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Exploring the New Model Charitable Remainder Annuity Trust Forms
On August 1, 2003, Treasury issued a series of revenue procedures that update previously issued model charitable remainder annuity trusts instruments. In this article, PGDC Editorial Board member and tax author J. Michael Pusey, CPA reviews the new forms in detail.
Special thanks to PGDC Editorial Board member Lynda S. Moerschbaecher, J.D., LL.M. for editorial review.
For the first time in over a decade the IRS has stepped into the arena of drafting charitable remainder trust documents. In 1972, the IRS issued a major Revenue Ruling1 to assist drafters after the 1969 tax law that brought us charitable remainder and lead trusts in tax-qualified form. In that ruling, the Service merely gave mandatory and optional provisions to use, without attempting to string them into what might be called a trust instrument. Then, over the years between 1972 and 1989, many published and private letter rulings affected the drafting of charitable remainder trusts.
The hodgepodge created by the various rulings was addressed beginning in 1989 and continuing into 1990 when the IRS released model or sample forms in several Revenue Procedures2. The revenue procedures provided a safe harbor of qualification if the provisions in the revenue procedures were used in the drafter's trusts without substantive change, other than the addition of provisions concerning matters of administration of the trust. However, the former IRS versions were bare bones as far as trusts are concerned and only covered the basic mandatory provisions. They did not cover any planning opportunities or flexibility needed in certain situations, and no trust administrative terms whatsoever. Planners and drafters did that outside the boundaries of the safe harbor IRS forms.
Now the IRS has released new revenue procedures, Rev. Procs. 2003-53 through 2003-60, stating that it was updating the old ones and adding new sample forms for additional types of trusts. This series covers only annuity trusts. While these samples cover some planning situations, it does not cover a wide variety of more sophisticated techniques and again does not provide any trust administration provisions which must meet the standards of local law. New model agreements for unitrusts will be forthcoming at some future date.
In this set of revenue procedures, the IRS makes note that if these forms are followed, deductions will be available to citizens and residents of the U.S. As a prefatory matter, it also states that the IRS will recognize as qualified CRATs any trust using these forms if (1) the trust operates consistently with the terms of the trust, (2) it is a valid trust under local law, (3) the alternatives given in the revenue procedures are "properly integrated into" the sample forms (as of yet an unknown factor), and (4) provisions other than those in the revenue procedure that may be used are "substantially similar" to those in the revenue procedure (it is also not clear what "substantially similar" will mean from their point of view).
The IRS further points out that a trust that contains substantive provisions in addition to those in the revenue procedures or the omission of terms in the sample forms will not necessarily disqualify the CRAT. But neither will it automatically be deemed qualified. Rulings on substantive provisions other than what is in the revenue procedures will be issued by the IRS.
The eight new revenue procedures containing model agreements for charitable remainder annuity trusts (CRATs) are as follows:
- Sample Inter Vivos CRAT for One Measuring Life (Rev. Proc. 2003-53)
- Sample Inter Vivos CRAT for Term of Years Annuity Period (Rev. Proc. 2003-54)
- Sample Inter Vivos CRAT for Consecutive Interests for Two Measuring Lives (Rev. Proc. 2003-55)
- Sample Inter Vivos CRAT for Concurrent and Consecutive Interests (Rev. Proc. 2003-56)
- Sample Testamentary CRAT for One Measuring Life (Rev. Proc. 2003-57)
- Sample Testamentary CRAT for Term of Years Annuity Period (Rev. Proc. 2003-58)
- Sample Testamentary CRAT for Consecutive Interests for Two Measuring Lives (Rev. Proc. 2003-59)
- Sample Testamentary CRAT for Concurrent and Consecutive Interests (Rev. Proc. 2003-60)
In general, the model agreements provide more detailed commentary and cover more circumstances than the old model agreements. It is important to note that the new agreements supersede Rev. Proc. 89-21, amplified byRev. Proc. 90-32. For example, the revenue procedures discuss payments to "financially disabled" beneficiaries, valuation of unmarketable assets, charity sharing in the annuity, and retention of assets after termination of the annuity in those rare instances when the trust provides for the conversion of the CRT to a charity.
