IRS Crafts Provision to Facilitate Use of CRATs

• DOI: http://doi.org/10.1002/npc.30245
• Date: 01 October 2016
• Published date: 01 October 2016

Bruce R. Hopkins’ NONPROFIT COUNSEL

October 20164THE LAW OF TAX-EXEMPT ORGANIZATIONS MONTHLY

Bruce R. Hopkins’ Nonprofit Counsel DOI:10.1002/npc

business is regularly carried on. As to the pivotal issue,

which is whether the business is substantially related to

the organization’s exempt purposes, the IRS stated that

the fact that the sales are conducted “in conjunction

with” the organization’s exempt activities “does not

compel a conclusion” that the Product sales also are

substantially related. The IRS recited the rule that the

sales do not lose their separate identity as a business

merely because they are carried on within the larger

context of other activities as part of the organization’s

functions (Reg. § 1.513-1(b)). Thus, the relationship

between exempt functions and the sales had to be

examined.

The organization posited that the Product sales con-

tribute importantly to its educational function in that

they may encourage buyers to visit its visitors’ center

or the educational pages of its website. But the IRS

wrote that the “mere reference” on a Product package

to another activity of the organization does not render

the Product educational or “contribute importantly” to

accomplishment of educational purposes. Likewise, the

fact that a piece of information, such as a customer’s

e-mail address, is acquired in the course of a commercial

endeavor and used in the context of exempt educational

functions does not make the endeavor substantially

related.

The IRS stated that the sales of the Product do

not impart any information at all, while the packaging

imparts “little that could not also be found on packages

offered by commercial” companies. The IRS thus con-

cluded that the Product sales do not contribute impor-

tantly to the conservation and prevention activities.

The IRS observed that the Product is marketed and

sold to the public in a manner similar to that of other

purveyors of similar items and thus is likely to be used

for the same purpose as that sold by other purveyors.

Thus, the IRS decided that there is no causal relation-

ship between the Product sales and the organization’s

exempt purposes.

Moreover, the IRS decided that the sales activity is

being conducted on a larger scale than is reasonably

necessary to effectuate conservation strategies. Thus,

the gross income attributable to the sales business in

excess of the needs of exempt functions constitutes

gross income from the conduct of unrelated business

(Reg. § 1.501(c)(3)-1(d)(3)). [24.4(a), (b)]

Commentary: This TAM is heavily redacted as to the

identity of the organization involved (understandably)

and as to the nature of the Product (less understand-

ably). In other words, the TAM has been squeezed

of so much factual content that its larger meaning is

obliterated. But it probably has little adverse bearing on

charitable organizations that use merchandise to further

exempt purposes and generate contributions. The best

IRS guidance in that regard is Priv. Ltr. Rul. 200722028

(summarized in the August 2007 issue). ◆

IRS CRAFTS PROVISION TO

FACILITATE USE OF CRATS

The IRS provided a prototype provision that may be

included in the governing instrument of a charitable

remainder annuity trust, which will be treated as a

qualified contingency, enabling the trust to continue

to qualify as a CRAT and sidestep the probability-

of-exhaustion test (Rev. Proc. 2016-42). This sample

provision triggers, under certain circumstances, early

termination of a CRAT, followed by an immediate

distribution of remaining trust assets to the charitable

remainder beneficiary.

Law

A CRAT makes annuity payments for the benefit of

one or more noncharitable beneficiaries, followed by

distribution of trust assets to one or more charitable

remainder beneficiaries (IRC § 664). To be qualified, a

CRAT must meet four basic requirements (summarized

in the Rev. Proc.), including payment of a sum certain

equal to 5 percent of the value of assets initially placed

in the trust to an income beneficiary. Also, a CRAT must

be a trust with respect to which a charitable deduction

is available (e.g., IRC § 170). As of the date of a gift, if

a transfer for charitable purposes is dependent on per-

formance of an act or happening of a precedent event

in order that it might become effective, a charitable

deduction is not allowed unless the possibility that the

charitable transfer will not become effective is so remote

as to be negligible (e.g., Reg. § 1.170A-1(e)). This

probability-of-exhaustion test is applied to determine

whether a CRAT complies with this regulatory require-

ment applicable to charitable transfers.

If there is a greater-than-5-percent probability that

payment of the annuity will defeat the charity’s interest

by exhausting the trust assets by the close of the trust’s

term, the possibility that the charitable transfer will not

become effective is not so remote as to be negligible

(Rev. Rul. 70-452). The probability of exhaustion, in

the case of a CRAT, is calculated first by applying the

assumed rate of return on CRAT assets (the IRC § 7520

rate) against the amount of the annuity payment; then,

a mortality table (in Reg. § 2031-7(d)(7)) is used to

determine the probability that the income beneficiary or

beneficiaries will survive exhaustion of the CRAT’s assets

(Rev. Rul. 77-374). (These rulings are discussed in the

April 1985 issue.)

If the probability that the life beneficiary or ben-

eficiaries will survive exhaustion of the CRAT assets is

greater than 5 percent, the charitable remainder interest

involved does not qualify for an income, estate, or gift

tax charitable deduction and the CRAT is not exempt

from federal income tax (IRC § 664(c)). If the assumed

rate of return at creation of the trust is equal to or