**Written by Lee Hoffman**

On August 8th of 2016 the IRS issued Rev. Proc. 2016-42. Until August 7, 2016, every charitable remainder annuity trust (CRAT) paying a life income interest (not for a term of year), had to meet two tests: first, the remainder value at the date of gift had to be at minimum 10% of the total value of the property transferred to the trust, and second, it also had to meet "the probability test".

Treasury Regulation 1.170A-1(e) provides that no charitable deduction is allowed unless the possibility that the charitable transfer will not become effective is "so remote as to be negligible."

In Rev. Rul. 70-452, this rule was made applicable to a split-interest transfers such as CRTs. If there is greater than a 5% chance that the payment to beneficiaries would exhaust the trust by the end of the trust term, there could be no deduction and therefore the CRAT would fail to meet the requirements of the governing section 664. This concept was made specific to CRATs in Rev. Rul. 77-374, and is based on two factors—first, the AFR rate (section 7520 rate) in relation to the annuity payout rate, and second, the mortality table used to determine the probability (Mortality Table 2000CM).

Rev. Proc. 2016-42 changes this picture beginning August 8, 2016 because at the current AFR rate, CRATs become almost useless as most of them fail the probability test. The Rev. Proc. gives planners a way out of this mess. But should you actually use what it offers as a solution?

This Rev. Proc. will change the required analysis and potential use of the charitable remainder annuity trust (CRAT).

- What is it?
- How is it calculated?
- What impact does it have on the use of a CRAT?
- What are the advantages and disadvantages of using the qualified contingency CRAT?
- When should you recommend it?

The answers to the above questions must be understood so you and your clients/donors can make the right choice.

Simply stated, it is a new Rev. Proc. that allows the drafter of the CRAT to insert a specific qualified contingency into the trust document that eliminates the need to meet the 5% probability test. Obviously, this is a very good thing because when the 7520 rates are as low as they are at the time of this writing many donors are excluded from establishing a CRAT because of their younger age, even though their risk tolerance is low and they would feel more secure with the level payments of the CRAT.

The mathematical answer to this question is simple. In all cases, if the deduction calculation for a CRAT for lives (regardless of the number of lives) passes the 10% remainder test the Rev. Proc. 2016-42 formula can be used to allow younger donors who would otherwise not be able to establish a CRAT to be able to do so. How much younger? That just depends on the 10% remainder test. You need to apply the 10% test at the creation of the trust. If it passes then you can use the qualified contingency.

The annuity payout rate and the 7520 rate are the starting points for the calculation. As you can see in the following chart, while the 5% annuity payout rate would pass the 10% test at age 60 and allow for the inclusion of the qualified contingency clause, at 5.25% and higher it would fail. The older the beneficiaries the higher the annuity payout rate that will pass the 10% remainder test. But as you will see, the higher the 7520 rate the more likely the trust may terminate when the qualified contingency is used.

So rule number 1 is that the calculation of the remainder interest is critical as to whether you can even use the qualified contingency for a certain client. If the calculation does not yield a deduction factor of at least 10% of the assets transferred to the trust all bets are off. The new qualified contingency cannot be used for that client. But as we see in the above chart, it can be used at age 60 with a single life and a 7520 rate of 1.8%. Two lives would require higher ages.

Unlike the charitable remainder unitrust, the CRAT is highly sensitive to the 7520 rate. The chart below, shows that the higher the 7520 rate the higher the charitable deduction and the more likely the 5% probability test will pass. In this case the 5% probability test passes when the 7520 rate is 2.6%. This is one reason you should always select the highest of the current months or prior two month’s 7520 rates. So at age 60 with a 2.6% 7520 rate there would be an option as to how you would want to draft the trust. While this is not important at today’s low rates it’s important for the advisor to know that as rates climb the possibility that the 60 year old (in this case) could pass the 5% probability test and eliminate the need for the Rev. Proc. 2016-42 qualified contingency. This is obviously true at all ages.

Let’s take a look at fact pattern but change the ages. The following chart illustrates the ten percent remainder interest test and the five percent probability test at various ages in five year increments. The annuity payout rate used was 5%, the payment frequency quarterly end of period, and the 7520 rate used 1.8%. The fair market value of the asset transferred to the trusts was $1,000,000.

By using the qualified contingency, the CRAT would pass at age 60 a full fifteen years earlier than would otherwise be possible. How long the trust would last is an unknown. That depends on the actual earnings of the trust, the annuity payout rate, and the 7520 rate used on the date the assets are transferred to the trust.

**NOTE: **Had the payment frequency been annual at the end of period the deduction for the 60 year old would have been $143,250, so keep that in mind if your deduction calculation fails using a quarterly payment frequency, an annual end of period payment frequency will always produce a higher deduction in a CRAT.

Up to this point we’ve only discussed the importance of the 7520 rate. Now we’ll get into an example of the actual calculation. The following is the example given in the Rev. Proc.

