IRS EXTENDS ANNUITY TRUSTS A LIFELINE

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1 IRS EXTENDS ANNUITY TRUSTS A LIFELINE Inclusion of sample language avoids 5% probability test. Section 7520 rates have been below 5% since the beginning of 2008, currently hovering at 1.4%. That s bad news for donors wishing to fund charitable remainder annuity trusts. Not only are annuity trusts subject to the same 10% remainder requirement as charitable remainder unitrusts [Code 664(d)(1)(D), (d)(2)(d)], they are also subject to a 5% probability test [Rev. Ruls and ]. No deduction is allowed for a charitable remainder annuity trust if the probability exceeds 5% that a noncharitable beneficiary of the trust will survive to the exhaustion of the trust fund. An annuity trust for which a deduction is not available is not a qualified charitable remainder trust [Letter Ruling ]. The 5% probability test is not really an issue when 7520 rates exceed 5% and the trust provides for the minimum 5% payout, but the lower the rates, the more difficult it is for annuity trusts to satisfy the probability test. For example, a 5% one-life annuity trust, assuming quarterly payments and a 1.4% 7520 rate, does not qualify for a donor age 74, although the charitable deduction of more than 47% easily satisfies the 10% remainder requirement. For a two-life annuity trust, both income beneficiaries would have to be at least age 77 to pass the 5% test. Recently released Revenue Procedure offers a possible solution for younger donors seeking the fixed payments of an annuity trust. Annuity trusts created on or after August 8 that include the exact language of the sample provision will not be subject to the 5% probability test. The provision calls for the early termination of the annuity trust and an outright distribution of trust assets to the charitable remainderman prior to the date on which an annuity payment would be made, if that payment would result in the value of the trust corpus falling below 10% of the value of the initial trust corpus. The early termination is considered a qualified contingency under Code 664(f). Language is included for both inter vivos and testamentary annuity trusts. The Revenue Procedure includes an example in which the donor, on January 1, transfers $1 million to a 5% annuity trust, with $50,000 payments to be made each December 31 and using a 7520 rate of 3%. Each year, the trustee is required to determine whether the value of the trust corpus, minus the $50,000 payment multiplied by a specified discount factor, is greater than $100,000 (10% of the initial value of the trust). The computation qualifies in each of the first 17 years. The value of the trust corpus as of December 30 in year 18 is $210,000. The computation is as follows: 1. $1,000,000 x 10% = $100, ($210,000 - $50,000) x [1/(1 +.03)] 18 $160,000 x (1/1.03) 18 $160,000 x $160,000 x = $93, Copyright 2016 Published by R&R Newkirk Co

2 Because the value of the trust corpus minus the $50,000 payment, multiplied by the discount factor, is less than $100,000, the trust terminates on December 30 of year 18 and the principal and income including the annuity payment that would otherwise have been payable to the income beneficiary is distributed outright to charity. Should donors be concerned about their annuity trusts ending early? While that is a possibility, trustees are likely to be able to get returns higher than what is presumed under current 7520 rates. Therefore, it may not be necessary to dip into corpus to the point where the 10% remainder value is reached. COURT DENIES DISTRIBUTIONS OF PRINCIPAL Trust terms don t provide for invasion of corpus due to financial need. Lillian Loucks directed that a perpetual charitable trust be created with assets following the deaths of two income beneficiaries. The trust, initially funded with $700,000 in 1991, has been paying equal amounts of income annually to the Otterbein United Methodist Church and a home for the elderly. In early 2015, the church petitioned the Orphans Court to allow distributions of its share of the principal, saying that income generated by the trust was insufficient to allow the church to meet the needs of the indigent people it served. The church claimed that Loucks did not intend the church to fail for lack of funds, adding that without payments of trust principal, the church will become insolvent and the court will then need to apply the cy pres doctrine to determine where its share of the trust income will be distributed. The court denied the church s request, finding nothing in the trust that would permit invasion of principal. Only when trust language is ambiguous can the court look to other tenets of trust construction to determine intent. Because Loucks trust clearly articulated her intent, the court found no reason to look beyond the document itself. The Superior Court of Pennsylvania agreed with the Orphans Court, finding no dispositive terms that would allow distributions of principal. There is nothing to indicate that Loucks could not have anticipated that one or both organizations would need funds in excess of the income generated from corpus. If distributions of principal were permitted due to financial need, the church s portion of the trust would eventually terminate, which is not permitted under the trust s terms. The court lauded the church s work on behalf of the poor, but said its responsibility is to interpret the trust terms, adding that the state of the church s budgetary affairs is not a factor in interpreting the terms of this trust (In re Estate of Loucks, 2016 PA Super 206). CHARITY GIVEN GREATER INVESTMENT OPTIONS Restrictions resulted in minimal return, hampering decedent s intent. Following the death of the last income beneficiary, Rockefeller University received funds from a trust created by James Martin in Martin s will directed that the Copyright 2016 Published by R&R Newkirk Co

