Thursday April 25, 2024
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8.2.1 State Regulations - The Administration
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CRT Payment Requirements
The charitable remainder trust (CRT) administration rules are specific, exacting and numerous. For instance, a CRT must pay a minimum of 5%, a maximum of 50% and produce a charitable deduction of 10% or greater. Once these requirements are met, the selected CRT percentage is multiplied times the value of the trust. If the amount is paid semiannually, quarterly or monthly, the payout amount is divided by two, four or twelve, respectively. With respect to the payout amount, distributions from CRTs are first ordinary income, then capital gain, then tax-free income and finally corpus. These rules are a small sample of the technical rules revolving around CRTs.
If the trust administration rules are not followed accurately and consistently, then the trustee runs the risk of disqualifying the charitable remainder trust and triggering tax penalties. See Estate of Melvine B. Atkinson v. Commissioner, 115 TC. No. 3, No. 20968-97 (July 26, 2000). Echoing this sentiment, the tax regulations state that a CRT must function exclusively as a CRT. For example, a CRT may not be a grantor trust because then the CRT would not be functioning exclusively as a CRT. Reg. 1.664-1(a)(4). This strict mandate set forth in the tax regulations should not be taken lightly by the uninitiated or the untrained.
Regulations Provide Some Flexibility
The strict CRT administration rules, however, are not without mercy. The tax regulations recognize that incorrect payments, either too high or too low, may occur even with the best trust administrators. Thus, there are corrective provisions specifically set forth in the tax regulations. For instance, if a trustee made an overpayment to an income beneficiary because of an incorrect trust valuation, then the income beneficiary is required to return the excess payment to the trustee within a reasonable time. Reg. 1.664-2(a)(1) and Reg. 1.664-3(a)(1).
In this situation, an income beneficiary may deduct from his or her gross income any amounts returned to the trust because of the overpayment. Reg. 1.664-1(d)(4). This seems only natural since no income beneficiary wants to pay income tax on returned payments. Conversely, if a trustee made an underpayment, then the trustee shall pay the income beneficiary the appropriate shortfall amount within a reasonable time.
Incorrect CRAT Valuation
A special circumstance may arise with respect to charitable remainder annuity trusts (CRAT) that should be noted. In some cases, donors may specify a fixed dollar amount for the annuity and later discover that the fixed dollar amount is less than 5% of the initial fair market value of the assets, e.g., the trustee underestimated the trust property in good faith.
At first blush, it appears that the CRAT would lose its tax-exempt status, because the trust fails the 5% minimum payout requirement. Fortunately, the tax regulations do not take such a hard-line position. Instead, it is permissible for the donor to receive the fixed dollar amount as stated in the trust document and not adversely affect the CRAT's qualification. This is true so long as the donor agrees to treat the initial fair market value of the trust as an amount equal to 20 times the annuity for charitable deduction purposes. Reg. 1.664-2(a)(2). In essence, the donor saves the CRAT's favorable tax status but receives a charitable deduction based upon an artificially lower trust fair market value.
Payment Guidelines for Payment Timelines
A CRT must make payments at least annually. Reg. 1.664-2(a)(1) and Reg. 1.664-3(a)(1). Generally, a CRT makes payments on a monthly, quarterly, semi-annual or annual basis. The donor, the donor's attorney and/or the trustee make this determination during the drafting of the trust document. From a trust administration standpoint, the more frequent the payments, the more time will be devoted to administering the trust.
Despite this "at least annually" payment requirement, there is some flexibility regarding end of the year payments. For example, a trustee may have trouble wrapping up financial obligations by December 31st and, therefore, may require additional time before an end of year payment can be made. Understanding this common dilemma, the tax regulations allow for a payment after the close of the taxable year if such a payment is made within a reasonable time, and the entire distribution amount in the hands of the income beneficiary is taxable. A reasonable time will not ordinarily extend beyond the date by which the trustee must file Form 5227 (including extensions). The deadline for filing Form 5227 is April 15. For trusts created prior to December 10, 1998, special rules may apply to payments after year-end. Reg. 1.664-2(a)(1) and Reg. 1.664-3(a)(1).
Income Reportable In Year When Payout Is Required
A CRT income beneficiary must include an annuity or unitrust payout in his or her income in the year the annuity or unitrust payout is required to be distributed. This is true even when the payment is not distributed until after the close of the taxable year. Reg. 1.664-1(d)(4).
