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Q. What should lawyers who plan charitable gifts have in common with surgeons and airline pilots?
A. Lawyers should use checklists, not to remember to remove all the sponges or put the landing gear down, but to properly draft charitable remainder trust agreements.
A defective trust can thwart a client’s wishes and result in loss of income, gift and estate tax charitable deductions. Did I mention that unnecessary capital gains can be incurred? As you can see, it’s important to get it right for our clients and to remember that people served by our nation’s charities are the ultimate beneficiaries of charitable remainder trusts (CRTs).
First, the lawyer helps the client decide if a CRT is the best way to make his or her charitable gift. And if so, how to choose wisely among standard (fixed percentage), net-income-with-make-up, net-income-without-makeup and flip charitable remainder unitrusts. Or, is a charitable remainder annuity trust preferable?
Here is a high-speed overview of the various charitable remainder trusts, followed by a suggested drafting checklist.
STAN-CRUT — Standard (“Fixed Percentage”) Charitable Remainder Unitrust. Pays the “recipient" (beneficiary) an amount determined by multiplying a fixed percentage of the net fair market value (FMV) of the trust assets, revalued each year. On the death of the beneficiary or survivor beneficiary (or at end of the trust term if the trust is measured by term of years — not to exceed 20 years) the charity gets the remainder. The fixed percentage can’t be less than 5 percent nor more than 50 percent and the remainder interest must be at least 10 percent of the initial net fair market value of all property placed in the trust. These percentage requirements also apply to the following charitable remainder trusts.
NIM-CRUT — Net-Income-With-Makeup Charitable Remainder Unitrust. Pays only the trust’s income if the actual income is less than the stated percentage multiplied by the trust’s FMV. Deficiencies in distributions (i.e., where the unitrust income is less than the stated percentage) are made up in later years if the trust income exceeds the stated percentage.
NI-CRUT — Net-Income-Without-Makeup Charitable Remainder Unitrust. Pays the fixed percentage multiplied by the trust's FMV or the actual income, whichever is lower. Deficiencies are not made up.
FLIP-CRUT. A trust set up as a NIM-CRUT or NI-CRUT. On a qualifying triggering event specified in the trust instrument (e.g., the sale of an unmarketable asset used to fund the trust) it switches (flips) to a STAN-CRUT. The regulations sometimes refer to this trust as a "combination of methods unitrust."
FLEX-CRUT. That's my name for a FLIP-CRUT drafted so as to give flexibility in determining when — if ever — a NIM-CRUT or NI-CRUT will flip to a STAN-CRUT. If you want a NIM-CRUT or NI-CRUT to flip on the sale of a parcel of real estate or on a specified date or event, say so in the CRT. But if you want maximum flexibility, specify that the trust is to flip on the sale of an unimportant unmarketable asset that is one of the assets used to fund the trust. That way you have flexibility in determining when — if ever — a NIM-CRUT or NI-CRUT will flip to a STAN-CRUT.
CAPITAL GAIN NIM-CRUT. Post-transfer-to-the-trust capital gains (governing state law permitting) can be treated as income for purposes of paying income to the income beneficiary. This provides another way of making up NIM-CRUT deficits in payments from earlier years.
FULL-MONTY CRUT. That's my coinage for a FLIP-CRUT that goes all the way — has FLEX-CRUT and CAPITAL GAIN CRUT provisions.
CHARITABLE REMAINDER ANNUITY TRUST (CRAT). Pays the income beneficiary ("recipient") a fixed dollar amount (at least annually) specified in the trust instrument. On the death of the beneficiary or survivor beneficiary (or at end of trust term if trust measured by a term of years — not to exceed 20 years) the charity gets the remainder. The fixed dollar amount must be at least 5 percent but not more than 50 percent of the initial net fair market value of the transferred assets and the remainder interest must be at least 10 percent of the initial net fair market value of all property placed in the trust. Additional contributions after the initial contribution may not be made to a CRAT. One caveat, CRAT must meet “the 5 percent probability test” of Rev. Rul. 77-374, 1977-2 CB 329. But, see Moor, 43 TCM 1530 (1982) if you ever have to do battle with the Internal Revenue Service on this issue.
DRAFTING CHARITABLE REMAINDER TRUSTS — CHECKLIST 22
1. Understand the meaning of every provision.
2. Spousal right of election: IRS has withdrawn Rev. Proc. 2005-24. It provided that unless its requirements were met, inter vivos charitable remainder unitrusts and annuity trusts will be disqualified — retroactively to the date of creation — if a spousal right of election now exists under state law, exists in the future, exists if the grantor (donor) of a CRUT or CRAT moves, marries or remarries. IRS may issue a new revenue procedure on this topic. So keep an eye out for it. And if possible, as a precaution, get a waiver from a current spouse now.
