In the recent Private Letter Ruling 202432004 (Aug. 8, 2024), the Internal Revenue Service concluded that the early termination of a charitable lead annuity trust (CLAT) through an accelerated distribution of the remaining annuity amounts to two private foundations (PFs) wouldn’t be: (1) considered an act of self-dealing under Internal Revenue Code Section 4941; (2) considered a taxable expenditure under IRC Section 4945; or (3) subject to tax under IRC Section 507.
CLAT Basics
A CLAT is a split-interest irrevocable trust designed to make fixed payments for a period of time to one or more designated public charities or PFs exempt from income tax under IRC Section 501(c)(3), with the potential to pass the remaining trust assets to noncharitable beneficiaries, such as family members, without gift or estate taxes. The charitable interest portion of the trust is wholly deductible for gift and estate tax purposes, and the noncharitable remainder interest is wholly taxable for gift or estate tax purposes. The value of the charitable interest is calculated as the present value of the stream of payments to the charity over the charitable term. The value of the taxable remainder interest is the difference between the trust’s initial value and the value of the charitable interest.
If the trust is a grantor trust, the grantor also receives an immediate charitable income tax deduction for the present value of the aggregate payments to be made to the tax-exempt entity, subject to the adjusted gross income limitations applicable to charitable donations. If it’s structured as a nongrantor trust, a separate taxpaying trust is created, allowing an unlimited charitable income tax deduction for the income paid to charity.
CLAT Treated as PF
In the facts of the ruling, a CLAT was created to provide a guaranteed annuity that would qualify for a gift tax charitable deduction under IRC Section 2522. As a split-interest trust, the CLAT was treated as a PF for certain purposes. The CLAT trust agreement required the trustees to pay a 20-year fixed annuity to each of two PFs treated as tax-exempt organizations described in Section 501(c)(3) and classified as PFs under Section 509(a). After the final annuity payments were made, the CLAT agreement provided that half of the trust estate should be paid out to each of two family trusts, provided certain conditions were met.
The PFs asked the CLAT trustees to distribute the remaining two annuity amounts before the end of the 20 years so they could devote the funds to their respective charitable missions. The CLAT represented that its trustees were willing to distribute the amounts if the CLAT obtained a favorable ruling from the IRS and if the trustees of the family trusts either executed a nonjudicial settlement agreement or consented to a court order approving the distribution, which the trustees of the family trusts agreed to do.
No Self Dealing
The IRS concluded that payment of the accelerated annuity payments from the CLAT to the PFs (without applying any present value discount) wouldn’t constitute an act of self-dealing under IRC Section 4941 because the PFs were excluded from the definition of “disqualified persons” as tax-exempt organizations described in Section 501(c)(3) and classified as PFs under Section 509(a). The self-dealing rules generally prohibit any direct or indirect financial transaction between a PF and virtually all persons closely related to the PF (commonly referred to as “disqualified persons”).
No Taxable Expenditure
The IRS also concluded that the accelerated annuity payments (again, without applying any present value discount) from the CLAT to the PFs wouldn’t be treated as a taxable expenditure subject to an excise tax under Section 4945(a). This was because the term “taxable expenditures” excludes amounts paid or incurred by a PF (for example, the CLAT) for a purpose specified in Section 170(c)(2)(B) (for example, religious, charitable, scientific, literary or educational purpose), and the payments to the PFs qualified for this exclusion.
No Termination Tax
Relying on Treasury Regulation Section 53.4947-1(e)(1), the IRS concluded that the CLAT wouldn’t be subject to the Section 507 “termination tax” imposed on any PF that notifies the IRS of its intention to terminate its status as a PF. This regulation provides, in part, that the provisions of Section 507 shall not apply to a split-interest trust by reason of any payment to a beneficiary that’s directed by the terms of the governing instrument of the trust and isn’t discretionary with the trustee. This exception applied to the CLAT because the CLAT, by its terms, was required to make annuity payments to the PFs, and the CLAT’s trustees didn’t have the discretion of whether to pay the annuity amounts.
Win-Win?
This PLR may provide the trustees of a CLAT with significant assets over the amount needed to satisfy the total charitable component with a level of assurance in making a lump-sum payment to the tax-exempt entity and terminating the trust before the expiration of the annuity payment term. The accelerated payment of the undiscounted annuity amounts may be a win-win for both the tax-exempt entity, which can apply the payment to accomplish its charitable purposes earlier than expected, and the trust beneficiaries, who gain quicker access to the remaining trust principal for their personal and financial use. Note that if the CLAT attempted to pay the present value of the charitable portion to the PFs, the proposed transaction would have violated the principles of Revenue Ruling 88-27, which concluded a CLAT agreement couldn’t permit commutation of the charitable portion based on present value calculations. Furthermore, consider whether a state’s attorney general needs to be consulted regarding the termination.
