Thinking About Flip'n Out?

Thinking About Flip'n Out?

Article posted in Charitable Remainder Trust on 25 March 1999| comments
audience: National Publication | last updated: 16 September 2012
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Summary

With the June 8, 1999 reformation deadline fast approaching, this issue of Planned Giving Online reviews the requirements for "flip" charitable remainder unitrusts and the steps planners should consider to take advantage of this window of opportunity.

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

The "Flip" unitrust represents one of the most important charitable gift-planning opportunities that has emerged in the last decade.

Why are donors, income recipients, and gift planners thinking about "flip'n out?" As many of you already know, IRS and Treasury recently promulgated final Regulations under Code1 Section 664. Under these new rules, not only can a donor create a new charitable remainder unitrust with a "flip" provision to meet his or her specific financial planning and philanthropic needs, but income beneficiaries of existing income exception unitrusts (including those with make-up provisions) can elect on a one-time basis to reform into a Flip unitrust provided they begin the process by June 8, 1999.

As will be discussed in more depth below, a Flip unitrust is particularly worthy of consideration where:

  • A donor has a parcel of real estate or another hard-to-value asset (an "unmarketable asset" under the new Regulations) and the donor desires a stable payout, but does not know when this asset will sell.
     
  • An income recipient is dissatisfied that the amount of the current income payout is below the stated payout amount in the income exception CRUT.
     
  • An income recipient is in the top graduated income tax bracket and desires to reduce the portion of income distributions that are taxable as ordinary.

WARNING! A trustee's failure to contact the income beneficiaries of an existing net income unitrust or non-compliant Flip unitrust regarding the opportunity to convert into a Flip CRUT by June 8, 1999 will subject itself to a potential breach of its fiduciary duties. Attorneys and charities should also consider the propriety of delivering similar notice to their respective clients and donors.

Background on Payout Formats

Prior to the promulgation of the final Regulations, a donor could choose from three different types of charitable remainder unitrusts ("CRUT"). A standard unitrust ("SCRUT") pays a fixed percentage of the net fair market value of its assets, valued annually. Thus, if the net fair market value of the SCRUT's assets on the first day of the taxable year were $100, a five percent fixed payout would generate a distribution of $5 for that year. If the net income of the SCRUT is less than $5, a portion of the SCRUT's principal will be distributed. In any event, the $5 will be distributed to the income recipient, whether from the SCRUT's principal or net income.

"Net income" as used in this context is a fiduciary income concept, not a tax term, and generally refers to dividends from corporate stock and interest income from fixed income instruments such as CDs and bonds. Sometimes, capital appreciation is included in the definition of net income, but the unitrust instrument and state law must be reviewed in that regard.

The second type of unitrust is a net income only unitrust ("NIOCRUT"). In this form, the unitrust amount is a formula composed of two elements: the fixed percentage amount (five percent of the net fair market value of the trust's assets, as described above) and the net income. The lesser of those two elements is the unitrust amount payout for the year. Thus, as in the example above, if $3 of net income is earned by the NIOCRUT, only $3 will be paid out to the income recipient. The difference between $5 (fixed percentage payout, as in the SCRUT) and $3 (net income) will never be paid out to the NIOCRUT's income recipient.

The third type of unitrust is a net income with make-up unitrust ("NIMCRUT"). In this form, the unitrust amount is determined in the same fashion as the NIOCRUT; however, in the previous example, if the trust was a NIMCRUT rather than a NIOCRUT, the trust will makeup the lost $2 if and when the net income in later years exceeds the unitrust amount due in that year. For example, if the net income of the NIMCRUT is $7 in year two of the trust, the NIMCRUT will pay out the $5 (the lesser of five and seven), and "makeup" the $2 not paid out in the prior year. Thus, the income recipient of the NIMCRUT will receive a unitrust amount equal to $3 in the first year and $7 in the second year.

The final Regulations create a fourth type of unitrust, the "Flip CRUT," which permits a NIOCRUT or NIMCRUT to convert into a SCRUT during the term of the trust. Thus, the nature of the income payout will change during the trust's term.

Blessing the Flip CRUT

Initially the "proposed" Regulations, issued in April of 1998 under Section 664 (specifically Regulation Section 1.664-3(a)(1)(i)(c)), created a rigid and somewhat complex structure for the Flip CRUT. Fortunately, the final Section 664 Treasury Regulations issued on December 10, 19982 are generally more favorable than the proposed Regulations insofar as Flip CRUTs are concerned, allowing greater opportunities and simplified requirements for flipping.

