Almost a year ago, a taxpayer asked the Internal Revenue Service to rule on three issues regarding a charitable lead annuity trust (CLAT) that he created. One of the taxpayer’s sons was the sole trustee of the CLAT, and the taxpayer and his spouse created a private foundation (PF) to be the income interest beneficiary of the CLAT. The taxpayer, his spouse and two of their three sons (including the one that was the sole trustee) were the PF’s directors.
The taxpayer asked the IRS to rule on 1) whether the funding of the CLAT was a completed gift for federal gift tax purposes; 2) whether the taxpayer was entitled to a gift tax deduction under Internal Revenue Code Section 2522, based on the present value of the CLAT’s annuity; and 3) whether, on the taxpayer’s death, the principal or any portion thereof would be included in his gross estate under IRC Sections 2033, 2035, 2036 or 2038. In Private Letter Ruling 201323007 (released June 7, 2013), the IRS stated that the funding of the CLAT was a completed gift; the taxpayer was entitled to a gift tax deduction; and no portion of the CLAT’s property would be included in the taxpayer’s gross estate. Here’s why.
The CLAT’s Terms
The CLAT provided that over the annuity period, it would pay a guaranteed amount to the PF and if, during that period, the PF would cease to exist, the trustee would distribute the annuity amount to one or more organizations having a similar purpose as the PF. The taxpayer could never exercise the power to distribute the annuity amount to an organization similar to the PF—only the sole trustee had this power.
The CLAT further provided that no part of the annuity could be prepaid or commuted by the trustee. The trustee was prohibited from engaging in self dealing; from retaining any excess business holdings; from making any investments that would subject the CLAT to tax; and from making any taxable expenditures. When the annuity period ended, the trustee, after making all required distributions under the CLAT, was to deliver and distribute the remaining CLAT property in equal shares to himself and his two brothers.
If the son, as sole trustee, failed or stopped serving as trustee, he had the power to appoint any individual (excluding his parents) or a corporate trustee to serve as sole or co-trustees. If he was unable to exercise this power, his brothers would acquire this power, as determined by the terms of the CLAT. As per the CLAT’s terms, the taxpayer and his spouse could never serve as trustee or hold any trustee powers.
PF Bylaw Amendments
At some point, the PF amended its bylaws to include that if any time the PF was a beneficiary of a charitable lead trust, charitable remainder trust or similar trust, and the trust was established by a director, officer or substantial contributor to the PF, that individual would be prohibited from any involvement in matters concerning funds received by the PF from such trust. Additionally, a director who establishes a charitable trust for the PF’s benefit wouldn’t be counted when establishing a quorum related to decisions involving funds received by the PF. Committees couldn’t include a director, member or substantial contributor to the PF.
A quorum (excluding the taxpayer) established a standing committee under the PF’s bylaws, with the sole authority to make investment and distribution decisions on behalf of the PF.
A Completed Gift and Corresponding Gift Tax Deduction
The IRS concluded that the taxpayer’s transfer to the CLAT was a completed gift for federal gift tax purposes and as such, he was entitled to a gift tax deduction based on the present value of the annuity payable to the PF.
Under Treasury Regulations Section 25.2511-2(b), a completed gift is any property of which a donor parts, so as to leave him with no power to change its disposition and control. A gift is incomplete under Treas. Regs. Section 25.2511-2(c) if a reserved power gives a donor the power to name new beneficiaries or change the beneficiaries’ interests.
IRC Section 2522(c)(B)(2) states that when an donor transfers an interest for the use of charitable purposes and that interest is retained by the donor, no deduction is allowed unless, in the case of any interest other than a remainder interest, the interest is in the form of a guaranteed annuity or a fixed percentage distributed yearly of the fair market value of the property. Under Treas. Regs. Section 25.2522(c)-(3)(c)(2)(vi)(a), a guaranteed annuity interest refers to an irrevocable right pursuant to an instrument of transfer; is an arrangement under which a determinable amount is paid periodically (but not less than annually) for a specified term; and is ascertainable.
Applying the above IRC sections and Treasury regulations, the IRS found that the taxpayer didn’t retain a power over the property transferred to the CLAT and didn’t retain any interest to alter or revoke the CLAT. Furthermore, he wasn’t allowed to serve as trustee; not permitted to vote on matters relating to disbursements made from the CLAT; and had no power over the CLAT account or committee. The annuity under the CLAT was thus a guaranteed annuity and as such, the transfer to the CLAT was a completed gift. Because the IRS found it was a completed gift, the taxpayer was entitled to a gift tax deduction under Section 2522, based on the present value of the guaranteed annuity payable to the PF.
No Inclusion in Gross Estate
IRC Section 2036(a) provides that the value of a decedent’s gross estate includes the value of all property in which the decedent has made a transfer, including by trust, under which he’s retained possession, right to income or the right to designate persons who shall possess or enjoy the property. In this case, the taxpayer created the CLAT that distributed a fixed amount annually to a PF for a term of years. At the end of the CLAT’s term, remaining CLAT property was to be distributed to trusts established for the taxpayer’s three sons. The taxpayer was never able to serve as trustee of the CLAT, never able to vote concerning annuity funds and thus retained no interest or reversion in the CLAT. As such, no portion of the CLAT would be included in the taxpayer’s gross estate.