3 principal be held in perpetual trust for the purpose of combating arteriosclerosis. The University has been allocating income to arteriosclerosis research since receiving the funds in Under the terms of the will, Rockefeller is restricted from selling stock of 17 named corporations and prohibited from purchasing mortgages, corporate bonds, preferred stock or government bonds while the value of the U.S. dollar remains unindexed to the price of gold. The University is also precluded from purchasing stock in companies engaged in steel, copper and railroad equipment production. The value of trust assets was more than $12.9 million at the end of However, six of the 17 named corporations subject to the sale restriction had ceased to exist as independent entities and shares in one corporation had lost more than half their value since The restricted securities are generating a 2.2% annualized return, far lower than the return on the University s endowment. Rockefeller asked the court to lift the investment restrictions, saying they have become impracticable, wasteful and an impediment to the prudent investment of the bequest. The New York attorney general agreed, saying that the removal would increase the income available for the purpose Martin specified in his will. The Supreme Court of the State of New York noted that under the equitable doctrine of deviation, a court can modify or permit a trustee to deviate from will or trust provisions if, because of circumstances not anticipated by the donor, the deviation furthers the purposes of the trust. The court found that allowing the University greater investment discretion was appropriate because economic circumstances had changed since the restrictions were imposed (In re Rockefeller University, 2016 NY Slip Op (U)). FAMILY S ACTIONS, NOT BUSINESS CLIMATE, CAUSE DROP IN VALUE Stock exchanged for promissory notes at discounted amount. Victoria Dieringer owned 425 of the 525 voting shares and 7,736.5 of the 9,220.5 nonvoting shares of DPI, a closely held real property management corporation. Her sons owned the remaining shares. Dieringer s shares passed to a trust at her death. The trust included $600,000 in specific charitable bequests and directed that the remainder pass to her private foundation. Her children received no monetary bequests under the will or trust. Her interest in the DPI shares was appraised at more than $14 million at her death. Several months after Dieringer s death in 2009, her sons elected S corporation status for DPI and voted to redeem the foundation s shares in exchange for promissory notes, citing concerns about excess business holdings [Code 4943]. The sons, on behalf of DPI, executed a short-term promissory note for $2,250,000 and a long-term note for $3,776,558 (later amended to $2,968,462), based on a post-redemption appraisal that included discounts for lack of control, marketability and voting power. The sons cited a poor business climate for the drop in market value between Dieringer s death and the appraisal. On its tax return, the foundation reported receipt of a noncash contribution 14 Copyright 2016 Published by R&R Newkirk Co

