The Internal Revenue Service's specimens for safe-harbor charitable remainder annuity trusts for inter vivos and testamentary trusts update, improve and greatly expand on those previously issued by the IRS. You'll find copious annotations on the underlying law and numerous alternative safe-harbor provisions. The IRS will recognize a CRAT as qualified if it is “substantially similar” to a specimen trust.

But don't just look at the specimens; also be careful to examine the footnotes (the annotations and alternative provisions) — they provide invaluable assistance in customizing a CRAT. Someone once said that a footnote is equivalent to going downstairs on one's wedding night to answer the doorbell. When it comes to the footnotes to the IRS specimens, you ignore the doorbell at your peril, because some of the alternative clauses should be in the vast majority of CRATs.

Helpful as the specimens, or sample forms, and their footnotes are, you still have your work cut out for you. You must first determine: the client's objectives; the type of property ownership (such as whether it is separate property or jointly held); who the donors are and whether they will be beneficiaries; whether the funding asset is marketable; the nature of the charitable remainder organization (for example, is it publicly supported or a private foundation?); that the payout is at least 5 percent and not greater than 50 percent; compliance with the 10 percent minimum-remainder-interest (MRI) requirement; whether the trust meets the 5 percent probability test of Rev. Rul. 77-374; and when to add or substitute an alternative provision. Of course, this is just a partial listing.

To get the whole ball of tax — the specimens, annotations and alternative provisions — see Rev. Proc. 2003-53 through Rev. Proc. 2003-60.

The IRS is now drafting specimen charitable remainder unitrusts and its annual work plan calls for publication before July 2004. But the best-laid plans of the IRS and men …

INTER VIVOS SPECIMENS

The Service's inter vivos specimen CRATs cover four situations. The Service doesn't tell you which one to use, so for cases in which it may not be obvious to all, I'll give you my views.

  • Annuity payments for one measuring life: Use this when the donor, or an individual designated by the donor, is to be the beneficiary.

  • Annuity payments for a term of years: The Internal Revenue Code authorizes a trust to make payments to an individual for a period of up to 20 years. The Code and regulations also authorize a trust to make payments to an individual for life or for a term of up to 20 years — whichever is longer, or shorter. The IRS doesn't supply a specimen trust (or an alternative provision) for drafting in that situation. But, hey, that's why the trust's drafter went to law school.

  • Annuity payments consecutively for two measuring lives: By this, the IRS means, for example, pay Alpha (the donor) for life and if she is survived by Bravo, pay him for life. A donor should use this form when she owns the funding assets as separate property and wishes to provide payments for herself and then for a survivor.

    Alert: The specimen does not provide for a donor to retain the right to revoke a survivor's payments, but an alternative provision does provide. Donors should use the alternative provisions here and retain the right — exercisable only by will — to revoke the survivor's payments to avoid making a gift to the survivor that could subject the donor to gift tax (or unnecessarily reduce any remaining $1 million gift tax exemption).

    A donor can also use the specimen when he doesn't wish to be a CRAT beneficiary but wants to provide payments to two other individuals, with one individual receiving the entire payment for life, after which it will go to a survivor beneficiary. In this situation, the right to revoke by will shouldn't be put in the agreement — otherwise the value of the trust assets will be includable in the donor's gross estate.

    Keeping the right to revoke when the donor is a beneficiary will result in inclusion of the trust assets in his gross estate, but those assets would have been included anyway because the donor kept the right to the life income. Of course, the donor's estate will get a 100 percent estate tax charitable deduction for the value of the charity's remainder interest at his death if the second beneficiary doesn't survive — resulting in a wash. The estate tax charitable deduction will be smaller if the second beneficiary does survive. An estate tax marital deduction is allowable if the survivor beneficiary is a spouse — unless the surviving spouse isn't a U.S. citizen, in which case the trust must be a qualified domestic trust to qualify for the estate tax marital deduction.

  • Annuity payments that are payable concurrently and consecutively for two measuring lives: This means, pay Alpha and Bravo jointly for life and then to the survivor of them for life. Use this trust for donors who are married and own the funding assets as joint property, tenants by the entirety, tenants in common or community property, and wish to provide payments for both of them and then for the survivor. The right to revoke each other's survivorship interest needn't be kept because the survivorship interest automatically qualifies for the gift tax marital deduction (assuming the spouses are U.S. citizens) and the estate tax marital deduction.

