Arthritis Foundation Texas Chapter Planned Giving Seminar May 20, 2010 PLANNING WITH CHARITABLE REMAINDER TRUSTS

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1 I. Generally. Arthritis Foundation Texas Chapter Planned Giving Seminar May 20, 2010 PLANNING WITH CHARITABLE REMAINDER TRUSTS R. Thomas Groves, Jr. Jackson Walker L.L.P. 901 Main Street, Suite 6000 Dallas, Texas (214) (direct) (214) (direct fax) A. Overview of the CRT. A trust that provides for a current beneficial interest in at least one beneficiary that is not a charitable organization and a future remainder interest in one or more charitable organizations is a split interest trust or a charitable remainder trust ( CRT ). The trustee makes current distributions to the current beneficiary or beneficiaries during the term of the trust and at the end of that term, the remaining trust property is paid to one or more charitable organizations. A current deduction for income, and gift, or estate tax purposes is allowable for the value of the future remainder interest at the time the trust is created only if the charitable remainder trust meets the requirements set out in IRC 664. IRC 170(f)(2)(A); IRC 2055(e)(2)(A); IRC 2522(c)(2)(A). Because of the charitable deduction and because of other features of the CRT, the CRT can be a very useful tool for wealth and charitable planning. 1. CRT Beneficiaries. a. Current Beneficiary(ies). i. One or More Named Persons. The current distributions from the CRT must be paid to one or more named persons. IRC 664(d)(1)(A), 664(d)(2)(A). Under the Code, person includes, in addition to an individual, a trust, an estate, a partnership, an association, a company, or a corporation. IRC 7701(a)(1). A named person or persons includes members of a named class of persons. Treas. Reg (2)(a)(3)(i), (a)(3)(i). ii. Must Be Living at Creation of Trust unless Payment is for Period of Years. All individual current beneficiaries must be living when the trust is created. Accordingly, if the current beneficiaries are identified as members of a named class, and the payment period is for life, all individual in the class must be alive and ascertainable when the CRT is created. Treas. Reg (a)(3)(i), (a)(3)(i). If, however, the payment period is for a period of years, afterborn individuals may be included in the named class. Id. Page 1

2 iii. Payments May Be Made For the Use of Current Beneficiary. Payments may be made for the use of a current beneficiary, thereby permitting distributions to the guardian of a minor or of any other individual who is under a legal disability. Id. iv. Charity May Receive Current Distribution. A part of the current distributions may be paid to one or more charitable beneficiaries, as long as there is at least one non-charitable current beneficiary. Treas Regs (a)(3)(i), (a)(3)(i). See PLR Current distributions to a charitable beneficiary may be a portion of the annuity or unitrust amount, the portion being either set out in the CRT or as determined by the trustee under a discretionary power to sprinkle a portion of the annuity or unitrust amount between the noncharitable current beneficiary(ies) and the charitable current beneficiary(ies). In addition, other amounts, such as the amount of income in excess of the annuity or unitrust amount, can be paid to a charitable organization. Treas. Reg (a)(4), (a)(4); however, the CRT must prohibit such payments from being made in kind, or if they can be made in kind, must provide that the adjusted basis of property distributed in kind be fairly representative of the adjusted basis of the property available for payment on the state of payment. Id. The inclusion of a charitable organization as a current beneficiary of an inter vivos CRT is seldom done because the CRT grantor is not permitted an additional income tax deduction for any portion of the annuity or unitrust amount or other payment payable to a charitable organization. Treas. Regs (2)(d), (3)(d). v. Payments from CRT to Trust for Current Beneficiary. Payments may be made from a CRT directly to a noncharitable trust for the benefit of a current beneficiary who is incompetent. Rev. Rul , C.B. 794, amplifying and superseding Rev. Rul , C.B See also PLR , approving payment from a CRT to a separate noncharitable irrevocable trust for an individual current beneficiary who has been adjudicated as incapacitated. The IRS has indicated that it has determined that an otherwise qualifying CRT making distributions for a named individual s life to another trust, whose only function is to receive and administer those distributions for the benefit of the named individual beneficiary will not be a qualified CRT unless the named individual is incompetent. PLRs , , and , revoking PLRs , , and , respectively. b. Remainder Beneficiary(ies). i. Qualifying Charitable Organizations. On termination of the last noncharitable current beneficiary s interest in the CRT, the remaining trust property must either be irrevocably distributed to or for the use of one or more charitable organizations. IRC 664(d)(1)(C), 664(d)(2)(C). ii. Qualifying Charitable Organizations Not Identical for Income vs. Estate/Gift Tax Purposes. The designation of a qualifying charitable remainder beneficiary may be complicated by the fact that organizations described in IRC 170(c) (for income tax charitable deduction purposes), IRC 2055(a) (for estate tax charitable deduction purposes), and IRC 2522(a) (for gift tax charitable deduction purposes) are not identical. For Page 2

