IRS Approves Retroactive CRT Amendment to Inter Vivos Trust

IRS Approves Retroactive CRT Amendment to Inter Vivos Trust

News story posted in Technical Advice Memoranda on 10 November 1998| comments
audience: National Publication | last updated: 18 May 2011
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Summary

Based on the legislative history to Code Section 2055(e)(3), the IRS has ruled in technical advice that a retroactive amendment of an inter vivos trust to qualify as a charitable remainder unitrust is permissible under the law.

TAM 9845001

PGDC SUMMARY:

Based on the legislative history to Code Section 2055(e)(3), the IRS rules that the retroactive amendment of an inter vivos trust to qualify as a charitable remainder unitrust is permissible under the law. The trust was amended to include the required provisions concerning (i) payment of death taxes, (ii) testamentary transfers and (iii) calculation of the unitrust amount when additional contributions are made. The IRS also noted that there are several issues with respect to the prior administration of the trust. First, the noncharitable beneficiaries are required to reimburse the trust for excess distributions made to them in prior years and these excess payments create questions about self-dealing. Second, the trust's investment in a limited partnership may have generated unrelated business taxable income. Finally, the gain on the sale of stock originally transferred to the trust may have been understated so the trust's accumulated capital gains account may need to be adjusted even if the trust was tax-exempt during the years of the sales.

POINTS TO PONDER:

Is the IRS showing more leniency towards poorly-drafted charitable remainder trusts these days? Does the IRS take a lenient approach towards charitable remainder trust administration issues in this Ruling?

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Date: July 13, 1998
Control Number: TAM-103398-98

Taxpayer's Name: * * *
Taxpayer's ID Number: * * *
Taxpayers's Address: * * *
Years Involved: * * *
Date of Conference: * * *
District Director: * * *

LEGEND:

Taxpayers = * * *
Trust = * * *
a = * * *
b = * * *
A = * * *
c = * * *
B = * * *
d = * * *
C = * * *
e = * * *
D = * * *
f = * * *
E = * * *
F = * * *
g = * * *
G = * * *
h = * * *
i = * * *
j = * * *
k = * * *
l = * * *
m = * * *
n = * * *
o = * * *
p = * * *
q = * * *
r = * * *
s = * * *
t = * * *
u = * * *
v = * * *

ISSUE:

Is the amendment of an inter vivos charitable remainder unitrust that is retroactive to the date of the creation of the trust permissible for federal tax purposes? CONCLUSION:

The amendment of an inter vivos trust to comply with the requirements for a charitable remainder unitrust effective retroactively to the date of the creation of the trust is permitted for federal tax purposes pursuant to the qualified reformation provisions of section 2055(e)(3) of the Internal Revenue Code. Therefore, deductions are allowed for income tax purposes under section 170(a) and for gift tax purposes under section 2522(a) for the present value of the remainder interest in the property transferred to the trust.

FACTS:

Taxpayers, husband and wife, created the Trust on a. The Trust prior to amendment provides that the trustee is to pay to Taxpayers (life beneficiaries) for life an amount from the Trust income equal to the lesser of b percent of the net fair market value of the trust property, valued annually. The unitrust payments are to be made annually, or more frequently when, in the discretion of the trustee, it is deemed advisable or necessary. The trustee has the authority to apportion the income between the life beneficiaries. If, for any year, the trust income is less than b percent, the trustee is to pay all the net income to the beneficiaries. If, for any year, the trust income is more than b percent, the trustee is to pay to the life beneficiaries any amount of the excess income to the extent that the aggregate of the amounts paid in prior years was less than the aggregate of the amounts required to be paid in those years based on the b percent figure. On the death of one of the noncharitable beneficiaries, the trustee is to continue to pay the unitrust amount to the surviving beneficiary for the remainder of his or her life.