It looks much more complex than it is. Let’s break it down.

Line 1 – Gift *10% =$100,000

Lines 2, 3 and 4 are just provided to give clarity to the results of each portion of the calculation. The following is an excel formula that places the answer into a single cell.

Excel Formula "=ROUND((C9-E9)*(1/(1+$J$14))^B9,0)"

Excel Formula with Variables "=ROUND((TrustValue – NextAnnuityPayment) *(1/(1+StartingDiscountRate))^FractionalYears , Rounded to the dollar)"

The end result is that the qualified contingency formula, in this case, yields an answer of $93,984 in year 18. It is the number you need to worry about. When the formula (calculated prior to the trust’s next payment) is less than 10%, the trust is terminated, payments cease, and the trust corpus is distributed to the charity or charities named in the trust.

While the trust is earning 5% and the annuity payout rate is 5% you would think that this trust could never terminate. But as you see in column 6 the trust value is being discounted each year by the 7520 rate. In this case the trust would terminate in year 127, so I wouldn't worry about it too much.

In this chart we’ve assumed the same 5% earnings rate but have increased the annuity to close to the maximum that will pass the 10% test for a 75 year old on the date the trust is created and funded, 8.8%. The trust will terminate at the end of year 16 (assuming an annual payment frequency).

Had the trust earned a higher rate of return it would increase the number of years before it terminated. If it had earned 8.8% equal to the annuity payout rate the results would have been the same as in Example 1.

Now let’s go back to our 5% annuity payout rate and 5% earnings rate in Example 1 and make one change. We’re going to change the 7520 rate to 8%.

The 5 and 5 trust in Example 1 terminated in year 127. This same trust with an 8% 7520 rate terminates in year 30. Why? Because the trust value is being discounted by 8% each year, not 1.8%

**NOTE:** We’re doing this for educational purposes. If the applicable federal midterm rate (the 7520 rate) increases to 8% our country probably can’t pay the interest on our debt, but you’ll understand the impact of the 7520 rate better.

**Black Monday** – Remember that the annuity payment from a CRUT is level based on the FMV of the assets that originally funded the trust. Don’t forget Black Monday where the DJIA dropped over 22 percent. The following chart assumes that this occurred in year 4 of the trust and then resumed its 5% earnings rate. Again, this is for educational purposes. The market actually regained it losses by about 1989. But would the trustee have the crystal ball to stay in the market. The trust in Example 1 that terminated in year 127 now terminates in year 27 even through $170,687 in trust assets in that year. The point is that declines in asset values in a CRAT can be very difficult to make up because the annuity payment is level unlike a CRUT where the payment fluctuates with the value of the trust.

*Trust fails in year 27*

As we’ve seen, when the 7520 rate goes up, the Rev. Proc. 2016-42 calculation will cause the qualified contingency to terminate the trust faster because of the accelerated discounting of the trust value in any given year. But keep in mind that the 7520 rate used in the calculation for a given trust is the rate at the original funding of the trust. So increasing 7520 rates will not affect existing trusts.

As the 7520 rate goes up, the 5% probability test can be passed at lower and lower ages and the new qualified contingency will not be necessary. In effect, one cancels out the other. As rates go up and down one method of qualification will allow younger income beneficiaries to qualify. And that I believe was the entire purpose of the new Rev. Proc, wasn’t it?

So which method to use? If the CRAT passes the 5% probability test personally I would NOT include the qualified contingency. The reason is simple, the CRAT passed the 5% probability test. If you include the qualified contingency you run the risk that the trust would at some point fail the test and be terminated, and here was no reason to include the qualified contingency in the first place. The bottom line is use it when you need to.

Another thought for the attorneys reading this article. I’d like your thoughts on this one. In the case of a testamentary CRAT we have no way of knowing what the 7520 rate will be. Give me your thoughts on how you’ll draft language that will allow either method (5% probability or 2016-42) to be used to assure the most likely positive outcome for the qualification of the trust at creation.

Now that we’re all totally confused I’d like to give you yet another option to think about. A CRAT whose term is based on a term of years is NOT subject to the 5% probability test of Revenue Ruling 77-374! A CRAT for a 20 year term and a 1.8% 7520 rate with generate a 10% remainder interest with an annuity payout rate of 5.362533%

You use a CRAT when your client absolutely wants the security of level payments. Here is the comparison of the CRUT and CRAT charitable deductions.

Since the CRUT deduction is barely affected by the fluctuations of the 7520 rate it will, at the current rate of 1.8% always produce a higher charitable deduction. It need only pass the 10% remainder interest test.

As you can see, there are now more ways to skin a CRAT. This is why your clients need you. Please leave a comment below and share this article with others so we can all advance in our understanding of charitable estate planning.

There is now more than one way to skin a CRAT - A look at the mathematics of Rev. Proc. 2016-42

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