3 example, certain nonprofit cemetery companies qualify under IRC 170(c), but not under IRC 2055(a) or 2522(a). 2. Term of CRT. The period of time for which payments are to be made to non-charitable beneficiaries must begin with the first year of the CRT and continue either for the life or lives of the current beneficiaries (which can include successive or concurrent and successive beneficiaries) or for a stated number of years. IRC 664(d)(1)(A), (2)(A). Treas. Regs (a)(5), -3(a)(5). a. Payments for Life or Lives. If a current individual beneficiary receives payments for life, payments must be made for the life of that individual and not for the life of another. Treas Regs (a)(5)(i). -3(a)(5)(i). If the payment is to be made to a class of individuals, it must be paid to each individual for life until the death of the last survivor. b. Payments for a Term of Years. If payments to the current beneficiary(ies) are to be made for a term of years, the term may not exceed 20 years. IRC 664(d)(1)(A), (2)(A); Treas. Regs (a)(5), -3(a)(5). If the current individual beneficiary dies during the term, annuity or unitrust payments can be made to the beneficiary s estate for the rest of the term or to a successor current beneficiary. See Rev. Rul 74-39, C.B c. Combination of Life or Lives and Term of Years. A term will not qualify if it is possible that the payment period to the current beneficiaries may go beyond both (i) the lives of the beneficiaries living at the creation of the trust and (ii) 20 years. The term of a CRT can be measured by the shorter of either a term of years not to exceed 20 or an individual life. Treas. Reg (a)(5)(i), -3(a)(5)(i). d. 10% Remainder Interest Requirement Affecting Term. A CRT will not be a qualified CRT unless the actuarial value of the remainder interest in the trust [at the time of its creation] is at least 10% of the initial market value of property transferred to the trust. IRC 664(d)(1)(D), (d)(2)(d). Since the value of the remainder interest at the time of its creation is dependent upon (a) the amount of the payment to the current beneficiaries, (b) the applicable IRC 7520 rate, and (c) the term of the CRT, the term of the CRT, when combined with the other applicable factors, may need to be less than the maximum period of time that would otherwise be permissible. 3. Types of CRTs - Generally. There are two types of qualified CRTs charitable remainder annuity trusts ( CRATs ) and charitable remainder unitrusts ( CRUTs ). IRC 664(a), (d)(1), (d)(2). a. CRAT. A CRAT is required to pay a fixed dollar amount annually to the current beneficiary(ies) (the annuity payment ). The fixed dollar amount may be expressed in the trust instrument as an absolute dollar amount or as a faction or percentage of the initial net fair market value of the property placed in the CRT. IRC 664(d)(1)(A), Treas. Regs (a)(1)(i), (ii), (iii). The amount paid annually to the current beneficiary(ies) remains constant throughout the term of the CRAT. Page 3

4 b. CRUT. A standard or fixed percentage CRUT is required to pay a fixed percentage of its net fair market value at least annually to the current beneficiary(ies), with the amount to be distributed in each year being determined by applying the fixed percentage to the fair market value of the trust assets as valued that year (the unitrust payment ). IRC 664(d)(2)(A), Treas. Regs (a)(1)(i)(a). Thus, the amount paid by a CRUT to the current beneficiary(ies) fluctuates from year to year with the net fair market value of the trust assets. In addition to this standard CRUT, there are three permissible variations of the CRUT, which are discussed in Part III of this outline. IRC 664(d)(3), Treas. Regs (a)(1)(i)(b), (c). c. One or the Other but Not Both. A trust qualifies as a CRT only if it is either a CRAT or a CRUT (or any of the CRUT variations.) Treas. Reg (a)(2). The different payment requirements for the two types of CRTs may not be combined without disqualifying the CRT. 4. Time for Payment of Annuity or Unitrust Payment. The IRC and the Treasury Regulations require that the annuity payment or the unitrust payment be paid not less often than annually, at or before the close of the taxable year. See IRC 664(d)(1(A), (d)(2)(a); Treas. Reg (a)(1)(i), -3(a)(1)(i). However, under certain circumstances, the regulations allow the payment of the annuity or unitrust payment to be made after the close of the taxable year: a. Payment from NICRUT or NIMCRUT. A payment from a NICRUT or a NIMCRUT (discussed in Part III of this outline) can be made after the close of the taxable year if the payment is made within a reasonable time after the close of the taxable year. Treas. Reg (a)(1)(i)(j). b. Payment from a CRAT or a Fixed Percentage CRUT. i. CRATs and Fixed Percentage CRUTs Created Before 12/10/1998. A CRAT or a fixed percentage CRUT created before 12/10/1998 the annuity or unitrust amount for any taxable year may be paid within a reasonable time after the close of that taxable year if the percentage to the current beneficiary(ies) is 15% or less. Treas. Reg (a)(1)(i)(b), -3(a)(1)(i)(h). After 12/10/1998. ii. CRATs and Fixed Percentage CRUTs Created On or (A) Taxable Years Ending After 4/18/1997; Pre- January 5, 2001 Distributions. For CRATs and fixed percentage CRUTs created on or after 12/10/1998, for distributions made before January 5, 2001 with respect to a taxable year of the trust ending after April 18, 1997, the annuity or unitrust amount for any taxable year may be paid within a reasonable time after the close of that taxable year if: Page 4