Elimination of Complex Asset Mix Rules

The proposed Regulations created an unworkable and complex percentage test (90%/50%) for unmarketable assets which could be placed in a Flip CRUT. Many participants at the Regulatory Hearing for the proposed Regulations on November 18, 1997 noted that the percentage test did not take into account significant costs that may be associated with the upkeep of a contributed asset or the tricky valuation issues involved with unmarketable assets. There was concern that the validity of a Flip CRUT would be questionable if asset valuations were ever challenged, even if the IRS challenge occurred well after the flip. Fortunately, the final Regulations eliminated this requirement.

Flip CRUT Requirements

Thanks in significant part to the efforts of the National Committee on Planned Giving, instead of the complex (90%/50%) tests, the final Regulations allow an income exception CRUT to flip once during its existence upon the occurrence of a "triggering event." The triggering event must be stated in the trust instrument.3 It must be either a specific date or a single event whose occurrence is not discretionary with, or under the control of, the trustee or any other person.4

Regulation Section 1.664-3(a)(1)(i)(d) notes that permissible triggering events include the sale of unmarketable assets as defined in Regulation Section 1.664-1(a)(7)(ii). The Flip CRUT must start out as an income exception CRUT and must end up as a SCRUT after the flip.5 The changeover to SCRUT status must take effect at the beginning of the taxable year following the year in which the triggering event occurs.6 If the CRUT began as a NIMCRUT, any make-up account existing at the time of the flip will be forfeited.7

There are ten examples of possible triggering events in the final Regulations.8 The seven permissible triggering events described are the sale of the donor's former personal residence,9 the sale of securities for which there is no available securities exemption permitting a public sale,10 when the income recipient reaches a certain age,11 when the donor gets married,12 when the donor divorces,13 when the income recipient's first child is born,14 and when the income recipient's father dies.15 It does not appear that these safe harbors are exclusive in nature. The examples of impermissible events relate to occurrences which are within the discretion of some person, including the sale of publicly traded stock,16 a request by the income recipient17 and a determination by the income recipient's financial advisor.18

Any triggering event outside of the listed safe harbors should be carefully considered. For instance, caution should be used if the desired triggering event is the income recipient's retirement. There is a good chance that retirement would be deemed to be a non-qualifying discretionary event. Moreover, the definition of "retirement" may be subject to differing interpretations. Unless further IRS guidance is obtained, it is probably best to be prudent and simply use a specific date that is expected to be the approximate date of retirement as the triggering event.

Reformation Proceedings

Gift Planners are also "flip'n out" because the final Regulations include a limited window of opportunity for existing income exception CRUTs and non-compliant Flip CRUTs to convert into compliant Flip CRUTs.19

If you have worked with a donor to create a Flip CRUT that does not comply with the new Regulations as described above, you must advise the donor/income recipients of the change in the law and provide him or her with an opportunity to fix the CRUT. For instance, non-compliant Flip CRUTs must conform to the new Regulations or risk disqualification and self-dealing implications.20

If a non-compliant Flip CRUT was created before December 10, 1998, the trust may be reformed to use the initial method for computing the unitrust amount for the entire term of the trust (that is, to take out the flip provision) or may be reformed to create a compliant Flip CRUT by initiating legal reformation proceedings by June 8, 1999.21 If a non-compliant Flip CRUT was created on or after December 10, 1998, the trust may be amended or reformed to use only the initial method for computing the unitrust amount for the entire term of the trust or may be reformed to create a compliant Flip CRUT by initiating legal reformation proceedings by June 8, 1999. A distinction seems to be drawn between the reformation or amendment of a non-compliant Flip CRUT that is created either before or after December 10, 1998.

The most exciting aspect of these reformation provisions is the opportunity to convert existing income exception CRUTs into Flip CRUTs. Any income exception CRUT may be reformed to a Flip CRUT if legal reformation proceedings are initiated by June 8, 1999.22

Regulation Section 1.664-3(a)(1)(i)(f)(3) indicates that the triggering event under a reformed trust instrument may not occur in a year prior to the year in which the court issues the order reforming the trust. An exception exists if the pre-reformation trust instrument provides for payment of the unitrust amount under an impermissible flip provision and the triggering event occurs before the reformation.