Nevertheless, I believe the revocation right generally should be kept. If for some reason the CRAT isn't qualified, the gift tax marital deduction won't be available. Keeping the right to revoke avoids a gift being made to the other spouse; thus, a gift tax marital deduction isn't needed. If the parties are divorced (the party is over) when the first spouse dies, the estate tax marital deduction won't be available. So keeping the right to revoke could be a good idea.

Heads up: The IRS states in the annotations that the donor must be an individual to qualify for the safe harbor. If there are two donors, they must be husband and wife. In Private Letter Ruling 9547004, the IRS ruled that a charitable remainder unitrust wasn't qualified because it had multiple grantors as beneficiaries — grandma, grandpa and their six grandchildren. Responding to numerous requests to withdraw this ruling and give the nod to multiple-grantor unitrusts, the letter ruling's author said that the IRS held to its position. The IRS staffer did say, however, that the letter ruling wouldn't apply if only the spouses were grantor-beneficiaries or if a multiple-grantor trust is a charitable remainder annuity trust (as opposed to a charitable remainder unitrust).

Now the IRS seems to impose the restriction on non-spouse-multiple-grantor CRATs by an annotation in a revenue procedure. Thus, a brother and sister, or domestic partners, who own property jointly can't create a CRT and qualify for safe-harbor protection.

Why did the IRS have a problem with multiple-grantor trusts? Apparently Private Letter Ruling 9547004 was the IRS's attempt to thwart the so-called near-zero-net-income-with-makeup charitable remainder unitrust.

Some donors apparently had created NIM-CRUTs to pass assets to family members at no or reduced gift tax. Yet, what the family member received down the line could have great value. A donor could, according to an IRS example, create a NIM-CRUT paying a unitrust amount to the donor for 15 years or his life, whichever is shorter, and then to the donor's daughter for her life. The donor's gift to his daughter was relatively small (discounted for the period she had to wait) compared to the amount the daughter actually would receive. Typically, said the IRS, she would receive something worth much more than the discounted value because the trustee could invest the NIM-CRUT assets in a way to produce little or no income while the donor was entitled to receive the income, creating substantial makeup amounts.

When the donor's interest ended, the trustee would switch to an income-producing investment. The trustee would then pay the daughter the makeup amount. That created an opportunity, said the IRS, to transfer property to a family member free of, or at greatly reduced, gift tax. (It's worth noting that this ploy couldn't have worked with a CRAT.)

IRS regulation Section 25.2702-1(c)(2), issued after the 1995 letter ruling, eliminates the near-zero-NIM-CRUT strategy by valuing the donor's retained interest at zero, making the value of the daughter's interest, in the example, equal to the full fair market value of the assets used to fund the trust.

A suggestion to the IRS: In light of this regulation, announce that multiple-grantor CRUTs and CRATs are allowable in all cases.

In addition to the inter vivos specimens, the IRS also provides specimen testamentary CRATs for four common situations: annuity payments for one measuring life, for a term of years, payable consecutively for two measuring lives, and concurrently and consecutively for two measuring lives.

ALTERNATIVE PROVISIONS

The IRS also gives alternatives to the specimens, so donors can customize their CRATs. One of the most significant alternatives provides for a donor to retain the right to revoke by will a beneficiary's survivorship interest. You'll want to look at all of the alternatives and annotations, but here are some other particularly important ones:

  • The annuity amount can be stated as a specific dollar figure instead of as a percentage (at least 5 percent and not more than 50 percent) of the initial net fair market value of the assets as finally determined for federal tax purposes.

    Generally, it isn't wise to use this alternative provision, unless the CRAT is funded with cash or an asset with a value that can be precisely determined on the date of the CRAT's creation.

    Setting the annuity payment as a specific dollar amount could result in inadvertently failing the 10 percent MRI requirement and the 5 percent probability test of Rev. Rul. 77-374. You can avoid this problem by providing that the annuity amount (the annual payment), “shall be a percentage of the initial net fair market value of the trust as finally determined for federal tax purposes.” If the annuity amount is stated at the outset as a sum certain, but the property turns out to be worth less than thought when the trust was funded, the IRS might disqualify the trust for not meeting the 10 percent MRI requirement and the 5 percent probability test of Rev. Rul. 77-374 or the 50 percent maximum-payout requirement.

