CHARITABLE REMAINDER UNITRUST COMPLIES, QUALIFIES FOR GIFT, MARITAL, AND CHARITABLE TAX DEDUCTIONS

Reference:

Section 664 -- Charitable Remainder Trusts

UIL Number(s) 0664.03-03

Full Text:

Date: December 16, 1994

Refer Reply to: CC:DOM:P&SI:1 TR-31-1512-94

LEGEND:
A = * * *
B = * * *
Trust = * * *
Trustee = * * *
State = * * *

C = * * *
x = * * *
Cite 1 = * * *

Dear * * *

This is in response to a letter dated November 18, 1994, and prior correspondence, submitted on behalf of A, requesting rulings concerning the qualification of a proposed trust as a charitable remainder unitrust under section 664(d)(2) and (3) of the Internal Revenue Code and on the income and gift tax consequences of a transfer to the Trust.

FACTS

A proposes to establish the Trust, to be governed by the laws of State, by executing a trust instrument and transferring property to the Trustee on behalf of the Trust.

Under the terms of the trust instrument, the Trustee will pay to A and B, A's spouse, while both are living, in such proportions (including all to one to the exclusion of the other) as the trustee, in the exercise of sole and absolute discretion, shall determine, and thereafter all to the survivor for the balance of his or her life, an amount equal to the lessor of: (a) the Trust income for the taxable year, and (b) the "unitrust amount," which is defined as 8% of the net fair market value of the trust assets valued as of the first day of each taxable year. If the trust income in any taxable year exceeds 8% of the net fair market value of the trust assets, the payment to A and B will include the excess, to the extent of any shortfall in prior years (the "make-up amount").

The trust instrument further provides that the Trustee shall determine the net fair market value of the assets of the Trust in accordance with the method described in section 1.664-3(a)(1)(iv) of the Income Tax Regulations, and that the accrued make-up amount will be treated as a liability of the Trust for this purpose.

Article fifteenth of the trust instrument provides that the Trustee can be removed only by C, the brother of A. If the Trustee is so removed, a replacement Trustee will be appointed by A, subject to the restrictions that the new Trustee cannot be A or B, and at least half of the Trustees shall always be persons who are not related or subordinate parties subservient to the wishes of A within the meaning of sections 672 and 674; any appointment in contravention of these restrictions is not effective.

Upon the death of the survivor of A and B, all of the then principal and income of the Trust will be distributed to such one or more organizations described in all of sections 170(c), 2055(a), and 2522(a), and in such proportions as A may appoint by a Will. However, if A fails to exercise this power of appointment, or if one or more of the organizations so appointed is not described in sections 170(c), 2055(a), and 2522(a), then the Trust income and principal will be distributed to one or more qualified organizations as the Trustee, in the exercise of sole and absolute discretion, shall determine.

The trust instrument is irrevocable, subject to three exceptions: (l) A reserves the power, exercisable only by Will, to revoke and terminate the survivorship interest of B; (2) B's interest automatically terminates upon the divorce of A and B; and (3) the Trustee is given the power to amend the Trust for the sole purpose of ensuring that the Trust qualifies and continues to qualify as a charitable remainder unitrust within the meaning of section 664(d)(2) and (3).

Article ninth of the trust instrument permits the Trustee to make investments without regard to whether the investment may be unproductive or underproductive. Moreover, article twelfth of the trust instrument provides that nothing in the Trust should be construed to restrict the Trustee from investing the trust assets in a manner that could result in the annual realization of a reasonable amount of income or gain from the sale or disposition of trust assets.

Article tenth of the trust instrument includes provisions for use by the trustees in the determination of what constitutes income or principal. Generally, the Trustee is instructed to allocate gains on trust assets to income only upon the receipt of cash or other property, by reason of sale or distribution. In addition, a portion of the net proceeds of dispositions of underproductive property is to be allocated to income.

Article fourth of the trust instrument provides that A will provide for the payment of any death taxes that may be imposed on the trust by reason of A's death from other property comprising part of A's gross estate, but that if B becomes the survivor recipient upon A's death, and if, notwithstanding A's provision for payment, death taxes are imposed on the Trust, B's interest will take effect upon A's death only if B furnishes the funds for payment of any death taxes for which the Trustee may be liable upon A's death.

