (to the extent of "excess" income) the deficiencies from prior years. The key to this plan, of course, is to be able to find appropriate high-growth assets during the pre-retirement years and high-income assets after retirement.

Some planners have suggested that one way this plan might be accomplished is if the trust invests in a commercial deferred annuity contract.5 Under the terms of the trust, the "inside build-up" in the contract is not treated as current income, so during the early years, there is no net income to pay out, and large deficiencies build up. When the donor reaches retirement age, the trustee begins making withdrawals from the annuity. For an annuity that is not held by an individual, those withdrawals will be treated as all income first6 (not part principal and part income under the usual annuity rules7)--normally a bad result. However, when the annuity is held in a NIM-CRUT, this means that there is a lot of income that can be used to make up the deficiencies.

Another way in which a NIM-CRUT might be invested for high growth initially, switching to high income at a later time, is for the trustee to invest the trust assets in a partnership which, it is anticipated, will probably not make distributions until some time in the future. Although the NIM-CRUT will be allocated its share of partnership income, loss, deduction, and credit for federal income tax purposes, it will not have income for trust accounting purposes until distributions are actually made from the partnership at some point in the future. As discussed below, this NIM-CRUT/partnership technique, in particular, has drawn the attention of the IRS.

In a training manual issued in late 1996, the IRS identified NIM-CRUTs used for income deferral and retirement as potentially violating the self-dealing rules.8 In the author's opinion, a properly drafted and carefully administered NIM-CRUT that has income deferral or retirement planning aspects is a legitimate planning technique under the Internal Revenue Code and regulations. However, the training manual is a clear indication that the IRS is bothered by this technique and will try to impose self-dealing penalties on NIM-CRUTs used in this way. As discussed below, the IRS followed up on its position in the training manual by adding income deferral NIM-CRUTs to the "no-ruling" list, and by soliciting comments on how the IRS might address these trusts in future regulations.

Ninth Circuit Holding On UBTI and CRTs

A CRT is generally tax-exempt.9 Income earned by a CRT is calculated at the trust level, but the trust itself pays no income tax. Instead, the payments made to the noncharitable beneficiaries carry out income and are taxed to them. Each payment retains the character of the income as received by the CRT, and is treated as, first, ordinary income (to the extent of the CRT's ordinary income for the current year and undistributed ordinary income from prior years); second capital gain (to the extent of the CRT's capital gain for the current year and undistributed capital gain from prior...