Friday April 26, 2024

3.1.1 Annuity Trust Duration and Recipients

Annuity Trust Duration and Recipients

Duration:   A charitable remainder annuity trust (CRAT) usually pays a fixed annuity for a life, lives or a term of up to 20 years, but other combinations are possible.

Early Termination of a CRAT:   It may be possible for a donor to terminate a CRT and cash out his or her interest.

Permissible Recipients:   Normally, the donor is the recipient for a one-life annuity trust, or donor and spouse for a two-life annuity trust, but again, other combinations are possible.

Qualified Contingency:   The duration of a charitable remainder trust may be shortened by a qualified contingency.

Rev. Proc. 2016-42's Qualified Contingency:   In Rev. Proc. 2016-42, the IRS created an alternative to the 5% Probability Test. A CRAT may avoid the 5% Probability Test if it is a qualified trust that includes specific language outlined by the IRS.

"Special Needs Trust":   Charitable remainder trusts may be drafted for a life, lives or a term of years. However, if a beneficiary is subject to a disability, then it may be desirable for the trust to have discretionary payment options.

3.8% Net Investment Income Tax:   In the Healthcare and Education Reconciliation Act of 2010, a 3.8% tax on NII was passed.

Duration

A charitable remainder annuity trust (CRAT) usually pays a fixed annuity for a life, lives or a term of up to 20 years, but other combinations are possible. Reg. 1.664-2(a)(1)(i). In most circumstances, the annuity is paid to the donor for one life, or to donor and spouse for two lives. Alternatively, the annuity may be paid for a term of 20 years.

It is also permissible to combine periods. The annuity may be paid for one or two lives, with a guaranteed number of years up to 20 years. In effect, this trust pays for the longer of the selected term of years or the two lives. If the life income beneficiaries pass away prior to the term of years, the balance of the term may be transferred to children, nephews, nieces or other family members. However, with a two-life annuity trust that includes a guaranteed term of years, a married couple does forego the marital deduction under Sec. 2056(b)(8) if one spouse passes away prior to the expiration of the specified term of years.

A trust also may be created for the lesser of a life or a term of years. For example, a trust may be created for a term of 20 years, but it will terminate if the income recipient passes away prior to that time and the remainder will be distributed to charity. This duration will result in a larger charitable deduction than a straight term of 20 years, since it is possible that the income recipient will pass away prior to the expiration of the term.

Finally, it is permissible to create an annuity trust for one or two lives plus a term of years. However, this agreement is only permissible if all current and successor annuity recipients are living at the inception of the trust, and the trust will terminate upon the earlier of the demise of all income recipients or the expiration of the term of years. In effect, the trust is created for one or two lives plus the lesser of the lives of the successor income recipients or the stated term of years. Reg. 1.664-2(a)(5)(i).

Early Termination of a CRAT
It may be possible for a donor to terminate a CRT and cash out his or her interest. There have been several Private Letter Rulings that have allowed such a transaction. Because the donor is not making another charitable gift by giving the income interest to charity, the rate of the month used for the calculation must be the rate that corresponds with the date the donor decides to terminate the trust. One of the prior two-month's rates cannot be used because no charitable deduction is allowable. Once the calculation is performed, the present value of the remainder interest is what the charity would receive when the trust is terminated and the balance, the present value of the income interest, is the part that the donor would receive in the cash out.

The donor will recognize gain on the cash out. Because the value of the income interest is considered an appreciated property type gift, in which the donor has a zero cost basis, the donor will pay capital gains tax on the full value of the amount received. See PLR 200152018.

A step that may need to be taken in terminating a charitable remainder trust early is to petition the probate court of the state under which the trust is formed. Going through the probate court may be necessary in some states as a means to terminating an irrevocable trust. During the process, it is important to have all parties consent to the early termination and seek the court's approval. In most cases, the court will not have an objection. Whether or not this step needs to be taken is a matter of local law. Therefore, if early termination of a trust is considered, it is wise to find out what the law in your area requires.

One other recommended step to take in terminating a charitable remainder trust early is to notify the State Attorney General of the early termination. The State Attorney General in most jurisdictions oversees all charitable trusts created under that particular state's trust law.

Permissible Recipients

Normally, the donor is the recipient for a one-life annuity trust, or donor and spouse for a two-life annuity trust, but again, other combinations are possible. However, it is permissible to create a trust for donor and child, nephew, niece or other relative, or for one or more unrelated persons.