3. Double check that the trust contains all the required governing instrument provisions.
4. A specimen — no matter how good — is lousy if it doesn’t cover or isn’t amended to cover the client’s situation.
5. Yesterday’s form — no matter how good — is terrible if it doesn’t take today’s changes in the law into account.
6. CRTs must, of course, comply with the federal tax laws. But state laws must also be taken into account.
7. The trust should reflect how the funding assets are owned—separate property, joint property, tenancy by the entirety, tenancy in common, community property. Ascertain the holding period and cost basis of each asset. That information is essential in determining the charitable deduction and how payments are taxable to the recipients (beneficiaries).
8. Confirm that no mortgages are on property used to fund a CRT. Funding a trust with mortgaged property will disqualify it.
9. Has the trust been drawn to avoid gift taxes (when possible) on an income beneficiary’s life interest?
10. Confirm that the spouses are U.S. citizens. If they aren’t, take the special rules that apply to alien spouses into account. (There’s a difference between an alien spouse and an alienated spouse. The latter may well be a U.S. citizen.)
11. IRS in 2003 issued specimen charitable remainder annuity trusts that are excellent.See Rev. Proc. 2003-53 through Rev. Proc. 2003-60 and in 2005 issued excellent specimen charitable remainder unitrusts. See Rev. Proc. 2005-52 through Rev. Proc. 2005-59. Of course, one size doesn’t fit all. IRS recognized that with ample annotations to many of the provisions and furnished alternate provisions. Use the IRS specimens as your guide. But make sure to read the annotations and in many cases you’ll want to mix and match and make your own modifications.
12. No matter how skillfully the trust is drawn, make sure that CRUTs and CRATs pass the 5 percent minimum payout requirement, the maximum 50 percent payout requirement, the 10 percent minimum remainder interest requirement and for CRATs, the 5 percent probability test of Rev. Rul. 77-374.
13. Make sure the trust has an appropriate trustee — e.g., an independent trustee for hard-to-value assets in a unitrust (or provide for a qualified appraiser) and for a sprinkling CRUT or CRAT.
14. Make sure the payments are made and are timely lest you run afoul of the rule that requires that a CRT not only meet the Code’s requirements, but also be administered according to its terms. In Atkinson, 309 F.3d 1290 (CA-11, 2002) the U.S. Court of Appeals for the Eleventh Circuit held that an inter vivos charitable remainder annuity trust’s failure to make payments resulted in complete loss of the estate tax charitable deduction (there were four survivor beneficiaries). And that was so even though substantial sums would go to charity. The loss of the charitable deduction cost the estate $2,654,976. U.S. Supreme Court denied cert., 540 U.S. 946 (2003).
15. The trust should meet state law investment requirements — for example, prudent investor rules. See: Americans for the Arts, The Poetry Foundation, and Lilly Endowment, Inc. v. Ruth Lilly Charitable Remainder Annuity Trust #1 National City Bank of Indiana, Trustee, and Ruth Lilly Charitable Remainder Annuity Trust #2, National City Bank of Indiana, Trustee, 855 N.E. 2d 592 (Ct. App. Ind. 2006). See also:Fifth Third Bank and Elizabeth Gamble Reagan v. Firstar Bank, N.A. Ohio App.1 Dist., 2006. See also: Estate of Rowe, N.Y. App. Div. (3rd Dept), 712 NYS2d 662 involving a charitable lead trust.
16. Check whether there is a tax strategy patent on a plan involving the contemplated CRT. Effective Sept. 16, 2011, tax strategy patents are no longer issued.
17. Don’t fund the trust with Sub S Corp stock. Doing so will kill the S election.
18. Check if there are any SEC restrictions on transferring securities to the CRT.
19. If life-insurance-wealth-replacement is part of the plan, make sure that the insurance is obtained before signing and funding the charitable remainder trust.
20. Is a right retained to substitute public charities for named private foundation remainder organizations? Doing so can avoid self-dealing concerns on terminating a CRT and dividing the assets between the income beneficiary and the charitable remainder organization. The client can also get a larger charitable deduction on a contribution of the remaining life interest to a public charity remainder organization.
21. Add additional items to this checklist to cover things that should have been covered by this checklist.
22. Finally, trust no one. If your mother tells you that she loves you — check it out.
© Conrad Teitell 2012. This is not intended as legal, tax, financial or other advice. So, check with your adviser on how the rules apply to you.