Opportunities and Burdens

The new Flip CRUT provisions create a unique opportunity for charities and gift planners to notify donors and clients about a potentially beneficial change in the law. New Flip CRUT strategies may be designed for retirement or education planning. If donors or income beneficiaries are dissatisfied with an existing NIMCRUT structure because of the difficulty of investing the trust assets to earn a sufficient income return to cover the unitrust payout, reformation to a Flip CRUT structure may enable the parties to change to a more suitable investment mix after the flip. Once the SCRUT structure becomes effective, the trustee will have a greater opportunity to invest for total return, which will likely produce more growth in principal for the ultimate benefit of charity and a larger current unitrust payout. Such an investment mix may also be able to generate more capital gain income relative to ordinary dividend and interest income, thus providing more after tax dollars for the income recipient.

Charities may also consider the delivery of notice as an opportunity to practice good stewardship, as well as promote future gifts. For instance, if the income beneficiaries express a lack of need for continued income, a request for a gift of the entire income interest in a CRUT would certainly be proper. In that event, the income recipient will be entitled to an income tax deduction for the present value of the income interest; the charitable remainder interest in the CRUT will likely be accelerated; and an immediate gift to charity will occur.

On the other hand, the Flip CRUT provisions clearly impose a burden on trustees and administrators of existing income exception CRUTs and defective Flip CRUTs to notify the income beneficiaries of the limited window of time for reformation. Attorneys and other charitable gift planners should likewise view this notice as an opportunity to make contact with their clients to proactively advise them on changes in the law which may benefit them. Certainly in the case of trustees, if such notification is not undertaken, they likely risk liability for breaching their fiduciary duties. The notice should describe the change in the law and its effect. The notice must clearly warn the income recipients of the June 8 deadline and the need for quick action. From a charity's perspective, to avoid creating inadvertent liabilities, the notice should require that the income recipients obtain independent counsel and guidance to determine whether a flip is even desirable in their individual cases.

Steps for Reformation

The rules regarding flip reformation proceedings and the steps for successful reformation will depend upon each state's laws, each local jurisdiction's procedural and substantive rules and each individual judge's method of handling the proceeding. However, some generalizations can be made about the necessary steps: The existing trust agreement must be reviewed and the desired amendment must be prepared and approved by the parties. The proper parties to the reformation proceeding must be determined and the appropriate consents obtained. The necessary steps to be undertaken in the reformation proceeding must also be determined, i.e., the proper court to handle the proceeding and the preparation of court pleadings. Since the Attorney General has an interest in charitable trusts under most (if not all) states' laws, the necessity and extent of the Attorney General's participation must be analyzed.

Need for Court Proceedings

Some have questioned whether court proceedings are necessary if the relevant state law includes provisions generally allowing amendment or reformation of a CRT without court proceedings. For instance, Maryland law provides for the reformation of a charitable remainder trust without application to a court, where the governing instrument is amended to conform to the provisions of Code Section 664 and the consent of each recipient named in the governing instrument is obtained.23

However, the final Regulations clearly contemplate the involvement of a court, requiring that a trustee must begin "legal proceedings" to reform under the Flip CRUT provisions by June 8, 1999.24 The Regulations also specifically provide that the Flip may not occur in a year prior to the year in which the "court issues the order reforming the trust."25

Why would the IRS require a court's intervention, if state law provided for a more simplified procedure? Does such a simplified procedure qualify as a "legal proceeding"?

In discussions with the drafters of the Regulations, IRS representatives indicated that the Service is not trying to create the most burdensome process to reform the trust. However, the IRS specifically requested comments on an easier or more streamlined reformation process when they issued the proposed Regulations. The IRS received no such comments.

Subsequent to the issuance of the final Regulations, one gift planner notified the IRS of a simplified process in at least one state, where court intervention was apparently not required as long as the State Attorney General was involved. In this particular case, the IRS representatives orally indicated that any such state process should be acceptable, so long as "all rights of the interested parties in the trust are preserved."

In analyzing the rather complex reformation process, it is easy to conceptualize circumstances where "preserving the rights of all interested parties" might get tricky. For instance, what is meaningful consent? If an income recipient is estranged from the family or cannot be reached quickly, can anyone other than that individual consent to the reformation? If the income recipient is an unborn child or a minor, is a guardianship proceeding necessary? Clearly an irrevocable charitable remainderman can bind itself to the reformation, but can a revocable charitable remainderman bind other charities that may get a piece of the CRUT pie at the termination of the trust? Is this a case for Attorney General involvement? If the NIMCRUT payout is high, i.e., over 10, 12 or 15%, can the conversion into a SCRUT be economically justified and is such a conversion in the best interest of all trust beneficiaries, especially the charity?

