When Do Life Income Payments from a Charitable Remainder Trust Really End?

When Do Life Income Payments from a Charitable Remainder Trust Really End?

Article posted in Charitable Remainder Trust on 13 July 1999| comments
audience: National Publication | last updated: 16 September 2012
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Summary

Charitable Remainder Trusts that are measured by the life of one or more individuals offer several options with respect to when trust payments terminate. Although the selection of final payment method may seem benign, it can have a significant effect on income recipients and charity.

by Marc D. Hoffman

The income tax regulations that govern charitable remainder annuity trusts and unitrusts offer a great amount of flexibility with respect to the trust's measuring term. The rules provide that the obligation to pay the annuity or unitrust amount begins on the day the trust is created and continues for either the life of one or more named individuals or for a term not to exceed 20 years.

If the income interest is payable for the life of an individual, it must be payable solely to that individual, or to that individual and an organization described in IRC §170(c). The regulations also permit trusts to be measured by several combinations of life and fixed term of years. If the trust is to be measured exclusively by a fixed term of years, the trust will generally terminate upon conclusion of the fixed measuring term.

A charitable remainder trust can also terminate earlier than the prescribed measuring term 1) if it is subject to a qualified contingency 1, 2) if the trustor exercises a retained right to revoke the income recipient's interest, or 3) when the income recipient contributes his or her income interest to the charitable remainderman.

When a trust is measured by the life or lives of one or more individuals, the regulations and IRS rulings provide two options with respect to when income payments terminate. The balance of this article describes these options and discusses some of the planning considerations associated with their use.

Trust Terminates with Last Regular Payment

Reg. §1.664-3(a)(5)(i) provides in part --

Payment of the amount described in subparagraph (1) of this paragraph may terminate with the regular payment next preceding the termination of the period described in this subparagraph. The fact that the recipient may not receive such last payment shall not be taken into account for purposes of determining the present value of the remainder interest.

This option simply directs that payments of the unitrust or annuity amount end with the last regular payment preceding death. Accordingly, even if the income recipient dies one day prior to next regular payment, no amount is payable to the income recipient's estate. If the trust is to continue for the benefit of a successor income recipient, the successor's income interest is deemed to begin on the day following the last regular payment to the primary income recipient.2 Thus, if the primary income recipient dies one day prior to the next regular payment, the entire payment will be made to the successor income recipient.

Rev. Rul. 72-395, §7.06 provides a sample provision for inclusion in the governing instrument of this optional provision: 3

The trustee shall pay to A in each taxable year of the trust during his life a unitrust amount equal to Y percent of the net fair market value of the trust assets valued as of the first day of such taxable year. However, the obligation of the trustee to pay such unitrust amount shall terminate with the payment next preceding the death of A. The unitrust amount shall be paid in equal quarterly installments from income and, to the extent that income is not sufficient, from principal. Any income of the trust for a taxable year in excess of the unitrust amount shall be added to principal.

A similar provision is provided for annuity trusts.

Trust Terminates on Date of Death

In the absence of the option to terminate payments with the last regular payment preceding death, the trust instrument must provide that income payments terminate on the date of income recipient's death. The regulations provide instructions that prorate the final payment.4This method is similar to the formula used to determine income payments for short taxable years that occur when a trust is initially funded or an additional contribution is made. Rev. Rul. 72-395, §6.05 provides sample language for this purpose:

In determining the (annuity or unitrust) amount, the trustee shall prorate the same, on a daily basis, for a short taxable year and for the taxable year of A's death.

It is important to note that the governing instrument must provide a final payment method. Rev. Rul. 79-428 holds that a charitable remainder trust instrument that contains no provisions regarding the proration of the specified distribution in the final taxable year of the trust and no provision allowing termination of the specified distribution with the regular payment next preceding the date of the life beneficiary's death is not a qualified charitable remainder trust under section 664.5

Planning Considerations

Because the choice of final payment method has no bearing on the computation of the present value of the remainder interest for income, gift, and estate tax deduction purposes, the selection may seem to affect only the destination of the final payment. Depending on the style of charitable remainder trust and investment fact pattern, however, the amount of the final payment can vary significantly.

