Drafting Formula Provisions For Testamentary CLTs

Drafting Formula Provisions For Testamentary CLTs

Article posted in Charitable Lead Trust on 17 January 2001| comments
audience: National Publication | last updated: 16 September 2012
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Summary

A testamentary CLT can be a useful charitable and estate planning technique, even for donors of relatively modest means. Formula provisions in testamentary CLTs are helpful because there are many unknown variables when a testamentary CLT instrument is prepared. A number of private letter rulings showing formulas for setting the term of a testamentary CLT and/or the charitable payout of the CLT are reviewed in this article.

by: Emanuel J. Kallina, II, Esquire & Jonathan D. Ackerman, Esquire

Introduction

A charitable lead trust (CLT) created upon the death of a donor can be a useful charitable and estate planning technique. This article explores issues that arise in drafting testamentary CLTs. Because the charitable mid term federal rate under Code1 Section 7520, the exact date of creation of the CLT and often the amount of assets going into a testamentary CLT are unknown factors at the time the CLT instrument is prepared, the use of a formula provision to set either the term of the CLT or the charitable payment amount is often the best option to achieve tax savings. Formulas reduce the risk generated by the unknown factors involved in establishing a testamentary CLT.

While inter vivos CLTs are often practical only for those donors who are wealthy enough to lose the income on the portion of their assets used to fund the CLT, testamentary CLTs can make sense even for donors of modest means. With a testamentary CLT, the donor retains use of the assets that will fund the CLT up until death. The assets used to fund a testamentary CLT will be included in the donor's estate for federal estate tax purposes. However, depending on the donor's goals, it may be possible to structure the CLT so that the estate tax charitable deduction completely offsets the value of the assets included in the estate and used to fund the CLT. There are no percentage limitations on the estate tax charitable deduction under Code Section 2055.

In addition, the basis of the assets used to fund a testamentary CLT receive a date of death basis which, if the assets are appreciated, may eliminate some of the gain that would have to be recognized on a future sale by the CLT or by the non-charitable beneficiaries of the CLT after the CLT ends.

Frequently, testamentary CLTs are used to preserve a family's interest in closely held stock in the face of a large estate tax burden where there are not enough liquid assets to pay the estate tax without selling the stock. The testamentary CLT may be especially useful when the stock-related estate tax mitigation provisions of Code Section 303 (allowing redemption of the stock to pay estate taxes) and Code Section 6166 (allowing an extension of time for the payment of estate taxes) are not available.

Background

A detailed discussion of the requirements for testamentary CLTs is beyond the scope of this article and anyone drafting a CLT should be careful to follow all of the applicable rules and requirements. However, a few notes on some of the requirements may be helpful in reviewing the formulas used in the private letter rulings discussed below because certain of the requirements are more likely to impact the formulas used.

In order to qualify for an estate tax charitable deduction under Code Section 2055, the lead interest in the CLT must be in the form of either a guaranteed annuity interest (for a CLAT) or a unitrust interest (for a CLUT).2 So far, the IRS has not published any sample forms for drafting CLTs as it has in the case of charitable remainder trusts. In contrast to charitable remainder trusts, CLTs need not be limited to 20 year terms and there is no 5% minimum or 50% maximum applicable to the charitable payout. The estate tax charitable deduction is based on the Code Section 7520 rate applicable to the month of the donor's death or either of the two months preceding the donor's death. If the rate for one of the two prior months is used, the donor's estate must file an appropriate election with the estate tax return. The longer the lead interest and the higher the charitable payout of the testamentary CLT, the greater the estate tax charitable deduction will be and the lower the value of the remainder interest.

A testamentary CLT will never be a grantor trust for income tax purposes and no income tax charitable deduction will be available to the donor. The CLT will be taxed as a complex trust under subchapter J of the Code and will be allowed an income tax charitable deduction under Code Section 642(c) for amounts actually paid to charity each year.

