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Friday, April 26, 2024
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GiftLaw Note:
The donor in this Ruling intended to create a standard charitable remainder unitrust (Type I), but instead executed a net income with makeup unitrust (Type II) due to a drafting error. The drafting error was discovered before the first tax return was filed and a court order reformed the trust ab initio. Moreover, the trust was administered as a Type I unitrust. On these facts, the IRS held that it would not be an act of self-dealing to reform the trust as described. However, no opinion was expressed as to whether or not the trust would be treated as a qualified remainder trust.
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This is in response to your letter dated November 6, 1996, and subsequent correspondence, concerning the qualification of Trust, after an amendment ab initio pursuant to a court order, as a charitable remainder unitrust under section 664 of the Internal Revenue Code. Trust also requests a ruling that the amendment ab initio is not an act of self-dealing under section 4941.
The information submitted states that A created Trust on Date a with the intention that Trust qualify as a charitable remainder unitrust under section 664(d)(2) of the Code. B is the trustee of Trust.
A established Trust with the assistance of E, an attorney. Following discussions with E, it was determined that Trust should provide for payment of a unitrust amount of eight percent of the net fair market value of the Trust's assets, payable from income and to the extent income was insufficient, then from principal. For purposes of this letter, this type of unitrust payment method will be referred to as a Fixed Percentage method.
However, Article 2 of the original Declaration of Trust executed on Date a (the Trust Instrument) provides that in each taxable year of Trust, the Trustee shall pay to A, for A's lifetime, and after A's death, in equal shares to A's two children, C and D, or the survivor for the lifetime of the two in each taxable year of Trust during their lifetime an amount equal to the lesser of: (a) the Trust income for the taxable year (as defined in section 643(b) of the Code and the regulations thereunder) and (b) eight percent (8%) of the net fair market value of the trust assets valued as of the first day of each taxable year, decreased as elsewhere provided in the case where the taxable year is a short taxable year or is the taxable year in which the last recipient dies, and increased as elsewhere provided in the case where there are additional contributions in the taxable year. If the trust income for any taxable year exceeds the amount determined under (b), the amount to be paid to the recipient shall also include such excess income to the extent that the aggregate of the amount paid to the recipient in prior years is less than 8 percent of the aggregate fair market value of the trust assets for such years. For purposes of this letter, this type of unitrust payment method will be referred to as a NIMCRUT payment method.
A, as Trustor of Trust, and B, as Trustee of Trust, represent that the NIMCRUT payment method included in the original Trust Instrument was not intended to be in the Trust Instrument. Notwithstanding A's clear intentions to include a Fixed Percentage method in the Trust Instrument, the NIMCRUT payment method was inadvertently included in the Trust Instrument due to an undetected scrivener error. The error in the payment method was discovered after the Trust's first tax return was filed.
Trust has submitted evidence of the following facts in support of A and B's representation that inclusion of the NIMCRUT provision in the Trust Instrument was in error: E, who drafted the Trust Instrument admitted to the mistake in an affidavit; E was undergoing cancer treatment at the time that the Trust Instrument was drafted; A filed a malpractice suit against E; and A contemplated having to contribute other assets (loan proceeds) to Trust in order to meet the payout requirement without having to sell certain Trust assets.
Since the creation of Trust, the Trustee has administered Trust as a charitable remainder unitrust with a Fixed Percentage payment method and not as a charitable remainder unitrust with a NIMCRUT payment method. This has made a material difference in the distributions since Trust's income in Year c was well below 8 percent of the fair market value of Trust's assets.
Because of this error, and because Trust is irrevocable, B, the Trustee, sought an order from Court, with notice to all beneficiaries and the state Attorney General, authorizing an amendment ab initio of Article 2 of the Trust Instrument, by removing the NIMCRUT payment method provision and inserting a Fixed Percentage payment method. State law permits reformation of trusts, upon approval of the court, to correct mistakes and accord with the creator's intent. No parties objected to the proposed reformation.
On Date b, Court issued an order that Trust be reformed, ab initio, contingent upon Trust receiving from the Internal Revenue Service a private letter ruling with regard to the reformation of Trust.
Court ordered that Article 2 of the Trust Instrument be reformed, ab initio, to provide that the Trustee shall pay to A, for A's lifetime, and after A's death, in equal shares, to A's two (2) children, C and D, or the survivor, for the lifetime of the two (thereinafter referred to as the "Recipient") in each taxable year of the Trust during their lifetime an amount equal to eight percent (8%) of the net fair market value of Trust assets valued as of the first business day of each taxable year, decreased as is provided in the case where the taxable year is a short taxable year or is the taxable year in which the last Recipient dies, and increased as elsewhere provided in the case where there are additional contributions in a taxable year. Payments to the Recipient shall be made from Trust income (as defined in section 643(b) of the Code and the regulations thereunder), and to the extent that income is not sufficient, from principal. Payments to the Recipient shall be made in quarterly installments. The first installment shall be made on Date d. Any income in excess of such payments shall be added to principal.
