CHARITABLE REMAINDER TRUSTS. The American College of Trust and Estate Counsel

Transcription

1 CHARITABLE REMAINDER TRUSTS... gathering windfalls and avoiding pitfalls and pratfalls by CONRAD TEITELL, LL.B., LL.M* The American College of Trust and Estate Counsel June 30, 2002 WARNING: MAY CAUSE DROWSINESS *A principal in the Connecticut- and Florida-based law firm of Cummings & Lockwood, resident in the firm s Stamford office. He is an adjunct visiting professor at the University of Miami School of Law and holds an LL.B. from Colum bia University Law School and an LL.M. from New York University Law School. Conrad Teitell 2002

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3 CHARITABLE REMAINDER TRUSTS... gathering windfalls and avoiding pitfalls and pratfalls TABLE OF CONTENTS I. CHARITABLE REMAINDER UNITRUSTS (CRUTS) AND ANNUITY TRUSTS (CRATS) A. High-speed overview... 1 B. The FLIP-CRUT... 3 C. Capital gain NIM-CRUTs post-transfer-to-the-trust capital gain allocation to income ok but not pre-transfer-to-the-trust gain... 9 D. Adding a flip provision to existing NIM-CRUTs and patching up existing defective FLIP-CRUTs E. Scrivener's error route to STAN-CRUT from NIM-CRUT or NI-CRUT. 15 F. Annual valuation of CRUT with unmarketable assets G. After year-end grace period for STAN-CRUT and CRAT payments H. Four-tier payment rule also applies to NIM-CRUTs and NI-CRUTs confirmation of 1972 regulation I. Valuing gift to family member who is a successor beneficiary of a NIM-CRUT or NI-CRUT J. NIM-CRUTS that invest in deferred annuities and controlled partnerships K. Five problem issues watch your step L. CRUTs and CRATs must meet 10% minimum remainder interest (10% MRI) and 50% maximum annual payout (50% MAP) requirements M. Unitrusts and annuity trusts are exempt from taxation. IRC 664(c) N. Governing instrument requirements O. Income tax aspects P. Caveat Q. Capital gain R. Major benefits of charitable remainder unitrusts and annuity trusts S. Gift tax rules including marital deduction rules T. Estate tax rules including marital deduction rules U. Q-TIP/CRUT COMBO a better plan V. Imperfectly operated charitable remainder annuity trust disqualified.. 60 W. Tax-exempt unitrusts and annuity trusts X. Gift of remaining life interest after gift of remainder interest, thereby accelerating charitable remainder Y. Collapsing a CRUT and dividing assets between beneficiary and charitable remainder organization Z. Collapsed NI-CRUT OK if income beneficiary healthy AA. Swap of CRUT life interest for gift annuity BB. CLAT trustee removed and surcharged failure to diversity. Implications for charitable remainder trusts too CC. H and W sever the knot and their CRUT CT

4 DD. Abusive CRT regulations (T.D. 8926, I.R.B. 492, issued 2/5/01) EE. Income redefined for CRTs, PIFs, other trusts proposed regs FF. The proposed regulations GG. Charitable remainder unitrusts HH. Pooled income funds II. What to do (or not do) now JJ. Reforming defective CRTs KK. Requirements for IRS to accept a faulty CRT s reformation IRC 2055(e)(3) deciphered LL. Reforming a defective CRT a primer MM. Tale of CRT that couldn t be reformed to satisfy IRS NN. Will contest settlement saves deduction OO. Prohibited contribution returned CRUT saved II. III. IV. POOLED INCOME FUNDS A. The basics B. Gift tax rules including marital deduction rules C. Estate tax rules including marital deduction rules D. Planning considerations E. Reforming defective pooled income funds to qualify for tax benefits. 107 F. Combining identical pooled income funds G. Pooled funds of merging charities H. The Philanthropy Protection Act of GIFT OF REMAINDER IN PERSONAL RESIDENCE OR FARM A. Basics B. Gift tax rules including marital deduction rules C. Estate tax rules including marital deduction rules D. Planning considerations CHARITABLE GIFT ANNUITIES A. Basics B. Gift tax charitable deduction C. Estate tax charitable deduction gift annuities created during donor's lifetime D. Gift annuities by will E. Planning considerations F. Philanthropy Protection Act of 1995 (P.L ) G. The deferred payment gift annuity V. USING TREASURY TABLES TO VALUE SPLIT-INTEREST GIFTS 4-CT

5 A. Background B. The tables' components interest and mortality C. The two-month lookback D. Making the election to use the two-month lookback E. Wrinkle for charitable remainder annuity trusts the "5% probability" test F. Pooled income funds G. Wrinkle for charitable gift annuities VI. SPECIMEN AGREEMENTS SPECIMEN CHARITABLE REMAINDER UNITRUST STAN-CRUT, ONE-LIFE NIM-CRUT, TWO-LIFE, DONOR'S SEPARATE PROPERTY FLIP-CRUT, TWO-LIFE, DONOR'S SEPARATE PROPERTY SPECIMEN CHARITABLE REMAINDER ANNUITY TRUST ONE LIFE, BANK AS TRUSTEE TWO LIVES, JOINT PROPERTY OR COMMUNITY PROPERTY SPECIMEN POOLED INCOME FUND GOVERNING INSTRUMENT, CHARITY IS TRUSTEE INCOME AGREEMENT ONE LIFE INCOME AGREEMENT TWO LIVES, JOINT AND SURVIVOR, JOINTLY OWNED PROPERTY OR COMMUNITY PROPERTY INCOME AGREEMENT TWO LIVES, SEPARATE PROPERTY SPECIMEN GIFT ANNUITY AGREEMENT ONE LIFE TWO LIVES, JOINT AND SURVIVOR, JOINT PROPERTY OR COMMUNITY PROPERTY TWO LIVES, SEPARATE PROPERTY SPECIMEN DEFERRED PAYMENT GIFT ANNUITY AGREEMENT ONE LIFE Conrad Teitell /15/02 5-CT

