Internal Revenue Service Explains Rules on Charitable Remainder Trusts

Following are excerpts from the text of the explanation the Internal Revenue Service released to explain new rules governing certain types of charitable remainder trusts. The new rules appeared in the Federal Register on December 10, Pages 68,188-194. In its explanation, the service compares the new rules with those it proposed in April 1997.

Trusts That Are Affected

In general, a charitable remainder trust provides for a specified periodic distribution to one or more beneficiaries (at least one of whom is a non-charitable beneficiary) for life or for a term of years with an irrevocable remainder interest held for the benefit of charity.

There are two types of C.R.T.’s: a charitable remainder annuity trust (CRAT) and a charitable remainder unitrust (CRUT). A CRAT pays a sum certain at least annually to the beneficiaries (the annuity amount). A CRUT pays a unitrust amount at least annually to the beneficiaries.

Generally, the unitrust amount is a fixed percentage of the net fair market value of the CRUT’s assets valued annually (fixed percentage CRUT). The unitrust amount can instead be calculated under one of two income-exception methods (income exception CRUT).

Under the first method, the unitrust amount is the lesser of the fixed percentage amount or the trust’s annual net income (net income method). Under the second method, the unitrust amount is determined under the net income method plus any amount of income that exceeds the current year’s fixed percentage amount to make up for any shortfall in payments from prior years when the trust income was less than the fixed percentage amount (NIMCRUT method). The shortfall in payments from prior years is commonly referred to as the “make-up amount.”

The revisions to the proposed regulations are discussed below.

Flip Unitrusts

A. Triggering Events

The proposed regulations provide specific rules for when a trust may convert from one of the income-exception methods of computing the unitrust amount to the fixed percentage method (flip unitrust). The proposed rule was designed for taxpayers who ultimately wanted the unitrust amount to be computed on the fixed percentage method but funded the trust with unmarketable assets that generate little annual income… . The final regulations expand the availability of the flip unitrust to certain other situations that the I.R.S. and Treasury believe are consistent with the legislative history indicating that a trustee should not have discretion to change the method used to calculate the unitrust amount.

The final regulations allow the governing instrument of a CRUT to provide that the CRUT will convert once from one of the income-exception methods to the fixed percentage method for calculating the unitrust amount if the date or event triggering the conversion is outside the control of the trustees or any other persons. The final regulations include examples of permissible and impermissible triggering events. For example, permissible triggering events with respect to any individual include marriage, divorce, death, or birth of a child. Also, the sale of an unmarketable asset such as real estate is a permissible triggering event. Examples of impermissible triggering events include the sale of marketable assets and a request from the unitrust recipient or the unitrust recipient’s financial adviser that the trust convert to the fixed percentage method.

The final regulations also provide that the conversion to the fixed percentage method occurs at the beginning of the taxable year that immediately follows the taxable year in which the triggering date or event occurs. Any make-up amount … is forfeited when the trust converts to the fixed percentage method.

The proposed regulations define unmarketable assets as assets other than cash, cash equivalents, or marketable securities… . The final regulations define unmarketable assets as assets other than cash, cash equivalents, or assets that can be readily sold or exchanged for cash or cash equivalents. For example, unmarketable assets include real property, closely held stock, and unregistered securities for which there is no available exemption permitting public sale.

Commentators requested that the final regulations permit conversions from the fixed percentage method to one of the income-exception methods and conversions from a CRAT to a CRUT. The flip unitrust allowed in the final regulations is the only type of permissible conversion. Thus, a CRAT cannot convert to a CRUT without losing its status as a CRT. Similarly, a CRUT using the fixed percentage method cannot convert to an income-exception method without losing its status as a CRT.

Timing of Payments

The proposed regulations provide that the payment of the annuity amount or the unitrust amount determined under the fixed percentage method must be made by the close of the taxable year in which it is due. The rules were proposed in response to abuses associated with the use of accelerated CRT’s… .

Although recent legislative changes have reduced the potential tax benefits of accelerated CRT’s, the I.R.S. and Treasury continue to be concerned about the potential abuse of the post-year-end grace period to produce a tax-free return of appreciation in the assets contributed to a CRAT or a fixed percentage CRUT. Therefore, the final regulations adopt rules similar to those in Notice 97-68 with certain modifications. The rules are effective for taxable years ending after April 18, 1997.

For CRAT’s and fixed percentage CRUT’s, the annuity or unitrust amount may be paid within a reasonable time after the close of the year for which it is due if (a) the character of the annuity or unitrust amount in the recipient’s hands is income … ; and/or (b) the trust distributes property (other than cash) that it owned as of the close of the taxable year to pay the annuity or unitrust amount and the trustee elects … to treat any income generated by the distribution as occurring on the last day of the taxable year for which the amount is due. In addition, for CRAT’s and fixed percentage CRUT’s that were created before December 10, 1998, the annuity or unitrust amount may be paid within a reasonable time after the close of the taxable year for which it is due if the percentage used to calculate the annuity or unitrust amount is 15 per cent or less.

Appraising Non-Liquid Assets

A CRUT must value its assets annually. The proposed regulations provide that, if a CRT holds unmarketable assets and the only trustee is the grantor, a non-charitable beneficiary, or a related or subordinate party to the grantor or the non-charitable beneficiary … the trustee must value those assets using a current qualified appraisal … from a qualified appraiser… .

The final regulations follow the proposed regulations and provide that the trust’s unmarketable assets must be valued by an independent trustee, or by a qualified appraisal from a qualified appraiser. The proposed regulations define an independent trustee as a person who is not the grantor, a non-charitable beneficiary, or a related or subordinate party to the grantor, or the non-charitable beneficiary within the meaning of Section 672(c) and the applicable regulations. The final regulations add the grantor’s spouse to the list of persons to whom an independent trustee cannot be related or subordinate. A co-trustee who is an independent trustee may value the trust’s unmarketable assets… .

The final regulations define unmarketable assets as assets other than cash, cash equivalents, or assets that can be readily sold or exchanged for cash or cash equivalents. For example, unmarketable assets include real property, closely held stock, and unregistered securities for which there is no available exemption permitting public sale. Rules for valuing unmarketable assets are effective for trusts created on or after December 10.

Trust Income to Beneficiaries

Under the proposed regulations, unitrust interests in an income exception CRUT that are retained by the donor or any applicable family member will be valued at zero when a non-charitable beneficiary of the trust is someone other than (1) the donor, (2) the donor’s U.S. citizen spouse, or (3) both the donor and the donor’s U.S. citizen spouse… . The I.R.S. and Treasury believe that, in addition to the NIMCRUT method, the net income method can be used to circumvent the intent of Section 2702. Therefore, the final regulations do not exempt from Section 2702 CRUT’s that use only the net income method… .

The final regulations clarify that Section 2702 will not apply when there are only two consecutive non-charitable beneficial interests and the transferor holds the second of the two interests… .

The potential abuse associated with income exception CRUT’s also exists with flip unitrusts. Therefore, under the final regulations, Section 2702 applies to a flip unitrust if the CRUT does not fall within one of the exemptions.

Sale of Trust Assets

The proposed regulations clarify that the proceeds from the sale of an income exception CRUT’s assets, at least to the extent of the fair market value of the assets when contributed to the trust, must be allocated to trust principal… . The final regulations maintain the prohibition on allocating pre-contribution gain to trust income for an income exception CRUT. However, the governing instrument, if permitted under applicable local law, may allow the allocation of post-contribution capital gains to trust income. Taxpayers do not have to treat the make-up amount as a liability when valuing the assets of a NIMCRUT.