Here are some of the major things to note about these new forms:
Term of Years Trusts
Unlike the old model agreements, the new model agreements include term of years trusts. A CRT may be for a term of years not to exceed twenty. In so far as the definition of a 20-year term, the inter vivos and testamentary model agreements comment: "Thus, for example, the annuity period of a CRAT for a term of 20 years will end on the day preceding the twentieth anniversary of the date the trust was created."3 The specific language varies however. The inter vivos trust model agreement focuses on the date property is transferred to the trust as the beginning of the annuity period. The testamentary model agreement focuses on the date of death. A testamentary CRAT is permitted to defer payment of the annuity until the trust is completely funded.
Note that a CRAT cannot receive additional contributions. However, with a testamentary CRAT, the initial contribution is deemed to consist of all property passing by reason of the decedent's death.
Only the term of years revenue procedures discuss "sprinkling" among beneficiaries.4 For example, the testamentary model provides that if there is authority to allocate among members of a class, "the trust instrument must provide that such trustee must be: (i) not a member of the recipient class; and (ii) prohibited from applying any part of the annuity payment in satisfaction of the trustee's own legal obligations." The inter vivos term of years revenue procedure adds that the trustee must be "independent" (not the donor or the donor's spouse, not related or subordinate to the donor).
Measuring the Annuity
The model agreements generally contemplate that the annuity may be expressed as a percentage or fixed dollar amount. The fixed dollar approach raises the risk of failing to satisfy various tests. For example, the annuity must be at least 5% of the initial net fair market value, and one may inadvertently fail this test if a fixed dollar approach is used and valuation is disputed by the IRS. Other tests that may be at risk by using the fixed dollar approach are the 50% maximum annuity rule, and the requirement that the charitable remainder be at least 10%. The 5% probability test, discussed below, may also be affected.
The private letter rulings are not entirely consistent, but the IRS has at times objected to using the phrase "for federal estate tax purposes" when the regulations read "for federal tax purposes."5 In PLR 7848046, the IRS objected to the phrase "for federal estate tax purposes," preferring the "for federal tax purposes" language. The basic approach in the new model agreements is to refer to final values "for federal tax purposes" in the inter vivos agreements, whereas the testamentary models look to values "as finally determined for federal estate tax purposes."6
The 5% Probability Test
The 5% probability test focuses on the risk that the charitable remainder might be defeated.7 While opinions vary, it is generally believed that the test applies to CRATs but not CRUTs.
The 5% probability test is mentioned in all of the CRAT model agreements except the term of years models. Rev. Proc. 90-32, now superseded, had savings clause language with respect to testamentary scenarios; i.e., pay a percentage but no more than would result in passing the 5% probability test. The new model agreements that mention the 5% probability test do not contain a savings clause, even in the testamentary scenarios. Failure of the 5% probability test is more likely to be a problem in a testamentary context because of the length of time between planning and creation of the trust.
In describing the results of failing the 5% probability test, the revenue procedures say no estate or gift tax deduction will be allowable. The relevant rulings deal with estate or gift tax deductions.8 However, the IRS has applied the 5% probability test to deny the trust qualified status under Section 664, including income tax exemption under Section 664(c), and an income tax deduction as well as gift tax charitable deduction.9 So while the revenue procedures issued in 2003 adhere fairly strictly to the issued rulings and regulations, one would not presume an income tax deduction or qualified trust if one failed the 5% probability test.
Paying the Annuity by Year End
Each of the model agreements comments that generally the annuity must be paid by year end, but then each cites the regulations for circumstances when the annuity may be paid within a reasonable time after year end.10 The testamentary model agreements add that payment may be deferred until the year the trust is completely funded.
Designating the Charity
The revenue procedures for inter vivos CRATs include additional language to limit the remainderman to a public charity. Limiting the charity to one described in Sections 170(c), 2055(a) and 2522(a) qualifies the trust, but one needs to add Section 170(b)(1)(A) language if the intent is to limit the charity to a public charity. Historically, this has been a much-discussed trap for the unwary that blindly followed the IRS model agreements only to find the income tax deduction limited to the rules governing private foundations.