6 CHARITABLE REMAINDER TRUSTS... gathering windfalls and avoiding pitfalls and pratfalls by Conrad Teitell, LL.B., LL.M.* I. CHARITABLE REMAINDER UNITRUSTS (CRUTS) AND ANNUITY TRUSTS (CRATS). A. HIGH-SPEED OVERVIEW. STAN-CRUT STANDARD CHARITABLE REMAINDER UNITRUST. Pays the income beneficiary ("recipient" in the regulations) an amount determined by multiplying a fixed percentage of the net fair market value (FMV) of the trust assets, valued each year. On death of beneficiary or survivor beneficiary (or at end of trust term if trust measured by term of years not to exceed 20 years) charity gets the remainder. The fixed percentage can t be less than 5% nor more than 50% and the remainder interest must be at least 10% of the initial net fair market value of all property placed in the trust. Sometimes the regulations refer to this trust as a "fixed percentage trust." NIM-CRUT NET INCOME WITH MAKEUP CHARITABLE REMAINDER UNITRUST. Pays only the trust s income if the actual income is less than the stated percentage multiplied by the trust s FMV. Deficiencies in distributions (i.e., where the unitrust income is less than the stated percentage) are made up in later years if the trust income exceeds the stated percentage. NI-CRUT NET INCOME CHARITABLE REMAINDER UNITRUST. Pays the fixed percentage multiplied by the trust's FMV or the actual income, whichever is lower. Deficiencies are not made up. FLIP-CRUT. A trust set up as a NIM-CRUT or NI-CRUT. On a qualifying triggering event specified in the trust instrument (e.g., the sale of the unmarketable asset used to fund the trust) it switches to a STAN-CRUT. The regulations sometimes refer to this trust as a "combination of methods unitrust." That's a trust that on a triggering event converts from the "initial method" (NIM-CRUT or NI-CRUT) to a fixed percentage unitrust (STAN- CRUT). FLEX-CRUT. That's my name for a FLIP-CRUT drafted so as to give great flexibility in determining when if ever a NIM-CRUT or NI-CRUT will flip to a STAN-CRUT. *A principal in the Connecticut- and Florida-based law firm of Cummings & Lockwood, resident in the firm s Stamford office. He is an adjunct visiting professor at the University of Miami School of Law and holds an LL.B. from Columbia University Law School and an LL.M. from New York University Law School. Conrad Teitell 2002 CAPITAL GAIN NIM-CRUT. Post-transfer-to-the-trust capital gains 6-CT

7 (governing state law permitting) can be treated as income for purposes of paying income to the income beneficiary. This provides another way of making up NIM-CRUT deficits in payments from earlier years. And that income can often be favorably taxed as capital gain (under the four tiers) to the beneficiary. FULL-MONTY CRUT. That's my coinage for a FLIP-CRUT that goes all the way has FLEX-CRUT and CAPITAL GAIN CRUT provisions. ACCELERATED (CHUTZPAH) CHARITABLE REMAINDER UNITRUST. A STAN-CRUT for a very short term of years (e.g., two years) with a sky-high percentage payout (e.g., 80%). The aim is to transform highly appreciated assets into cash returned to the donor while avoiding almost all capital gains tax. IRS announced in 1994 that it would challenge those trusts. Most people thought that the 10% minimum remainder interest and 50% maximum unitrust amount requirements of the 1997 law killed those trusts. And that the regulations' grace period rules for making payments after year-end added the final (and unnecessary) nail to the coffin. ACCELERATED (COLOSSAL CHUTZPAH) CHARITABLE REMAINDER UNITRUST. A later scheme, bare outline. The settlor (I won t call him a donor) transfers appreciated assets to a STAN-CRUT having a term and percentage payout that satisfy the 50% maximum payout and the 10% minimum remainder interest requirements. The trust earns no income in Year 1 and sells no appreciated property. But a payment must be made in Year 1. So the trustee borrows from an outsider to make that payment. In Year 2 an amount is again borrowed to make that year s payment. And so on each year. The loans are repaid from proceeds from the sale of trust assets. Another version tosses in a "collar" (a combination put and call). The taxshelter promoters concluded that these new accelerated-cruts would transform highly appreciated assets into cash returned to the settlor while avoiding most capital gains tax (the same financial benefit promised for the original accelerated-crut). The promoters said that new accelerated-cruts wouldn t be stymied by the Code and regulations that wiped out the original version. While acknowledging that IRS could challenge these trusts under the self-dealing and acquisition indebtedness rules, the promoters said the battle could be won in court. See page 80 for regulations issued by IRS to deal with abusive CRTs. NEAR-ZERO NIM-CRUT. A NIM-CRUT that gave the donor an interest typically for a term of years (shorter than the donor's life expectancy) with a successor life interest for a family member and remainder to charity. The trust was structured so that the family member's successor interest had little or no actuarial value for gift tax purposes. This NIM-CRUT pays little or no income to the donor for the term of years, building up huge deficits. Once the 7-CT