Section 664(d)(2) of the Code provides that for purposes of section 664, a charitable remainder unitrust is a trust (A) for which a fixed percentage (which is not less than 5 percent) of the net fair market value of its assets, valued annually, is to be paid not less often than annually, to one or more persons (at least one of which is not an organization described in section 170(c) and, in the case of individuals, only to an individual who is living at the time of the creation of the trust) for a term of years (not in excess of 20 years) or for the life or lives of such individual or individuals, (B) from which no amount other than the payments described in subparagraph (A) may be paid to or for the use of any person other than an organization described in section 170(c), and (C) following the termination of the payments described in subparagraph (A), the remainder interest in the trust is to be transferred to, or for the use of, an organization described in section 170(c) or is to be retained by the trust for such a use.
Section 1.664-3(a)(4) of the Income Tax Regulations provides, in part, that the trust may not be subject to a power to invade, alter, amend, or revoke for the beneficial use of a person other than an organization described in section 170(c) of the Code. Notwithstanding the preceding sentence, the grantor may retain the power exercisable only by will to revoke or terminate the interest of any recipient other than an organization described in section 170(c).
Based solely on the facts (including relevant documents) and representations submitted, we conclude that the judicial reformation of Trust, ab initio, does not violate section 664 of the Code and the regulations thereunder. Accordingly, we conclude that the judicial reformation, ab initio, of Trust does not adversely affect Trust's qualification as a charitable remainder unitrust under section 664.
Section 4941(a)(1) of the Code imposes a tax on any act of self-dealing between a disqualified person and a private foundation, payable by the disqualified person.
Section 4941(a)(2) of the Code generally imposes a tax on the participation of a foundation manager in an act of self-dealing knowing that it is such an act, payable by the foundation manager.
Section 4941(d)(1)(E) of the Code provides that the term "self-dealing" means any direct or indirect transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation.
Under section 4946(a) of the Code the term "disqualified person" with respect to a private foundation includes a substantial contributor to the foundation (including the creator of a trust), a family member of a substantial contributor (including children), and a foundation manager (including a trustee).
Section 4947(a)(2) of the Code provides generally that split-interest trusts are subject to the provisions of section 4941 in the same manner as if such trusts were private foundations, but, under section 4947(a)(2)(A), not with respect to any amounts payable under the terms of such trust to income beneficiaries, unless a deduction was allowed under section 170(f)(2)(B), 2055(e)(2)(B), or 2522(e)(2)(B).
Section 53.4947-1(c)(2)(i) of the Foundation and Similar Excise Taxes Regulations provides that under section 4947(a)(2)(A), section 4941 does not apply to any amounts payable under the terms of a split-interest trust to income beneficiaries unless a deduction was allowed under section 170(f)(2)(B), 2055(e)(2)(B), or 2522(e)(2)(B) with respect to the income interest of any such beneficiary.
As a charitable remainder unitrust under section 664(d)(2) of the Code, Trust is a split-interest trust described in section 4947(a)(2) and therefore subject to section 4941, which imposes an excise tax on acts of self-dealing. The creator, the creator's children, and the Trustee are all disqualified persons with respect to Trust. Therefore, their involvement in certain transactions with Trust may be acts of self-dealing under section 4941.
Ordinarily, we would consider a charitable remainder trust's reformation of its payment provision to be an act of self-dealing under section 4941(d)(1)(E) of the Code. However, under the circumstances presented in this case, we find no act of self-dealing, since we are satisfied that the signatory parties to the Trust Instrument never intended to create a NIMCRUT payment method trust in the first place. A key fact in our consideration is that Trust has been consistently administered using the Fixed Percentage method. Another is that the payment provision error was discovered, and action to correct the error was taken, in a relatively short period of time after Trust was created. Another is E's sworn admission of a drafting mistake. Another is the lack of evidence that A or other income beneficiaries are reducing their own taxes or using the benefit of hindsight in making the change to the Fixed Percentage payment method.
Consequently, the amendment ab initio of the Trust Instrument is not an act of self-dealing under section 4941 of the Code.
Except as specifically set forth above, no opinion is expressed as to the federal tax consequences of the above described facts under any other provision of the Code. Specifically, no opinion is expressed concerning whether Trust is or was a charitable remainder unitrust within the meaning of section 664(d)(2).
This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.
In accordance with the power of attorney on file with this office we are forwarding a copy of this letter to Trust.
Sincerely yours,
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H. Grace Kim
Assistant to the Branch Chief, Branch 2
Office of the Assistant Chief Counsel
(Passthroughs and Special Industries)
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