Thursday March 28, 2024

3.1.3 Annuity Trust Payouts

Annuity Trust Payouts

Percentage Limits:   A charitable remainder annuity trust must pay a minimum of 5% of the initial net fair market value of the trust at least annually to one or more persons.

AFR Selection for the 10% MDI Test:   Annuity trusts must qualify for a minimum 10% charitable deduction.

Charitable Contribution is Allowable:   The key phrase is "If an income, estate, or gift tax charitable contribution is allowable . . ."

Conservative Counsel:   The "consistency" principle is universally followed by courts in interpreting documents.

Very Conservative Counsel:   And what if counsel is very conservative and desires yet greater comfort?

Percentage Limits

A charitable remainder annuity trust must pay a minimum of 5% of the initial net fair market value of the trust at least annually to one or more persons. Sec. 664(d)(1). In addition, the annuity trust may not pay more than 50% of the initial fair market value annually. Reg. 1.664-2(a)(1).

If a donor specifies a dollar amount, and it is subsequently determined that the dollar amount is less than 5% of the initial fair market value of the assets, it is permissible for the donor to receive the dollar amount and for the charitable deduction to be based on a sum equal to 20 times the dollar amount. Reg. 1.664-2(a)(2)(iii).

An additional requirement for a 10% minimum deduction test was created in the Taxpayer Relief Act of 1997. Sec. 664(d)(1). The annuity trust must produce a charitable deduction equal to 10% or more of the initial net fair market value of the trust corpus. This requirement may result in donors not qualifying for a one-life annuity trust, even with a 5% minimum payout. The charitable deduction should always be checked to make certain that it exceeds the 10% minimum requirement.

Example 3.1.3A Excess Value In Trust

Assume that donor Mary Smith creates a charitable remainder annuity trust and selects a $50,000 annuity, paid quarterly for her lifetime. She assumes that the stock transferred to the trust is valued at $1 million, producing a 5% annuity trust. However, the stock is actually valued at $1,200,000. So long as the charitable deduction is based on the $1 million value (20 times $50,000), the trust will be deemed valid and the income tax deduction permitted.

AFR Selection for the 10% MDI Test

Annuity trusts must qualify for a minimum 10% charitable deduction. Sec. 664(d)(1). And the charitable deduction is calculated using an applicable federal rate (AFR) selected under the provisions of Sec. 7520. This section requires that calculation of "any remainder or reversionary interest shall be determined-- (1) under tables prescribed by the Secretary, and (2) by using an interest rate (rounded to the nearest 2/10ths of 1 percent) equal to 120 percent of the Federal midterm rate in effect under Sec. 1274(d)(1) for the month in which the valuation date falls."

The language continues, "If an income, estate, or gift tax charitable contribution is allowable for any part of the property transferred, the taxpayer may elect to use such Federal midterm rate for either of the 2 months preceding the month in which the valuation date falls for purposes of paragraph (2)."

The question arises - can the 10% test be met using the current month AFR or the AFR from one of the two prior months?

Charitable Contribution is Allowable

The key phrase is "If an income, estate, or gift tax charitable contribution is allowable . . ." Note that there is no requirement for the charitable contribution to be "allowable under the Federal midterm rate in effect under section 1274(d)(1) for the month in which the valuation date falls." It is simply improper interpretation to write language in the Code that does not exist in the current language.

The key word is "allowable." And "allowable" is used in the sentence that permits the two prior-month AFRs to be used. It seems consistent with English usage that "allowable" means "allowable" under any of the potential three AFRs. If the drafter intended to require passage of any test with a minimum of two or three of the AFRs, then the language would surely have explicitly so indicated.

Any interpretation other than permitting passage of tests with one of the three AFRs produces potentially inconsistent results. If real property is divided between two trusts, as is clearly foreseen by the "transfers of more than 1 interest in the same property" provision, then the basic rule that internal consistency is required if there are two potential interpretations mandates permitting use of any of the three AFRs for the 10% minimum deduction interest test.

Example 3.10.3B Selection of AFR for 10% MDI Test

Donor John Smith owns a parcel of real property. He transfers an undivided 40% interest in the real property into a term of 20 years annuity trust paying 6% to his three children. He transfers the remaining undivided 60% interest in the real property into an annuity trust paying 12.16% to himself for a term of 10 years. He also transfers $1,000 in cash to his term of 10 years annuity trust. The AFR for the month of transfer is 6.0% and the AFR for the prior month is 6.4%.

The term of 20 years trust qualifies for a charitable deduction under both the 6.0% AFR and the prior month's 6.4% AFR. Thus, the test for "contribution is allowable for any part of the property" is clearly met. John Donor selects the higher deduction available for the prior month's 6.4% AFR. And since the "contribution is allowable for any part" test has been met, he may also use the 6.4% AFR for the 60% of the real property contributed to his 10 year annuity trust. In fact, for the 60% interest, the "taxpayer shall use the same rate with respect to each such interest" language requires John Donor to use the 6.4% AFR to calculate the deduction. Therefore, the undivided 60% interest transferred to the term of 10 years annuity trust produces a 10% charitable deduction under the 6.4% prior-month AFR.

But John also gives $1,000 in cash to the term of 10 years annuity trust. This contribution fails the 10% minimum deduction test with the current month 6% AFR, but also passes the test with exactly a 10% deduction under the 6.4% prior-month AFR. Question - is the $1,000 contribution limited to using only the current-month AFR, thus producing a unitrust that is simultaneously qualified with the real property gift and unqualified with the cash gift?

This interpretation simply is not consistent. The same annuity trust funded by one donor with two gifts at one time cannot be both qualified and unqualified. Yet it is obviously inconsistent for the undivided 60% real property interest to qualify and for the $1,000 cash gift to fail the 10% minimum deduction interest test. The interpretation principle of seeking internal consistency mandates a meaning of "allowable" that permits use of any of the available three AFRs for purposes of the 10% minimum deduction test. Both the property gift and the cash gift are permitted to use the prior month's 6.4% AFR for deduction calculation purposes.

Conservative Counsel

The "consistency" principle is universally followed by courts in interpreting documents. But what if counsel is conservative and desires greater comfort? And perhaps in some location there is a Treasury staff person or Tax Court judge who is an advocate for inconsistency. Even in this very unlikely case, there is no major risk. The charitable deduction for the qualified annuity trust under the current month AFR will also equal 10%. Since the term of 10 years annuity trust qualifies in all other respects and the change will not vary the charitable deduction by more than 5%, there is a right at any time to reform the payout percentage under Sec. 2055(e), in the very unlikely case that an "advocate of inconsistency" would request such a change.

Very Conservative Counsel

And what if counsel is very conservative and desires yet greater comfort? In this case, merely use the AFR from the current month and avoid the issue entirely. The small increase in permissible payout may not be of sufficient value to the donor to use the prior month rate, rather than the current month AFR.


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