8 family member's successor interest starts, the trust investments change and the deficits built up during the period of the donor's interest are paid to the successor family member trust beneficiary. So he or she gets a valuable actual interest (but not a valuable actuarial interest) at little or no gift tax cost. And the assets are not taxable in the donor's estate. Treasury regulations relegate this trust to history. CRAT CHARITABLE REMAINDER ANNUITY TRUST. Pays the income beneficiary ("recipient" in the regulations) a fixed dollar amount (at least annually) specified in the trust instrument. On the death of the beneficiary or survivor beneficiary (or at end of trust term if trust measured by a term of years not to exceed 20 years) charity gets the remainder. The fixed dollar amount must be at least 5% but not more than 50% of the initial net fair market value of the transferred assets and the remainder interest must be at least 10% of the initial net fair market value of all property placed in the trust. Caveat. CRAT must meet 5% probability test of Rev. Rul , CB 329. But see Moor, 43 TCM 1530 (1982). Note re examples in this outline. All of them are mine unless I say they come from the IRS. B. THE FLIP-CRUT. Who wants a FLIP-CRUT? Let's stipulate that the individual wants to make a charitable gift. Two types of individuals come to mind. First the donor who craves a STAN-CRUT. She likes the assurance of annual payments and the potential favorable tax treatment of payments under the four-tier taxation rules. But she has an unmarketable asset (paying little or no income) that can't be sold quickly. So she had to settle for a NIM-CRUT that didn't require annual income if the trust didn't earn it. With the FLIP-CRUT, this donor is no longer locked in with a NIM-CRUT for the entire trust term. The other candidate for a FLIP-CRUT is the individual who is in no hurry to get income. He likes the NIM-CRUT and considers it a way to provide income down the road (e.g., on retirement). He may be happy to stay with a NIM-CRUT forever and his trust can be so drafted. Or, down the road he may want the assurance of annual payments provided by the STAN-CRUT (and the potentially favorable tax treatment of his payments under the four tiers). So he may well choose a FLIP-CRUT. He should keep in mind that all "make up" payments will be forfeited when the trust flips. But a post-transferto-the-trust-capital-gain provision may save the day. And if the donor doesn't now know whether he wants to stay with a NIM-CRUT for the entire trust term or flip to a STAN-CRUT at a later date, he should consider the FLEX- CRUT (forgive this additional coinage; but see "FLEX-CRUT practice pointer" for the details). The allowable triggering event. A NIM-CRUT's or NI-CRUT's governing 8-CT

9 instrument may allow a one-time flip to a STAN-CRUT on any one of these triggering events: A sale of unmarketable assets held by the trust. Unmarketable assets are assets other than cash, cash equivalents or assets that can be readily sold or exchanged for cash or cash equivalents. For example, unmarketable assets include real property, closely held stock and unregistered securities for which there is no exemption allowing public sale. Reg (a)(7)(ii). A specific date; or A single event whose occurrence is not discretionary with, or within the control of, the trustee or any other persons (the notconsidered-discretionary test). A triggering event based on the sale of unmarketable assets as defined in Reg (a)(7)(ii) (see above) or the marriage, divorce, death or birth of a child with respect to any individual meets the not-considered-discretionary test. IRS's examples of permissible and impermissible triggering events (with my editing). In all cases the charitable remainder trust (CRT) is a NIM-CRUT or NI-CRUT with a flip provision in its governing instrument. Example 1. Donor funds CRT with his former personal residence. CRT is to flip to a STAN-CRUT as of the first day of the year after the year in which CRT sells the house. Verdict: permissible triggering event. Comment. It is crucial that Donor vacate the house before transferring it to the CRT. There once was an old lady who lived in her shoe, but she couldn't live in her unitrust not even for a nanosecond. Doing so would be prohibited self-dealing. Example 2. CRT is funded with cash and an unregistered security having no Securities and Exchange Commission exemption allowing public sale. CRT is to flip to a STAN-CRUT on the earlier of the stock's sale or when the restrictions on public sale lapse or are lifted. Verdict: permissible triggering event. Comment. Publicly traded stock subject to SEC rules is not always deemed marketable. How so? A fair market value deduction is allowable for gifts of qualifying publicly traded stock to private foundations but IRS privately ruled that a gift to a private foundation of publicly traded stock subject to SEC rule 144 volume and resale limitations does not qualify for fair market value deductibility. Letter Ruling But it may be marketable if the restrictions aren't on all of donor's holdings. Letter Ruling Caution: Make sure you're dealing with unmarketable securities if the trust has a flip provision. Still different rules apply to stock subject to SEC rule CT

10 Example 3. CRT is funded with cash and stock that may be publicly traded under SEC rules. CRT is to flip to a STAN-CRUT when the stock is sold. Verdict: impermissible triggering event because the stock's sale is within the trustee's discretion. Example 4. Sarah creates CRT for her ten-year old granddaughter, Gwendolyn. CRT is to flip to a STAN-CRUT as of the first day of the year after the year in which Gwendolyn turns 18. Verdict: permissible triggering event. Example 5. CRT is to flip to a STAN-CRUT as of the first day of the year after the year in which the donor is married. Verdict: permissible triggering event. Comment. "Sorry dear, we'll have to put off our wedding for awhile. My CPA says this isn't a good time for my NIM-CRUT to flip to a STAN-CRUT." Query. If not postponed, but the marriage is later annulled (void ab initio), must the STAN-CRUT revert to a NIM-CRUT? Example 6. If the donor divorces, CRT will flip to a STAN-CRUT as of the first day of the year after the year of the divorce. Verdict: permissible triggering event. Comment. New provision in antenuptial agreements? "If at any time during the marriage either party seeks a divorce, the party against whom the divorce proceeding is brought and who at the time is a beneficiary of a FLIP-CRUT that has not yet converted from a NIM-CRUT to a STAN-CRUT shall have the option of staying the proceeding for a period of up to two years." Example 7. CRT will flip to a STAN-CRUT as of the first day of the year after the year in which the beneficiary's first child is born. Verdict: permissible triggering event. Example 8. CRT will flip to a STAN-CRUT as of the first day of the year after the year in which the beneficiary's father dies. Verdict: permissible triggering event. Example 9. CRT will flip to a STAN-CRUT as of the first day of the year after the year in which the beneficiary's financial adviser determines that the trust should flip to a STAN-CRUT. Verdict: impermissible triggering event because the change is triggered by an event within a person's control. Example 10. CRT will flip to a STAN-CRUT as of the first day of the year after the year in which the beneficiary asks the trustee to flip the trust to a STAN-CRUT. Verdict: impermissible triggering event because the change is triggered by an event within a person's control. 10-CT

