David T. Leibell and Daniel L. Daniels, principals in Cummings & Lockwood LLC in Stamford, Conn., report:

  • IRS issues series of rulings ultimately approving CRT termination in unusual circumstances.

    “Did you ever have to make up your mind?” Although Lovin' Spoonful sang those lyrics in 1966 they might just as well have been thinking about the Internal Revenue Service 40 years later, given a trio of contradictory rulings in which the Service granted approval, then withheld approval, then ultimately decided it would grant approval after all, to the termination of a charitable remainder trust (CRT) and the division of the trust's assets between the noncharitable income beneficiary and the charitable remainderman.

In Private Letter Ruling 200525014 (issued June 24, 2005), B and C established a net income with makeup charitable remainder unitrust (NIMCRUT) to pay B and C the lesser of the net income of the trust and 15 percent of the value of the trust assets each year for the lives of B and C. Upon the death of the survivor of B and C, the trust assets were directed to be distributed to a private foundation established by B and C. B and C asked the Service to approve an early termination of the NIMCRUT in which B and C on the one hand, and the private foundation on the other, would receive pro rata shares of the trust assets equal to the present actuarial value of each set's respective interest in the trust assets on the date of the termination. The termination was to be accomplished in a court proceeding with the approval of the state attorney general. B and C's doctor certified that neither B nor C had a lower than average life expectancy. On the basis of these facts, the Service ruled that the termination would not result in a prohibited act of self-dealing because the early termination would not result in the noncharitable beneficiaries receiving a greater portion of the trust assets than they otherwise would have been expected to receive had the trust continued for their lifetimes.

PLR 200525014 was revoked without explanation in PLR 200614032 (issued April 7, 2006). Two weeks later, in PLR 200616035 (issued April 21, 2006), the Service reconsidered the ruling request and, “based on… additional information” submitted by the taxpayer, approved it. The additional information was that B and C had exercised their power to change the charitable remainder beneficiary of the NIMCRUT from their private foundation to various public charities.

What was going on here?

The Service treats the early termination of a CRT as a sale of the income beneficiary's interest to the charitable remainder beneficiary for an amount equal to the actuarial value of that interest. Under the facts of PLR 200525014, the donors' private foundation was the charitable remainder beneficiary of the NIMCRUT and, according to the ruling, the donors were disqualified persons with respect to that foundation. Under Internal Revenue Code Section 4941, any sale or exchange of assets between a disqualified person and his private foundation is a prohibited act of self-dealing. Accordingly, the conclusion of PLR 200525014 — that no self-dealing occurred — was incorrect and the Service properly revoked the ruling. In PLR 200616035, however, the private foundation was removed as a remainder beneficiary and replaced with public charities. Therefore, the deemed sale of the donors' income interest was no longer subject to Section 4941.

Three planning notes: First, the drafter of the NIMCRUT at issue in PLR 200525014 did well by her client to include provisions for the charitable remainder beneficiary to be changed at any time. Without that provision, the favorable ruling ultimately obtained probably would not have been possible. Second, the Service made much of the fact that the income beneficiaries in this case did not have a less than average life expectancy. This is important to prevent any gaming of the system. In an early termination of a CRT, the income beneficiary receives an amount equal to the discounted present value of the remaining annuity or unitrust payments which would have been made had the income beneficiary lived for his or her actuarial life expectancy. If the income beneficiary is in poor health, an early termination results, in the Service's view, in the income beneficiary receiving a windfall and, accordingly, a prohibited act of self-dealing. Finally, planners advising their clients on the early termination of a CRT should be sure to inform the client that the transfer is treated as a sale of the income interest and that the income beneficiary is assumed to have a zero basis in the income interest under IRC Section 1001(e). Accordingly, the entire amount received by the income beneficiary will be a taxable gain.