No estate taxes can be paid from the assets targeted for the funding of a testamentary CLT. If estate taxes are paid out of amounts used to fund the CLT, an interrelated, or circular, computation must be used to determine the estate taxes and the estate tax charitable deduction. This complex calculation is necessary because the estate tax cannot be known without knowing the charitable deduction and the charitable deduction is in turn reduced by the estate tax. If the CLT is created out of the donor's residuary estate, applicable estate planning drafting should provide for payment of all taxes, debts and expenses before creation of the trust.3

A CLT is a split interest trust under Code Section 4947(a)(2) so the trust instrument must comply with the requirements of Code Section 508(e). That is, the instrument must contain the appropriate prohibitions on violations of the private foundation excise tax rules. Note that there is an exception to the prohibitions against excess business holdings and jeopardizing investments where the value of the charitable interest is no more than 60% of the fair market value of the CLT assets.4

In the case of a CLAT, the annuity amount must be determinable as of the date the CLAT is created. With a testamentary CLAT, the determination of the value of the CLAT may be the date of the donor's death or 6 months after death if the donor's estate elects to use the alternate valuation date under Code Section 2032. However, the CLAT document should direct that the annuity payments begin as of the date of death and contain procedures for retroactively determining amounts due when the payments begin after the date of death, otherwise the IRS may deny the estate tax charitable deduction.5

The annuity amount must be expressed as a sum certain readily determinable on this valuation date. The annuity may be stated as either a percentage of the fair market value of the assets on the date of transfer to the CLAT or as a fixed amount. The annuity may run for a term of years or for the life or lives of certain individuals.6 Although there is no specific prohibition on additional contributions to a CLAT as is the case with a charitable remainder annuity trust, the CLAT document should specifically prohibit additional contributions.

A CLUT provides for a fixed percentage of the fair market value of the CLT assets, determined annually, to be paid to charity each year.7 Although CLUTs have not been particularly popular for inter vivos planning in recent years, they are frequently used for testamentary planning, especially where there are generation-skipping transfer tax considerations. These rulings provide an excellent roadmap for drafting and structuring testamentary CLTs and are described in detail below.

IRS Rulings on Testamentary CLT Formulas

The following description of some private letter rulings issued by the IRS indicates formulas that have met with IRS approval. The specific formulas used in the testamentary CLTs are included here for reference where the formulas are given in the rulings.

PLR 9118040

In PLR 9118040, a testamentary CLAT was to be funded with the residue of a decedent's estate after the payment of certain specific bequests and with certain trust funds included in the decedent's estate because of a power of appointment held by the decedent. As the IRS observed, the amount going into the CLAT could not be known until the decedent's death. The goal of the formula discussed in this ruling was to calculate a term for the CLAT of 20 years or less that would reduce the federal estate taxes payable by the estate to zero or to the lowest amount possible.8

The decedent's estate asked the IRS to rule on whether a reformation of the formula provision for the CLAT would be a qualified reformation under Code Section 2055(e) and on whether the trust would qualify as a guaranteed annuity trust as reformed. The IRS ruled favorably on both points. With respect to the qualification of the trust as a guaranteed annuity trust, the IRS concluded that the trust satisfied the specified term requirement necessary for an estate tax charitable deduction, assuming it met the other requirements of Code Section 2055 and the related Regulations. The IRS also stated that the use of the formula was permissible here because it "satisfies the requirement that a guaranteed annuity must be for a specified term."9

The IRS quoted Regulation Section 20.2055-2(e)(vi)(a), which indicates that a guaranteed annuity is "an arrangement under which a determinable amount is paid at least annually for a specified term or for the life or lives of an individual(s) who is living at the date of death of the decedent." The IRS observed that the amount is determinable if it is possible to ascertain the exact amount to be paid under the instrument as of the date of the decedent's death or the alternate valuation date if the alternate valuation date is applicable. The IRS noted that the annuity term was determinable as of the date of the decedent's death based on a formula contained in the trust instrument even though the term was not expressly stated in the trust instrument.10

The detailed 8-step reformed formula used in the CLAT in PLR 9118040 was as follows:

The term of the Charitable Lead Trust shall be for that period of time, not to exceed 20 years, that results in a charitable deduction allowable with respect to the value of the payments of the annuity amount that is necessary to reduce the federal estate tax payable because of the grantor's death to zero (or the lowest amount possible) based upon values as finally determined for federal estate tax purposes in the Grantor's estate, taking into account prior taxable gifts (if any) and all other available credits and deductions that may be allowed in determining such tax, and using valuation methods, tables, factors, and applicable rates prescribed by the appropriate provisions of the Internal Revenue Code and the United States Treasury regulations, Rulings, Procedures, and guidelines promulgated pursuant thereto. When determining the term of the Charitable Lead Trust, the trustee shall follow the procedures below using values as finally determined for federal estate tax purposes in the Grantor's estate:

1. The trustee shall determine or obtain from the personal representative of the Grantor's estate the value of the grantor's taxable estate for federal estate tax purposes, exclusive of the charitable deduction that may be allowable for this Charitable Lead Trust. From this amount, the trustee shall deduct the amount that can pass free of tax by reason of the allowable unified credit and any other credits available in determining the federal estate tax payable in the Grantor's estate.

2. The trustee or personal representative of the Grantor's estate shall determine the amount passing to this Charitable Lead Trust, valued at the date of the decedent's death, or alternate valuation date if applicable.

3. The trustee shall determine the annuity amount by multiplying the amount determined in step 2 above by the annual percentage payout rate of 8% set forth in subparagraph 2(a) of the Charitable Lead Trust.

4. The trustee shall then divide the result of Step 1 by the appropriate adjustment factor to reflect the quarterly frequency of payment of the annuity amount. The trustee shall determine the appropriate adjustment factor from tables prescribed by the appropriate provisions of the applicable United States Treasury Regulations and publications issued by the Internal Revenue Service.

5. The trustee shall then divide the amount determined in step 4 above by the annuity amount determined in step 3 above.

6. The trustee shall then determine the two term-of-years annuity factors between which fall the result determined in Step 5. The trustee shall determine these factors based on the applicable Treasury regulations or publications issued by the Internal Revenue Service using the applicable assumed rate of return prescribed by Section 7520 of the Internal Revenue Code (or comparable provisions of any subsequent tax statute).

7. The number of whole years for which the Charitable Lead Trust must be in effect in order to produce a charitable deduction in an amount that will reduce the federal estate tax liability on the Grantor's estate to zero will be that number of years which corresponds to the lesser of the two annuity factors determined in step 6. The trustee shall then interpolate between this annuity factor and the other annuity factor determined in step 6 in order to determine the total number of whole years and whole months the Charitable Lead Trust must last in order for the amount of the charitable deduction allowable with respect to this Charitable Lead Trust to be the smallest amount necessary to reduce the federal estate tax liability on the Grantor's estate to zero.

8. The duration of the Charitable Lead Trust shall be the lesser of that number of whole years and whole months as determined in Step 7 or 20 years.11

PLR 9128051

In PLR 9128051, a testamentary 20-year CLAT created under a husband and wife's revocable trust was to be funded at the death of the survivor of the spouses. The revocable trust was to become irrevocable at the death of the first spouse to die. The surviving spouse had a testamentary power of appointment over the trust assets. The trust agreement provided that the CLAT would be funded at the death of the surviving spouse with the assets remaining in the surviving spouse's trust over which the surviving spouse had not exercised his or her power of appointment, reduced by the debts of the surviving spouse. However, the agreement also provided that the amount going into the CLAT would not exceed 1/2 of the surviving spouse's gross estate if a descendant of the spouses was alive 30 days after the death of the surviving spouse.12 The formula appears tied to concerns about keeping the value of the charitable interest at 60% or less of the value of the CLAT assets to avoid the prohibitions on excess business holdings and jeopardizing investments. The spouses may have assumed the CLAT would be funded with closely held business interests.13

The spouses asked the IRS for a ruling that the formula contained in the trust instrument for determining the annual annuity amount would satisfy the guaranteed annuity amount requirements necessary for an estate tax charitable deduction. The IRS ruled favorably on this point, stating, "To the extent that property does, in fact, pass to the charitable lead annuity trust without being subject to the liabilities of the estate of either Taxpayer, the estate of the survivor of the Taxpayers will be entitled to an estate tax charitable deduction under section 2055 for the present value of the guaranteed annuity." The IRS observed that the formula satisfied the requirement that a guaranteed annuity must be determinable because it was based on a formula in the governing instrument even though the annuity amount was not expressly stated in the governing document. The IRS noted that the annuity would be ascertainable as of the date of the surviving spouse's death and so would be a guaranteed annuity as long as the estate's liabilities, including debts, expenses, federal estate taxes and state death taxes, were not paid from property passing into the CLAT.14