11 Comments on defining and then pulling (squeezing, according to my old drill instructor) the trigger: A sale of unmarketable assets held by the trust. A FLIP-CRUT fails if the triggering event is "discretionary with, or within the control of, the trustees or any other persons." It all depends on how you define "discretionary with... the trustees or any other persons." Happily, the regulations state that a sale of unmarketable assets is not discretionary, etc. That (together with the absence of the percentage tests of the proposed regulations) means that a NIM-CRUT, for example, could be funded with one share of closely held (unmarketable) stock and 100 shares of publicly traded (marketable) stock and qualify as a FLIP-CRUT. The trustee would, in effect, have great discretion. She could flip this baby at any time by selling the one share of closely held stock. (See my caution, however, under FLEX- CRUTs a few paragraphs from here.) This gives greater flexibility (if that's what is desired) than keying the flipping event to a specific date or the "marriage, divorce, death, or birth of a child with respect to any individual." A specific date. Not too much to say about this a date is a date is a date. Although if pressed which side of the International Date Line? A single event whose occurrence is not discretionary with, or within the control of, the trustee or any other persons (the notconsidered-discretionary test). The regulations say that marriage, divorce, death or birth of a child are not "discretionary with... the trustees or any other persons." And that's hunky-dory because it's pro-taxpayer. The specified permissible triggering events (marriage, divorce, etc.) in the regulation and its examples are not exclusive. So you can specify other triggering events but be sure to define the event with "great specificity." Retirement is one event that comes to mind. That would be a natural time to flip from a NIM-CRUT to a STAN-CRUT. But what is retirement? You know it when you see it is not enough. I know of an 80-year old lawyer who still works long hours all week but leaves at 3 o'clock on Saturday afternoons. He considers himself retired or at least semi-retired. If in doubt seek a letter ruling before getting trigger-happy and before funding the CRT. FLEX-CRUT practice pointer. If you want a CRT to flip on the sale of a parcel of real estate, on a specified date or event say so in the CRT. BUT if you want maximum flexibility, specify that the trust is to flip on the sale of an unimportant unmarketable asset that is one of the assets used to fund the trust. That way you have great flexibility in determining when if ever a NIM-CRUT will flip to a STAN-CRUT. 11-CT

12 Can a CRT qualify as a FLIP-CRUT if it is funded with just one share of closely held (unmarketable) stock and a bunch of marketable assets? Why not? The proposed regulations' 90% test was eliminated in the final regulations. If this technique were to be questioned by IRS, my answer would be: "Thy regulations and Example 2 thereunder comfort me." "Example 2. Y is funded with cash [a marketable asset] and an unregistered security for which there is no available exemption permitting public sale under the Securities and Exchange Commission rules. The governing instrument of Y provides that the change in method for computing the annual unitrust amount is triggered on the earlier of the date when the stock is sold or at the time the restrictions on its public sale lapse or are otherwise lifted. Y provides for a combination of methods that satisfies paragraph (a)(1)(i)(c) of this section." The final regulations and its examples nowhere specify that the unmarketable asset must meet more than a de minimis test. But who knows how IRS would view this? Be careful not to be hoist by your own petard avoiding a hex on the flex. Differentiate between a trustee's selling the unmarketable asset on its own and a beneficiary's directing the trustee to do so. The latter could under an IRS broad reading of Example 10 of the regulations (and that's often the way IRS reads, except when it narrowly reads) disqualify the trust. Example 10 states that it is an impermissible triggering event for the beneficiary to order the trustee to flip the trust. Is asking the trustee to sell the unmarketable asset, in effect, asking the trustee to flip the trust? It has been suggested that a beneficiary could whisper to the trustee in a motel room with the water running. But you don't want to do that. So how to avoid the problem? The FLIP-CRUT (and FLEX-CRUT version of a FLIP-CRUT) donor can be his or her own trustee and sell the unmarketable asset at any time (meeting the annual valuation requirement with an independent trustee or a qualified appraisal, of course). Time of flip don't shoot yourself in the foot: a FLIP-CRUT converts from a NIM-CRUT or NI-CRUT to a STAN-CRUT at the beginning of the taxable year that follows the taxable year of the triggering event. Reg (c)(2). For example, Donor's NIM-CRUT provides that it is to convert to a STAN-CRUT on his marriage, and he marries on December 1, His trust becomes a STAN-CRUT on January 1, Forfeiture of NIM-CRUT'S make-up amounts (deficits) side effect and warning. Once a NIM-CRUT converts to a STAN-CRUT (in the taxable year following the triggering event) all deficits in earlier payments are forfeited. Reg (c)(3). Example. Donor funded her 5% FLIP-CRUT on January 1, 2000 with Greenacre, an unmarketable asset having a $100,000 fair market value on the trust's creation. The triggering event is to be Greenacre's sale. The asset's basis is $30,000. CRTs take over the donor's basis and holding 12-CT