The Trust prior to amendment further provides that any income for the taxable year in excess of the unitrust amount is to be added to principal. If the net fair market value of the trust assets is incorrectly determined, then within a reasonable period after the value is finally determined, for federal tax purposes, the trustee is to pay to the life beneficiaries (in the case of undervaluation), or to receive from the life beneficiaries (in the case of overvaluation) an amount equal to the difference between the unitrust amount properly payable and the unitrust amount properly paid. In determining the unitrust amount, the trust is to prorate the same on a daily basis for a short taxable year and for the taxable year of the surviving beneficiary's death.

The Trust prior to amendment provides that on the death of the survivor of the life beneficiaries, the trustee is to distribute all of the principal and income of the Trust (other than any unitrust amount due the surviving beneficiary) to the following beneficiaries (Charitable Beneficiaries) in the following amounts:

(1) A -- c percent;
(2) B -- d percent;
(3) C -- e percent;
(4) D -- f percent;
(5) E -- e percent;
(6) F -- g percent; and
(7) G -- e percent.

If a Charitable Beneficiary is not an organization described in sections 170(b)(1)(A), 170(c), 2055(a), and 2522(a) at the time the principal or income is to be distributed to it, then the trustee is to distribute the principal and income to the one or more organizations described in sections 170(b)(1)(A), 170(c), 2055(a), and 2522(a) as the trustee, in his sole discretion, selects.

Section Eleven of the Trust prior to amendment provides that the Trust is irrevocable unless and until the Commissioner of Internal Revenue or his or her delegate makes a final determination that the Trust does not qualify as a charitable remainder unitrust within the provisions of section 664 or corresponding provision of any subsequent federal tax law, or if the trustee, in his sole discretion, determines that an amendment is necessary for the trust to qualify as a charitable remainder unitrust within the provisions of section 664. In the event of such a determination, the Trust instrument may be amended for the sole purpose of causing the Trust to conform to such provision.

Under the terms of the Trust before and after the amendments, the original trustee and any successor trustee must be independent trustees with respect to Taxpayers.

The Trust's h return, which was filed on i, showed an ordinary loss of j. The net fair market value of the Trust assets was reported to be k.

On l, Taxpayers received a distribution from the Trust in the amount of m. The notation on the check indicated that the distribution was for h, even though the Trust's h return showed no income. It is represented that the trustee's computation of the distribution was based on the belief that the Trust should determine the amount due on a fiscal year, rather than a calendar year, basis and that the distribution was intended to be for the first full 12 months of the Trust ending in n.

The Trust's o return indicated that the net fair market value of the Trust assets was p as of the beginning of o. The net income reported on the Trust's o return was g. On r, Taxpayers received a distribution in the amount of s. The notation on the check indicated that the s was a partial distribution for o.

In late o, Taxpayers became concerned that the trustee's administration of the Trust might violate the private foundation rules or other tax laws and regulations. They requested information from the trustee concerning Trust investments. Other than a summary of the investments made by the trustee, Taxpayers received no information from the trustee until t.

The trustee purportedly resigned as trustee by letter, dated u. The individual designated as the successor trustee never accepted the Trust. The original trustee continued signing checks drawn on the Trust's checking account, including payments to himself for trustee's fees, until a successor trustee was appointed on v. The new trustee filed the o tax return as soon as he received the necessary records from the original trustee.

Taxpayers requested that the new trustee amend the Trust to insure that it qualified as a charitable remainder trust. The trustee amended the Trust pursuant to the authority granted him under Section Eleven to amend the Trust for the sole purpose of qualifying the Trust as a charitable remainder unitrust within the meaning of section 664. The amendments to the Trust were effective as of the date the Trust was originally created.

The amendments corrected three defects in the Trust as originally drafted. First, the provision concerning estate taxes described in Rev. Rul. 82-128, 1982-2 C.B. 71, was added so that the secondary life estate will terminate if the recipient does not pay any estate taxes that the Trust may be required to pay. Second, the provision concerning testamentary transfers as required by section 1.664-1(a)(5) of the Income Tax Regulations was added to the Trust. Finally, the formula for determining the unitrust amount for any tax year in which additional contributions are received by the Trust was corrected in accordance with the provisions of section 1.664-3(b).