4 of DPI stock valued at $1,858,961 and the two promissory notes, along with significant capital losses on the stock sales. Dieringer s estate reported a charitable deduction of $18.8 million, based on the date-of-death value of the DPI stock. The IRS reduced the estate s charitable deduction. Property in an estate is generally valued at its date-of-death value [Code 2032]. An election can be made to use the alternate valuation method if doing so will decrease the value of the gross estate [Reg (b)]. The estate argued that because the alternate valuation date was not elected, the charitable deduction was the date-of-death value of the stock, not the amount received by the foundation. The Tax Court agreed with the IRS that Dieringer s sons never intended to effect decedent s testamentary plan. The court said post-death events did not support the substantial decline in the value of DPI shares in just seven months. The sons thwarted Dieringer s plan by the redemption, and the estate therefore was not entitled to the full amount of the claimed charitable deduction (Estate of Dieringer v. Comm r., 146 TC 8). COURT REJECTS ATTEMPT TO SWAP BEQUESTS Spouse stuck with IRA and income in respect of a decedent. Vivian Sukenik received certain real property from an inter vivos trust at the 2013 death of her husband, Charles. The balance of the trust passed to the couple s private foundation. In 2009, Charles had executed an IRA beneficiary designation form naming Vivian as the death beneficiary. When Vivian learned that she was the beneficiary of Charles $3.2 million IRA, she asked the Surrogate s Court of New York to reform the trust to add a $3.2 million pecuniary bequest to her. She also wanted to reform the IRA beneficiary designation form to name the foundation. This reformation would allow Vivian to avoid the receipt of income in respect of a decedent, resulting in a more tax efficient distribution. Courts have the power to reform an instrument where needed to achieve a decedent s intent. They rarely use this power to correct a mistake, unless required to prevent the testator s intent from being subverted. Reformations generally are not done simply to maximize available tax exemptions or deductions. The change Vivian requested is not prompted by a drafting error or subsequent change in the law, said the court, noting that Charles himself thwarted the tax efficiency of his own estate plan by making Vivian the beneficiary of the IRA. Vivian s arguments rest on the assumption that those executing testamentary instruments intend to minimize taxes, said the court, but nothing points to Charles intent to reduce taxes. The court found no authority to reform a clear and unambiguous instrument in order to remedy the adverse tax consequences of poor estate planning. Doing so would open the flood gates to reformation proceedings aimed at curing any and all kinds of inefficient tax planning, said the court (In re Reformation Proceedings in the Estate of Sukenik, 2016 NY Slip Op 31217(U)). Copyright 2016 Published by R&R Newkirk Co

5 NO RELIANCE, NO PLEDGE Charity s claim against estate denied. Educational Institute Oholei Torah-Oholei Menacham filed a claim against the estate of Isaac Kramer, seeking $1.8 million. The Institute produced a pledge card and promissory note. The Surrogate s Court dismissed the petition. Under New York law, charitable pledges have been upheld on the theory that they are a unilateral offer of a donor to make a future gift which, when accepted by the charity incurring a liability, ripens into a binding, enforceable contract, noted the court. The Supreme Court of the State of New York agreed, saying the Institute failed to accept Kramer s pledge, since it did not incur any liability in reliance. The estate s motions were properly granted (In re Kramer, 2016 NY Slip Op 4221). TAX ON IRD OFFSET BY DEDUCTION Trust will receive cash from testator s IRAs. An individual named a trust as the sole designated beneficiary of his multiple IRAs. At the owner s death, the IRAs were to be distributed to a foundation. The trust will receive lump sum distributions of cash from the IRAs, which it will then distribute to the foundation in the same tax year. The IRAs constitute income in respect of a decedent in the estate [Code 691(c)(1)]. Although the value of the IRAs will constitute IRD to the trust, Code 642(c)(1) allows a deduction in computing taxable income for any amount, without limitation, which, pursuant to the terms of the trust, is paid for a charitable purpose. Provided the trust pays the lump sum distributions to the foundation in the year received, it is entitled to a deduction equal to the amount of IRD included in gross income as a result of the distributions from the IRAs, the IRS ruled (Ltr. Rul ). ORGANIZATION CHANGES USE OF CONTRIBUTED FUNDS Donors want funds returned if not used as promised. Carolyn Cohen and Randi Wax were asked to donate to a fund to either purchase or build a permanent home for the Kabbalah Centre International, Inc. in San Diego. As a result of the solicitation, Cohen gave more than $450,000 and Wax gave more than $300,000. In 2013, the Centre informed some donors to its building fund that it would not be buying or building a facility and asked that donors approve the use of funds for other purposes. Neither Cohen nor Wax were informed of the change in plans. When Cohen learned that no facility would be bought or built, she asked for her money back. The Centre refused. 16 Copyright 2016 Published by R&R Newkirk Co