13 period (that's important to know but irrelevant for this example). The CRT is valued on the first day of each year with payments on the last day of each quarter. The NIM-CRUT's payment for 2000 is 5% x $100,000 or the actual income, whichever is lower. The trust had no 2000 income. So there is a $5,000 deficit to be made up in later years with any income that exceeds the unitrust amount (5% x the trust's FMV for the year). On January 1, 2001, the CRT is valued at $120,000 so the unitrust amount for that year is $6,000. Again there is no income for the year. On January 1, 2002, the CRT is valued at $140,000 so the unitrust amount for 2002 is $7,000. Again, no income for the year. To sum up the total deficits for the three years is $18,000 ($5,000 for 2000, $6,000 for 2001 and $7,000 for 2002). Greenacre is sold on January 8, 2002 for $140,000. The NIM-CRUT becomes a STAN- CRUT on January 1, 2003 (the taxable year following the taxable year of the triggering event). The makeup amount of $18,000 (deficit) is forfeited. But, hey, that's the price to be paid for the ability to convert a NIM-CRUT to a STAN-CRUT. Right? But wait a minute. Antidote to deficit forfeiture on converting from NIM-CRUT to STAN- CRUT. The donor's savvy adviser drafted the FLIP-CRUT with a provision that all capital gains attributable to post-transfer-to-the-trust appreciation is in all cases defined as income for purposes of making unitrust payments. (Note: State law must permit this.) This provides a method for making up deficiencies (also not a bad idea in many cases for a non-flip NIM-CRUT). Added benefit. The payments can be favorably taxed as capital gain (assuming no lingering tier-one ordinary income) to the beneficiary under the four-tier unitrust rules. See below for a discussion of CAPITAL GAIN NIM- CRUTs and for proposed regulations prohibiting giving trustee discretion to define capital gain as accounting income. Flashing back to the example. The deficit for the three years was $18,000. The post-transfer-to-the-trust gain on a sale was $40,000. If the trust had a capital-gain-as-income-to-the-beneficiary provision, there would be no forfeiture of the $18,000 deficit when the trust becomes a STAN-CRUT in To set the stage for the greatest amount of post-transferred-to-thetrust appreciation to be used to make up short falls before the trust flips, consider providing that the trust is to be valued on the last day of each taxable year. That assumes the assets will be worth more at the end of the year than at the beginning of the year. C. CAPITAL GAIN NIM-CRUTS POST-TRANSFER-TO-THE-TRUST CAPI- TAL GAIN ALLOCATION TO INCOME OK BUT NOT PRE-TRANSFER-TO- THE-TRUST GAIN. This type of trust can be highly beneficial for NIM-CRUTs and super-duper for FLIP-CRUTs. It may be helpful to slug through some rules before going to the practice pointers. 13-CT

14 Background CAPITAL GAIN NIM-CRUT. This trust if state law allows defines capital gain as income for purposes of making the unitrust payments. This provides a method for making up NIM-CRUT shortfalls or deficiencies and the payments can be favorably taxed as tier-two capital gain to the beneficiary under the four-tier unitrust taxation rules. An early favorable letter ruling appeared to authorize both pre- and post-contribution gain to be treated as income. (The trust takes over the donor's basis and holding period in the transferred asset.) Letter Ruling But a later ruling said that only post-contribution gain could be defined as income. Letter Ruling Also, IRS ruled that a trust with a capital-gain-as-income provision must reduce the trust assets' FMV for purposes of computing the annual unitrust amount by any deficits in payments to the extent the "liability" exceeds the trust's unrealized appreciation. However, the "amount treated as a liability need not exceed the trust's unrealized appreciation that would be trust income under the terms of the governing instrument and applicable local law if the trustee sold all the assets in the trust on the valuation date." Letter Rulings and More background self dealing. A CAPITAL GAIN NIM-CRUT used as an income deferral and retirement plan violates the self-dealing prohibitions, IRS told its agents in a training manual. Topic K of "1996 (for FY 1997) Exempt Organizations CPE Technical Instruction Program Textbook." Separately, IRS privately approved a CAPITAL GAIN NIM-CRUT allocating post-transferto-the-trust gain to "income" but then stated that it wasn't ruling on whether the trustee's control over the timing and amount of realized income from the sale of trust assets would constitute self-dealing. Letter Ruling Comment. The final regulations and IRS's explanation of the regulations don't deal with the self-dealing concerns raised by IRS's training manual and the letter rulings. The final regulations follow and expand upon the proposed regulations. Pre-transfer-to-the-trust capital gain cannot be allocated to income. Reg (a)(1)(i)(b)(4). If permitted under applicable local law, however, the governing instrument may allocate post-transfer-to-the-trust capital gains to income. Both the proposed and final regulations are silent on whether the make-up amount of a CAPITAL GAIN NIM-CRUT must be treated as a liability when valuing the trust's assets. (See the letter rulings discussed in the background paragraph, above.) However, IRS's explanation in the preamble to the final regulations states: "Taxpayers do not have to [emphasis supplied] treat the makeup amount as a liability when valuing the assets of a NIM-CRUT." Query. Does this mean that they can treat it as a liability? Suppose a trust created before the final regulations had a governing instrument provision that treated the makeup as a liability. Must the trust now be amended or reformed? If the "make-up-as liability provision" is not authorized, or is 14-CT

15 optional, should trustees go back in time and refigure the unitrust amounts without the liability provision? Make adjusting payments? Trusts and donors file amended returns? Help!!! Naturally, don't include a "make-up-as-liability provision" in any new NIM- CRUTs. FLIP-CRUT practice pointer. Strongly consider including in FLIP-CRUTs a post-transfer-to-the-trust-capital-gains-as-income provision. That could eliminate or reduce a forfeiture of unitrust amounts. FLIP-CRUTs become STAN-CRUTs the tax year following the triggering event. All shortfalls (deficits) in all prior years while the trust was a NIM-CRUT (and in the prior year if a NI-CRUT) are lost. But the deficit might be eliminated or reduced with a capital-gain-as-income provision. How so? Example. On January 1 of year 1 Donor funds her 5% FLIP-CRUT with an unmarketable asset that has a FMV of $100,000 and a cost basis of $60,000. The trust takes over the donor's cost basis (holding period too). But the pre-transfer-to-the-trust appreciation is irrelevant for purposes of this example. The trust's governing instrument provides that any post-transfer-tothe-trust capital gain on a sale may in the trustee's discretion be treated as income. The trust starts out as a NIM-CRUT and is to become a STAN- CRUT the year after the unmarketable asset is sold. The trust is to be valued on the last day of each year. The trust has no income in years 1, 2 or 3. December 31 value Unitrust amount year 1 $110,000 $ 5,500 year 2 120,000 6,000 year 3 130,000 6,500 Shortfall $18,000 On December 31 of year 3 the trust sells the unmarketable asset for $130,000. The trust becomes a STAN-CRUT in year 4 (the year following the triggering event). So say the regulations. Reg (c)(2). Any deficits in years 1, 2 or 3 are forfeited. But wait. The governing instrument authorizes the trustee to treat post-transfer-to-the-trust capital gain as income and he does so. The fair market value of the trust was $100,000 on funding and the trust appreciated to $130,000. The trust can pay the $18,000 shortfall from the capital gain (treated as income for purposes of making payments to the beneficiary) and there is no forfeiture. Added benefit. The payment can be favorably taxed as capital gain under tier two. Without the capital-gain-asincome governing instrument provision, the $18,000 would have been forfeited by the beneficiary as the price of flipping from a NIM-CRUT to a STAN-CRUT. Naturally, each case should be decided on its own circumstances and, of course, state law. Letter Ruling dealt with this situation. The trustee, in its fiduciary capacity, may reasonably allocate to the income of the trust [for purposes of making distributions to the income 15-CT