5 (1) the character of the annuity or unitrust payment in the hands of the current beneficiary(ies)is in its entirety income under the tier system for characterizing CRT distributions under IRC 664(b)(1), (2), and (3); and/or (2) if and to the extent it is characterized as corpus (under IRC 6645(b)(4), the trust pays the annuity or unitrust payment by distributing property (other than cash) that is owned by the trust at the close of the taxable year for which the payment is made and the trustee elects to treat any income generated by the distribution as occurring on the last day of the day of the taxable year of the trust for which the annuity or unitrust payment is due. Treas. Reg (a)(1)(a)(i)(a), excluding paragraphs 2(a)(1)(i)(a)(2) and (3); Treas. Reg (a)(1)(i)(g), excluding paragraphs -3(a)(i)(g)(2) and (3). (B) Taxable Years Ending After 4/18/1997; Distributions On or After January 5, For CRATs and fixed percentage CRUTs created on or after 12/10/1998, for distributions made on or after January 5, 2001, with respect to a taxable year of the trust ending after April 18, 1997, the annuity or unitrust amount for any taxable year may be paid within a reasonable time after the close of that taxable year if: (1) the character of the annuity or unitrust payment in the hands of the current beneficiary(ies) is in its entirety income under the tier system for characterizing CRT distributions under IRC 664(b)(1), (2), and (3); and/or (2) (i) if and to the extent it is characterized as corpus (under IRC 6645(b)(4), the trust pays the annuity or unitrust payment by distributing property (other than cash) that is owned by the trust at the close of the taxable year for which the payment is made and the trustee elects to treat any income generated by the distribution as occurring on the last day of the day of the taxable year of the trust for which the annuity or unitrust payment is due; or (ii) the trust pays the annuity or unitrust payment by distributing cash that was contributed to the trust (with respect to which a deduction was allowable under IRC 170, 2055, 2106, or 2522); or (iii) the trust pays the annuity or unitrust payment by distributing cash received as a return of basis in any asset that was contributed to the trust (with respect to which a deduction was allowable under IRC 170, 2055, 2106, or 2522) and that is sold by the trust during the year for which the annuity or unitrust payment is made. Treas. Reg (a)(1)(a)(i)(a), -3(a)(1)(i)(g). c. Reasonable Time. For purposes of permitted payments of an annuity or unitrust payment within a reasonable time after the taxable year for which the payment is made, the trust will satisfy the reasonable time requirement if it makes the payment before the due date, including extensions, for Form 5227, Split-Interest Trust Information Page 5

6 Return, for the year in which the payment is due. Treas. Regs (a)(1)(i1)(b), - 3(a)(1)(i)(k). d. Late Payment. If a CRT pays the annuity or unitrust payment for a taxable year after the close of that taxable year and if it does not meet one of the applicable requirements for making the payment within a reasonable time after the close of the taxable year, the trust will be deemed to have (i) failed to function exclusively as a charitable remainder trust; (ii) engaged in a prohibited act of self-dealing for purposes of IRC 4941; (iii) unrelated debtfinanced income for purposes of IRC 514; and (iv) received an additional contribution. Treas. Regs (a)(1)(i)(a), (b), -3(a)(1)(i)(g), (h), (j). In the case of a CRAT the deemed additional contribution will disqualify the trust. Treas. Reg (b). 5. CRT Investments. a. Restricting Trustee s Investment Powers. A trust will not be a qualified CRT if the trust instrument contains any provision that restricts the trustee from investing the trust assets in a manner that could result in the annual realization of a reasonable amount of income or gain from the sale or disposition of trust assets. Treas. Regs (a)(3). Any restriction in the trust instrument that requires the trustee to retain or invest in a certain type of investment or prohibits some class of investment will disqualify the trust as a CRT. See Rev. Rul , C.B. 213; PLR Where the trust instrument contains non-binding expressions of desire or opinion as to specific assets, the IRS has concluded that the trustee has not been restricted from investments so as to disqualify the trust as a CRT. See PLR , PLR A provision requiring the trustee to consult with the donor or the current beneficiary before disposing of a trust asset will be deemed to violate this requirement. See PLR , PLR ; See PLRs and b. S-Corporation Stock. A CRT may not hold S corporation stock because the ownership of such stock would disqualify the corporation as an S corporation. IRC 1361(c)(2)(A). A CRT may not be an electing small business trust. IRC 1361(e)(1)(B)(iii). A CRT may not be the subject of a qualified subchapter S trust election under IRC 1361(d)(2). Rev. Rul , C.B CRTs and Taxation. a. Trust is Income Tax Exempt. A CRT is entirely exempt from all federal income taxes, including capital gains taxes. IRC 664(c)(1). Accordingly, if a grantor funds a CRT with appreciated property, the trust may sell the property free of income taxes and invest the full amount of the sales proceeds for the benefit of the current beneficiary(ies). On the other hand, if the grantor had sold the appreciated property personally, he or she would have only the after-tax proceeds available for reinvestment. This makes the CRT an attractive vehicle for a charitably inclined person considering the sale of a highly appreciated asset. Income. b. Trust is Subject to Excise Tax on Unrelated Business Taxable If a CRT has any unrelated business taxable income ( UBTI ), the trust is subject to a Page 6

7 100% excise tax on that UBTI. IRC 664(c)(2). Before 2007, the penalty for a CRT s having UBTI was a loss of its tax exemption altogether, so that all of its income was taxable. i. UBTI. UBTI is defined under IRC 512, determined as if IRC applied to the CRT. UBTI could occur, for example, if the trust operated a business, borrowed funds to purchase investments, held mortgaged property, or invested in a partnership or limited liability company that has any UBTI. A CRT could have UBIT resulting from a failure to timely make the required annuity or unitrust payment to the current beneficiary(ies) (Treas. Reg (a)(1)(i), -3(a)(1)(i)(a), (g), (h)) or fails to make a timely payment of real property taxes or assessments, resulting in a lien on trust property. IRC 514(c)(2)(C). ii. IRC 512(b) Modifications. The IRC 512(b) modifications to the definition of UBTI apply in computing a CRT s UBTI. See Treas. Reg (c)(2). Thus, the IRC 512(b)(12) $1,000 deduction will permit a CRT to have up to $1,000 in gross income classified as UBTI before it will have any UBTI subject to the 100% excise tax. iii. Excise Tax Allocated to Corpus. The excise tax on UBTI (and any other excise taxes that might be imposed on the CRT) are allocated to corpus and thus, are not deductible in determining taxable income distributed to a current beneficiary. Treas. Regs (c)(1), (d)(2). iv. UBTI is Trust Income. The CRTs UBTI is trust income for purposes of determining the character of a distribution made to a beneficiary. Treas. Reg (c)(1). Trust income is allocated among the categories of income set out in Treas. Reg (d)(1) without regard to whether part of the income is UBTI. c. Tax Year. All trusts, both existing and newly created, have been required to report on a calendar year basis for federal tax purposes, for taxable years beginning after 12/31/1986. There is an exception for tax-exempt and wholly charitable trusts described in IRC 501(a) and 4947(a)(1), respectively. Since a CRT is not a tax-exempt trust described in IRC 501(a) or a wholly charitable trust described in IRC 4947(a)(1), it is required to use the calendar year for tax purposes. d. Taxation of Current Beneficiary(ies). Distributions to the current beneficiaries are taxed to the current beneficiaries using a four-tier system. IRC 664(b); Treas. Regs (d)(1). These tier rules apply for every taxable year of the trust, even if the truest has UBTI. See Treas. Reg (c). Under the four-tier system, regardless of the actual trust income for a particular year, all payments of the annuity or unitrust payment are deemed to be made first from ordinary income, second from capital gains, third from other income (typically tax-exempt income), and last from trust corpus. IRC 664(b). Current and previously undistributed income of each tier must be exhausted in the tiered order before income in the next tier is deemed distributed. i. Character of Distributions. The income categories and classes are used to determine the character of a CRT distribution in the hands of a current Page 7