LAW AND ANALYSIS

1. QUALIFICATION OF TRUST UNDER SECTION 664

A ruling is requested that Trust qualifies as a charitable remainder unitrust under section 664(d)(2) and (3).

Section 4 of Rev. Proc. 94-3, 1994-1 C.B. 447, 453, lists issues on which the Service ordinarily will not issue letter rulings. Among these issues are whether a charitable remainder trust that provides for unitrust payments satisfies the requirements described in section 664. In lieu of seeking the Service's advance approval of a charitable remainder unitrust, taxpayers are directed to follow the sample trust provisions in Rev. Proc. 90-31, 1990-1 C.B. 539. By following the sample provisions, taxpayers can be assured that the Service will recognize the trust as meeting all of the requirements of a charitable remainder unitrust, provided that the trust operates in a manner consistent with the terms of the trust instrument and provided it is a valid trust under local law.

Pursuant to Rev. Proc. 94-3, the Service will not rule on whether the Trust qualifies as a charitable remainder unitrust under section 664. The trust agreement contains provisions, however, that are not included in, or are different from, the sample provisions outlined in Rev. Proc. 90-31. Therefore, we will rule on whether these provisions comply with the requirements for a charitable remainder unitrust under section 664.

Section 1.664-1(a)(4) provides that a trust must meet the definition of and function exclusively as a charitable remainder trust from the creation of the trust. For purposes of section 664, the trust is deemed to be created at the earliest time that the trust is not treated as a grantor trust under subpart E, part 1, subchapter J of the Code.

Section 664(d)(2) provides that, for purposes of this section, a charitable remainder unitrust is a trust --

(A) from which a fixed percentage (which is not less than 5 percent) of the net fair market value of its assets, valued annually, is to be paid, not less often than annually, to one or more persons (at least one of which is not an organization described in section 170(c) and, in the case of individuals, only to an individual who is living at the time of the creation of the trust) for a term of years (not in excess of 20 years) or for the life or lives of such individual or individuals,

(B) from which no amount other than the payments described in subparagraph (A) may be paid to or for the use of any person other than an organization described in section 170(c), and

(C) following the termination of the payments described in subparagraph (A), the remainder interest in the trust is to be transferred to, or for the use of, an organization described in section 170(c) or is to be retained by the trust for such a use.

Section 664(d)(3) provides that, notwithstanding the provisions of paragraphs (2)(A) and (B), the trust instrument may provide that the trustee shall pay the income beneficiary for any year --

(A) the amount of the trust income, if such amount is less than the amount required to be distributed under paragraph (2)(A), and

(B) any amount of the trust income which is in excess of the amount required to be distributed under paragraph (2)(A), to the extent that (by reason of subparagraph (A)), the aggregate of the amounts paid in prior years was less than the aggregate of such required amounts.

Section 1.664-3(a)(1)(i)(b)(1) provides that the amount of trust income for purposes of section 664(d)(3) is the amount of trust income as defined in section 643(b) and the regulations thereunder.

Section 643(b) provides that, for purposes of subparts A through D, part i, subchapter J, chapter 1, the term "income", when not preceded by the words "taxable", "distributable net", "undistributed net", or "gross", means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which a fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument and applicable local law shall not be considered income.

Section 1.643(b)-1 provides, however, that trust provisions which depart fundamentally from concepts of local law in the determination of what constitutes income are not recognized. For example, if a trust instrument directs that all the trust income shall be paid to A, but defines ordinary dividends and interest as corpus, the trust will not be considered one which under its governing instrument is required to distribute all its income currently for purposes of section 642(b) (relating to the personal exemption) and section 651 (relating to "simple" trusts).