6 Cohen and Wax eventually filed suits, alleging breach of contract and breach of the implied covenant of good faith and fair dealing. They also said that the Centre was guilty of fraud, unfair business practices and obtaining property under false pretenses, since the promise that the funds would be used for a building was false when made. The Centre filed anti-slapp motions in both cases. The Centre would have to show that its actions arose from an act in furtherance of its protected speech in connection with a public issue. The Centre claimed that, in soliciting funds, it was engaged in a furtherance of its exercise of protected speech. Cohen and Wax argued that their causes of action arose from the Centre s breach of contract and fraud, neither of which is protected speech. The trial courts in the cases denied the Centre s anti-slapp motions. The Court of Appeals of California rejected the Centre s argument that, because all of the claims arose out of the Centre s charitable solicitations, the wrongful conduct was protected activity. In general, charitable solicitations are within the protection of the First Amendment, and neither Cohen nor Wax seek to enjoin the Centre from soliciting funds, the court noted. The donors contend that the wrongful act was the failure to either use the funds to buy or build a facility or to return the contributions. Both argued that if the Centre makes a promise about the use of the solicited funds, it must use the funds in that manner or return them. The court agreed with the denial of the anti- SLAPP motions, saying that while charitable solicitation is protected by the First Amendment, alleged fraud is not (Cohen v. Kabbalah Centre International, Inc., B258226, B258231). CHARITY CAN SUE ATTORNEY FOR ERROR IN WILL Organization was intended beneficiary of instrument. Alice Dumville s estate was to pass to her mother, if alive at Alice s death. If her mother was not alive, the estate was to pass to the Richmond Society for the Prevention of Cruelty to Animals (RSPCA). Dumville s mother predeceased her, but the title company informed the drafting attorney that the will as written left the RSPCA only the tangible personal property worth about $72,000; the real property worth about $600,000 passed by intestacy. The attorney, as co-executor of the estate, sought to correct his scrivener s error, based on Dumville s intent. The court found the language unambiguous and declined to reform the will, resulting in the real property passing to Dumville s intestate heirs. The RSPCA sued the attorney, alleging breach of contract and professional negligence. The organization claimed that as a third-party beneficiary of the contract between Dumville and her attorney, the RSPCA had a cause of action. The attorney s testimony from the reformation action was admitted against him. The court awarded damages of more than $600,000 to the RSPCA. The Supreme Court of Appeals of Virginia noted that beneficiaries under testamentary instruments are an exception to the general rule that third-parties may Copyright 2016 Published by R&R Newkirk Co

7 not enforce contracts. An intended beneficiary is an integral part of the obligations assumed by the parties. The attorney knew Dumville sought to benefit the RSPCA and specifically agreed to draft the will to accomplish that goal. The RSPCA became the intended beneficiary of both Dumville s will and of her contract of employment with the attorney. The attorney argued that the statute of limitations for any breach expired three years after the will was executed in 2003, not three years from Dumville s 2008 death. The court disagreed, saying that prior to Dumville s death, she could have changed her will, so the RSPCA had a mere expectancy. Lacking a vested interest, the RSPCA had no standing until Dumville s death (Thorsen v. Richmond Society for the Prevention of Cruelty to Animals, Record No ). 18 Copyright 2016 Published by R&R Newkirk Co