3.10.3 Unitrust Payouts

A unitrust payout percentage must comply with three basic rules. The trust must pay a minimum of 5%, a maximum of 50% and a percent that produces a charitable deduction of 10% or greater. The 5% minimum and 50% maximum requirements are easy to understand. The 10% Minimum Deduction Interest (MDI) is understood if one reviews the basics of the charitable deduction.

Unitrusts must qualify for a minimum 10% charitable deduction. Sec. 664(d)(2)(D). 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 completed using the current month AFR or the AFR from one of the two prior months?

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 Sec. 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.

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 unitrust under the current month AFR will also equal 10%. Since the unitrust 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.

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.

Most unitrusts are created with 5% or 6% payouts. There are two reasons for selecting a lower percentage. First, one of the greatest economic advantages of charitable trusts is the ability to accumulate assets tax-free inside the trust. For unitrusts that last 20 or more years, the actual economic benefit is quite close, whether a higher or lower unitrust percent is selected. The lower percent unitrust will pay less in the early years and, as a result of compounded tax-free growth, will produce higher income than the high payout trust in later years. Overall, the value of the income distributed for a trust of this duration will be approximately the same.

The primary question is -- will a person be happier with less income now and more income later or with more income now and less income later? Human nature and experience tells us that the very clear answer is that the happiest unitrust grantors are those who have chosen to have less income now and more income later by selecting a 5% or 6% payout trust. With total returns in excess of that amount, the trust corpus grows and the income grows proportionately.

In some cases, the deduction with a 5% or 6% trust may not be fully utilized over this year plus the permissible five carry-forward years. While the family CPA may be tempted to suggest that the payout be increased to 8%, 9% or 10% in order to reduce the deduction to the amount that will probably be fully utilized, this strategy is generally good tax planning and very poor economics.

The economic advantage of the income stream that matches the family goals is typically of much greater importance than the possibility that a carry forward might be lost seven years into the future. Given the uncertainty of knowing income levels or even tax laws for seven years, it is far more important to plan for the present than for some far future date. Thus, your author's counsel is to use the 5% or 6% trust and enjoy all of the principal and income growth benefits that those percentages permit.