Charitable Remainder Annuity Trusts: Important Development

A charitable remainder annuity trust (CRAT) must meet two tests:

Test 1: Actuarial Value. The charitable remainder must be at least 10 percent, computed using the tables prescribed for split-interest charitable gifts; and

Test 2: 5 Percent Probability of Exhaustion (POE). Even if there’s an actuarially determined minimum remainder interest value satisfying Test 1, charitable deductions (income, gift and estate) aren’t allowable unless the probability that the charitable transfer won’t become effective is so remote as to be negligible. If there’s more than a 5 percent probability that the non-charitable income beneficiary (or beneficiaries) will survive the exhaustion of the trust assets, that probability isn’t so remote as to be negligible.¹

With historically low Internal Revenue Code Section 7520 rates (1.4 percent this month), it’s possible to easily pass the 10 percent minimum remainder interest (Test 1), but flunk the 5 percent probability of exhaustion (Test 2).

IRS Creates Alternative for Test 2

For CRATS created on or after Aug. 8, 2016, the Internal Revenue Service came out with a new alternative to Test 2—the early termination qualified contingency provision. The IRS will treat the sample provision in Revenue Procedure 2016-42 (below) as a qualified contingency within the meaning of IRC Section 664(f). Inclusion of the IRS’ sample provision (below) in the CRAT won’t cause it to fail to qualify as a CRAT under IRC Section 664. Any CRAT containing the sample provision won’t be subject to the 5 percent POE test in Revenue Ruling 77-374.

Why the 5 percent POE Test Is Easily Flunked

According to the IRS:

Low interest rates in recent years have greatly limited use of a CRAT as an effective charitable-giving vehicle. For example, in May of 2016, the section 7520 rate was 1.8 percent. At this interest rate, the sole life beneficiary of a CRAT that provides for  the payment of the minimum allowable annuity (equal to 5 percent of the initial FMV of the trust assets) must be at least 72 years old at the creation of the trust for the trust to satisfy the probability of exhaustion test. The section 7520 rate has not exceeded the minimum 5 percent annuity payout rate since December of 2007, which has necessitated testing for the probability of exhaustion for every CRAT created since that time.

Section 664(f)(1) provides in general that, if a trust would, but for a qualified contingency, meet the requirements of section 664(d)(1)(A) (relating to CRATs) or section 664(d)(2)(A) (relating to charitable remainder unitrusts), the trust is treated as meeting these requirements. Section 664(f)(2) provides that, for purposes of determining the amount of any charitable contribution (or the actuarial value of any interest), a qualified contingency is not taken into account. Section 664(f)(3) defines a qualified contingency for purposes of section 664(f) as any provision of a trust which provides that, upon the happening of a contingency, the payments described in section 664(d)(1)(A) or (d)(2)(A) (as the case may be) will terminate not later than these payments otherwise would terminate under the trust. 

To get the protection of the early termination qualified contingency rules: The governing instrument must have the precise language (below) of the sample provision of Rev. Proc. 2016-42. [emphasis supplied] A CRAT that has a “substantive provision similar but not identical to that provided in the Rev. Proc. will not necessarily be disqualified, but neither will such a provision be assured of treatment as a qualified contingency under section 664(f).² 

Comment. By comparison, the "Simon Says" game is child’s play.

Two Ways to Now Pass POE

Way 1: The 5 percent POE test of Rev. Rul. 77-374.

Way 2: The early termination qualified contingency provision of Rev. Proc. 2016-42.                                                 

The IRS’ safe-harbor provision can cause the early termination of the CRAT, followed by an immediate distribution of the remaining trust assets to the charitable remainder beneficiary.

The IRS explains:

Specifically, this provision provides for early termination of the trust (and thus the end of the ability to make any more annuity payments) on the date immediately before the date on which any annuity payment would be made, if the payment of that annuity amount would result in the value of the trust corpus, when multiplied by a specified discount factor, being less than 10 percent of the value of the initial trust corpus.

The sample provision is designed to ensure that the benefit from the creation of the CRAT will be available only where there is a significant benefit to charity. See Staff of the Joint Comm. on Taxation, 105th Cong., General Explanation of Tax Legislation Enacted in the 105th Congress, JCS-23-97 at 289-290 (1997). This provision also is designed to ensure that the charitable remainder beneficiary will receive an amount that accords with the charitable deduction allowed to the donor on creation of the trust. See H.R. Rep. No. 91-413, pt. 1, at 59 (1969), 1969-3 C.B. 200, 238, and S. Rep. No. 91-552, 88 and 90 (1969), 1969-3 C.B. 423, 480-81. Finally, this provision is designed to expose the charitable remainderman to some, but not all, of the investment performance risk of the CRAT assets.³

Sample Provisions

Here’s the IRS’ sample provision for inter vivos CRATs:

The first day of the annuity period shall be the date the property is transferred to the trust and the last day of the annuity period shall be the date of the Recipient's death or, if earlier, the date of the contingent termination. The date of the contingent termination is the date immediately preceding the payment date of any annuity payment if, after making that payment, the value of the trust corpus, when multiplied by the specified discount factor, would be less than 10 percent of the value of the initial trust corpus. The specified discount factor is equal to [1 / (1 + i)^t], where t is the time from inception of the trust to the date of the annuity payment, expressed in years and fractions of a year, and i is the interest rate determined by the Internal Revenue Service for purposes of section 7520 of the Internal Revenue Code of 1986, as amended (section 7250 rate), that was used to determine the value of the charitable remainder at the inception of the trust. The section 7520 rate used to determine the value of the charitable remainder at the inception of the trust is the section 7520 rate in effect for [insert the month and year], which is [insert the applicable section 7520 rate].⁴

For a testamentary CRAT, the IRS says that the phrase “the property is transferred to the trust” (the first underlined phrase) in this sample language must be replaced with “of my death”:

If the inter vivos or testamentary CRAT is created using the sample form provided in Rev. Proc. 2003-53, 2003-2 C.B. 230, or Rev. Proc. 2003-57, 2003-2 C.B. 257, respectively, the insertion of this sample provision in place of the second sentence of paragraph 2 of that sample inter vivos form, or in place of the second sentence of paragraph 1 of the sample testamentary form, respectively, will satisfy the requirements of a qualified contingency as described in section 6.03 of each revenue procedure.

If the CRAT annuity is payable consecutively for two measuring lives. The phrase  “the Recipient’s death” (the second underlined phrase) in the sample provision must be replaced with “the death of the survivor of the Initial Recipient and the Successor Recipient(s).” See Rev. Proc. 2003-55, 2003-2 C.B. 242, and Rev. Proc. 2003-59, 2003-2 C.B. 268. If the CRAT annuity instead is payable concurrently and consecutively for two measuring lives, the second underlined phrase in the sample provision must be replaced with "the Survivor Recipient's death". See Rev. Proc. 2003-56, 2003-2 C.B. 249, and Rev. Proc. 2003-60, 2003-2 C.B. 274.⁵

Comment. These sample provisions scare the living daylights out of me. And as we shall see, even if you hit the sample language right on the nose, this is a treacherous way to qualify a CRAT.

IRS’ Example

Here’s an example the IRS gives in the revenue ruling:

On January 1, Year 1, Donor transfers property valued at $1,000,000 to Trust, an inter vivos trust providing for an annuity payment of $50,000 (5 percent of the value of the initial trust corpus) on December 31 of each year to S for S's life followed by the distribution of trust assets to Charity. Trust includes the precise language of the sample provision in section 5 of this revenue procedure providing for an early termination contingency and specifies the section 7520 rate in effect for January, Year 1, which is 3 percent. But for the early termination provision, Trust meets all of the requirements of section 664(d)(1). In accordance with this revenue procedure, the IRS will treat the early termination contingency as a qualified contingency under section 664(f). Therefore, the early termination provision does not cause Trust to fail to qualify as a CRAT under section 664. In addition, Trust qualifies as a CRAT regardless of whether it passes the probability of exhaustion test on January 1, Year 1.

Each year, prior to payment of the annuity to S, the trustee performs the calculations required to determine if Trust will terminate early in accordance with the terms of the qualified contingency. In each year from Year 1 through Year 17, the trustee determines that the value of the trust corpus, minus the $50,000 annual payment, and then multiplied by the specified discount factor, is greater than 10 percent of the initial trust corpus. The value of the trust corpus as of December 30 in Year 18 is $210,000. Only in Year 18 does the value of the trust corpus as of December 30, when reduced by the annuity payment and multiplied by the specified discount factor, fall below 10 percent of the value of the initial trust corpus. The calculations required to determine if Trust will terminate early in Year 18 are as follows:

1. $1,000,000 x 10 percent = $100,000

2. ($210,000 - 50,000) x [1 / (1 + .03)¹⁸]

          $160,000 x (1/1.03)¹⁸

          $160,000 x 0.970874¹⁸

          $160,000 x 0.587397 = $ 93,984.

Because the value of the trust corpus ($210,000), when reduced by the annuity payment ($50,000) and then multiplied by the specified discount factor (0.587397), is less than 10 percent of the value of the initial trust corpus ($100,000), Trust terminates on December 30, Year 18, and the principal and income remaining in Trust (including the annuity payment for Year 18 that otherwise would have been payable to S) then must be distributed to Charity.⁶

Potential Danger

Nationally recognized charitable and estate planning lawyer Lawrence Katzenstein of St. Louis alerts us to the potential danger of this early termination qualified contingency provision. According to Larry, here’s how the formula works: The trust ends not when the trust has declined to 10 percent of its original value, but when the remaining trust assets as discounted are less than 10 percent of the trust’s original value.

In the IRS example (above), the trust still has 21 percent of its original value before the next payment and 16 percent of its original value after the next payment. But because that remaining value is discounted, it falls to 9.3984 percent of the trust’s original value. So remember the downside of using the Rev. Proc. language: The beneficiary’s annuity may end unexpectedly because of a downturn in the market just when the beneficiary really needs the income.