Annuity Trusts and Standard Payout Format Unitrusts

Charitable remainder annuity trusts are required to pay a fixed annuity amount at least annually. Similarly, charitable remainder unitrusts that bear a standard payout format are required to pay a unitrust amount6, also at least annually. Payments from annuity trusts and unitrusts can be made at the beginning or end of each annual, semi-annual, quarterly, monthly, and only in the case of annuity trusts, weekly period. In order to strike a balance between the income recipient's need for regular income and administrative convenience, most charitable remainder trusts provide for income payments at the end of each quarter.

Because annuity trust and standard payout format unitrusts are required to make distributions, even if doing so requires invading corpus, the maximum difference between final payment methods will be limited to the amount of the final periodic payment. Given the size of some charitable remainder trusts, this amount may be significant and worthy of consideration.

Payments Delayed for Administrative Accommodation

Occasionally, circumstances will dictate that a trustee is unable to make a periodic payment on a timely basis. In such case, the regulations permit payments to be made within a reasonable period after the close of the tax year in which the payment was due, without jeopardizing their status under section 664(d).7 A reasonable time is generally no later than date on which the tax return for the year in which the payment is due is required to be filed. Therefore, a trust can delay payment until April 15th of the following year with additional extensions until October 15th, if necessary. This accommodation is unavailable if the trust's payout or annuity rate exceeds 15%. In such cases, the payout must be made by the end of tax year in which it is due.8

It is important to note that if a payment has been earned by an income recipient, but has not been paid because of this administrative accommodation, the payment will be considered having been made when it was due. Accordingly, if a payment is delayed for administrative accommodation and the income recipient dies prior the payment being made, for purposes of determining the final payment method, the payment will be considered as having been made when it was due.

Example 1: White is the life income recipient of an 8% annuity trust. The trust makes payments at the end of each calendar quarter, but has failed to make any payments during the year due to a lack of investment liquidity. The trust instrument provides that the trust is deemed to terminate with the last regular payment prior to White's death. White dies on September 15th, having received no payments for the year.

Although we find no specific authority on this scenario, because White was entitled to receive the distribution, we believe that White's estate should be entitled to receive payments applicable to March 31st and June 30th, but will not be entitled to the prorata distribution for the final partial quarter.

Net Income Unitrusts

The greatest amount of care in final payment method selection must be given to charitable remainder unitrusts that contain a net income or net income with make-up option. Net income unitrusts are required to distribute, at least annually, the lesser of the unitrust amount (determined by multiplying the fair market value of trust assets on the annual valuation date(s) by the trust's fixed payout rate) and trust income (as defined in the trust instrument). Accordingly, if a net income unitrust produces no accounting income during the taxable year, it will have nothing to distribute in satisfaction of the unitrust amount.

Trust income is usually defined in the trust instrument as that term is defined under IRC §643(b) and the regulations thereunder. The Revised Uniform Income and Principal Act adopted by most states defines income to include interest, dividends, rents, and royalties. Unless otherwise defined in the trust instrument, and subject to state law, income does not include capital gains. In addition, some states include distributions from commercial annuity contracts, to the extent they exceed basis, as income.

Make-Up Option

Net income unitrusts may include a make-up option. Under this option the trust pays income in excess of the full unitrust amount to the extent the aggregate of amounts paid in prior years were (by reason of the net income limitation) less than the aggregate of the fixed percentage amounts for such prior years. These foregone amounts are commonly referred to as the "deficiency account." The make-up option enables a trust to repay deficiencies from prior years by paying out excess income earned in the current year.

NIMCRUT Deficiency Account Not a True Liability

It is important to note that a NIMCRUT deficiency account is not considered as a liability for purposes of determining the final trust payment. The obligation to repay any deficiency account balance arises only when the trust generates income in excess of the amount it is required to distribute in satisfaction of the annual unitrust amount.