In the present situation, State law provides rules for determining whether an amount is properly chargeable to income or principal. Specifically, section x states:

(a) A trust shall be administered with due regard to the respective interests of income beneficiaries and remaindermen. A trust is so administered with respect to the allocation of receipts and expenditures if a receipt is credited or an expenditure is charged to income or principal or partly to each:

(1) In accordance with the terms of the trust instrument, notwithstanding contrary provisions of this chapter;

(2) In the absence of any contrary terms of the trust instrument, in accordance with this chapter; or

(3) If neither of the preceding rules of administration is applicable, in accordance with what is reasonable and equitable in view of the interests of those entitled to income as well as those entitled to principal, and in view of the manner in which men of ordinary prudence, discretion and judgement would act in the management of their own affairs.

Cite 1.

In the present situation, the trust instrument provides that gains realized on Trust's assets are to be allocated to trust income, and such an allocation is permitted under State law. Thus, under the terms of the governing instrument and applicable local law, the amount of trust income for purposes of the computations under section 664(d)(3) includes the appreciation in trust assets once the appreciation is realized by the sale or other disposition of those assets.

The unitrust amount determined under section 664(d)(2)(A) is a fixed percentage of the fair market value of the trust's assets valued annually. For a trust described in section 664(d)(2), the unitrust amount is paid each year to the noncharitable beneficiary. If the trust's income is insufficient to cover the unitrust amount, the principal must be invaded to make-up a shortfall. Under these circumstances, the fair market value of the trust assets will decrease by the unitrust amount that was paid from principal. The unitrust amount for the subsequent years will be decreased accordingly.

The income exception provision of section 664(d)(3) was enacted by Congress to permit greater flexibility for certain charitable remainder gifts, but it was crafted in such a manner as to prevent the manipulation of the trust assets to the detriment of the charitable remainder interest. If the income exception provision is included in a trust's governing instrument, this provision prevents the trust from having to invade corpus when the income for the year is below what was originally contemplated. For purposes of this provision, the determination of what constitutes trust income is to be made under the applicable local law and, thus, is not to include items such as capital gains which must be allocated to the trust principal. S. Rep. No. 552, 91st Cong., 1st Sess. 87-89 (1969); reprinted in 1969-3 C.B. 423, 480-481.

For a trust described in section 664(d)(2) and (3), the unitrust amount determined under section 664(d)(2)(A) is used as the ceiling for the amount payable to the noncharitable beneficiary each year and for the amount of any deficiency that may be made up in future years. Provided the trust income does not exceed the current year's unitrust amount and any deficiency from prior years, the trust income is paid out to the noncharitable beneficiary each year. As envisioned by Congress, the trust income used to pay the unitrust amount would never include amounts that in prior years had been included in the fair market value of the trust assets on which the fixed unitrust amount had been based.

The allocation of capital gains to trust income creates the potential to manipulate the trust assets to the detriment of the charitable remainder interest. Year after year, the trustee naturally includes any unrealized appreciation in determining the fair market value of the trust's assets on which the unitrust amount is based. Then when the trustee chooses to realize the appreciation by selling the assets, the realized appreciation is taken out of the base. The realized appreciation becomes trust income that will be paid to the noncharitable beneficiary to the extent of the current year's unitrust amount and any deficiency in the unitrust amounts from prior years. Thus, the trustee has inflated the unitrust amount each year by amounts that will be payable to the noncharitable beneficiary upon the sale of assets. Under these circumstances, the amount that will be paid to the charitable organization at the termination of the trust may well be less than the amount that would be paid to the charitable organization if the fixed unitrust were paid each year pursuant to section 664(d)(2)(A).

The income exception of section 664(d)(3) may not be used in a manner that would allow the value of assets actually passing to the charitable organization to be less than it would have been under section 664(d)(2)(A). If under the terms of the governing instrument and applicable local law the trust's capital gains are allocated to trust income, then the trust's obligation to pay the prior years' deficiency to the noncharitable beneficiary must be accounted for to the extent that the trustee would trigger that obligation if he sold the assets on the valuation date.

Thus, in determining the fair market value of the assets on the annual valuation date, the governing instrument must require the trustee to treat as a liability the amount of any deficiency for prior years computed under section 664(d)(3)(B). The amount treated as a liability need not exceed the trust's unrealized appreciation that would be trust income under the terms of the governing instrument and applicable local law if the trustee sold all the assets in the trust on the valuation date. This trust provision will ensure that the timing of the realization of the gain by the trustee cannot be manipulated to the detriment of the charitable remainder interest.

