The crux of the clutch CRUT crutch: how to fix an impermissible split-interest trust to obtain an estate tax charitable deduction.

• Author: Pratt, David
• Position: Charitable remainder unitrust

Creating a charitable remainder trust (CRT) at death is a technique that has been used for many years to obtain an estate tax charitable deduction in a decedent's estate. The Internal Revenue Code (1) contains numerous requirements that an otherwise nondeductible split-interest trust must satisfy in order to be accepted as a qualifying CRT. Unfortunately, due to mistake or otherwise, there are instances when one or more of such requirements are not satisfied, in which case the CRT fails to qualify as such and the estate tax charitable deduction is lost. The good news (especially for the lawyer who drafted the CRT) is that the code includes a mechanism that allows such a trust to be reformed so that the "broken" CRT can be cured and the deduction can be taken (the qualified reformation regime). The rules to reform the trust are complex. This article discusses such rules, provides a roadmap to navigate them, and concludes with alternatives for situations in which a reformation will not be allowed.

Charitable Remainder Trust Requirements

Section 2055(e)(2) prohibits the estate tax charitable deduction for transfers of charitable remainder interests in so called "split-interest trusts" unless the trust qualifies as a charitable remainder annuity trust (CRAT) or a charitable remainder unitrust (CRUT). (2) To qualify as a CRAT, a trust must provide 1) at least annually to one or more then-living noncharitable beneficiary(ies) in what must be the sole noncharitable distribution, a fixed-dollar annuity ranging from 5 percent to 50 percent of initial trust asset fair market value (FMV) for the beneficiary's life or for a maximum 20-year term; and 2) at termination, the entire remainder interest with an actuarial value of at least 10 percent of initial trust asset FMV (tested at inception, not termination) must pass to one or more qualified charities. (3) The CRUT requirements are essentially identical, except that the annual noncharitable distribution must be a unitrust amount between 5 percent and 50 percent of annually determined trust asset FMV. (4)

Reformations Required Even After IRS Provides Sample Forms

Section 664 and the Treasury Regulations promulgated thereunder (5) also include technical requirements. (6) In an effort to assist taxpayers and drafters of CRTs (and consequently reduce the administrative burden of technically deficient trusts that were clearly intended to be CRTs), beginning in 1989, the Internal Revenue Service promulgated sample trust language (most recently updated in 2003 and 2005) for CRATs and CRUTs. (7) While the existence of government-issue CRT forms should have substantially reduced the need for a qualified reformation regime, it appears, at least based on private letter rulings (PLRs) issued in this area, that practitioners continue to draft impermissible split-interest trusts. (8)

Qualified Reformation Requirements

* What Interests May Be Reformed?

--Section 2055(e)(3) allows the charitable deduction for split-interest trusts that are subject to a "qualified reformation," defined as a change within a governing instrument (by reformation, amendment, construction, or otherwise) of a "reformable interest" into a "qualified interest." A qualified interest is any interest for which a charitable deduction would normally be allowable if made outright {i.e., under [section]2055(a)). A reformable interest is any interest for which the charitable deduction would be allowed but for the split-interest prohibition.

* How Much Can Interests Vary?

--For a reformation to be "qualified," the difference between the actuarial value of the qualified (post-reformation) interest and reformable (pre-reformation) interest cannot exceed 5 percent of the actuarial value of the reformable (pre-reformation) interest. Stated differently, the value of the charitable remainder interest cannot be less than 95 percent or more than 105 percent of its original actuarial value on the date of the decedent's death. Although this variance requirement technically applies only to the charitable remainder interest, in practice, the adjustment of the life tenancy beyond 5 percent of the charitable remainder interest value in either direction will preclude the charitable deduction because such modification will, in turn, impermissibly alter the value of the charitable remainder interest.

For example, consider an impermissible split-interest trust with a single noncharitable life tenancy interest actuarially valued at $100,000 and a charitable remainder interest actuarially valued at $900,000. Under the qualified reformation regime, the charitable remainder interest after the reformation cannot be actuarially valued at less than $855,000 or more than $945,000. Inversely, the noncharitable life tenancy interest's post-reformation actuarial value must be valued at less than $145,000 (necessitating a charitable remainder interest reduction to $855,000) and more than $65,000 (dictating a charitable remainder interest increase to $945,000).

An additional wrinkle exists if the pre-reformation trust provides for an annuity or unitrust amount substantially outside the 5 percent to 50 percent CRT "window" set forth in [section]664(d). For instance, an otherwise permissible split-interest trust with a 1 percent unitrust amount must be increased to 5 percent (the statutory floor) to qualify as a CRUT, but if the modification causes the date-of-death actuarial value of the charitable remainder interest to decrease by more than 5 percent, the reformation will not be qualified and a charitable deduction would be denied. As such, it is critical that a practitioner "run the numbers" prior to pursuing a qualified reformation.

* Retroactivity and Tenancy Duration Requirements--The qualified reformation regime also requires that the nonremainder interest(s) terminate at the same time as originally drafted. For example, if the decedent's child has a term certain interest in the split-interest trust, the reformation cannot convert the child's interest to a life tenancy.

The final requirement for a qualified reformation is also straightforward: The change must be...