In the process of amending the Trust to correct these defects, the trustee restated the Trust to follow closely the wording of the sample trust document set forth in Rev. Proc. 90-31, 1990-1 C.B. 539. No substantive changes were made to the provisions of the Trust other than specifying the recipient of the unitrust amount during the joint lives of Taxpayers. Under the Trust, as amended, the trustee is to pay to Taxpayers in cash, in kind, or partly in each, in equal shares during their lifetimes a unitrust amount equal to the lesser of the Trust income and b percent of the net fair market value of the Trust assets valued as of the first taxable year of the Trust.

The Trust, as amended, also provides that the Trust is irrevocable. The trustee, however, has the power, acting alone, to amend the Trust in any manner required 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).

LAW AND ANALYSIS:

Section 170(f)(2)(A) provides that in the case of property transferred in trust for the benefit of both charitable and noncharitable beneficiaries, no deduction for income tax purposes is allowed for the value of a contribution of a remainder interest to a charitable organization unless the remainder interest is in a trust that is a charitable remainder annuity trust or a charitable remainder unitrust (described in section 664), or a pooled income fund (described in section 642(c)(5)).

Section 170(f)(7)(A) provides that a deduction shall be allowed under section 170(a) in respect of any qualified reformation (within the meaning of section 2055(e)(3)(B)). Section 170(f)(7)(B) provides that for purposes of this paragraph, rules similar to the rules of section 2055(e)(3) shall apply.

Section 2522(c) provides that in the case of property transferred in trust for the benefit of both charitable and noncharitable beneficiaries, no deduction for gift tax purposes is allowed for a contribution of a remainder interest to a charitable organization unless the remainder interest is in a trust that is a charitable remainder annuity trust or a charitable remainder unitrust (described in section 664) or a pooled income fund (described in section 642(c)(5)).

Section 2522(c)(4)(A) provides that a deduction is allowed under section 2522(a) in respect of any qualified reformation (within the meaning of section 2055(e)(3)(B)). Section 2522(c)(4)(B) provides that for purposes of this paragraph, rules similar to the rules of section 2055(e)(3) shall apply.

Section 664(d)(2) provides that 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 the 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 170(c) or is to be retained by the trust for such use.

Section 664(d)(3) provides that instead of the amount described in section 664(d)(2)(A), the trust instrument may provide that the unitrust amount is the amount of the trust income if less than the amount described in section 664(d)(2)(A) and any amount of trust income in excess of the amount described in section 664(d)(2)(A) to the extent that the aggregate of the amounts paid in prior years was less than the aggregate of the amounts described in section 664(d)(2)(A).

Section 2055(e)(3)(B) defines the term "qualified reformation" to mean a change of a governing instrument by reformation, amendment, construction, or otherwise that changes a reformable interest into a qualified interest but only if --

(i) any difference between --

(I) the actuarial value (determined as of the date of the decedent's death) of the qualified interest, and
(II) the actuarial value (as so determined) of the reformable interest, does not exceed 5 percent of the actuarial value (as so determined) of the reformable interest,

(ii) in the case of --
(I) a charitable remainder interest, the nonremainder interest (before and after the qualified reformation) terminated at the same time, or
(II) any other interest, the reformable interest and the qualified interest are for the same period, and

(iii) such change is effective as of the date of the decedent's death.

The Tax Reform Act of 1969 (1969 Act) imposed new requirements that had to be met in order for a charitable deduction to be allowed for income, gift, and estate tax purposes for the transfer of a split interest to charity (i.e., part charitable and part non-charitable). The 1969 Act required that in the case of a remainder interest in trust, the interest passing to charity must be in either a charitable remainder annuity trust, a charitable remainder unitrust, or a pooled income fund.

In 1974, Congress first permitted reformation of charitable remainder trusts to conform to the requirements of the 1969 Act. Subsequent to 1974, Congress extended the period for reformations several times and also extended the reformation procedure to other types of split-interest charitable contributions. Because of the repeated need to extend the period to reform governing instruments and the fact that the failure to meet the 1969 Act rules often resulted in reduced amounts passing to charity, in the Tax Reform Act of 1984 (1984 Act) Congress enacted a permanent rule permitting the reformation of split-interest charitable contributions. Under these permanent rules an income, gift, or estate tax charitable deduction is allowed for property passing to charity in respect of any qualified reformation of a reformable interest into a qualified interest. See H.R. Rep. No. 432, 98th Cong., 2nd Sess. 1516 (1984).