This confusion was fueled by a 1995 private letter ruling in which the Service held that when a net income unitrust includes capital gains in its definition of trust income, any outstanding deficiency account balance must be treated as a "liability" for the purpose of determining the annual unitrust amount.9

The ruling was based on a unitrust that allocated all gains realized on trust assets (whether attributable to appreciation occurring before or after contribution) to trust income. This particular trust exploited the fact that because a charitable remainder trust takes over the donor's cost basis and holding period of assets transferred to it (for the purpose of determining the taxation of trust distributions), the trust should be also able to use the donor's cost basis in determining gain and, therefore, trust income.

Example 2: Suppose Green contributed $1,000,000 in non-dividend paying closely-held stock, having a zero dollar cost basis, to a 10% NIMCRUT that defined income to include pre-gift gains. With no public market for the stock, the trustee was then required to hold the stock for 10 years; after which, the issuing corporation redeemed the stock for $1,000,000. Assuming no variation in valuation during the holding period, the deficiency account balance at the time of sale would be $1,000,000. Based on the trust's definition of income, the entire $1,000,000 would be distributed to Green in satisfaction of the current unitrust amount and deficiency account balance. The trust would be exhausted with no remainder interest payable to charity.

In an effort to stem the potential for compounding the deficiency account itself, the IRS held that any outstanding deficiency account balance should be treated as a liability in determining the fair market value of the trust assets for purposes of calculating the annual unitrust amount. The use of the term "liability" is unfortunate, if not inappropriate. A deficiency account is not a liability or debt of the trust at all because the obligation to pay down the deficiency account balance does not arise until the trust produces excess income with which to pay it. Were it a true liability, the trust may have debt-financed income under the unrelated business income rules. We doubt this was the Service's intent.

Proposed regulations under IRC §664 prohibit defining pre-contribution gains as income based on the premise that allocating amounts to trust income that are part of the fair market value of the contributed property on which the charitable deduction is based would be inconsistent with Congress' intent to assure that the amount claimed as a charitable deduction for the contribution to the trust relates to the projected growth of the assets contributed less the expected distributions to the income beneficiaries.10 Unfortunately, the aforementioned ruling and several others that have followed have not clarified whether the liability treatment also extends to trusts that define income as including only post-gift gains.11 Informal conversations with the Service have suggested that based on the proposed regulations, treatment of the deficiency account as a liability will no longer apply. Hopefully, the Service will formalize the application of this position to post-gain trusts in final regulations.

Capital Gains as Income

When post-gift gains are allocable to income, the possibility exists that a large deficiency account balance may be paid upon sale of the contributed property. The following example illustrates the effect the final payment method can have on trust distributions:

Example 3: Suppose Smith transfers non-income producing raw land valued at $1,000,000 to a net income unitrust bearing an 8% payout rate and containing a make-up option. Assume the trust instrument defines income to include post-gift appreciation. This means that any appreciation in the value of the contributed property beyond its value on the date of contribution that is realized on sale by the trust is deemed income for trust accounting purposes. Smith is the sole life income recipient and receives payments at the end of each calendar quarter. Suppose the property sits in the trust for a period five years, after which, it is sold on April 1 for a net amount of $1,400,000. At the time of sale, the deficiency account balance attributable to the make-up option is $400,000. Under this fact pattern, the amount distributable to Smith on June 30 would be $400,000. However, Smith dies on June 29.

How much income will Smith's estate receive? If the final payment is based on the last regular payment, Smith's estate will receive nothing. If the final payment is based on Smith's date of death, his estate will receive $400,000.

Income Deferral Unitrusts

The previous fact pattern is analogous to other investment assets as well. NIMCRUTs are also used for retirement planning purposes by investing in assets that produce no trust accounting income for a predetermined period of years, or that produce such income only at the discretion of the trustee. Investment assets used for this purpose include zero coupon bonds, growth stocks, common trust funds, investment partnerships, and commercial deferred annuity contracts.