Larry doubts the revenue procedure’s contingent termination technique will be used very often. Donors of relatively modest means often create CRATs to get the security of fixed income. But if the donor knows that the trust may end prematurely, even though it still has substantial assets remaining, that may dampen the donor’s enthusiasm for the technique. Remember that the test isn’t that the trust ends when it has declined to 10 percent of the original value. Rather, the test is that the trust must end when the amount remaining in the trust after the next payment as discounted from date of gift to test date has declined to more than 10 percent of the original value. In the example in the IRS' own revenue procedure, the trust must end even though it still holds $210,000 of the original $1 million that funded the trust. How many donors will want to take this risk?

Larry also notes that technique will require extra diligence on the part of the trustee, who will have to determine before each payment is made whether the trust can continue or must terminate.

Larry cautions that even if you use the qualified contingency method to satisfy the 5 percent exhaustion test, you still have to pass the 10 percent remainder test. Because the purpose of the revenue procedure—and the formula used—is to insure that the charity will receive a remainder equal actuarially to 10 percent of the original trust amount, why can’t the qualified contingency method also be used to qualify a trust that passes the 5 percent test but doesn’t satisfy the 10 percent remainder test? (That can easily happen if the IRC Section 7520 rate is higher than the annuity payout rate but the beneficiary is very young or there are multiple beneficiaries.) The reason is that the 10 percent remainder test is statutory and can’t be changed just by IRS action. It’s only because the 5 percent exhaustion test is regulatory that a revenue procedure can be used to modify it.

Larry makes the final point that the revenue procedure states incorrectly that: “If the Section 7520 rate at creation of the trust is equal to or greater than the percentage used to determine the annuity payment, then exhaustion will never occur under this test.” That will always be true for a trust paying annually at the end of each year. But a trust paying more frequently than annually, as is usually the case, can flunk the exhaustion test even if the Section 7520 rate at creation of the trust is equal to the percentage used to determine the annuity payment. That’s because more frequent payments increase the effective rate of the annuity. For example, the probability of exhaustion is 7.844 percent for a CRAT for a 60 year old measuring life paying a 10 percent annuity quarterly at the end of each quarter even though the applicable Section 7520 rate is also 10 percent.⁷

Is Alternative Helpful?

With Larry’s cautions in mind, is the early termination qualified contingency provision helpful for a donor who craves a CRAT but until now couldn’t have one because the CRAT would flunk the 5 percent probability of exhaustion test of Rev. Rul. 77-374?

The first question to ask: If there were no 5 percent probability of exhaustion test, would a CRAT be the most desirable life-income plan?

For an individual who wants fixed payments, arguably yes. But remember a CRAT can run dry. A charitable gift annuity (CGA) is often a better choice.          

And for younger beneficiaries, a charitable remainder unitrust (CRUT) provides a potential hedge against inflation (but no hedge against deflation). CRUTs offer flexibility—STANCRUTs, NIMCRUTs, NICRUTs and flip CRUTS.

Takeaways 

I’d tell a client who has their heart set on a CRAT not to create one if it flunks the 5 percent probability of exhaustion test of Rev. Rul. 77-374. The early termination qualified contingent alternative of Rev. Proc. 2016-42 is too harsh, as Larry points out. A CGA or a CRUT would be a better choice.

Some Tax Thoughts

Belt, suspenders, velcro and hands-holding-up-pants provision. The CRAT provides: This trust on its creation satisfies the 5 percent probability of exhaustion test of Rev. Rul. 77-374. But, if it doesn’t, then the language of Rev. Proc. 2016-42 (CRAT has that language) shall govern the termination date rather than the date of death.

Why would this super-duper-fail-safe provision even be considered?

Suppose a mistake is made in determining that the 5 percent probability of exhaustion was met? That’s no excuse at the IRS.

Another suppose. A donor’s CRAT is drafted and funded on or after the Aug. 8, 2016 effective date of the early termination qualified contingency rule of Rev. Proc. 2016-42. Turns out that it flunks the 5 percent probability of exhaustion test of Rev. Rul. 77-374 on its creation and doesn’t have the early termination qualified contingency language of Rev. Proc. 2016-42.

Is all lost? The lawyer who drafted the CRAT should immediately notify their malpractice insurance carrier, then take a trip to the courthouse to reform the CRAT based on scrivener’s error to insert early termination qualified contingency language. That could save the day—and the CRAT.

If all else fails. Although the court in Moor⁸ upheld the probability of exhaustion test, it held the CRAT to be qualified because its earnings were greater than the required annual payout. Not a persuasive decision, and it’s a memorandum decision at that. But remember: I said, “If all else fails.”

Final words. I salute the IRS and Treasury for its early termination qualified contingency alternative. It addresses the difficulty of a CRAT’s meeting the 5 percent probability of exhaustion test of Rev. Rul. 77-374.

But, I wouldn’t advise a client (for reasons stated in this article) to create a CRAT if qualification depended on reciting and following the early termination qualified contingency provision of Rev. Proc. 2016-42.

Endnotes

1. Revenue Ruling 77-374.
2. Ibid.
3. Ibid.
4. Ibid.
5. Ibid.
6. Ibid.
7. Emails and telephone conversation with Lawrence Katzenstein on Sept. 8, 9 and 12, 2016.
8. Moor, 43 TCM 1530 (1982).