16 beneficiary] some or all of the post-contribution capital gain realized by the trust on the sale or other disposition of any stock, bond or other security that produced limited or no income during the period owned by the trust. IRS rules that the trust qualifies. IRS rules that this allocation is allowable under state law. But see contrary proposed regulations on page 84 of this outline. Practice pointer for NIM-CRUTS without flip provision. Also, consider a post-transfer-to-the-trust-capital-gain-as income provision. That's a way to make up deficits and have them favorably taxed as tier-two capital gain. Suppose an existing FLIP-CRUT or NIM-CRUT has no post-transfer-to-thetrust-capital-gain-as-income provision. Can you now put one in? IRS says you can if it's missing because of a scrivener's error. Let's go to the two 1998 letter rulings. Donor wanted to create two STAN-CRUTs. Before the trusts were created, his lawyer and accountant decided it would be better to create NIM-CRUTs and to allocate post-transfer-to-the-trust capital gain to income. The lawyer redrafting the trusts included a net-income-with-makeup provision but forgot to include the provision allocating post-transfer-to-the-trust capital gain to income. The accountant explained the net-income and allocation provisions to the donor when he signed the agreements and he agreed to them. The donor wanted to reform the trusts to include the missing provision. His state's law allocates capital gain to principal but a donor can change that and specify that capital gain should be treated as income. IRS ruled that reforming the trusts to allocate post-transfer-to-the-trust capital gain to income wouldn't adversely affect their qualification under IRC 664 and would govern how the unitrust amounts are computed, provided a state court determined the provision was missing because of scrivener's (read lawyer's) errors. Letter Rulings and Effective date. The rules prohibiting the allocation of pre-transfer-to-the-trust capital gain to trust income apply to sales or exchanges after April 18, Reg (a)(1)(i)(b)(5). In the preamble to the proposed regulations, IRS said that for sales or exchanges on or before that date, it "will continue to challenge any attempt to allocate pre-contribution gain to trust income as being fundamentally inconsistent with applicable local law and with the amount of the charitable deduction claimed." The allocation of pre-transferto-the-trust capital gain to income from sales or exchanges before April 19, 1997, should not, however, be challenged by IRS. I base that on the effective date language of the final regulations and the absence in the final regulations of IRS's pugnacious statement in the proposed regulations. If IRS doesn't read it that way, this issue will have to be duked out with IRS in court. D. ADDING A FLIP PROVISION TO EXISTING NIM-CRUTS AND PATCHING UP EXISTING DEFECTIVE FLIP-CRUTS. FLIP-CRUT effective dates and transitional rules. The FLIP-CRUT rules 16-CT

17 are effective for trusts created on or after December 10, Reg (f)(1). Defective FLIP-CRUTS created on or after December 10, When an attempted FLIP-CRUT doesn't comply with the FLIP-CRUT rules, it will be a qualified CRUT only if it is "amended or reformed" to use the initial method (NIM-CRUT or NI-CRUT) for computing the unitrust amount for the entire trust term. Reg (f)(2). So, for example, a NIM-CRUT is to become a STAN-CRUT on the sale of a specific marketable asset. That is a defective triggering event. So you are stuck with a NIM-CRUT. But you can't just ignore the defective flip language and go on as a NIM-CRUT. The offensive language must be removed either by amendment (if authorized by the governing instrument and/or state law) or by reformation. Otherwise, applicable income, gift and estate tax charitable deductions (and gift and estate tax marital deductions) will be disallowed. And the CRT will not be tax exempt. Other than that, not to worry. History lesson the expired June 30, 2000 deadline. A defective FLIP- CRUT created on or after December 10, 1998 could have been reformed to become a qualified FLIP-CRUT (not stuck with the original method) if the reformation proceedings were begun by June 30, (That was an extension of the original June 8, 1999 deadline). Defective FLIP-CRUT created before December 10, If that trust has a defective triggering event or other disqualifying flip provision it could have been reformed (the alternative of amendment was not stated in the regulations) to use the initial method (e.g., NIM-CRUT) for computing the unitrust amount for the entire trust term. Reg (f)(2). Again, it wasn t sufficient to ignore the defective flip language and continue as a NIM-CRUT. Amendment was given as an alternative to reformation for failed FLIP- CRUTs created on or after December 10, 1998 (discussed above) but not for those trusts created before December 10, Was this a drafting oversight by IRS or was it based on some unstated policy reason? More on this in just a minute. Existing qualified NIM-CRUTS and NI-CRUTS whether created before December 10, 1998 or on or after that date with no flip provisions whatsoever could become qualified FLIP-CRUTS if the trustee began legal proceedings to reform by June 30, Hooray for IRS and Treasury for being responsive to those who maintained that it would only be fair to allow donors whose trusts had no flip provisions to reform their trusts to contain those provisions (in light of the proposed regulations' that allowed individuals who already had FLIP-CRUTs before there was clear authority for them to reform their trusts to comply with the final regulations). The reformation just described will not cause the "trust to fail to function exclusively as a charitable remainder trust... or to engage in... self- 17-CT