If a CRAT is for a term of years, it is permissible to name a class of individuals. Reg. 1.664-2(a)(3)(i). For example, a donor could create a charitable remainder annuity trust with the income distributed among grandchildren. It is also permissible to grant the trustee the power to "sprinkle" among the grandchildren, so long as there is an independent trustee under Sec. 674(c). Rev. Rul. 77-285.

Another option is for a trust to be the beneficiary of a payment from a term of years charitable remainder annuity trust. However, if the CRAT is a one-life trust, payments to a second trust are deemed permissible only if the single beneficiary is incompetent. PLR 9718030.

The payout from a CRAT may be made within a reasonable time after the close of the calendar year, if the annuity is 15% or less of initial net fair market value. Reg. 1.664-3(j). However, if the payout exceeds 15%, then either the payout must be made prior to year end or the trustee must elect to treat the payment as though it had been made by December 31.

Qualified Contingency

The duration of a charitable remainder trust may be shortened by a qualified contingency. Sec. 664(f). It is permissible to shorten the duration of a trust based on an objective occurence, such as marriage, divorce or a similar defined event. If the specified event takes place, then the trust may be terminated and the remainder transferred at that time to charity. Since the event is generally contingent, there is no increase in the income tax deduction, regardless of the nature of the event.

Rev. Proc. 2016-42's Qualified Contingency

In Rev. Proc. 2016-42, the IRS created an alternative to the 5% Probability Test. A CRAT may avoid the 5% Probability Test if it is a qualified trust that includes specific language outlined by the IRS. Under the Rev. Proc. 2016-42 language, if the trust corpus declines by 10% of the initial trust corpus (with discounting at the initial applicable federal rate), the annuity trust will terminate and the corpus must be distributed to the specified charities. This provision may be called the "10% Termination Test."

More information on this qualified contingency as well as sample language can be found in GiftLaw Pro chapter 3.1.4.

"Special Needs Trust"

Charitable remainder trusts may be drafted for a life, lives or a term of years. However, if a beneficiary is subject to a disability, then it may be desirable for the trust to have discretionary payment options. Thus, some grantors have preferred to create a charitable remainder trust that makes distributions to a second trust. The second trust is usually described as a "special needs trust" and permits discretionary distributions for the support and care of an individual with a financial, physical or mental disability.

In Rev. Rul. 2002-20; 2002-17 IRB 794 (29 Apr 2002), the Service set forth guidelines for charitable remainder trusts that make payments to special needs trusts. First, if the charitable remainder trust is for a term of twenty years or less, then it may make distribution to a special needs trust. However, if the charitable remainder trust is payable for a lifetime, then it should meet several requirements. First, the trust must be for one lifetime and the beneficiary must be under a disability that renders him or her unable to manage personal financial affairs, as defined in Sec. 6511(b)(2)(A). Second, special needs trust should follow one of three formats:

I. Flow Through Trust. "The trust may be a "Flow Through Trust," in which the unitrust payouts are made to the special needs trust and then are distributed to the beneficiary. Additional distributions may be made under a trustee discretionary power. The remainder will be distributed to the income recipient's estate.

II. Discretionary Trust. Alternatively, the special need trust may have a discretionary payment provision, which permits the trustee to make payments that would not supplant governmental benefits otherwise available. With a discretionary special needs trust, the remainder of the trust is payable to the estate of the special needs person.

III. Discretionary with Power of Appointment Trust. Finally, a discretionary trust may be created with the income recipient holding a testamentary general power of appointment. If the special needs person does not exercise the general power when he or she passes away, then the remainder may be distributed to family or to charity.
Since unitrust payments may be made for the benefit of, rather than to an income recipient, the unitrust may make payments to a special needs trust because the payments are, in effect, received by the special needs person. The above options are also available for an annuity trust.

In addition, it is possible for gift annuity payments to fund a special needs trust. While the gift annuity provides for fixed payments over the life of the person with special needs, distributions from the gift annuity to the trust must be limited and based on special needs. To avoid disqualifying the individual from receiving government aide, it is best to permit distributions to the trust at the discretion of a special trustee knowledgeable of the federal requirements.

3.8% Net Investment Income Tax

In the Healthcare and Education Reconciliation Act of 2010, a 3.8% tax on NII was passed. The tax applies generally for married couples with income over $250,000 and for other persons with income over $200,000. Purely charitable trusts and pooled income funds are excluded from the tax.