8 beneficiary, regardless of whether the trust is exempt from tax under IRC 664(c) in the year of distribution, and that the character determination is made as of the end of the trust s taxable year. Treas. Reg (d)91)(ii)(a). If there are different classes of income in the ordinary income category, the distribution from that category is treated as made from each class, in turn, until exhaustion of the class, beginning with the class subject to the highest federal income tax rate and ending with the class subject to the lowest rate. Treas. Regs (d)(1)(ii)(b). If there are difference classes of net gain in the capital gains category, the distributions from that category is treated as made first from the short-term capital gain class and then from each class of long-term capital gain, in turn, until exhaustion of the class, beginning with the class subject to the highest federal income tax rate and ending with the class subject to the lowest rate, with additional rules applicable to two or more classes within a category that are subject to the same current rate but one will be subject to a different rate in the future. Id. If there is more than one current beneficiary to whom an annuity or unitrust payment is made, each recipient is treated as receiving a pro rata share of each category of income and corpus. Treas. Regs (d)(3). ii. Distribution to Charitable Organization. If the trust makes a distribution to a charitable organization, other than a distribution of a portion of the annuity or unitrust payment, the distribution is deemed to have been made out of the four tiers, but the order of the tiers is in the reverse of that prescribed for distribution to noncharitable current beneficiaries. Treas. Reg (e)(1). When a charitable organization receives a part of the annuity or unitrust payment, the normal tier rules apply. Treas. Reg (d)(1)(ii)(a). 7. Qualified Contingencies. Under IRC 664(f), a CRT may provide that the annuity or unitrust payments are to end and the CRT is to terminate upon the occurrence of a specified contingency, thereby accelerating the charitable remainder interest. A contingency is qualified if the occurrence of the contingency causes the CRT to terminate on a date not later than it would otherwise terminate (i.e., upon the expiration of the stated term of years or upon the death(s) of the individual current beneficiary(ies)). The existence of the qualified contingency is not, however, taken into account for purposes of determining the value of the charitable contribution or the actuarial value of any interest in the trust. IRC 664(f)(2). 8. Must Meet Definition of CRT and Function as CRT from Date of Creation. To be a qualified CRT, the trust must satisfy the definition of a CRT and function exclusively as a CRT from the date of its creation. Treas. Regs (a)(4). a. Date of Creation. The trust will be deemed to be created at the earliest time that neither the grantor nor any other person is treated as the owner of the entire trust under the grantor trust rules set out in IRC and the regulations thereunder, but in no event prior to the time property is first transferred to the trust; accordingly, an inter vivos CRT is never deemed to be created before the date on which property is transferred to the trust, but could be created later if on the date of its actual creation, the grantor or any other person is treated as the owner of the trust under the grantor trust rules. In applying the grantor trust rules for this purpose, neither the grantor nor the grantor s spouse will be treated as the owner of the trust merely because the grantor or his spouse is named as the recipient. Treas. Reg (a)(4). Page 8

9 b. Grantor or Other Person Treated as Owner of Entire Trust. ii. Retained Powers to Revoke. If the grantor retains the power to revoke an otherwise qualifying CRT, then the trust is not deemed to be created until the power of revocation ceases to exist because the power to revoke the trust causes the grantor to be treated as the owner of the entire trust under IRC 676(a). Thereafter, the trust will qualify as a CRT, because it will at all times from and after the date of its creation function exclusively as a CRT. Treas. Regs (a)(6), Ex. (1). However, if the grantor creates a CRT and retains the power to revoke only one-half of an otherwise qualifying CRT, the grantor will be treated as the owner of only ½ of the trust, not the entire trust. In this case, the trust is deemed created, not on the date the power to revoke as to one-half lapses, but on the date of actual creation. Consequently, a charitable deduction is not allowable either at the creation of the trust or when the grantor s power to revoke terminates (at his death) because the trust did not satisfy the definition of a charitable remainder trust from the date of its creation. Treas. Regs (a)(6), Ex (2). ii. Income Applied in Discharge of Grantor s Legal Obligations. A grantor will be deemed to be the owner of the trust where it income is applied in discharge of the grantor s legal obligation. Therefore, if a grantor transfers mortgaged property to the trust and remains liable on the mortgage but the trust makes the mortgage payments, a disqualifying of the trust as a CRT may result. See IRC 677, Treas. Regs (a)-1(d), PLR This result can also apply where the assets transferred to the trust bear the expenses associated with its creation. TAM c. Special Rule Regarding Testamentary CRTs. Under the regulations, a CRT will never be deemed to have been created before it first receives property. Treas. Reg (a)(4). But the regulations also provide that a testamentary CRT is deemed created at the date of the decedent s death, even through the trust is not funded until the end of a reasonable period of administration or settlement of the decedent s estate. Treas. Reg (a)(5). However, the terms of the testamentary CRT must provide that the trust s obligation to pay the annuity or unitrust payments to the current beneficiary(ies) begins as of the date of the decedent s death, but that actual payment may be deferred until the end of the trust s taxable year in which it us fully funded. Id. As a practical matter, the trustee may make payments to the current beneficiary(ies) on an estimated basis even before the end of the trust s taxable year in which it is fully funded. If payments are deferred or if estimated payments are made prior to the full funding of the trust, a correcting adjustment in the payments must be made within a reasonable period of time after the close of the CRT s taxable year in which it is fully funded. In the case of an underpayment, the trust must pay the excess to the annuity or unitrust recipient, and the case of an overpayment, the recipient must pay the difference to the trust. Treas. Regs (a)(5(i). All payments are to include interest, and the applicable rate of interest is as follows: (i) the IRC 7520 rate for transfers made after 4/30/89; (ii) 10%, for CRTs under instruments executed on or after 8/9/84 and before 5/1/89 and not subsequently amended; (iii) 6% or 10% for instruments executed or amended after 10/24/83 and before 8/9/84; and (iv) 6% for instruments executed before 10/25/83 and not subsequently amended. Treas. Reg (a)(5)(iv). Page 9