In the present situation, all gains realized on the sale or other disposition of Trust's assets are allocated to trust income under the terms of the governing instrument and applicable local law. The governing instrument provides that for purposes of determining the unitrust amount each year, the fair market value of the assets shall be reduced by the amount of any deficiency in unitrust payments from prior years but such reduction shall not exceed the amount of the unrealized gain in Trust's assets as of the valuation date. Thus, because the trust provision allocating capital gains to trust income is coupled with a trust provision treating a specific amount of any unitrust deficiency as a liability in valuing the trust's assets, these provisions comply with the requirements for a charitable remainder unitrust described in section 664(d)(2)(3) and the regulations thereunder.

Based solely on the information submitted and the representations set forth above, and viewed in light of the applicable law and regulations, we rule that the provisions of the Trust that differ from Rev. Proc. 90-31 comply with the requirements for a charitable remainder unitrust under section 664.

2. GIFT AND ESTATE TAX RAMIFICATIONS

A ruling is requested that no gift tax will be due as a result of the creation of the trust, and that no estate tax will be due upon A's death as a result of the creation of the trust.

Section 2501 imposes a tax for each calendar year on the transfer of property by gift during the calendar year by any individual, resident or nonresident.

Section 2522(a) provides a gift tax charitable deduction in the case of gifts made during the calendar year to or for the use of a corporation, trust, community chest, fund, or foundation that is organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes.

Section 2522(c) provides that when a donor transfers an interest in property to a person, or for a use, described in section 2522(a) and an interest in the same property is retained by the donor, or is transferred or has been transferred (for less than an adequate and full consideration in money or money's worth) from the donor to a person, or for a use, not described in section 2522(a), no deduction shall be allowed for the interest which is, or has been transferred to the person, or for the use described in section 2522(a) unless, in the case of a remainder trust, the interest is in a trust which is a charitable remainder annuity trust or a charitable remainder unitrust described in section 664.

Section 2523(a) provides that when a donor transfers during the calendar year by gift an interest in property to a donee who at the time of the gift is the donor's spouse, there shall be allowed as a deduction in computing taxable gifts for the calendar year an amount with respect to such interest equal to its value.

Under section 2523(b) the deduction under section 2523(a) is disallowed when, on the lapse of time, on the occurrence of an event or contingency, or on the failure of an event or contingency to occur, the interest transferred to the spouse will terminate or fail if the donor retains in himself an interest in such property, and if by reason of such retention the donor may possess or enjoy any part of the property after such termination or failure of the interest transferred to the donee spouse.

Section 2523(g) provides that if, after the transfer, the donee spouse is the only non-charitable beneficiary (other than the donor) of a qualified remainder trust, section 2523(b) shall not apply to the interest in such trust which is transferred to the donee spouse. Under section 2056(b)(8)(B)(ii), the term "qualified charitable remainder trust" means a charitable remainder annuity trust or charitable remainder unitrust (described in section 664).

Section 25.2523(g)-1(a)(3) of the Gift Tax Regulations provides that the donee spouse's interest need not be an interest for life to qualify for a marital deduction under section 2523(g).

Section 25.2523(g)-1(a)(4) provides that a deduction under section 2523(g) is allowed even if the transfer to the donee is conditioned on the donee spouse's payment of state death taxes, if any, attributable to the qualified charitable remainder trust.

Under section 2001, a tax is imposed on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States.

Section 2055(a) provides an estate tax charitable deduction in the case of bequests, legacies, devises, or transfers from the decedent to or for the use of a corporation, trust, community chest, fund, or foundation that is organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes.

Section 2055(e) provides that where an interest in property has passed from the decedent to a person, or for a use, described in section 2055(a), and an interest in the same property passes or has passed (for less than an adequate and full consideration in money or money's worth) from the decedent to a person, or for a use, not described in section 2055(a), no deduction shall be allowed for the interest which passes or has passed to the person, or for the use described in section 2055(a) unless, in the case of a remainder trust, such interest is in a trust which is a charitable remainder annuity trust or a charitable remainder unitrust described in Section 664.