Example 4: Suppose Jones transfers appreciated assets to a NIMCRUT. The assets are sold and the proceeds immediately reinvested in a tax-deferred variable annuity. The trust instrument defines income to include "distributions from an annuity contract." Jones is in his fifties and does not yet need income from the trust, so the trust assets are allowed to accumulate. Ten years passes when Smith is suddenly taken ill and has extraordinary medical expenses. The trustee decides to generate trust income by making a significant partial withdrawal from the annuity contract. The withdrawal will be deemed income to the trust when cash is actually received from the trust. This occurs; however, Jones dies prior to the next regular payment date.

As with the previous example, if the final payment is based on the last regular payment, Jones' estate will receive nothing. If the final payment is based on Jones' date of death, his estate will receive the full withdrawal amount (to the extent of the current unitrust amount and deficiency account balance).

When the possibility exists that income may be deferred within a net income unitrust, it may be prudent to direct that income payments terminate upon death in order to give trustors and trustees the greatest amount of flexibility in distribution planning.

Retained Right of Revocation

When a trustor creates a charitable remainder trust naming a person other than a spouse as an income recipient, the trustor can forestall the recognition of a taxable transfer to the income recipient by reserving the power in the trust instrument to revoke the income recipient's interest, thereby making the transfer incomplete for gift tax purposes. Notwithstanding the transfer tax planning aspects of this choice, such rights are also retained to enable donors to exercise an element of control over the income recipient. If such a right is exercised, the trust is deemed to terminate on the date of death of the trustor. If the power is exercised, it will most likely be based on the fact the trustor does not want the income recipient to enjoy any more income. A trustor who reserves this power may, therefore, desire to have payments terminate with the last regular payment preceding death.

Qualified Contingency

A second method of terminating an income recipient's interest is by the use of a qualified contingency. IRC §664(f)(3) defines a qualified contingency as "any provision of a trust which provides that, upon the happening of a contingency, the unitrust or annuity trust payments will terminate no later than such payments would otherwise terminate under the trust." As with retained rights of revocation, the use of a qualified contingency probably means the trustor no longer desires the income recipient to enjoy income from the trust. However, the language in the Code is not clear with respect to how the final payment is to be made. In the absence of clear authority, we presume that the final payment method applicable to the trust based on its normal measuring term would also apply to the termination of payments in the case a qualified contingency terminates the trust in advance.

Income Tax Considerations

When income payments terminate upon the income recipient's death, any payments made to the decedent's estate should be includible on the decedent's final income tax return. After the payment of income taxes, the net amount will then be passed according to the terms of the decedent's estate plan with possible estate tax liability. If the trust terminates with the last regular payment, no additional income amounts will be subject to income tax or includible in the decedent's estate. Income tax planning should therefore consider whether the trust has a successor income recipient, the relation of the successor to the primary income recipient, and the dispositive provisions of the income recipient's estate plan. If, for example, the donor is the sole income recipient of the trust and the balance of the estate is earmarked for charity, it may be preferable to have the trust terminate with the last regular payment to avoid income taxation of any additional amount.

Summary

A well-designed charitable remainder trust considers the unique facts, circumstances, and planning objectives of the donor. Careful selection of the final payment method is but one of the factors to be considered in designing a trust that best accomplishes the donor's personal and philanthropic planning objectives.



  1. IRC §664(f)(3)back

  2. Rev. Rul. 74-386,1974-2 C.B. 189back

  3. Rev. Rul. 72-395, 1972-2 CB 340, §7.06back

  4. Reg. §1.664-3(a)(1)(v)(b)(1)(i)back

  5. Rev. Rul. 79-428, 1979-2 C.B. 253back

  6. The unitrust amount is determined by multiplying the fair market value of the trust assets on the valuation date(s) by the fixed payout rate.back

  7. Regs. §§1.664-2(a) and 3(a)(1)back

  8. Notice 97-68back

  9. Ltr. Rul. 9511007back

  10. This amendment is proposed to be effective for sales or exchanges after April 18, 1997. For sales or exchanges on or before the effective date of this amendment, the Service will continue to challenge any attempt to allocate pre-contribution gain to trust income as being fundamentally inconsistent with applicable local law and with the amount of the charitable deduction claimed.back

  11. Ltr. Ruls. 9511029; 9609009; and 9643014back

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