On Dec. 12, 2014, the Internal Revenue Service issued Private Letter Ruling 201450003, in which it considered whether an estate is entitled to a charitable deduction under Internal Revenue Code Section 2055(a)1 if a portion of a defective charitable remainder trust (CRT) was reformed to satisfy the statutory requirements for a charitable remainder unitrust (CRUT) as described in IRC Section 664 and applicable regulations. Based on the facts, the IRS concluded that the proposed reformation would be a “qualified reformation” within the meaning of Section 2055(e)(3) provided that: (1) the reformation is effective under local law and (2) the CRUT, as reformed, meets the requirements of Section 664. Assuming that the reformation is a qualified reformation, the decedent’s estate will be entitled to a federal estate tax charitable deduction under Section 2055(a) equal to the present value of the charitable remainder interest and the charitable income interest of the CRUT.
Claiming Charitable Deduction
By way of background, a decedent’s estate is entitled to claim a charitable deduction pursuant to Section 2055(a) when the decedent transfers property to a CRT, as long as the remainder is in the form of a CRUT, an annuity trust or a pooled income fund.2 This requirement was imposed in 1969 to ensure that a charity, as the remainder beneficiary of a particular trust, wouldn’t receive property worth less than the amount of the charitable deduction claimed by an estate.3
In many instances, decedents dying after 1969 failed to revise their testamentary documents to comply with the new statutory requirements for deductibility. This failure disqualified such a decedent’s estate from claiming a charitable deduction, which had the potential effect of increasing transfer taxes imposed on the decedent’s estate and diminishing the amounts passing to charity.
In 1974, Congress enacted Section 2055(e)(3), which provided a mechanism whereby a fiduciary could make a qualified reformation, including a post-mortem reformation, of an otherwise defective CRT.4 If a qualified reformation of a defective CRT occurs, an estate is entitled to a charitable deduction under Section 2055(a).
Thus, Section 2055(e)(3) benefits charities by “alleviat[ing] the difficulties caused by the complex requirements of the Tax Reform Act of 1969 relating to split-interest bequests.”5 Since 1974, courts have liberally construed Section 2055(e)(3) to effect Congress’ purpose.6 In PLR 201450003, the IRS similarly construed Section 2055(e)(3) to permit the reformation of a portion of the defective CRT into a valid CRUT.
CRT Established
On Date 1, the decedent created a revocable trust. Pursuant to Article Third of the revocable trust, on the decedent’s death, the trustees were to establish the CRT. The CRT was to pay income equally to the decedent’s mother and another beneficiary, and, on the death of the survivor of them, the CRT was to terminate, and the balance of the principal of the CRT was to be distributed to charity. Pursuant to Article Sixth of the revocable trust, the executor of the decedent’s estate was entitled to request funds from the revocable trust (which, presumably, includes funds otherwise earmarked for the CRT) to pay: (1) transfer taxes imposed as a result of the decedent’s death, (2) the decedent’s debts and the expenses of the estate, and (3) any bequest under the decedent’s will.
On Date 2, the decedent died, having been predeceased by his mother. In his will, the decedent devised the remainder of his estate to the CRT.
On Date 3, the executor of the decedent’s estate and the trustees of the CRT (the fiduciaries) filed a petition in state court to reform the CRT pursuant to Section 2055(e)(3). The fiduciaries filed the petition within 90 days after the last date (including extension) for filing the decedent’s estate tax return.
The fiduciaries propose to reform the CRT to create both the CRUT and an administrative trust (the A-Trust), effective as of the decedent’s death.
On reformation, the principal of the CRT will be divided as follows: (1) $Y will be transferred to the CRUT, and (2) the balance will be transferred to the A-Trust. Once the administration of the estate is completed, the then principal of the A-Trust will be distributed to the CRUT.
The unitrust term for the CRUT will begin on the date of the decedent’s death and end on the date of the beneficiary’s death. During the term, the trustee is to distribute X percent of the net fair market value of the CRUT (determined as of the first day of each taxable year) in quarterly payments (the unitrust amount”). The unitrust amount is divided between the beneficiary and the charity, A percent to the beneficiary and B percent to the charity.
On the termination of the term, the principal of the CRUT and any accrued but undistributed income of the trust passes outright to charity.