The House Ways and Means Committee Report underlying section 2055(e)(3) states a qualified reformation is a change in the governing instrument of a trust which changes a reformable interest into a qualified interest if two requirements are met. AS UNDER PRESENT LAW, THE REFORMATION MUST BE RETROACTIVE TO THE DATE OF DEATH IN THE CASE OF TESTAMENTARY TRUSTS OR TO THE DATE OF CREATION IN THE CASE OF INTER VIVOS TRUSTS and should provide for correction of any overpayments or underpayments prior to reformation.

H.R. Rep. No. 432 at 1517-18 (emphasis added)

Thus, the legislative history underlying section 2055(e)(3) makes clear that the principles of that section are applicable to inter vivos trusts and that in order to be a qualified reformation, the reformation of an inter vivos trust must be retroactive to the date of the trust's creation.

Section 2055(e)(3)(C)(ii) and (iii) imposes a time limit to begin the court proceeding to reform a trust if the noncharitable interest is not expressed either in specified dollar amounts or a fixed percentage of the fair market value of the property (taking into account the provisions of section 664(d)(3)). In the present situation, the noncharitable interest in the Trust prior to amendment is stated as a unitrust amount that meets the definition contained in section 664(d)(2) and (d)(3). Therefore, provided the other provisions for a qualified reformation contained in section 2055(e)(3) are met, the Trust may be amended at any time to comply with provisions of section 664.

The only substantive change in the rights of the beneficiaries under the amendments involved the allocation of the unitrust amount between Taxpayers during their joint lives. Under the Trust prior to amendment, the independent trustee could determine how the unitrust payment would be divided between Taxpayers during their joint lives. Under the terms of the Trust before and after the amendments, the trustee is required to be an independent trustee. An independent trustee of a charitable remainder trust is permitted to have the discretion to sprinkle the unitrust amount among named beneficiaries. See Rev. Rul. 77-73, 1977-1 C.B. 175. The trustee's amendment to the Trust to provide for equal distributions to Taxpayers during their joint lives is merely an exercise of that permitted discretion.

We note, however, that the Trust did not operate in accordance with its terms. The unitrust amount was to be prorated on a daily basis for any short year. Therefore, because the Trust had no income during h, no unitrust amount was payable with respect to h. In addition, the unitrust amount paid with respect to o was in excess of the Trust's net income for that year. The noncharitable beneficiaries are required to reimburse the Trust for these excess distributions in accordance with section 1.664-3(a)(1)(iii).

Pursuant to section 4947(a)(2), charitable remainder trusts are subject to many of the rules governing private foundations. The operation of this Trust raises questions that need to be examined in this area. First, the excess distributions made with respect to h and o may be acts of self-dealing within the meaning of section 4941(d) and therefore may be subject to the tax imposed under section 4941(a) and (b). Second, the Trust invested in a limited partnership that may have generated unrelated business income with the meaning of section 512. If the Trust has any unrelated business income for a tax year, the Trust loses its exemption from income tax for that year under section 664(c). As a result, all the income of the Trust would be taxed as if the Trust were a complex trust for any year in which the Trust has unrelated business income.

Finally, the examining agent has indicated that the gain reported by the Trust on the sale of the stock originally contributed to the Trust was considerably understated. the understated gain resulted from using a higher basis to compute the gain than the donor's adjusted basis in the stock. Adjustments need to be made to the amount of gain realized by the Trust so that the amount of gain properly reflects the donor's adjusted basis in the stock. Even if the Trust is tax-exempt during the years that the stock was sold, the proper amount of gain needs to be reflected in the accumulated capital gains account described in section 664(b)(2).

CAVEAT:

A copy of this technical advice memorandum is to be given to Taxpayers. Section 6110(j)(3) provides that it may not be used or cited as precedent.

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