The inter vivos revenue procedures generally discuss that the retention of the right to change the charity results in an incomplete gift for gift tax purposes. The income tax deduction arises from funding the trust, and so the income tax deduction is not delayed even if the gift to the charitable remainderman is incomplete for gift tax purposes. The regulations require that the trust provide a procedure for naming an alternate charity if the charitable remainderman is not qualified.11 If a charity shares in the annuity, the CRAT model agreements provide that if gift/estate tax deductions are desired for the charitable lead interest, a procedure should be in the agreement to identify an alternative charity if the named charity that shares in the annuity is not qualified at the time of payment. The model agreements seem to contemplate the remainderman need not be designated in that each of the eight procedures states the trust may restrict the charity to a qualified charity, "but grant to a trustee or other person the power to designate the actual charitable remainderman." The IRS does not apply the contemporary receipt requirement of Section 170(f)(8) to CRTs.12 The rationale for this policy decision is found in the preamble to the proposed regulations:
"The grantor of a charitable lead trust, a charitable remainder annuity trust, or a charitable remainder unitrust is not required to designate a specific organization as the charitable beneficiary at the time the grantor transfers property to the trust. As a result, there is often no designated donee organization available to provide a contemporaneous written acknowledgment to a taxpayer. In addition, even if a specific beneficiary is designated, the designation is often revocable..."
Caveat: Each of the inter vivos model agreements comments: "Any named charitable remainderman must be an organization described in Section 170(c) at the time of the transfer to the charitable remainder annuity trust." In each of the testamentary model agreements, there is the same statement except for the additional reference to the estate tax provision.13 The revenue procedures cite a statute which basically says that after the termination of the annuity, the trust distributes the remainder to a qualified charity (or the CRT keeps the assets and becomes a charity).14 The regulations also focus on the qualified status of the charity at the time the remainder is paid to the charity.15 In this author's judgment, the statement in the revenue procedures focusing on the status of the charity at the time of funding misses the basic approach of the Code and regulations, which is to focus on the charity's status when it gets the assets.
The new revenue procedures basically say prorate in a short year, and then they reference the regulations on how to prorate. The CRT is required to have a calendar year.16
Typically, its initial year is a short year. There is also proration (less than a full year's annuity) in the year the annuity ends, which is not necessarily a short, final year because the CRT is granted a reasonable period to wind down before distributing it assets to charity. The final distributions to charity(ies) may extend beyond the December 31st of the year in which the annuity terminates.
Proration between Beneficiaries
When the model agreements clearly contemplate the transition between two beneficiaries of the annuity, they now expressly provide for proration between the beneficiaries.17 However, this is not necessarily a requirement.18
Qualified Contingency under Section 664(f)
Each of the eight model agreements contemplates the option of terminating the annuity as a result of a "qualified contingency." One of the requirements of a term of years trust is that the term must be ascertainable from inception, and there may have been some concern that Section 664(f) might be a problem in a term of years trust. The inclusion of Section 664(f) language as an alternative in the term of years model agreements would seem to indicate that this is not a problem.
Testamentary Right to Revoke / Anti-Invasion Language
Two of the revenue procedures incorporate the testamentary right to revoke the beneficiary's annuity, and these are also the only two model agreements that include anti-invasion-to-pay-tax language.19 The anti-invasion concern basically imposes on the surviving beneficiary the requirement that he/she pay any estate tax to avoid invading the trust. Yet there is a very broad statement in both of the revenue procedures that have a "tax payment clause" which says: "If it is possible that all or part of the fair market value of the trust assets will be includible for federal estate tax purposes in the gross estate of the donor, the trust must contain a tax payment clause. If federal estate taxes and state death taxes are paid from other sources, the tax payment clause will never become operative. Nevertheless, the tax payment clause is necessary because it ensures that the trustee will never be required to pay federal estate taxes or state death taxes from the trust assets."20
If the testamentary right to revoke could possibly cut off a lifetime interest, conservative planners sometimes worry whether the CRT is a qualified trust. The general rule is that a lifetime interest must be payable for life.21 While the better argument is that the testamentary right to revoke is a permissible exception, the worry is that the testamentary right to revoke could violate the payable-for-life rule for lifetime interests.22
The issue of cutting off a lifetime interest does not arise if the grantor is the initial lifetime beneficiary.23 Interestingly, the issue may arise in one of the new revenue procedures which contemplate lifetime interests and the grantor as one of the co-beneficiaries.24 The interest of the co-beneficiary, if he or she survives the grantor-beneficiary, is terminated if the grantor exercises the testamentary right to revoke. If the co-beneficiary survives the grantor, his or her interest goes from a portion of the annuity to 100% of the annuity, or zero if the grantor does exercise the testamentary right to revoke. Obviously, the IRS considers this permissible, but the broader issue of cutting off a lifetime interest will likely still be debated. One could argue that it is the new 100% interest that is terminated in the revenue procedure, while others will argue the co-beneficiary's lifetime interest was obviously cut off.