The formula for determining the annuity amount for the CLAT in this ruling was as follows (using values as finally determined for federal estate tax purposes for the estate of the surviving spouse):

1. The initial net fair market value of the assets that pass to the charitable lead annuity trust must be determined either with a date of death valuation or the alternative valuation date in accordance with section 2032(b) of the Code.

2. The trustee shall determine the appropriate interest rates available under section 7520 of the Code (or comparable provisions of any subsequent tax statute) at the date of death of the surviving Taxpayer.

3. The trustee shall determine the largest factor from among the available interest rates determined under step 2 for an annuity for a term of 20 years from the tables prescribed by the appropriate provisions of the applicable United States Treasury Regulations and publications issued by the Internal Revenue Service.

4. The trustee shall then divide the result of step 3 into 60, carrying the quotient to two decimal places.

5. The trustee shall then multiply the result of step 4 by the initial net fair market value of the assets that pass to the charitable lead annuity trust as finally determined for federal estate tax purposes in the estate of the survivor of the Taxpayers. This amount is the annual amount payable from the charitable lead annuity trust.15

PLR 9631021

In PLR 9631021, not only was a formula to be used to determine the annuity amount and term, but a power holder was also to select only one of two potential testamentary CLATs for funding. In this ruling, a taxpayer's will provided that 1/4th of the taxpayer's estate, without reduction for debts, taxes, fees or expenses of administration, would go to one of two CLATs as selected by the taxpayer's daughter within 9 months of the taxpayer's death. The taxpayer intended that the daughter (or other power holder if the daughter were not living) would choose the CLAT that results in an estate tax charitable deduction as close as possible to the estate tax value of the trust.16

In response to a request by the taxpayer, the IRS ruled that both of the CLATs qualified as guaranteed annuities under Regulation Section 20.2055-2(e)(2)(vi). The IRS observed that the formula used to set the term of the CLAT is based in part on the initial fair market value of the property going into the CLAT as finally determined for federal estate tax purposes and thus the term is determinable as of the date of the taxpayer's death based on a formula contained in the trust instrument even though the term is not expressly stated in the instrument. Because the term would be determinable as of the date of the taxpayer's death, the IRS stated that the CLAT would satisfy the specified term requirements.17

In addition, the IRS ruled that the daughter's power of appointment to select which CLAT to fund would not prevent the property passing to the selected CLAT from qualifying for an estate tax charitable deduction. The IRS observed that the daughter's discretion was limited to select between two CLATs, both of which satisfy the requirements of Regulation Section 20.2055-2(e)(2)(vi) and yield the same charitable deduction. In response to a related request by the taxpayer, the IRS ruled that the amount passing to the selected CLAT would qualify for an estate tax charitable deduction.18

The formula used in the will in this ruling was as follows:

ANNUITY AMOUNT

1. The annuity amount is determined by multiplying the amount that passes to Annuity Trust I under the terms of Taxpayer's will by the applicable §7520 rate plus one percent. The applicable §7520 rate is equal to the lowest of the interest rates under §7520 for the month in which the applicable valuation date falls or either of the two months preceding the month in which the applicable valuation date falls.

TERM OF ANNUITY

1. The Annuity Amount is multiplied by the appropriate adjustment factor to reflect the quarterly, end of period frequency of payments.