    At the other end of the spectrum, it's dangerous to set the annuity amount as a sum certain rather than a “percentage of the initial net fair market value of the assets as finally determined for federal tax purposes.” The 5 percent minimum-payout requirement could be flunked if the property turns out to be worth more than thought at the trust's funding.

    An arcane — but possibly important — point about CRATs: Even if a grantor of an inter vivos CRAT underestimates in good faith the initial net fair market value of the property placed in trust as finally determined for federal tax purposes, and specifies a fixed dollar amount for the annuity that is less than 5 percent of the initial net fair market value, there is a way for the CRAT to still meet the 5 percent minimum payment requirement. The process involves the grantor or his representatives consenting, by agreement with the IRS district director, to accept an amount equal to 20 times the annuity as the fair market value of the property placed in trust for purposes of determining the appropriate charitable deduction. Reg. Section 1.664-2(a)(2)(iii).

    Caution: IRS's specimens don't recite IRC Section 170(b)(1)(A). That's one of the alternative provisions.

  • Proration of annuity amount for last year of trust: The specimens prorate the annuity amount payable to a beneficiary on a daily basis for the number of days that the beneficiary lived in the last taxable year. As an alternative, the payments can terminate with the payment preceding the beneficiary's death. This means that the charitable remainderman will receive more and there will be no payment to the beneficiary's estate.

    For a two-life trust, the IRS specimen provides that the next payment after the first beneficiary's death be prorated between the first beneficiary's estate and the survivor beneficiary. An alternative provision allows for the payments to the first beneficiary to terminate on his death and the survivor to receive the entire payment subsequent to the first beneficiary's death (with no pro rata payment to the first beneficiary's estate).

  • Prohibitions against self-dealing, taxable expenditures, jeopardy-investments and excess-business holdings: The specimens prohibit the trustee from engaging in any act of self-dealing or making any taxable expenditures. But if a CRAT provides for payments of part of an annuity amount to an IRC Section 170(c) organization, the trust also must prohibit investments that jeopardize the trust's exempt purpose and retaining any excess-business holdings.

  • Early distributions to charity: The trust instrument may provide that an amount other than the annuity shall be paid (or may be paid at the discretion of the trustee) to an IRC Section 170(c) charity. If that distribution is made in kind, the adjusted basis of the property distributed must be fairly representative of the adjusted basis of the property available for distribution on the date of distribution. See Reg. Section 1.664-2(a)(4).

    Note: The donor gets no charitable deduction for any amounts distributed to the charity.

  • Possible disqualification: Funding a CRAT “with certain types of assets may disqualify it,” says the IRS in an annotation, citing Section 1.664-1(a)(7) and Rev. Rul. 73-610, 1973-2 C.B. 213.

    Actually, it's not the funding that causes possible problems. Reg. Section 1.664-1(a)(7) provides that a trust funded with unmarketable assets isn't qualified unless the assets are valued by an “independent trustee” or a “qualified appraiser.” Rev. Rul. 73-610 (cited by IRS) dealt with a donor who funded a trust with collectibles (tangible personal property) and kept the right to enjoy them for life. That differs from a donor transferring a collectible to a CRAT but not keeping enjoyment of the asset. Although funding a trust with tangible personal property doesn't qualify the donor for an income tax charitable deduction if he or related family members are trust beneficiaries, the trust is nevertheless qualified.

  • Trustee provisions: Alternate or successor trustees may be designated in the trust instrument. It also may contain other administrative provisions relating to the trustee's duties and powers, as long as those provisions don't conflict with the Code and regulations governing charitable remainder trusts.

  • Tax payment clause: If all or part of the fair market value of the trust assets might be includable in the donor's gross estate for federal estate tax purposes, the trust must provide that any state and federal estate taxes be paid from sources other than the trust. Even if the tax payment clause will never become operative, the clause is necessary because it ensures that the trustee will never be required to pay state or federal estate taxes from the trust assets. See Section 664(d)(1)(B); Section 1.664-1(a)(6), Example 3; and Rev. Rul. 82-128, 1982-2 C.B. 71.

