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By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney, Washington, DC
A charitable remainder trust allows a donor to take an income, estate and/or gift tax charitable deduction for an amount transferred in trust, where the income of the trust (expressed as a percentage of the trust's initial or yearly fair market value) is paid to the donor (and/or others designated by him) for a specified term or for life, and the remainder is paid to charity at the end of the term. The charity's remainder interest in the trust must be equal to at least 10% of the value of the assets placed in the trust. The amount of the deduction is limited to the actuarial value (determined under §7520 from IRS tables) of the remainder interest at the time of the contribution.1
There are a number of types of inter vivos and testamentary charitable remainder trusts. The two standard variations are the charitable remainder annuity trust (CRAT) in which the donor and/or other noncharitable beneficiaries receive a fixed dollar amount ("sum certain"), which may be expressed as a percentage of the initial fair market value of the assets, and the charitable remainder unitrust (CRUT), in which the donor and/or other noncharitable beneficiaries receive a stated percentage of the value of the trust's assets determined annually. In either case, the stated percentage – either initial or annual – of the value of the trust's assets that is used to calculate the payout must be no less than 5% and no more than 50%.
Subcategories within the CRUT category include the "income only" unitrust (or "NICRUT"), which pays the noncharitable beneficiary the lesser of the net income of the trust (as defined in the trust instrument, which must not be inconsistent with state law) or a fixed percentage of the fair market value of the assets of the trust, determined yearly, and the net-income-with-makeup charitable remainder unitrust ("NIMCRUT"), which includes an optional "make-up" provision allowing any amount not distributed in a year in which the trust had no income (or income that was less than the stated unitrust percentage) to be "made up" in later years if the trust produces income in excess of the unitrust percentage in those years. The NIMCRUT may be appropriate for unitrusts with assets which are not readily marketable or which will produce little or no income in the earlier years of the trust.
Estate of Schaefer v. Commissioner 2
On February 21, 2006, Arthur Schaefer ("Decedent") created and funded (with nonvoting LLC interests) two trusts: Arthur E. Schaefer Charitable Remainder Unitrust Number 1 (Trust 1) and Arthur E. Schaefer Charitable Remainder Unitrust Number 2 (Trust 2) for the benefit of his two sons during the trusts' noncharitable terms.
The trust agreements provide for quarterly distributions to the income beneficiaries during the "Unitrust Period" of the lesser of the net trust accounting income for the taxable year or a percentage, equal to 11% for Trust 1 and 10% for Trust 2, of the net fair market value of the trust assets, valued annually. At the end of the Unitrust Period the remainder of the principal and income in each trust is to be distributed to a charitable organization.
Decedent died in Wisconsin on March 9, 2007, a little over a year after the trusts were established. His estate did not claim a charitable contribution deduction for any portion of the trusts on its Form 706. Instead, the estate reduced the amounts reported on Schedule G, Transfers During Decedent's Life, by the amounts it deemed to be charitable.
The IRS issued a notice of deficiency, in which it explained that the estate was not allowed a charitable contribution deduction for the values of the remainder interests of the trusts because the trusts did not meet the requirement that the value of the charitable remainder interest be at least 10% of the net fair market value of the property on the date of contribution, and the estate had not shown any other basis upon which the charitable remainder interests in the trusts should be discounted.
After pre-trial stipulations of fact, the only remaining issue was whether the trusts met the 10% remainder requirement. The parties agreed that the estate was not entitled to the charitable contribution deduction if the values of the charitable remainder interests in Trust 1 and Trust 2 were calculated on the basis that 11% or 10%, respectively, of the net fair market value of the assets is distributed each year. However, they also agreed that the estate was entitled to the charitable contribution deduction if the values of the charitable remainder interests were calculated on the basis that an amount equal to each trust's net income, determined using the (lower) §7520 rate, was distributed each year.
The text of §664(e), while reasonably specific on how to value a charitable remainder interest of a standard CRUT, is, in the view of the Tax Court, ambiguous, or silent, concerning how to value the remainder interest under the NIMCRUT exception. Thus, the estate argued that NIMCRUT distributions should be determined, not under the general rule, but under an exception to this rule that would require the remainder interest to be valued by using the §7520 rate to determine the trust's expected income, so long as the §7520 rate is above 5% of the net fair market value of the assets.
Given this ambiguity, the court consulted the legislative history to §664(e), which, in the Senate report,3 "makes clear that where there is a net income provision, the distribution amount or rate set forth in the trust instrument is to be used for valuation purposes even though distributions may be limited by net income."4
The regulations,5 stated the court, are less clear. The court pointed out, however, that "[i]ndependent of the regulations," the IRS has issued administrative guidance on the subject of valuing a remainder interest in a NIMCRUT on several occasions.6 That administrative guidance "asserts that the remainder interest of a NIMCRUT is valued using the fixed percentage stated in the trust instrument, regardless of the fact that distributions are limited to trust income," and even in Rev. Rul. 72-395, with reference to a sample provision, explained that "notwithstanding the *** [net income makeup provision], the computation of the charitable deduction will be determined on the basis that the regular unitrust amount will be distributed in each taxable year of the trust." Similarly, Rev. Proc. 2005-54 states: "For purposes of determining the amount of the charitable contribution, the remainder interest is computed on the basis that an amount equal to the fixed percentage unitrust amount is to be distributed each year, without regard to the possibility that a smaller or larger amount of trust income may be the amount distributed."
While the court noted that it is not bound by revenue rulings or procedures, they are entitled to deference when thoroughly reasoned and consistently adhered to over a long period of years. In this case, "the guidance has withstood the test of time."
The court determined that:With regard to the statute before us, the legislative history and the administrative guidance point us to only one conclusion—that the value of the remainder interest of a NIMCRUT must be calculated using the greater of 5% or the fixed percentage stated in the trust instrument. Accordingly, the estate must use an annual distribution amount of 11% or 10% of the net fair market value of the trust assets when valuing the remainder interests of Trust 1 and Trust 2, respectively. Because the parties have previously stipulated that the estate would not be entitled to a charitable contribution deduction if the remainder interests are valued using this method, respondent's determination denying the charitable contribution deduction is sustained.
The Schaefer trusts therefore failed the 10% test and no deduction for the value of the remainder was allowable.
Note that most estate planning actuarial software (such as, e.g., NumberCruncher and Tiger Tables) assumes that the IRS's position is the correct one in providing values for interests in charitable remainder trusts. It is unclear, however, whether the estate in Schaefer used such software.
For more information, in the Tax Management Portfolios, see Rosepink and Bradley, 865 T.M., Charitable Remainder Trusts and Pooled Income Funds, and in Tax Practice Series, see ¶6280, Charitable Deduction — Section 2055.
Copyright©2015 by The Bureau of National Affairs, Inc.
3 Section 664(e), which governs valuing a remainder interest in a CRAT or a CRUT, was enacted as part of 1969 TRA. The underlying House bill containing the provisions for CRATs and CRUTs did not include a provision allowing for distributions to be limited to net income. H.R. 13270, 91st Cong., §201 (1969) (as passed by the House, Aug. 7, 1969). A Senate amendment included both §664(d)(3), which allowed for distributions to be limited to net income, and §664(e), which provided for valuing the remainder interest of the trust.
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