Section 2056(a) provides that, for purposes of the tax imposed by section 2001, the value of the taxable estate shall, except as limited by section 2056(b), be determined by deducting from the value of the gross estate an amount equal to the value of any interest in property which passes or has passed from the decedent to the surviving spouse, but only to the extent that such interest is included in determining the value of the gross estate.

Under section 2056(b)(1), the deduction under section 2056(a) is disallowed where, on the lapse of time, on the occurrence of an event or contingency, or on the failure of an event or contingency to occur, an interest passing to the spouse will terminate or fail if an interest in such property passes or has passed (for less than an adequate and full consideration in money or money's worth) from the decedent to any person other than such surviving spouse (or the estate of such spouse); and if by reason of such passing, such person may possess or enjoy any part of such property after such termination or failure of the interest so passing to the surviving spouse.

Section 2056(b)(8) provides that, if the surviving spouse is the only noncharitable beneficiary of a qualified charitable remainder trust, section 2056(b)(1) shall not apply to any interest in such trust which passes or has passed from the decedent to the surviving spouse. The term "qualified charitable remainder trust" means a charitable remainder annuity trust or a charitable remainder unitrust (described in section 664).

In the present case, under the terms of the Trust, A retains the right to revoke by will B's survivorship interest. The trust also provides that B's interest will terminate in the event of divorce of A and B. During the joint lives of A and B, B is the only non- charitable beneficiary other than A. The fact that B's interest in the Trust will terminate in the event of divorce does not result in the failure of the interest to qualify under section 2523(g). Accordingly, B's interest in the charitable remainder unitrust prior to the death of A will qualify for the gift tax marital deduction under section 2523(g). B's Survivorship interest in the trust is revocable by will by A and is, therefore, not a completed gift. A's interest in the charitable remainder unitrust is a retained interest and is, therefore, not subject to gift tax. The remainder interest that passes to charity upon the death of the survivor of A and B qualifies for the gift tax charitable deduction under section 2522. We conclude, therefore, that as a result of the transfer of property to the proposed charitable remainder trust there will be no gift tax due.

Upon A's death, if B's survivorship interest in the charitable remainder unitrust is not revoked in A's Will, such interest will qualify for the estate tax marital deduction under section 2056(b)(8). The remainder interest that will pass to charity upon B's death (or upon A's death, if A revokes B's survivorship interest by Will) will qualify for the estate tax charitable deduction under section 2055(e). We conclude, therefore, that upon A's death, no estate tax will be due as a result of the inclusion of the charitable remainder unitrust in A's gross estate.

3. INCOME TAX CHARITABLE DEDUCTION

Rev. Proc. 90-31 states that for transfers to a qualifying charitable remainder unitrust, the remainder interest will be deductible under section 170(f)(2)(A) for income tax purposes, if the charitable remainder beneficiary otherwise meets all of the requirements of that provision. Because we have ruled that the provisions of the Trust do not disqualify it under section 664 if it otherwise qualifies as a charitable remainder unitrust, A will be entitled to an income tax deduction under section 170 in any year that property is transferred to the Trust, if the Trust qualifies as a charitable remainder unitrust. Section 1.664-4 provides rules for computing the fair market value of the remainder interest.

Except as specifically set forth above, no opinion is expressed or implied concerning any other provision of the Trust or as to the federal tax consequences of the formation or operation of Trust under the provisions of any other section of the Code. Specifically, no opinion is expressed as to whether the Trust otherwise qualifies as a charitable remainder trust under section 664.

A copy of this letter should be attached to A's federal income tax return for the tax year in which the Trust is formed. A copy of this letter is enclosed for that purpose.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) provides that it may not be used or cited as precedent.

Sincerely yours,

DIANNA K. MIOSI
Senior Technician Reviewer
Branch 1
Office of the Assistant Chief Counsel
(Passthroughs and Special Industries)
Enclosures (2):

copy of this letter
copy for section 6110 purposes