10 B. Private Foundation Restrictions and Excise Taxes. Because CRTs are not exempt from tax under IRC 501(a), not all of their unexpired interests (that is, the interests of the current beneficiary(ies) are devoted to charitable purposes, and they have amounts in trust for which a deduction was allowed (or would have been allowable) under IRC 170, 2055, or 2522, they are split-interest trusts and are treated as if they were private foundations for purposes of certain private foundation provisions of the Code ( IRC 4947(a)(2)). Those private foundation provisions of the Code, however, do not apply with respect to any amounts payable under the terms of a CRT to current beneficiaries unless a deduction was allowed for such amounts for income, estate, or gift tax purposes. Therefore, the private foundation provisions of the Code, discussed below, that are enumerated in IRC 4947(a)(2), have no application to annuity or unitrust payments made to individual current beneficiaries. The private foundation provisions that are made applicable to CRTs by IRC 4947(a)(2) (other than with respect to annuity or unitrust payments made to individual current beneficiaries), include the following: 1. Self-Dealing. Neither the donor of property to a CRT nor any member of his or her family nor any related interests (called disqualified persons ) may buy, sell, lease, borrow, lend, or use property of the CRT, nor may a CRT buy, sell, lease, borrow, lend, or use property of the grantor, any member of his or her family or any related interest. IRC This is the most important private foundation provision applicable to CRTs. Violations of the self-dealing provisions of IRC 4941 result in a tax equal to 10% of the amount involved on the disqualified person involved in the act of self-dealing and in some cases, a tax equal to 5% of the amount involved on participating trustees of the CRT. If the act of self-dealing is not corrected in a timely manner, a second tier tax of 200% of the amount involved is imposed on the participating disqualified person and a second tier tax of 50% of the amount involved on trustees who refuse to correct the selfdealing act. The proscription against self-dealing must be kept in mind when planning any arrangement that would otherwise have trust property bought by the donor or any similar arrangement. Virtually all dealings between the CRT and the donor (or any family member of the donor or any related interest) are prohibited. 2. Taxable Expenditures. IRC 4945 imposes an excise tax on each taxable expenditure made by a private foundation. Taxable expenditures include amounts paid or incurred by a private foundation (1) to carry on propaganda or influence legislation; (2) to influence elections or to carry on voter registration drives; (3) as a grant to an individual for travel, study or other similar purposes (in the absence of IRS approval of the grant making procedures); (4) as a grant to other private foundations, unless the granting foundation monitors the use of the grant funds; or (5) grants for any noncharitable purpose (that is, a purpose other than one set out in IRC 170(c)(2)(B)). This excise tax has little practical implication for CRTs in most situations. 3. Excess Business Holdings and Investments Jeopardizing Charitable Purpose. IRC 4943 imposes an excise tax on the value of the excess business holdings of any private foundation; excess business holdings exist if the foundation, together with all disqualified persons, own in the aggregate more than 20% of the voting stock of an incorporated business or the corresponding interests in unincorporated Page 10

11 business enterprises. IRC 4944 imposes a tax on a private foundation (and in some cases the managers of the foundation) for investing any amount in such a manner as to jeopardize the carrying out of the foundation s exempt purposes. The excess business holdings provisions and the jeopardy investment provisions do not apply to CRTs, unless a current beneficiary is a charity described in IRC 170(c), 2055(a), or 2522(a) and a deduction was allowed for a gift of such income interest. IRC 4947(b)(3). C. Funding CRTs. Some difficult choices may need to be faced with respect to the type of property the donor should put into his or her CRT. The selection of which property to use to fund a CRT raises a number of considerations, with some types of properties raising special problems. 1. Safest Property. The safest asset for funding a CRT, in terms of avoiding adverse tax consequences to the donor, the CRT, and the CRT trustee is cash or passive investments. 2. Property with Special Planning Problems. Some of the types of property which raise special planning problems are as follows: a. Property That Produces UBTI. Since a CRTs unrelated business taxable income is subject to a 100% excise tax, property that produces unrelated business taxable income is not well suited for transferring to a CRT unless a quick sale is anticipated. b. Mortgaged Property. Funding a CRT with real property that is encumbered by a mortgage liability can created a number of problems: i. Constructive Sale. Any transfer of encumbered property creates a constructive sale of the property for tax purposes that can produce taxable gain to the transferor. See Treas. Reg (a)(3) ; Rev. Rul , C.B. 80. The Tax Court has held that the amount of a nonrecourse mortgage is included in the amount realized. Brown v. Commr, TC Memo See also Goodman v. United States, 85 AFTR2d , USTC 50,162 (SD Fla. 1999) (limited partner's contribution to charity of a limited partnership interest subject to nonrecourse liabilities constituted a bargain sale. ii. Debt-Financed Income. Indebtedness on property held in a CRT may result in debt-financed income under IRC 514 which, in turn, will case the CRT to be taxable on all of its income (and not just the portion that is debt financed. See IRC 664(c). iii. Self-Dealing. The constructive sale of encumbered property to the CRT may be an act of self-dealing prohibited under IRC iv. Disqualification of the Trust. The IRS s apparent position is that a CRT will be disqualified if it holds property encumbered by a mortgage, on the theory that the mortgage is a debt of the donor, and the use of trust income to discharge that debt renders the trust a grantor trust under IRC 677(a) and Treas. Regs (a)-1(d), thus disqualifying it under Treas. Regs (a). See PLR Page 11