These questions have no real answer in the abstract. The trust instrument itself, state law and specific economic analyses will dictate the answers to these questions. Certainly, new questions will surely arise as the unique facts of each case are analyzed.

Another key question is who should make these determinations? If the trustee of the trust makes a determination without court intervention, the trustee may subject itself to claims by trust income recipients or remainder beneficiaries. Some of those recipients or beneficiaries may not have even been contemplated at the time of the reformation. Others may argue that their interests weren't properly protected. If the trustee goes forward without going to court and such a claim is made, can the IRS in hindsight challenge the validity of the reformation, because a court order was not obtained or the rights of all interested parties were not protected?

Suppose a gift-planning adviser fails to obtain court approval, since "all rights of the interested parties in the trust are preserved." Suppose further that the IRS representatives who enunciated this standard are no longer working at the Service when the adviser is faced with a challenge to a reformed Flip CRUT. On what theory would the adviser be able to argue that no court proceeding was necessary? The adviser certainly has no literal authority in the final Regulations themselves that would allow for anything other than a court-approved reformation. Relying on a standard enunciated by two IRS representatives and not supported by specific regulatory authority may create some concern on the part of the adviser.

The two IRS representatives who saw no need for a court proceeding if "all rights of the interested parties in the trust are preserved" are both knowledgeable and highly professional attorneys. Their integrity and knowledge of the area cannot be questioned. The issue does not revolve around the accuracy of their statements, but around the certainty of their gracious and kind solution.

Going to court in a vast majority of the cases should be a simple matter. If all interested parties consent (assuming the charitable remainderman is irrevocably designated in the trust instrument), obtaining a court order reforming the trust should be a "slam dunk."

The lesson seems to be clear: go to court. Without published and authoritative written guidance from the IRS on this issue, it would not be prudent, and may be treacherous, to rely on any state law provision allowing a non-judicial reformation.



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

  2. See T.D. 8791.back

  3. Treas. Reg. §1.664-3(a)(1)(i)(c).back

  4. Treas. Reg. §1.664-3(a)(1)(i)(c)(1).back

  5. Treas. Reg. §1.664-3(a)(1)(i)(c).back

  6. Treas. Reg. §1.664-3(a)(1)(i)(c)(2).back

  7. Treas. Reg. §1.664-3(a)(1)(i)(c)(3).back

  8. Treas. Reg. §1.664-3(a)(1)(i)(e).back

  9. Treas. Reg. §1.664-3(a)(1)(i)(e)(Example 1).back

  10. Treas. Reg. §1.664-3(a)(1)(i)(e)(Example 2).back

  11. Treas. Reg. §1.664-3(a)(1)(i)(e)(Example 4).back

  12. Treas. Reg. §1.664-3(a)(1)(i)(e)(Example 5).back

  13. Treas. Reg. §1.664-3(a)(1)(i)(e)(Example 6).back

  14. Treas. Reg. §1.664-3(a)(1)(i)(e)(Example 7).back

  15. Treas. Reg. §1.664-3(a)(1)(i)(e)(Example 8).back

  16. Treas. Reg. §1.664-3(a)(1)(i)(e)(Example 3).back

  17. Treas. Reg. §1.664-3(a)(1)(i)(e)(Example 10).back

  18. Treas. Reg. §1.664-3(a)(1)(i)(e)(Example 9).back

  19. Treas. Reg. §§1.664-3(a)(1)(i)(f)(2) and (3).back

  20. It is interesting to note, however, that a literal reading of Code Section 664 and the old Regulations thereunder arguably permitted a flip between the different CRUT forms, even on an annual basis. Code Section 664(d)(3) provides as follows, "Notwithstanding the provisions of paragraphs 2(A) and (B), the trust instrument may provide that the trustee shall pay the income recipient for any year, ... [emphasis added]" the NIOCRUT or NIMCRUT amount. Treas. Reg. §1.664-3(b) even more clearly states that the governing instrument may provide that, instead of the SCRUT unitrust amount, the trust shall pay for any year either the NIMCRUT or NIOCRUT unitrust amount.back

  21. Treas. Reg. §1.664-3(a)(1)(i)(f)(2).back

  22. Treas. Reg. §1.664-3(a)(1)(i)(f)(3).back

  23. Section 14-304 of the Estates and Trusts Article of the Annotated Code of Maryland.back

  24. Id.back

  25. Id.back

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