Funding the Trust with Certain Types of Assets
The new revenue procedures comment that: "In addition, funding the trust with certain types of assets may disqualify it as a charitable remainder trust. See Sec. 1.664-1(a)(7) and Rev. Rul. 73-610, 1973-2 C.B. 213."25 The regulations cited deal with unmarketable assets which cannot be readily sold for cash or cash equivalents and provide that the trust must have any necessary appraisals done by an independent trustee or adhere to the requirements for a "qualified appraisal." They do not say that unmarketable assets disqualify the trust. The ruling cited deals with the contribution of an antique collection with retention of use by the CRAT's beneficiary. The CRAT was also funded with other income producing assets. The problem was seemingly not the non-income-producing nature of the antiques, which should not be fatal per se, but the retention of use by the beneficiary which prevented the trustee from investing in a manner that would produce reasonable income or gain.26 In this author's judgment, the new revenue procedure shouldn't be read to imply antiques or other assets that cannot be readily sold are per se fatal. For example, it is generally conceded that, subject to the rules governing gifts of tangible personal property, a CRT may be funded with such assets as a musical instrument.27
Of course, it is often a bad idea to fund a CRAT with non-income-producing property that is difficult to sell because there is no income-limitation feature possible with the annuity trust. With a CRUT, one may consider adding an income limitation (usually with make-up) to delay payouts if necessary, but this isn't possible with CRATs. It is particularly true of a CRAT that it should be funded with significant liquid assets and, usually, property that can be readily sold. None of the assets used to fund a CRAT or CRUT should be subject to restrictions that prevent the trustee from investing in a manner to produce reasonable income or gain.
Historically, the model agreements have included provisions concerning Section 4943, taxes on excess business holdings, and Section 4944, jeopardy investments. Typically, these statutes do not apply because the charity does not share in the income interests. The new CRAT agreements make these optional provisions in those rare instances when the charity shares in the annuity.
In general, the new model agreements are helpful in that they set forth much more detail than the old ones from 1989 and 1990, incorporating the types of annotations from the 1972 ruling with the kinds of samples of the 1989 and 1990 forms, and, in addition some alternative paragraphs. On the other hand, they do present a set of more or less "do-it-yourself" trust samples with recipe-like instructions as to how to insert the new alternate provisions.
See, e.g., PLR 7732058back
See Regs. 1.664-2(a)(6)(i), (iv); 1.664-3(a)(6)(i), (iv)back
See, e.g., Rev. Proc. 2003-55, Sec. 4, inter vivos CRAT for consecutive interests for two measuring lives, which provides: "If the Successor Recipient survives the Initial Recipient, the trustee shall prorate on a daily basis the next regular annuity payment due after the death of the Initial Recipient between the estate of the Initial Recipient and the Successor Recipient."back
Rev. Proc. 2003-55 (inter vivos, consecutive interests and two measuring lives), and Rev. Proc. 2003-56 (inter vivos, concurrent and consecutive interests)back
Rev. Proc. 2003-55, Sec. 5.03(1), Rev. Proc. 2003-56, Sec. 5.03(1). Citations therein are omitted in the quotation.back
Regs. 1.664-2(a)(5) (annuity trust), and Regs. 1.664-3(a)(5) (unitrust). See Sec. 664(d)(1)(A), (2)(A). See situation 1 of Rev. Rul. 76-291, 1976-2 CB 284, which was issued prior to the enactment of Section 664(f).back
Sundry arguments could be advanced on this point. Numerous private letter rulings could lead one to believe cutting off a lifetime interest with a testamentary right to revoke is not a problem. See, for example, PLR 7928014, PLR 7929056, and PLR 9511029.back
Rev. Proc. 2003-56back
Rev. Proc. 2003-53 and the other model agreementsback