Rev. Proc. 2005-24 CRT Could Lose Exempt Status Because of Tax Trap

Rev. Proc. 2005-24 CRT Could Lose Exempt Status Because of Tax Trap

Article posted in Charitable Remainder Trust on 4 April 2005| comments
audience: Leimberg Information Services, National Publication | last updated: 18 May 2011
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Summary

Under recently issued Revenue Procedure 2005-24, a charitable remainder trust can now lose its tax exemption years after it is established merely because the grantor moves to another state or remarries! In this important article from Leimberg Information Services, St. Louis attorney Lawrence P. Katzenstein alerts readers that trustees of charitable remainder trusts will now need to be more vigilant.
By Lawrence P. Katzenstein
Edited by Stephan R. Leimberg

FACTS:

STATUTORY RIGHT OF ELECTION RULES ARE CHANGING

In most if not all common-law states, a surviving spouse has a statutory right to elect to take a share of a deceased spouse's estate in lieu of the testamentary provisions the deceased spouse may have madeor not madefor the surviving spouse.

Traditionally, this right of election applied only to a decedent's probate estate. Absent a showing of intent to defraud the surviving spouse of marital rights, trusts established by the decedent during lifetime were usually not subject to the statutory right of election.

But the elective share rules have been changing. Many states have adopted the provisions of the Uniform Probate Code. These UPC rules extend a surviving spouse's right of election to an "augmented estate" which may include lifetime gifts as well as non-probate assets such as trusts created during lifetime.

These more modern election statutes typically take into account the length of marriage and other factors in determining how much of the "augmented estate" will be subject to the statutory right of election.

BASIC UNDERLYING ASSUMPTION IS CHARITY GETS REMAINDER!

A CRT's tax exempt status and the donor's initial charitable income tax deduction all rest on the basic assumption that, what is left in the trust at the death of the donor, will eventually pass to charity.

IRS CONCERN:

The IRS is concerned that if a CRT grantor's spouse can elect to take all or a portion of the charitable remainder trust as a part of the "augmented estate" at the donor's death, the bedrock assumption underlying the charitable remainder trust is shattered.

The Service thus has a legitimate concern and a nice problem to solve: how preserve the tax deduction for charitable remainder trusts in view of the fact that, under these modern probate statutes, a portion of the trust may eventually pass (NOT TO CHARITY) but to a spouse exercising an elective share right?

MERE EXISTENCE OF ELECTIVE RIGHT AND MERE POSSIBILITY CHARITY WOULN'T TAKE ARE SUFFICIENT TO CAUSE LOSS OF EXEMPTION!

The thrust of the Revenue Procedure is that the mere existence of a right of election, whether or not it may be exercised, and the resulting possibility that the charitable remainder trust may be invaded for the benefit of a surviving spouse, causes a trust to fail to qualify under Code Section 664.

SPOUSAL WAIVERS NOW REQUIRED

The Revenue Procedure deals with this by requiring irrevocable waivers of the right of election against the CRT if applicable state law provides for such right. This will generally be only in common law states since in community property law states the spouse already has a vested interest in one-half of the community property.

OLD TRUSTS GRANDFATHERED:

For CRTs created before June 28, 2005 the Service will not require a spousal waiver of right of election.

Those trusts can still lose their tax exemption but only if the surviving spouse ACTUALLY EXERCISES a right of election.

Bad News: If that happens, the CRT will fail to qualify FROM THE DATE OF CREATION!

Good News: The revocation of tax exempt status from date of creation will, in many cases, be a meaningless gesture since the statute of limitations may have run both for the donor and the trust.

NEW TRUSTS:

For CRTs created on or after June 29, 2005, the failure of the donor's spouse to waive the right of election in accordance with the requirements of the Revenue Procedure will result in the CRT failing to qualify from date of creation WHETHER OR NOT the spouse exercises the right of election.

PLANNING TIPS:

It is critical that the spouse of a grantor or presumably BOTH spouses in the case of a trust funded by husband and wife irrevocably waive a right of election in those states in which the right of election includes an augmented share.

That waiver must be valid under applicable state law, in writing and signed and dated by the spouse. (The spouse does not, of course, have to waive any right to receive lifetime distributions from the CRT).