12 v. Solutions to Potential Problems. There are a number of solutions to the problems that would be created by funding a CRT with mortgaged property. (A) Use Other Property. If at all possible, use other property; this is the easiest and most practical approach if problems for the donor, the CRT and the CRT trustee are to be eliminated or minimized. (B) Re-Allocate the Debt. If the creditor will permit, allocate the debt to one portion of the property and contribute the newly unencumbered portion of the property to the CRT. As a practical matter, lenders are seldom enthusiastic about surrendering a portion of the security for the debt. (C) Donor Makes Payments and Holds Trust Harmless. The donor could continue to remain liable on the debt and make payments on the debt pursuant to an agreement to hold the CRT harmless with respect to the debt. Though theoretically sound, there is no express authority to rely on this approach. (D) Fund the Trust with Option to Purchase. The CRT might be funded with not the encumbered real property itself, but with an option to acquire the property at a price less than its net value. This would be most useful in a situation where a sale of the property to an independent third party is contemplated. Although the IRS initially approved this structure in PLR , the IRS subsequently withdrew that PLR for reconsideration (PLR ) and later announced in another PLR that the transfer into a CRUT of an option to purchase encumbered property would disqualify the trust. PLR c. Interests in Businesses. Although no rule prohibits transfers of interests in closely held businesses, such as stock or partnership interests to CRTs, operating difficulties can arise, particularly under the private foundation restrictions that apply to CRTs. i. Excess Business Holdings. If the excess business holdings rule under section 4943 applies to the CRT (because it has a charity as a current beneficiary), then the transfer of such an interest to such a CRT may violate the excess business holdings rule. ii. Jeopardy Investments. If the jeopardy investments rule under section 4944 applies to the CRT (because it has a charity as a current beneficiary), then the holding of such an interest by such a CRT may be a jeopardy investment, subjecting the CRT to the excise tax on jeopardy investments. iii. Self-Dealing. If the business is to be continued after the transfer of an interest in the business to the CRT, with the donor and/or the donor s family members continuing as co-owners with the trust, chances of a violation of the self-dealing prohibition under IRC 4941 are high. Each decision about salary, limited distributions and other matters involving the donor or his or her family members will have to be reviewed in light of IRC 4941 as well as the regular income tax rules. If the business is to be sold, different selfdealing problems arise. Frequently, the only logical purchaser (or only acceptable purchaser) is a Page 12

13 person who is a disqualified person for purpose of the self-dealing rules. If the CRT s interest is redeemed, it will be likely that the redeeming enterprise will be a disqualified person and a selfdealing violation will occur, unless the redemption qualifies under IRC 4941(d)(2)(f), which requires that the trust receive no less than fair market value and that all of the securities of the same class as that held by the trust are subject to the same terms. II. Specific Considerations for Charitable Remainder Annuity Trusts. A. Annuity Payment. 1. Minimum/Maximum Annuity Payment. With a CRAT, the annuity amount payable to the current beneficiary(ies) is fixed at a sum certain or percentage that must be equal to at least 5% but nor more than 50% of the net fair market value of the assets contributed to the trust, valued as of the date the assets are transferred to the trust). IRC 664(d)(1)(A); Treas. Regs (a)(1). 2. Protects Charitable Remainder Beneficiaries from Inflation. Since the annuity is fixed throughout the term of the trust, inflation during the trust term of a CRUT benefits the charitable remainder beneficiaries. B. Valuation of Remainder/Charitable Deduction. The income, estate, and gift tax charitable deductions for the charitable remainder interest in a CRAT is the net fair market value of the property placed in the trust less the present value of the annuity payments. Treas. Reg (c). The rules relating to the deduction for transfers to a CRAT are set out in IRC 170 (income tax), IRC 2055 (estate tax), IRC 2106 (estate tax on estates of nonresident aliens), IRC 2522 (gift tax) and the regulations thereunder. Treas. Reg (d). Generally, the appropriate valuation date is the date on which the property is transferred to the trust by the donor, except that for estate tax deduction purposed, the valuation date is the date of the decedent s death unless alternate valuation is elected pursuant to IRC Treas. Reg (c). The present value of the annuity is computed under Treas. Reg T(d) for transfers for which the valuation date is on or after 5/1/2009, or under Treas. Regs A(a) for transfers for which the valuation date is before May 1, Treas. Reg (2)(d). C. No Additional Contributions. No additional contributions may be made to a CRAT and the governing instrument of a CRAT must so provide. Treas. Regs (b). For this purpose, all property passing by reason of the death of the grantor is considered a single contribution even if complete funding of the CRAT requires several transfers from the grantor s estate during its administration. Treas. Regs (b). D. No Amounts Payable to Noncharity Other than Annuity Payments. No amount other than the annuity payment can be paid from a CRAT to a person other than a charity. IRC 664(d)(1)(B); Treas. Regs (a)(4). Trustees may be paid compensation, but the compensation may not be payable out of the annuity payment and the CRAT will be disqualified if the governing instrument authorizes such payment. PLRs , Page 13