However, distributions from Sec. 664 charitable remainder annuity trusts and unitrusts (individually a "CRT") may be subject to tax. Proposed Reg. 1.1411-3(c)(2)(i) states that the NII for a CRT beneficiary is the lesser of the total distribution or the accumulated NII of the unitrust or annuity trust. If there are multiple beneficiaries, the trustee is required to apportion the NII pro rata.

Trustees and CRT accountants will be required to start tracking NII as of January 1, 2013. Accumulations of income and gain prior to that date will not produce NII, even if distributed in future years. Under Reg. 1411-3(c)(2), the NII will be tracked inside the trust and distributed prior to other items. In this regard, the NII distribution is similar to the requirement to distribute all ordinary income prior to distribution of other types of income or principal from a CRT.

Case Studies on Annuity Trust Duration and Recipients

Sailing with the Rate of the Month:   Robert and Mary Smith, 78 and 76, respectively, are both retired engineers. In addition to their work careers, both Robert and Mary have participated significantly with charities. Robert was a long-time lover of ships and sailing. In fact, he actually sailed across the Atlantic at one point in his life. His passion for sailing resulted in his active involvement on the board of a sailing preservation society. Mary, on the other hand, loved the arts. While Robert was off sailing to Europe, she flew ahead and used her extra time to explore all of the major art museums in Europe. Her passion for art led her to join the board of a regional art museum.

Salesman Closes Deal on CRAT:   Ken Blair, 60, is retiring this year. After 30 years in the automobile business, Ken is ready and, more importantly, able to call it quits. Ken has worked very closely with his financial advisor, Peter James, and is pleased with his retirement plan's success. Ken's IRA is currently valued at $1 million, and Ken also has an individual stock account valued at $800,000. Ken owns his $400,000 home free and clear. After a review of Ken's financial situation, Peter and Ken determined that Ken needs $80,000 per year for a comfortable retirement lifestyle.

Marketing Ideas During Soft Markets and Dropping Interest Rates, Part 3 - Two-Layer Charitable Lead Annuity Trust:   Jack Henry, 50, is ill and is expected to live only about five years longer. As a result, Jack has turned his attention to his family and wrapping up loose ends regarding his finances. His current estate plan already provides that his wife Judy receive the bulk of his estate.

Marketing Ideas During Soft Markets and Dropping Interest Rates, Part 10 - Commercial Real Estate, Investment Land and Homes:   Jack Henry, 80, is a very concerned American. Having grown up during the Great Depression, Jack developed certain attitudes towards the stock market and savings. As a result, he saved consistently and conservatively during his entire life.

The Charitable Financing Plan:   Louise Collins, age 50, has been Vice President of Finance for a major Internet provider for the past five years. As part of her compensation, she has been granted nonqualified stock options over that period that are now worth over $1,000,000. This year, due to the escalating value of the stock price, she chose to exercise $500,000 worth of these options, purchasing 5,000 shares of stock. The stock was trading at $100 per share at the time of exercise and her option price was $20 per share. Therefore, as a result of exercising these options, she is required to report $400,000 in ordinary income on her income tax return. She immediately sold the stock and now has $500,000 invested in a money market fund.

Financing for a Song:   John Elton, age 72, is a very popular musician and songwriter. He recently wrote a song for an internationally known celebrity who was tragically killed in an auto accident, so John decided to give away all the proceeds of the song to charity. However, he still has the original manuscript for the song, which, if auctioned, would probably sell for about $5,000,000.

Exit Strategies for Real Estate Investors, Part 14:   Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. Karl's passion was real estate, and he was very successful in his investments.

CRAT vs. CGA – Which is the Better Choice?:   Frederick Fischer, a widower, purchased 1,000 shares of stock in a new pharmaceutical company in 1990 through an Initial Public Offering (IPO) for $100,000. The company has been very successful, having introduced a number of new drugs that have taken the market place "by storm." The stock in the company has skyrocketed and is now worth over $1,000,000, yet pays very low dividends, currently less than 1%. Mr. Fischer is very concerned that the market is due for a substantial correction and would like to sell the stock and reinvest in a more balanced portfolio. He would like more income as he anticipates cash needs for health care as he grows older. Applying a federal and state capital gains tax rate, he would owe about $180,000 in capital gains taxes on the sale of the stock. This leaves him $820,000 to reinvest for income in the range of 6%, or $49,200 per year.