18 dealing (under IRC 4941) if the trustee begins legal [reformation] proceedings... by June 8, 1999." Reg (f)(3). Reformation proceeding begun after June 30, 2000 to add a flip provision to a NIM-CRUT or NI-CRUT. Try that "unauthorized" maneuver and the trust will "fail to function exclusively" as a charitable remainder unitrust under Reg (a)(4). The consequences of that are not spelled out, but at a minimum, the CRT will not be tax-exempt, and income, gift and estate tax charitable deductions already claimed could be jeopardized and a later estate tax charitable deduction on a donor's death for a charitable remainder (after payments to a survivor beneficiary) will be denied. The gift and estate tax marital deductions (an indirect result) would be lost. And oh yes, everybody in sight could be deemed to "engage in an act of selfdealing under section 4941." IRS Notice extending to June 30, 2000 the June 8, 1999 deadline to begin a reformation proceeding to add a flip provision to a NIM-CRUT or NI- CRUT might in some cases have made the reformation procedure easier. Notice stated: "Many practitioners have also inquired whether the term <legal proceedings in (a)(1)(i)(f)(3) requires a judicial reformation if non-judicial reformations are permitted under state law. The Treasury Department and the Service will clarity that the term <legal proceedings includes a non-judicial reformation that is valid under state law, but that a non-judicial reformation must be completed by June 30, 2000." [Emphasis supplied] Taxpayers seeking a non-judicial reformation should have ascertained what their state law requires for such a reformation to be valid. For example, in some states, a non-judicial reformation requires the consent of all beneficiaries, including potential beneficiaries. In addition, in some states, the state's Attorney General has jurisdiction over charitable remainder trusts and must be notified of or consent to a reformation on behalf of the named or unnamed charitable beneficiaries. In some cases, the state's Attorney General may more closely oversee charitable remainder trusts in which the specific charitable organization is not named in the governing instrument or is subject to change by the grantor or another person. A long-shot way to reform a NIM-CRUT or NI-CRUT to add a flip provision now that the June 30, 2000 deadline has long expired. Seek relief under Reg to extend the time for meeting a regulatory (as opposed to a statutory) deadline. It s hard to get 9100 relief and it s not known whether IRS would grant it for a FLIP-CRUT reformation. But it could be worth a try. Does reg spell relief? Here are the requirements: Taxpayer must have acted reasonably and in good faith and the 18-CT

19 extension will not prejudice the government. Taxpayer has acted reasonably and in good faith if: (i) the request for relief was made before the failure is discovered by the IRS; (ii) failure to act was caused by events beyond the taxpayer s control; (iii) the taxpayer was unaware of the need to act; (iv) taxpayer reasonably relied on the written advice of the IRS; or (v) taxpayer reasonably relied on a qualified tax professional. Taxpayer has not acted in good faith if taxpayer: (i) seeks to alter a return position for which an accuracy-related penalty has been or could be imposed; (ii) was informed in all material respects of the required act and chose not to do anything; or (iii) uses hindsight in requesting relief. The government s interests are prejudiced if: (i) granting relief would result in a taxpayer having a lower tax liability; or (ii) the taxable year involved is closed by the statute of limitations. Submit detailed affidavits and other information from knowledgeable individuals including taxpayer, describing events leading to failure to timely act and discovery of such failure including: (i) extent of reliance on tax professional; (ii) whether affected tax returns were timely filed; (iii) when the affected tax returns should have been filed; or (iv) upon request, submit copies of tax return on which the action should have been taken. Request for relief is a request for a letter ruling and must comply with applicable procedures and pay applicable fee. Told you this wouldn t be easy. E. SCRIVENER'S ERROR ROUTE TO STAN-CRUT FROM NIM-CRUT OR NI- CRUT. A 1998 letter ruling tells about a donor who intended to create a STAN- CRUT. But his attorney mistakenly drafted a NIM-CRUT. The scrivener's error was discovered after the trust's first tax return was filed. The trustee consistently administered the trust as a STAN-CRUT and the donor considered adding other assets to the trust so that it could meet the payout requirement without having to sell some assets. The trustee got a court order reforming the trust ab initio (from the beginning) to a STAN-CRUT. None of the interested parties the life beneficiaries, the charitable remainder organization and the state attorney general objected to the reformation. The court's reformation order was conditioned on the trustee's obtaining a favorable IRS private letter ruling. 19-CT

20 IRS ruled that reforming the trust from a NIM-CRUT to a STAN-CRUT wouldn't adversely affect the trust's CRT qualification under IRC 664 and would not be an act of self-dealing under IRC 4941(d)(1)(E) although it generally would be. Letter Ruling IRS's rationale. The trust was consistently administered as a STAN-CRUT and the error was discovered and action taken to correct it soon after the trust's creation. The attorney who drafted the trust was undergoing cancer treatment at the time and admitted the mistake under oath. Further, the donor sued him for malpractice. There's no evidence that the donor or other income beneficiaries reduced their tax liability or used hindsight in reforming the trust to a STAN-CRUT. My word processor made me do it letter ruling. A later 1998 letter ruling tells about spouses who received a letter from a charity explaining the taxation of STAN-CRUTs and a copy of IRS's specimen STAN-CRUT agreement. They asked their lawyer to draft a STAN-CRUT but he mistakenly drafted a NIM-CRUT. Spouses' CPA told them of the mistake soon after they as trustees began making unitrust payments to themselves as beneficiaries. The lawyer admitted that he used the wrong word processing form. Further, the husband's notes taken at a meeting with the lawyer show that the couple wanted to create a STAN-CRUT and thought the lawyer was doing so. The couple said that they never even heard of a NIM- CRUT. IRS was asked the consequences of a judicial reformation of the trust to a STAN-CRUT. IRS ruled that the trust would continue to qualify under IRC 664, provided the state court determined that a scrivener's (read lawyer's) error was made when the trust was drafted. Further, any additional transfers to the modified trust would qualify for the gift tax charitable deduction under IRC 2522(a). IRS wasn't asked about the income tax charitable deduction. Letter Ruling More thoughts on scrivener's error path to STAN-CRUT. By meeting the June 30, 2000 deadline (and other requirements) a NIM-CRUT or NI-CRUT could have been reformed to become a STAN-CRUT after it flips. The lawyer need not have said that he has flipped and made a mistake. But after June 30, 2000, a flip provision can be added to a NIM-CRUT or NI-CRUT or the trust can go immediately to a STAN-CRUT only if the lawyer takes the fall under the scrivener's error route and only if IRS follows the policy of the two 1998 letter rulings just discussed. IRS conditioned its approval on a state court's finding that the trust should be reformed based on a scrivener's error. As always, letter rulings aren't precedents. F. ANNUAL VALUATION OF CRUT WITH UNMARKETABLE ASSETS. Background. A CRUT must value its assets annually. The legislative history way back in 1969 "contemplated" denying income (but not gift and estate) tax charitable deductions to donors (who were to be beneficiaries) 20-CT