  • CRAT to continue in existence for benefit of charity: The governing instrument requirements of IRC Section 508(e) must be included in the trust instrument if, after the termination of the annuity period, two conditions are met: (1) the trust provides that it shall continue in existence for the benefit of the charitable remainderman and, as a result, the trust will become subject to the provisions of IRC Section 4947(a)(1); and (2) the trust will be treated as a private foundation within the meaning of IRC Section 509(a), as modified by IRC Section 4947(a)(1). The trust instrument may limit application of the provisions of Section 508(e) to after the termination of the annuity period when the trust continues in existence for the benefit of the charitable remainderman.

    Note: When the trust provides for the corpus to be retained in trust for the charitable remainderman, the higher deductibility limitations in IRC Section 170(b)(1)(A) for the income tax charitable deduction won't be available (even if the charitable remainderman is restricted to a public charity) because the contribution of the trust corpus is made “for the use of” rather than “to” the charitable remainderman. See Reg. Section 1.170A-8(b).

  • Sprinkling the annuity amount among members of a named class at the trustee's discretion: A CRAT isn't qualified if any person has the power to alter the amount paid to any named person other than an IRC Section 170(c) organization, “if the power would cause any person to be treated as the owner of the trust, or any portion thereof, if subpart E were applicable to the trust.” Section 1.664-2(a)(3)(ii). See Rev. Rul. 77-73, 1977-1 C.B. 175. A trustee's discretionary power, exercisable solely by that trustee, to allocate the annuity amount among the members of a class would cause the trustee to be treated as the owner of all or a portion of the trust under IRC Section 678(a) if the trustee: is a member of the class; may apply trust income or corpus to satisfy his own legal obligation; or actually exercises the power to satisfy his support obligation. Therefore, if any trustee is given the discretionary power (exercisable solely by that trustee) to allocate the annuity among members of a class, the trust instrument must bar any member of the recipient class from serving as trustee or applying any part of the annuity payment to satisfy the trustee's own legal obligation.

  • Multiple remaindermen: The remainder interest may pass to more than one charitable organization, as long as each organization is described in IRC Section 170(c), 2522(a) and, if needed, Section 2055(a). See Reg. Section 1.664-2(a)(6)(i). Note: Add IRC Section 170(b)(1)(A) if the donor wishes to benefit only public charities and attain the greater tax benefits for remainder gifts to those charities.

REQUIREMENTS FOR PROTECTION

Of course, simply following the specimens and alternative provisions doesn't guarantee the CRAT's qualification for safe-harbor treatment. The Service also specifies that CRATs satisfy the following additional conditions to qualify for that protection:

  • The Code requirements not relating to the provisions of the governing instrument must be met.

  • The trust must operate in a manner consistent with the terms of the trust instrument.

  • The trust must be a valid trust under applicable local law.

  • The trust instrument must be substantially similar to the IRS's sample in the applicable revenue procedure, or properly integrate one or more alternative provisions from the revenue procedure.

A trust instrument that contains substantive provisions in addition to those in the revenue procedure (other than properly integrated alternative provisions from the revenue procedure, or provisions necessary to establish a valid trust under applicable local law that are not inconsistent with the applicable federal tax requirements), or that omits any of the provisions of the revenue procedure (unless an alternative provision is properly integrated), “will not necessarily be disqualified, but neither will that trust be assured of qualification under the provisions of this revenue procedure.”

Parthian shot: It's not enough to have all the bells and whistles. Even if a trust is exactly the same as an IRS safe-harbor specimen, it must actually operate as a charitable remainder trust and do what the trust instrument specifies. Otherwise, a host of unfavorable consequences follow: income, gift and estate tax charitable deductions will be denied; all capital gains will be taxable; and the gift and estate tax marital deductions will be lost. Thus, bad tax things can happen to good people who make charitable gifts.

The U.S. Court of Appeals for the 11th Circuit (Atkinson, No. 01-16536, 10/16/02) held that a charitable remainder annuity trust's failure to comply with the required-annual-payment regulations resulted in complete loss of the estate tax charitable deduction — even though substantial sums would go to charity. The loss of the charitable deduction cost the estate $2,654,976.

In a footnote, the appellate court dealt with the issue of payment of estate taxes attributable to the caregiver's life interest: “Since we decide that the trust was not a CRAT because of its failure to pay [the beneficiary] a lifetime annuity, we do not reach the issue of whether the trust additionally failed due to its exposure to estate tax liability.”

The donor's estate has petitioned the U.S. Supreme Court to take the case on appeal. But it's a long way to certiorari.