Qualified Reformation Requirements
Unless the reformation of a portion of the CRT into the CRUT constitutes a qualified reformation within the meaning of Section 2055(e)(3), the estate wouldn’t be entitled to claim a charitable deduction under Section 2055(a) for any portion of the CRT. For the reformation to constitute a qualified reformation, the following must be true: (1) the CRT is a reformable interest within the meaning of Section 2055(e)(3)(C); (2) the CRUT is a qualified interest within the meaning of Section 2055(e)(3)(D); (3) the actuarial value of the remainder interest of the CRUT (as of the decedent’s date of death) doesn’t deviate by more than 5 percent from the actuarial value of the remainder interest of the CRT (as of the decedent’s date of death); (4) the noncharitable interests in the CRT and CRUT both terminate at the same time; and (5) the reformation of the CRT into the CRUT was retroactive to the date of the decedent’s death.
Reformable Interest
The IRS addressed whether the CRT is a reformable interest within the meaning of Section 2055(e)(3). Because the fiduciaries commenced a judicial proceeding to reform the CRT within 90 days after the last date (including extensions) for filing the decedent’s estate tax return (which the executor was required to file), the CRT was deemed a reformable interest within the meaning of Section 2055(e)(3)(C)(iii).
Qualified Interest
The IRS considered whether the CRUT was a qualified interest within the meaning of Section 2055(e)(3)(D). Based on the proposed terms of the CRUT, it satisfied the requirements set forth in Section 664 and the corresponding regulations, so the IRS determined that the CRUT was a qualified interest.7
Actuarial Test
The IRS determined that the actuarial test was satisfied because the actuarial value of the remainder interest of the CRUT (as of the decedent’s date of death) didn’t deviate by more than 5 percent from the actuarial value of the remainder interest of the CRT (as of the decedent’s date of death).8
Equal Duration Test
The IRS determined that the equal duration test was satisfied because the noncharitable interests in the CRT and CRUT both terminate upon the date of the beneficiary’s death. 9
Effective Date Test
The IRS concluded that the effective date test was satisfied because the reformation of the CRT was retroactive to the date of the decedent’s death.10
Effect of A-Trust
Finally, the IRS determined that the existence of the A-Trust (and the fact that the A-Trust will pay estate taxes and administration expenses) wouldn’t disqualify the trust from qualifying as a CRUT under Section 664.
IRS Conclusion
Because all the applicable tests were met, the IRS determined that the reformation of a portion of the CRT into the CRUT would be a qualified reformation within the meaning of Section 2055(e)(3) because the CRUT, as reformed, meets the requirements for a CRT under Section 664. Accordingly, the decedent’s estate will be entitled to a federal estate tax charitable deduction under Section 2055(a) for both the present value of the remainder interest and the income interest (that is, B percent of the unitrust amount) of the CRUT.
Opportunity to Save Charitable Deduction
What appears to distinguish this PLR from others addressing qualified reformations is that the IRS authorized the fiduciaries to bifurcate the CRT into two separate trusts, only one of which qualifies for a charitable deduction. Going forward, while one can’t rely on this PLR as precedent, it provides yet another opportunity for planners to save a charitable deduction.
Endnotes
1. Unless specifically stated to the contrary, all Section references shall be to the Internal Revenue Code of 1986, as amended.
2. IRC Section 2055(e)(2).
3. Oxford Orphanage, Inc. v. United States, 775 F.2d 570, 571 (1985) (citing Oetting v. United States, 712 F.2d 358, 360-61 (8th Cir. 1983)).
4. IRC Section 2055(e)(3)(B).
5. Estate of Crafts v. Commissioner, 74 T.C. 1439, 1455 (1980) (citing S. Report 93-1063, 93d Cong., 2d Sess. (1974)).
6. See, e.g., Oxford Orphanage, Inc. v. United States, 775 F.2d 570, 571 (1985) (citing Estate of Crafts v. Comm’r, 74 T.C. 1439, 1455 (1980)).
7. IRC Section 2055(e)(3)(D).
8. IRC Section 2055(e)(3)(B)(i).
9. IRC Section 2055(e)(3)(B)(ii).
10. IRC Section 2055(e)(3)(B)(iii).
Elizabeth Bowers is an associate in the Personal Planning Department of Proskauer Rose, LLP, resident in the Boca Raton office.
