By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney, PC, Washington, DC
In PLR 201216045, the IRS ruled that a testamentary charitable lead annuity trust (CLAT) could make variable, ascending (by 20% per year) annuity payments to the CLAT's charitable income beneficiary over its 10-year term without violating any of the requirements applicable to CLATs under the income, estate, or excise tax provisions of the Internal Revenue Code (the "Code").
Under the facts of the ruling, CLAT was established by Decedent through a living trust that became irrevocable upon Decedent's death. CLAT's sole charitable lead beneficiary is Foundation, an organization that is exempt under §501(c)(3) and that is classified as a private Foundation. CLAT's remainder beneficiaries are trusts for Decedent's descendants, and two of three of CLAT's trustees are Decedent's son and daughter (as are two of three of Foundation's trustees).
According to the provisions of the CLAT trust indenture, the annuity payments under the trust are to be paid to the charitable recipient or its successor in interest, for 10 years. To determine the annuity amount during that period, the trust indenture provides that "the annual annuity amount shall be an amount that will produce a present value under §7520 for the non-charitable remainder interest equal to zero or as close to zero as possible without exceeding zero."
On Decedent's federal estate tax return, his estate claimed a deduction for the full value of the amount used to fund the CLAT. Decedent's estate received a closing letter from the IRS accepting the estate tax return as filed.
Sometime thereafter, CLAT's trustees, with the consent of Foundation and the remainder beneficiaries, and with notice to the state attorney general's office, filed a complaint with the state probate court requesting in part, that the court construe the formula for determining the annuity amount to permit variable ascending annuity payments, commencing on Decedent's date of death and continuing for the 10-year annuity term, with annuity payments made to ascend each year by 120% of the prior year's payment over the annuity term, rather than a straight-line annuity payment over the 10-year term. The complaint explained that construing the formula as a straight-line annuity would make it unlikely that the trustees could make the annuity payments over the entire term. Therefore, the trustees would be unable to satisfy Decedent's intentions regarding the gift of the lead annuity interest to the charitable beneficiary. The trustees provided schedules showing a comparison to the straight-line method that demonstrated that a variable ascending annuity payment method would result in a higher total payout to Foundation.
In response, the probate court issued an order construing that both straight line and variable ascending annuity payment formulas are actuarial equivalents of one another (based on the §7520 rate applicable at the settlor's death) and either form of payment is permitted under the trust agreement's formula clause. The order is subject to the condition that the trustees request and receive a favorable private letter ruling from the IRS.
The IRS issued numerous rulings relating to the qualification and operation of the CLAT, among them determinations that the construction of the terms of the CLAT by the state court's order, allowing ascending annuity payments over the 10-year annuity term would not: (i) constitute direct or indirect self-dealing under §4941; (ii) subject the CLAT to the excise tax on undistributed income under §4942; (iii) subject the CLAT to the tax on excess business holdings under §4943; (iv) be a jeopardy investment under §4944; (v) be a taxable expenditure by the CLAT under §4945; and/or (vi) constitute a taxable termination of the CLAT's private foundation status under §507.
Perhaps most importantly, the IRS ruled that the terms of the CLAT, as construed by the state court's order to permit variable ascending annuity payments throughout the 10-year term will satisfy the requirements of §2055(e)(2) and, therefore, property of the taxable estate of the Decedent passing to the charitable lead trust will qualify for a charitable deduction under §2055(a). Moreover, the CLAT (which, unlike a charitable remainder trust, is not tax exempt) will be allowed a deduction under §642(c) for each taxable year in an amount equal to the annuity amount paid from the charitable lead trust's gross income during such taxable year in accordance with the charitable lead trust's terms, commencing on the Decedent's death and continuing for the 10-year annuity term, except that no charitable deduction will be allowed for any amounts allocable to the trust's unrelated business income for the taxable year.
The IRS appeared to reason that the terms of the CLAT on the date of Decedent's death provided for a deductible guaranteed annuity interest. A "guaranteed annuity interest" is the right pursuant to the instrument of transfer to receive a guaranteed annuity. A guaranteed annuity is an arrangement under which a determinable amount is paid periodically, but not less often than annually, for a specified term of years of for the life or lives of certain individuals.1 An amount is determinable if the exact amount which must be paid under the conditions specified in the instrument of transfer can be ascertained as of the appropriate valuation date. The Revenue Service noted that "[t]he state court's construction, an event that occurred after the date of Decedent's death, does not affect the charitable qualification of the trust or the estate's eligibility for a charitable deduction for that interest."
Since 2007, when the IRS published two revenue procedure that provided sample forms of inter vivos and testamentary charitable lead annuity trusts,2 estate and charitable planning practitioners have speculated on the extent to which a CLAT's annuity payments could be "backloaded" - i.e., increased - over the lead term of the CLAT. Those revenue procedures state that "the governing instrument of a CLAT may provide for an annuity amount that is initially stated as a fixed dollar or fixed percentage amount but increases during the annuity period, provided that the value of the annuity amount is ascertainable at the time the trust is funded." The Rev. Procs. also note that "CLATs are not subject to any minimum or maximum payout requirements." The Rev. Procs. thus on their face seemed to allow an increasing annuity to be paid by a CLAT. Parallel regulations under Code §27023 permit accelerating payments (up to a maximum of 120 percent per year) for grantor retained annuity trusts (GRATs) and grantor retained unitrusts (GRUTs).
The combination of these statements in the Rev. Proc. lead to the development of the backloaded grantor CLAT (which, unlike the CLAT in PLR 201216045, is an inter vivos CLAT), sometimes referred to as a "variable" CLAT or "V-CLAT," or, where the initial payments to charity are nominal during the lead term, followed by a large balloon payment in the CLAT's final years, as a "shark-fin" CLAT.
Critics of these CLATs have argued that, in the absence of further guidance, they may risk the settlor's income, gift or estate tax deduction because, despite the statements in Rev. Proc. 2007-45, it has never been explicitly sanctioned by the IRS, and may run afoul of existing regulations - particularly with regard to the "guaranteed annuity" requirement. Others, however, have taken comfort from the statements in the 2007 Rev. Procs., as noted above.4
While PLR 201216045 does not answer all questions relating to CLATs with ascending payments (and does not address at all CLATs with "descending" - i.e., frontloaded - payments), it does provide some base-line parameters for structuring such CLATs. It also provides needed flexibility (perhaps at the cost of seeking probate court approval) in drafting testamentary CLATS, which, under the PLR, apparently need not contain precise formulas5 to "zero out" the remainder interest.
For more information, in the Tax Management Portfolios, see Etheridge, 866 T.M., Charitable Income Trusts, and in Tax Practice Series, see ¶6280, Charitable Deduction - Section 2055.
1 Regs. §20.2055-2(e)(2)(vi)(a).
2 See Rev. Proc. 2007-46, 2007-29 I.R.B. 102, and Rev. Proc. 2007-45, 2007-29 I.R.B. 89.
3 Regs. §25.2702-3(b)(1)(ii), (c)(1)(ii).
4 For two contrasting views of the validity of "shark-fin" CLATS, see Fox and Teitelbaum, "Validity of Shark-Fin CLATs Remain in Doubt Despite IRS Guidance," Estate Planning (Oct. 2010) (reprinted in LISI Charitable Planning Newsletter #162), and Pratt, Goldberger & Lee, "Biting Back: Responding to the Attack on Shark-Fin CLATs," #163 (10/5/10).
5 See, e.g., the formulas in PLRs 199947022, 199927031 and 9840036.