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Wednesday, May 1, 2024
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Case Studies |
Marketing Ideas During Soft Markets and Dropping Interest Rates, Part 9 - Draft Testamentary CRUTs not CRATs
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Case:
Jeanne Henry, 85, is a very concerned American. Having grown up during the Great Depression, Jeanne developed certain attitudes toward money and savings. As a result, she saved consistently and conservatively during her entire life. Jeanne is now concerned with her two children's financial security. They, unfortunately, have not saved as successfully and have fewer retirement resources. Accordingly, Jeanne would like her estate plan to provide financial security for her son Tim, 60, and her daughter Judy, 55.
Recently, Jeanne met with her attorney to discuss her options. She told her attorney that she wanted to create a $1 million charitable remainder annuity trust with a 6% annuity payout at her death. Jeanne liked the idea of her children receiving a fixed payout for the rest of their lives.
Question:
What problems are associated with Jeanne's current plan? Should Jeanne proceed nevertheless? What suggestions can Jeanne's attorney make to help resolve the issue?
Solution:
In order to qualify as a charitable remainder annuity trust, a trust must pass two tests: the 10% minimum deduction test and the 5% probability test. Both tests depend heavily upon the applicable federal rate (A.F.R. or rate of the month). Therefore, AFR rates play a vital role in drafting CRATs. This is especially true with testamentary CRATs, because the date of death (and funding of the trust) is unknown. Thus, counsel must draft testamentary CRATs that would qualify under worst case scenarios (i.e. low AFRs and untimely deaths).
In this instance, Jeanne wants to establish a $1 million testamentary 6% payout CRAT for her two children. Under "normal" economic conditions, this plan would be commendable. However, interest rates are at low levels and so are AFR rates. Recent AFRs have been just right around 2%. If Jeanne dies when the AFR is low, her CRAT may be forced to use an AFR at or below 2%. Unfortunately, because no one can predict interest rates Jeanne's 6% payout CRAT may fail the 5% probability test and, accordingly, not be a qualified CRAT.
It is possible to draft formula language to alleviate this problem (i.e., reduce the payout to qualify the trust). However, two problems still remain. First, Jeanne's trust does not provide the intended dollar amount to her children, which was of utmost importance to her. Second, even with reducing the trust payout to 5%, the trust may still fail to qualify under any of the three available AFRs. Therefore, if rates remain in the 2% range, no formula language could save the trust.
Jeanne's attorney suggested a $1 million testamentary 6% payout CRUT instead. Because unitrusts are less influenced by the AFR and not subject to the 5% probability test, it is much easier to qualify a testamentary trust as a CRUT. Even with a 2% AFR, a 6% CRUT easily passes the 10% minimum deduction test. In addition, the trust will pay $60,000 to Tim and Judy in the first year (just like the CRAT). Hopefully, if the trust principal grows the payments to Tim and Judy will also grow over the years.
Considering the uncertain economic climate and unknown life expectancy of Jeanne, her attorney's suggestion to draft a CRUT instead of a CRAT will protect the charitable deduction. In the end, Jeanne accomplished all of her goals while still adhering to her deeply rooted beliefs regarding savings and money. She provided her children with financial security, yet prevented them from invading the trust corpus.
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