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Charitable Remainder Trusts and the Section 170(c) Drafting Trap
Private letter ruling 9818027 raises the question of whether the Internal Revenue Service is taking a more liberal approach with respect to reformation of split interest trusts.
This ruling involved a charitable remainder unitrust funded with publicly traded securities. The governing instrument named the donor and the donor's daughter as co-trustees. It stated that the remainder of the trust property was to be distributed to an organization specified in the trust instrument upon the donor's death. If the specified organization were not in existence or were not defined in each of Internal Revenue Code Sections 170(c), 170(b)(1)(A), 2055(a) and 2522(a) at that time, then the trustee was to create an organization described in Code Section 509(a)(3) (a supporting organization) to take the remainder interest.
The reference to Code Section 170(c) in the governing instrument encompassed both private foundations and public charities but the inclusion of the reference to Section 170(b)(1)(A) had the effect of limiting the available recipients of the remainder interest to public charities.
While the general rule is that fair market value is used to calculate the income tax charitable deduction, Code Section 170(e)(1)(B) provides that income tax deductions for charitable contributions to most private foundations are limited to the donor's basis in the property contributed. Code Section 170(e)(5) contains a special rule allowing fair market value to be used to calculate the deduction for gifts of publicly traded stock to private foundations but the gift must fall within the timing parameters of this Section in order for fair market value to be used.
In the private letter ruling 9818027, the donor proposed to reform the governing instrument to provide that the donor would be allowed to designate substitute charitable remainder beneficiaries as long as such remainder beneficiaries were qualified under Code Sections 170(c), 2055(a) and 2522(a) at the time of the distribution of the remainder interest. The letter ruling indicated that applicable state law permits the amendment of an irrevocable trust if all interested parties consent to the amendment and that applicable state law gives the state's attorney general the right to object to the proposed reformation on behalf of named or unnamed charitable remainder beneficiaries.
The donor submitted evidence to show that it was her intent from the outset to name a family-controlled private foundation as the remainder beneficiary of the unitrust. The Service noted that the donor had provided "a comprehensive explanation of her overall estate plan, copies of documents evidencing that estate plan, and letters from her former representative who drafted the estate planning documents, including the unitrust" to show her intent to leave "the bulk of her assets to one or more private foundations controlled by family members." The Service stated that the evidence also confirmed that one of the donor's primary concerns "was to allow her family to direct the ultimate charitable disposition of her assets after her death."
The Service cited portions of the Treasury Regulations under Code Section 664 regarding the requirements for a valid charitable remainder trust, including Regulation Section 1.664-1(a)(1)(i), which requires the remainder interest to be irrevocable, and Regulation Section 1.664-3(a)(ii), which reads in part as follows:
A trust is not a charitable remainder unitrust if any person has the power to alter the amount to be paid to any named person other than an organization described in section 170(c) if such power would cause any person to be treated as the owner of the trust, or any portion thereof, if subpart E, part 1, subchapter J, chapter 1, subtitle A of the Code were applicable to such trust.
In addition, the Service referred to Revenue Ruling 76-8, 1976-1 C.B. 179. Revenue Ruling 76-8 held that a grantor or a recipient of the unitrust amount may have the power to designate the charitable remainder beneficiary of a charitable remainder trust as long as the charity is described in Code Sections 170(c), 2055(a) and 2522(a). The Service observed, "The ruling does not require that the remainder beneficiary must also be an organization described in section 170(b)(1)(A)."
In holding that the proposed reformation at issue in the private letter ruling would not violate Section 664 or the Regulations thereunder, the Service observed, "Because the proposed reformation is the correction of a drafting error, it will not be treated as violating the requirement that the remainder interest to charity must be irrevocable."
Finally, citing Revenue Ruling 79-368, 1979-2 C.B. 109, and Code Section 170(e)(1)(B)(ii), the Service ruled that the donor must file an amended return after the reformation to reduce the amount of her income tax charitable deduction to her adjusted basis in the securities. Revenue Ruling 79-368 held that the deduction for the value of the remainder interest in a charitable remainder trust would be limited to the donor's basis by Section 170(e)(1)(B)(ii) if the grantor or the unitrust recipient has the power to designate an organization specified in Code Section 170(c) as remainder beneficiary and if that beneficiary need not also be an organization specified in Section 170(b)(1)(A). In the letter ruling, the donor's gift via the unitrust did not fall within the timing parameters of Code Section 170(e)(5).
A Reformable Interest?
It is interesting that the Service did not directly address the reformation provisions of the Code in this private letter ruling. Code Section 170(f)(7) provides for "qualified reformations" of charitable contributions via split interest trusts within the meaning of Code Section 2055(e)(3)(B) and states that rules similar to those in Section 2055(e)(3) will apply. Code Section 2522(c)(4) contains similar references to Section 2055(e)(3) for reformations of split interest trusts for gift tax charitable deduction purposes.
Under Section 2055(e)(3), a split interest trust may be reformed if certain detailed requirements are met. A "qualified reformation" is "a change of a governing instrument by reformation, amendment, construction, or otherwise" with the result that a "reformable interest" becomes a "qualified interest." In general, a reformable interest means one that would have been deductible but for the split interest trust limitations imposed by the Tax Reform Act of 1969. In addition, the interest of beneficiaries in the trust prior to the vesting of the remainder interest must be expressed as either a specific dollar amount or a fixed percentage, taking into account the rules under Code Section 664. If the specific dollar amount or fixed percentage rules are not met, then Section 2055(e)(3)(C)(iii) indicates that judicial proceedings are necessary to implement the reformation. In order to qualify for reformation, the actuarial value of the charitable interest after reformation cannot differ from the actuarial value of the charitable interest before reformation by more than five percent of the actuarial value of the charitable interest before the reformation.
In this case, the Service did not even raise the technical reformation rules under Code Section 2055(e)(3). It appears to apply a "mistake of fact" concept. The CRT document was drafted in a fashion that was inconsistent with the donor's intention.
Other Reformable Drafting Errors?
How far will the IRS go? Perhaps the IRS will consider other changes, so long as the donor's intent was clear at the creation of the trust but not carried out because of drafting errors. For instance, what if the facts of PLR 9818027 are reversed? One of the most common drafting errors involving CRTs involves citing Section 170(c) when in fact the donor intends for the remainder interest to pass only to an organization described in Section 170(b)(1)(A). That error can result in a significant reduction in the donor's charitable contribution income tax deduction. This is evidenced by the fact that in PLR 9818027, the Service required the taxpayer to file an amended income tax return to reduce their charitable contribution deduction. Could such a trust be reformed to permit an increased charitable income tax deduction?
Several other common errors or omissions also come to mind. Will the IRS permit the addition of a provision that prohibits the payment of death taxes from trust corpus as required by Rev. Rul. 82-128? Will the IRS permit the addition of the right to revoke the charitable remainder beneficiary or permit the addition of a right to revoke the income beneficiary's interest in the trust, causing inclusion in the donor's gross estate and no immediate gift? Will the IRS permit the change of non-charitable income recipients?
While we cannot assume that the Service is liberalizing its views on reformation from one private letter ruling alone, the ruling does give us hope that the Service might be moving towards a more flexible approach. And any assistance the Service provides to encourage charitable giving is always well received.