2. The amount that passes to Annuity Trust I is to be divided by the amount determined under (1) above.

3. The two terms-of-years annuity factors between which falls the result determined in (2) above are obtained from Table B of IRS Publication 1457. Then, the result determined in (2) above is interpolated between the two terms-of-years annuity factors, in order to determine the additional number of whole months the Annuity Trust I is to be in effect in order for the amount of the charitable deduction to be equal (or nearly equal as possible) to the value of the amount that passes to Annuity Trust I. The result obtained is the term of Annuity Trust I.19

According to the IRS, the annuity amount and term of the second CLAT would be determined in the same manner as in the first CLAT except that the annuity amount for the second CLAT would be determined by multiplying the amount passing to the second CLAT by the applicable Code Section 7520 rate plus 2%.20

In addition to the rulings on the qualification of the CLATs as guaranteed annuity trusts and on the qualification for the estate tax charitable deduction described above, the IRS also ruled that (i) the power given to the taxpayer's descendants to change the independent trustee would not prevent the CLATs from qualifying as guaranteed annuities; and (ii) the funded CLAT would be allowed income tax charitable deductions under Code Section 642(c) or pursuant to Code Section 512 for amounts actually paid to charity.21

PLR 9840036

In PLR 9840036, the term of a testamentary CLUT was to be determined under a formula tied to the surviving spouse's available generation-skipping transfer tax exemption. The CLUT was to be created after certain specific bequests at the death of the second to die of a husband and wife from property remaining in the survivor's trust. The CLUT was to be funded with property having a date of death value equal to the lesser of $5 million or 25% of the surviving spouse's adjusted gross estate. The CLUT would also receive 25% of any assets not otherwise disposed of in the estate.22

The taxpayers requested rulings that the lead interest in the CLUT would qualify as a unitrust interest and that the estate of the surviving spouse would qualify for an estate tax charitable deduction for the present value of the unitrust interest. The IRS ruled favorably on both points as well as on a generation-skipping transfer tax issue. Even though the term of the CLUT was not specified in the trust instrument, the IRS noted that the term would be determined by a specified formula and all variables of the formula for determining the term would be fixed and determinable as of the date of the surviving spouse's death. Therefore, the IRS stated that the term of the CLUT would be ascertainable and determinable as of the date of death of the surviving spouse.23

The trust instrument in this ruling provided that the CLUT term begins on the date of the surviving spouse's death and "ends as many years later as necessary to produce an initial value for the remainder interest that comes closest to, but does not exceed, the survivor's GST exemption." The instrument contained an alternate provision to apply if the generation-skipping transfer tax were repealed. In that case, the CLUT term would be "the number of years that comes closest to producing a charitable deduction in the survivor's estate of 80 percent of the total value of the property transferred to the Charitable Lead Trust from the Survivor's Trust." The instrument specified that the applicable interest rate under Code Section 7520 for the month prior to the surviving spouse's death was to be used.24

PLR 199927031

In PLR 199927031, various testamentary CLATs and CLUTs were to be created with formulas for determining the amount of the annuity interests or unitrust interests, respectively. Some CLATs were to have 13 year terms and some were to have 19 year terms. The CLUTs were to have terms of either 29 years or 35 years. The CLUT formula was tied to achieving certain generation-skipping transfer tax advantages.25

The IRS ruled that the annuity interests in the CLATs would be guaranteed annuity interests under Code Section 2055(e)(2)(B) and an estate tax charitable deduction would be available for the present value of the annuity interests. Similarly, the IRS ruled that the unitrust interests in the CLUTs would be qualified unitrusts interests under Code Section 2055(e)(2)(B) and an estate tax charitable deduction would be available for the present value of the unitrust interests. The CLATs and CLUTs would be entitled to take income tax charitable deductions under Code Section 642(c) for amounts actually paid to charity each year. A number of favorable rulings were also given on various generation-skipping transfer tax issues.26

The formula for determining the annuity amounts to be paid from the CLATs was as follows:

For the respective charitable terms, the Trustee shall pay such annuity amount in each taxable year of the trust to [Charity] . . . from each of the "A" Trusts, using a term of thirteen (13) years, and from each of the "B" Trusts, using a term of nineteen (19) years, that will produce a present value under §7520 of the [Internal Revenue] Code for the non-charitable remainder interest related to each of the ***** trusts equal to, or as close as possible as equal to without exceeding, [$Z].27

The instrument directed the trustee to use the lowest available Code Section 7520 rate for the month of the taxpayer's death and the two months preceding death. The instrument stated that the annuity amount would be fixed as of the date of the taxpayer's death based on this rate.28

Similarly, the formula for determining the unitrust amount to be paid from the CLUTs was as follows:

For the respective charitable terms, the Trustee shall pay for each taxable year of the trust, to [Charity] . . . such percent of the net fair market value of the trust principal valued as of the first day of each taxable year of the trust, which percent remains unchanged throughout the charitable term and is a certain determined percent for the "C" Trusts which trusts last twenty-nine (29) years and a different percent for the "D" Trusts which trusts last 35 years, as will produce a present value under §7520 for the non-charitable remainder interest related to each of the ***** "C" Trusts and "D" Trusts that is the greater of: (1) an amount equal to, or as close as possible as equal to, but not exceeding, ***** of [Taxpayer's] remaining available GST tax exemption (as is required to be allocated among the "C" Trusts and "D" Trusts in Paragraph TENTH, C, of [Taxpayer's] Last Will and Testament), or (2) [W]; . . .29

As described by the IRS, the instrument also stated the taxpayer's intention "that all of Taxpayer's remaining available GST exemption at Taxpayer's death be applied equally to the ***** CLUTs resulting in an inclusion ratio of zero or as close as possible to zero with respect to each trust." For purposes of the formula, the instrument indicated that the trustee was to use the lowest available Code Section 7520 rate from among the month of the taxpayer's death and the two months preceding the taxpayer's death. The instrument stated that the unitrust amount would be fixed as of the date of death based on this rate.30

PLR 199947022

In PLR 199947022, a decedent's will established two 20 year testamentary CLATs with formulas tied to producing a certain estate tax charitable deduction. The first CLAT was to be funded with assets having a specified value of $a. According to the IRS, the formula provided that the annuity amount to be paid was to be "equal to that percentage of the initial net fair market value of the assets of Trust 1 ($a) as shall produce a guaranteed charitable annuity interest and estate tax deduction equal to (or as nearly equal as possible) in value to b% of the initial net fair market value of the entire trust fund." The second CLAT was identical except for the remainder provisions.31

The IRS ruled that the formulas contained in the CLATs satisfied the determinable amount rule of the guaranteed annuity requirements. Even though the annuity amounts were not stated in the governing instrument, the IRS noted that the annuity amounts were determinable as of the date of the taxpayer's death based on a formula contained in the instrument. Because the annuity amounts could be ascertained on the date of the taxpayer's death, the IRS ruled that they were guaranteed annuities and an estate tax charitable deduction would be allowed. In addition, the IRS concluded that the CLATs would be able to take income tax charitable deductions under Code Section 642(c) for amounts actually paid to charity. The IRS also gave favorable rulings on a disclaimer issue under Code Section 2518.32

Conclusion

A testamentary CLT can be a valuable charitable and estate planning technique, even for donors of relatively modest means. Formulas are helpful in establishing testamentary CLTs because there are so many unknown factors, including the charitable mid term federal rate, the exact date of creation of the CLT and the assets to be used in funding the CLT, when a testamentary CLT instrument is prepared. As explored in this article, a number of IRS private letter rulings show formulas for setting the term of a testamentary CLT and/or the charitable payout of the CLT that have been approved by the IRS and are excellent roadmaps for drafting and structuring testamentary CLTs.


Footnotes


  1. All references to the Code in this article are to the Internal Revenue Code of 1986, as amended from time to time.back

  2. IRC § 2055(e)(2)(B).back

  3. PLR 8033091.back

  4. See IRC § 4947(b)(3).back

  5. See Rev. Rul. 80-123.back

  6. See Treas. Reg. § 20.2055-2(e)(2)(vi) and T.D. 8923back

  7. IRC § 2055(e)(2)(B).back

  8. PLR 9118040.back

  9. Id.back

  10. Id.back

  11. Id.back

  12. PLR 9128051.back

  13. See Teitell, "Charitable Lead Trusts," 1.10.back

  14. PLR 9128051.back

  15. Id.back

  16. PLR 9631021.back

  17. Id.back

  18. Id.back

  19. Id.back

  20. Id.back

  21. Id.back

  22. PLR 9840036.back

  23. Id.back

  24. Id.back

  25. PLR 199927031.back

  26. Id.back

  27. Id.back

  28. Id.back

  29. Id.back

  30. Id.back

  31. PLR 199947022.back

  32. Id.back

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