Using a CRT to Provide Child Care:   Carolyn Adams, age 35, is about to have her first child. She and her husband, David, have been successful stockbrokers over the last 15 years and have accumulated an aggressive stock portfolio that is now valued at over $1.5 million. Carolyn and David have made the decision that Carolyn will not work outside the home for at least the first five years of the child's life. However, they are concerned that they have established a lifestyle that requires her income to make their budget. In fact, they just purchased a new home in an exclusive area of the city in which they live. Last year, each of them made $100,000 in commission income; but in crunching the numbers on the family budget, they feel that they can live comfortably on $150,000 per year. Assuming that David will continue to make at least $100,000 per year, they will need to find a way to replace at least $50,000 of Carolyn's annual income.

An Installment Purchase with Nothing Down and No Principal Repayment:   Lynne Thompson, age 60, owns an apartment building that she purchased a number of years ago for $200,000. The fair market value of the building is now $500,000 and her depreciated cost basis (based on straight-line depreciation) is $100,000. She no longer desires to manage the property and would like to sell. However, she is concerned about the capital gains taxes that would be due upon sale. The apartment building is located next door to her alma mater, which has expressed an interest in purchasing the apartments for much-needed dormitory space. However, the university does not have the funds to purchase the building for $500,000 in cash. Her ultimate desire would be for the university to have the property, but, based upon her financial situation, she is not able to gift the property to the university. If she could somehow make a gift to her university and still receive $500,000 from the property, she would be very happy.

A Bridge to the Future – A Unitrust or an Annuity Trust:   Douglas and Tracy Fletcher, ages 60 and 56 respectively, have been asked to make a lead gift of $1 million to an endowment campaign recently initiated by the local philharmonic symphony. They have accumulated a substantial portfolio of stock over the past 10 years due to the run-up in the worldwide stock markets. They were fortunate to purchase shares via an IPO in an Internet company three years ago and those shares have soared. The shares were purchased for $50,000 and now are worth $1 million. They would like to use these shares to fund the gift to the symphony but would also like to consider receiving an income stream from the stock for a period of time.

Achieving a Proper Balance:   Martha White retired five years ago after teaching 40 years at the local elementary school. She never married and has an older brother and sister who live close by. Martha's pension, Social Security income and fixed-income investments provide her with adequate income but inflation has begun to have an effect on her income stream. She has saved well over the years and does have $900,000 in fixed-income investments, but the current return on those investments averages about 5-6%. She has what one would term as an "oversimplified financial plan" in that she has invested 100% of her money in fixed-income investments such as certificates of deposits and treasury notes and bonds. Martha doesn't understand stocks and feels that those kinds of investments are just "too risky." Therefore, she has adopted a very safe (but very low-yielding) investment approach.

Private Letter Rulings

PLR 199903001 Charitable Remainder Annuity Trust and Special-Needs Trust:   The parent of a disabled child desired to leave one-half interest in a home outright to charity, with a life estate in the other one-half interest to a special-needs trust for the life of the child and the remainder interest from this trust to charity. Other assets are to go to a charitable remainder annuity trust that pays to a special-needs trust.

PLR 200010035 Current Distributions of CRAT Income and Principal to Charity Permitted:   Ariana and Bruce Fila established a charitable remainder annuity trust (CRAT) to pay a 7% annuity interest to them for their lifetimes and then distribute the remainder to their private foundation (Foundation).

PLR 200430012 CRAT May Terminate Upon Beneficiary's Remarriage:   Prior to marriage, Donor and Spouse entered into an ante-nuptial agreement. Pursuant to the agreement, Donor would provide certain financial benefits to Spouse in the event Donor died before Spouse. Such benefits included a yearly salary, monthly maintenance payments, free rent, health care coverage and a lump sum payment.

Related Topics on Annuity Trust Duration and Recipients

3.1.7  CRAT Document Requirements:    Very specific document requirements and applicable regulations for charitable remainder annuity trusts are set forth in Sec. 664. The document must specify an annuity amount for a life, lives or a term of up to 20 years.

3.10.1  Unitrust Duration and Recipients:    A charitable remainder unitrust (CRT) pays a fixed percentage for a life, lives, a term of up to 20 years, or a combination of a life or lives and a term up to 20 years. Reg. 1.664-3(a)(5)(i). In most circumstances, the income is paid to the donor for one life or to donor and spouse for two lives. Alternatively, the unitrust amounts may be paid for a term of no more than 20 years, or for a combination.

      Quiz-Basic



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