21 who transferred unmarketable assets to CRUTs unless independent trustees valued the assets. But the Code and long-standing Treasury regulations imposed no independent-trustee requirement. Many cautious practitioners, however, provided for independent trustees to value hard-to-value assets (e.g., real estate and closely held stock). A 1994 letter ruling seemed to say that if you don't have an independent trustee for unmarketable assets, you don't have a qualified CRUT. Letter Ruling But letter rulings aren't precedents. Treasury regulations now spell out the rules. Valuation of unmarketable assets the regulations. If unmarketable assets are transferred to or held by" a CRUT to qualify for income, gift and estate tax charitable deductions and to be treated as functioning exclusively as a CRUT all required valuations must be performed exclusively by an independent trustee, or determined by a qualified appraisal from a qualified appraiser (defined in Reg A-13(c)(3), (5)). Note: The requirements for a qualified appraisal and qualified appraiser are the same as those for substantiating the income tax charitable deduction for gifts of hard-to-value property. Further note. The preamble to the regulations (but not the regulations) uses the word "current" qualified appraisal (as defined in Reg A-13(c)(3). So meet the "current" test of that regulation. It provides that if an appraisal is required, the gift must be made within 60 days after the date of the appraisal. The property can be appraised after the date of the gift (the appraisal to state the property's value on the date of the gift). How this translates to a unitrust's annual valuation is not abundantly clear to me. Suggestion: Until IRS issues further guidance have the appraisal made on the valuation date or soon thereafter. All appraisals should be for the value on the valuation date. Don't have an appraisal that precedes the valuation date. Unmarketable assets regulations' definition by what they ain't. Assets that are not cash, cash equivalents, or other assets that can be readily sold or exchanged for cash or cash equivalents. Reg (a)(7)(ii). Unmarketable assets regulations' examples. Real property, closely held stock and unregistered securities for which there is no available exemption permitting public sale. Reg (a)(7)(ii). Independent trustee regulations' definition by who he or she ain't. A person who is not the grantor of the trust, a noncharitable beneficiary, or a related or subordinate party to the grantor, the grantor's spouse, or a noncharitable beneficiary (within the meaning of IRC 672(c) and its regulations). Qualified appraisal requirements referred to in CRUT regulations. Those are the rules that apply to a donor who claims an income tax charitable deduction of over $5,000 for a gift of property other than publicly traded securities (over $10,000 for non-publicly traded stock). The donor must have 21-CT

22 the appraisal in hand by the due date (including extensions) of the income tax return on which the deduction is claimed. And, an appraisal summary Form 8283 (Noncash Charitable Contributions) must be annexed to the return. Reg 1.170A-13(c)(3). Qualified appraiser requirements. To be a qualified appraiser, an individual must: (1) hold himself or herself out to the public as an appraiser; and (2) state credentials showing that he or she is qualified to appraise the type of property being valued. A qualified appraiser may not be related to or regularly employed by the donor or the charitable donee and may not be a party to the transaction by which the donor acquired the property being appraised, unless the property being appraised is donated within two months of the date of acquisition and its appraised value does not exceed the purchase price. Reg A-13(c)(5). Effective date. The valuation-of-unmarketable-assets rules "are applicable for trusts created on or after December 10, A trust in existence as of December 10, 1998, whose governing instrument requires that an independent trustee value the trust's unmarketable assets may be amended or reformed to permit a valuation method that satisfies the requirements of [Reg (a)(7)] for taxable years beginning on or after December 10, 1998." Reg (f)(4). (Translation: starting with the 1999 taxable year.) My interpretation of effective date provision: CRUTS created on or after December 10, 1998 two allowable methods: (1) If unmarketable assets are transferred to or held by a CRUT, the annual valuation must be performed exclusively by an independent trustee. A nonindependent trustee may be a co-trustee as long as he or she doesn't value the trust assets. And the independent trustee's role may be (but need not be) limited to the annual valuation. (2) As an alternative, an independent trustee is not required if all valuations of unmarketable assets are determined by a current qualified appraisal from a qualified appraiser (defined in Reg A-13(c)(3), (5)). CRTS "in existence as of [I interpret that as meaning before] December 10, 1998." If the governing instrument requires that an independent trustee value unmarketable assets, the trust may be amended or reformed to permit valuations by a current qualified appraisal from a qualified appraiser. Department of nuances. Suppose a CRUT created before December 10, 1998 has no independent trustee and no provisions dealing with valuation of unmarketable assets. The effective date provision can in my opinion be read as not requiring an independent trustee or a current qualified appraisal by a qualified appraiser and that could apply to assets in the trust on December 10, 1998 and any unmarketable assets later transferred to or bought by the trust. IRS may not, of course, interpret it this way. So watch 22-CT