14 1. No Principal Invasion for Current Individual Beneficiaries. Accordingly, there can be no invasion of trust principal for the current individual beneficiaries except to the extent need to fund the annuity payment. 2. No Payments for Invasion for Payment of Taxes, Debts, and Expenses. A testamentary CRAT cannot bear the cost of any taxes payable as a result of the grantor s death, any expenses of administration of the deceased grantor s estate or any debts of the deceased grantor. Treas. Reg (a)(6), Exs. (3), (4), and (5). A CRAT created on or after 10/4/1982 must provide that the vesting of the interest or the secondary current beneficiary upon the death of the primary current beneficiary is contingent upon the secondary beneficiary s payment of any death taxes attributed to his or her annuity interest. Rev. Rul , C. B. 71. E. 5% Probability Test. The IRS has taken the position that a estate tax or gift tax deduction is not available if at the creation of the CRAT the possibility that the required annuity payments from the CRAT might consume the trust corpus is not so remote to be negligible, and that the test to determine whether that possibility is so remote as to be negligible is more than a 5% probability that a noncharitable current beneficiary will survive the exhaustion of corpus. Rev. Rul , C.B See also Estate of George H. Moore, T.C. Memo This 5% probability rule applies only to CRATs and not to CRUTs. Ltr. Ruls , F. Advantages and Disadvantages of the CRAT. 1. Deferred Giving for Donor Wanting Income Stream. The CRAT is beneficial for a grantor with appreciated property who may intend to make a significant charitable disposition on death but who wishes to use the income during lifetime and wants a steady income stream. 2. Assumed Rates of Return for Valuation Purposes Compared to Actual Rates of Return. When the assumed rates of return to be used for purposes of valuing the present value of the annuity payments exceed actual rates of return that can be realized on the CRAT s assets, the value of the CRAT s charitable remainder interest (and thus, the amount of the charitable deduction) tends to be over-valued. On the other hand, when the assumed rates of return to be used for purposes of valuing the present annuity payments is less than actual rates of return that can be realized on the CRAT s assets, the value of the CRAT s charitable remainder interest (and thus the amount of the charitable deduction) tends to be under-stated. 3. Fixed Annuity Stream for Other Persons. Where a grantor wants to provide a fixed stream of payments to persons other than him, and benefit charity, he can use a CRAT. The present value of the annuity payments to other persons is a gift for gift tax purposes, except that in cases where the grantor s spouse is the only current beneficiary (other than the grantor) of a CRAT, the value of the present value of annuity payments to the spouse qualifies for the gift tax marital deduction. IRC 2523(g). Page 14

15 4. Charitable Deduction Greater than for CRUT. A CRAT will generally produce a larger charitable deduction than will a comparable CRUT. 5. No Invasion of Corpus. Corpus of a CRAT cannot be invaded on a discretionary basis to meet unanticipated future needs of current beneficiaries. 6. No Additional Contributions. Since no additional contributions can be made to a CRAT, additional CRTs will need to be established if the grantor wants to incorporate more CRTs into his or her planning. 7. Recordkeeping/Administration. The recordkeeping and other aspects of administration are less onerous on the trustee of a CRAT than the trustee of a CRUT. III. Specific Considerations for Charitable Remainder Unitrusts. A. Unitrust Payment. 1. Minimum/Maximum. In a CRUT, the distribution to the current beneficiary(ies) is fixed at a stated percentage of the annual value of the trust assets. The fixed percentage must be at least 5% but not more than 50%. IRC 664(d)(2)(A). 2. Protects Current Beneficiaries from Inflation. The CRUT s variable unitrust payment tied to revalued asset values offers the current beneficiaries protection against the negative impact of inflation. However, if asset values go down for any year, so does the amount of the unitrust payment. 3. Variations on the Standard CRUT. The standard CRUT provides for unitrust payments based on a fixed percentage of the value of the CRUT assets, determined annually, throughout the term of the CRUT. In addition, there are three permissible variations of the CRUT, under which the unitrust payments are or may be other than the fixed percentage of asset values, determined annually, for the entire CRUT term. Neither of these three variations affect the method of valuation of the charitable interest in the CRUT. a. NICRUT or Net Income Only CRUT. The net income only CRUT (or NICRUT) is subject to all of the usual rules governing CRUTs, but with one difference: if it does not realize enough current income to make the required unitrust distribution, its distributions are reduced to the amount of the net income earned. IRC 664(d)(3)(A); Treas. Regs (a)(1)(i)(b)(1). In a NICRUT, the interests of the charitable remainder beneficiary(ies) are protected against erosion since the trustee is prohibited form invading corpus for the benefit of the current beneficiary(ies). A NICRUT is typically utilized in situations where the trust will received illiquid assets with a yield below the projected unitrust payment. Without the net income limitation on payments to the current beneficiary(ies), the trustee would be required, in any year when net income is less than the fixed percentage unitrust amount, to distribute principal to make up the difference. Page 15