TIMING THE WAIVER:

When does the waiver have to be obtained? The Revenue Procedure provides that the waiver must be obtained on or before the date that is six months after the due date (excluding extensions of time to file actually granted) of IRS Form 5227 for the year in which the later of the following occurs:

1. the creation of a trust;

2. the date of the grantor's marriage to the spouse;

3. the date that the grantor first becomes domiciled in a jurisdiction whose law provides a right of election that could be satisfied from assets of the trust; or

4. the effective date of applicable state law creating a right of election.

BE AWARE OF THIS GLITCH!

The timing of waiver provision almost certainly includes an unintentional error. Note the language above: the waiver must be obtained on or before "the date that is six months after the due date (EXCLUDING extensions of time to file actually granted) a Form 5227.

Didn't the drafter really mean INCLUDING extensions of time to file actually granted?

If extensions of time are really excluded, as the language seems to indicate, then whether or not the extension of time to file was granted or not granted is irrelevant. In fact, the language as it now exists leads to an odd result. Only extensions of time to file actually granted are excluded, but extensions of time to file not actually granted would be included! This is obviously not what was intended.

HURRY UP AND DO WHAT?

So what do we do now?

Theoretically nothing need be done at present even with new trusts if state law does not provide for election against an augmented share which includes assets of a charitable remainder trust.

However, if the state later adopts such a law, or if the grantor later moves to a state which has such a law, obtaining a waiver will be necessary to maintain the continued tax exempt status of the trust.

Perhaps that means that we should always obtain waivers from spouses of grantors of charitable remainder trusts, even in those cases where state law does not so provide for an augmented share election.

The problem is that the if the state does not yet have such a provision, state law requirements for a waiver will not be known, and the waiver must comply with state law under the Rev. Proc.

My opinion? I think a waiver of some kind is a good idea in all of these cases.

One way to make certain that the waiver is obtained might be to include the waiver provisions and spouse's consent in the charitable remainder trust and have the spouse sign the waiver in the trust.

Unless these steps are taken, it is doubtful that the waiver will be obtained when it is necessary. A corporate trustee is unlikely to know that the grantor has remarried and the grantor is unlikely to be aware, perhaps years after the trust was created, that additional steps are necessary to preserve the tax exempt status of the trust.

SPOUSE NEED ONLY WAIVE RIGHT TO TAKE CRT ASSETS

Note that the spouse's waiver does not have to be a waiver of the spouse's entire right of election. It merely has to be a waiver of the right to elect against the assets of the charitable remainder trust. Again, state law will determine whether this kind of partial waiver is permitted.

EXAMPLES FROM THE REV. PROC:

Examples in the Revenue Procedure fill in some of the gaps.

Example 4: This example notes that if later in the same year the trust is created, the applicable state law is amended to provide that the augmented estate does not include the assets of a charitable remainder trust, and if the amendment applies retroactively, no waiver would be required.

Example 5: This example explains that a waiver contained in a prenuptial agreement will be effective unless the agreement is subsequently found to be invalid or unenforceable.

A final example deals with a situation where spouse 1 waives the elective share right and subsequently dies, followed by grantor's remarriage to spouse 2 who refuses to waive the elective share right with regard to the assets of the trust. In this case the trust will qualify up until the date of the second marriage but not thereafter.

PARTING REMARKS:

1. Given the importance of this Revenue Procedure, it is surprising and disappointing that it was not issued in proposed form so that members of the bar and representatives of charitable organizations and trustees could comment.

2. In the case of trusts which lose their exemption because of a remarriage or later state adoption of a new law election law, loss of the CRT's tax exemption will not be particularly significant. Even where the loss of exemption is effective from date of creation, if the statute of limitations has run for the year in which the deduction was taken and in which capital gain generated by appreciated property was sheltered from taxation, loss of the tax exemption may mean only that any ordinary income in excess of the amount distributed will be taxable to the trust and any capital gains incurred in the future will be subject to capital gains tax.

Given current low interest rates and dividend yields, it is unlikely in most cases that the trust will have income greater than the 5% minimum distribution requirement. It may make little or no difference at the beneficiary level since under the tier system applicable to charitable remainder trusts, donors will have been paying income tax in any event on amounts distributed from the income tiers.

3. Because of the significant risks the Revenue Procedure poses for donors to charitable remainder trusts, perhaps states with these augmented share right of election laws should amend their statutes so that the election right would not extend to any trust which has received contributions for which a charitable deduction was allowable.

HOPE THIS HELPS YOU HELP OTHERS!

Larry Katzenstein

Edited by Steve Leimberg

CITE AS:

Steve Leimberg's Charitable Planning Newsletter # 73 (April 1, 2005) at http://www.leimbergservices.com


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