16 b. NIMCRUT or Net Income with Makeup CRUT. A net income with makeup CRUT or NIMCRUT is a NICRUT with an additional feature: the terms of the trust provide that any amount by which the trust income falls short of the required unitrust amount is to be distributed in subsequent years to the extent the trust s income exceeds the required unitrust distribution in such later years. IRC 664(d)(3)(B); Treas. Regs (a)(1)(i)(b)(2). Capital gains can be allocated to income if permissible under local law and an adjustment is made in the in the annual revaluation of the trust for the amount of any deficiency in unitrust payments for prior years. PLR i. Use of NIMCRUT. A NIMCRUT might be utilized in situations where the donor wants to protect the charitable remaindermen from erosion in the trust assets but wants the current beneficiaries to recoup any missed payments that resulted because the net income in any year or years was less than the fixed percentage unitrust payment amount, if the trust generates in any year more net income than is needed to fund that year s fixed percentage unitrust payment to the current beneficiaries. c. Flip CRUT. A third CRUT variation is the Flip CRUT. A Flip CRUT starts out as a NICRUT but later flips from its net income limitation to become a standard CRUT paying a fixed percentage of corpus valued annually, regardless of actual trust income. Treas. Reg (a)(1)(i)(c), effective for CRTs created on or after 12/10/98. i. Flip Triggers. The flip must be triggered on a specific date or by a single event whose occurrence is not discretionary with, or within the control of, the trustees or any other persons. Treas. Reg (a)(1)(i)(c). Examples of such events (which must be specified in the trust instrument) include the sale of unmarketable assets (such as real property, closely held stock, and unregistered securities for which there is no available exemption permitting public sale (Treas. Reg (a)(7)(ii)), as well as marriage, divorce, death, or the birth of a child. Treas. Reg (a)(1)(i)(d). Examples of impermissible triggering events include the sale of marketable assets and a request from the current beneficiary that the trust convert to the fixed percentage payment. ii. Effective Date of Flip. The flip must occur as of the beginning of the taxable year immediately following the year in which the triggering event occurs. Treas. Reg (a)(1)(i)(c)(3). iii. FLIP NIMCRUT. The CRUT may begin as a NIMCRUT and later flip on permissible triggering event; however, any makeup amount is forfeited upon the flip. Treas. Reg (a)(1)(i)(c)(3). d. Allocation of Proceeds from Sale of Trust Assets. Proceeds from the sale or exchange of any assets contributed to the trust by the donor must be allocated to principal and not to trust income at least to the extent of the fair market value of those assets on the date of their contribution to the trust. Proceeds from the sale or exchange of any assets purchased by the trust must be allocated to principal and not to trust principal at least to the extent of the trust's purchase price of those assets. Except for the foregoing, proceeds from the sale or exchange of any assets contributed to the trust by the donor or purchased by the trust may Page 16

17 be allocated to income, pursuant to the terms of the governing instrument, if not prohibited by applicable local law. A discretionary power to make this allocation may be granted to the trustee under the terms of the governing instrument but only to the extent that the state statute permits the trustee to make adjustments between income and principal to treat beneficiaries impartially. Treas. Reg (a)(1)(b)(3). If any proceeds from the sale or exchange of trust assets are properly allocated to income, an adjustment must be made in the in the annual revaluation of the trust for the amount of any deficiency in unitrust payments for prior years. PLR B. Valuation of Charitable Interest. The present value of the remainder interest in a CRUT is determined by computing an adjusted payout rate and following the procedures outlined in Treas. Regs (e)(3) or (4), depending on whether the unitrust payment is to be made for the life of an individual or a term of years. 1. Determination of Adjusted Payout Rate. For transfers into CRUTs made after 4/30/1989, the adjusted payout rate is determined by multiplying the fixed unitrust percentage stated in the CRUT document (whether it is a standard CRUT, a NICRUT, a NIMCRUT, or a Flip CRUT) by a payout factor contained in Table F under Treas. Regs (e)(6). This adjusted the basis fixed percentage for the fact that the payout sequence of the unitrust payment (the frequency and timing of payments during each calendar year) affects the amount of trust corpus that will on termination of the CRUT, go the charitable remainder beneficiaries. The CRUT document should specifically state the date or dates on which the unitrust payment is to be made; if it does not so state, it is to be assumed that the distribution of the unitrust payment will be payable on the first day of the period for which the payment is made. Treas. Regs (4)(a)(3). For example, if the CRUT document states that the unitrust amount is to be paid in equal quarterly installments but does not state a specific payment date, it is to be assumed that the quarterly payments are to be made on the first day of the quarter, which assumption will reduce the amount of the deduction for the gift of the charitable remainder interest. 2. Valuation Factor. The adjusted payout rate is then matched to the CRUT s stated term of years listed in Table D under Treas. Reg (e)(6), in the case of a CRUT where the unitrust payment is to be made for a stated term of years, or to the appropriate nearest age of the measuring life in Table U(1) (cross reference to Treas. Regs T(e)(5)), where the unitrust payment is payable for the life of one individual. In many situations, the precise adjusted payout rate determined from Table F will not be listed in either Table D or Table U(1), and in such situations, it is necessary to interpolate the appropriate factor. Treas. Regs T(e)(5) (for valuation dates after 4/30/2009), or A(f0(5) (for valuation dates after 4/30/1999 and before 5/1/2009). Examples of the interpolation computation methods are in Treas. Regs T(e)(5). Once the appropriate valuation factor is obtained from either Table D or Table U(1), the present value of the charitable remainder interest is determined by multiplying the valuation factor by the net fair market value of the assets paced in the trust. 3. Other Situations. Some CRUTs will provide for unitrust payments for more than one measuring life for example, the unitrust payment is to be made to Individual A for his life and then to Individual B for her life, if she is living on the death of Individual B; or the unitrust payment is to be made to Individual A and Individual B, while the are both living, Page 17