In-Kind Distributions
Generally, trustees make annuity and unitrust payments with checks, cash or electronic transfers. However, distributions in-kind are permissible, i.e., distributing actual trust property. In the case of a distribution made in property other than cash, the amount paid shall be considered as an amount realized by the trust from the sale or other disposition of property. In other words, it will be treated as a sale for trust accounting purposes.
More importantly, the distribution of property in-kind will not avert taxable income to the income beneficiary. Consequently, the payment will likely be taxable under the four tier accounting rules. In addition, the basis of the distributed property in the hands of the income beneficiary is the fair market value of the property at the time it was distributed. Reg. 1.664-1(d)(5).
It is also possible to make distributions in-kind to charitable organizations. In the event a trust distributes property in-kind to a charitable organization, the trustee would record the transaction using a reverse four-tier accounting structure, i.e. principal, tax-free income, capital gain income and ordinary income. Reg. 1.664-1(e).
Example 8.2.1B In-Kind Distributions Example
On January 1st, Tom and Thelma Cook funded a five-year CRUT with a 15% payout using $800,000 of stocks with a cost basis of $100,000. The Cooks, however, prefer that the trustee of the CRUT not sell and diversify the stock holdings because they believe the portfolio is excellent "as is." Furthermore, the Cooks would like the CRUT payouts to be the actual stock - an in-kind distribution - as opposed to cash payouts.
After the first year of the trust, the trustee must distribute property in-kind worth $120,000 (800,000 x 15%). The trust will realize $105,000 of the $120,000 as capital gain income and $15,000 (100,000/800,000 x 120,000) as corpus. Under the four tier accounting rules, the Cooks will report $105,000 of capital gain income and the remaining $15,000 will not be taxable. Finally, the Cooks new basis in the distributed stock will be $120,000, which was its FMV at the time it was distributed.
Trust's First and Last Taxable Years
CRT payments for short tax years must be adjusted and paid accordingly. In the case where a CRT's taxable year is less than 12 months, then the CRT payout must be prorated for the amount of time the trust is in existence. The calculation set forth in the tax regulations is quite simple. In determining the prorated amount, the trustee simply takes the payment for the year and multiplies it by a fraction. The fraction's numerator consists of the number of days in the trust's short taxable year, and the fraction's denominator is 365 or 366 in the event of leap years.
In the event of a CRT's last taxable year, the trustee has two choices. First, a trustee may follow the same computation for short taxable years as described above, e.g., the number of days that the trust is in existence divided by 365 or 366 multiplied times the CRT payout. Alternatively, the trust document may provide that no final prorated payment need be made. In other words, an income beneficiary or an estate would be giving up any accrued right to income between the last regularly scheduled CRT payout and the trust's termination date. Reg. 1.664-2(a)(1) and Reg. 1.664-3(a)(1).
Example 8.2.1A First Taxable Year Example
Bob Bright created a $100,000 CRUT with a 5% payout on November 1st. The trust's tax year closed on December 31st, and the trustee needed to make a distribution to Bob. The unitrust payout was determined by taking $5,000 (100,000 x 5%) and multiplying it by the "days in existence" fraction.
In this case, the trust was in existence for 61 days, i.e., November 1 - December 31. Thus, the fraction consisted of 61 as the numerator and 365 as the denominator. If a leap year was present, then the fraction denominator is 366. Based upon this fraction, the unitrust payout for this year was $835.62 (5,000 x 61/365). Accordingly, the trustee distributed this amount within a reasonable time.
Administration of Testamentary CRTs
The initial trust administration of testamentary CRTs can be quite complex. In many instances, a testamentary CRT is deemed created on the date of the donor's death. However, due to estate administration, litigation and other delays, a testamentary CRT is rarely funded at the time of the donor's death. Nevertheless, the CRT administration rules and requirements technically take effect immediately. Not surprisingly, this common delay in trust funding causes a trust administration problem, since the trustee has no assets in which to fulfill the mandated CRT payments.
Fortunately, if permitted by local law or by the governing instrument, the trustee's requirement to make a CRT payment may be deferred until the end of the taxable year in which occurs the complete funding of the trust. Reg. 1.664-1(a)(5) and Rev. Rul. 92-57. Upon complete funding, the trustee must pay to the income beneficiaries any annuity or unitrust amounts owed plus interest. Generally, the rate of interest is the Sec. 7520 rate for the month in which the valuation date occurred, e.g., date of donor's death. If one of the prior two months rates were used for the charitable estate tax deduction, then the elected alternative rate would apply.
Private Foundation Rules Apply
Because some private foundation rules apply to charitable remainder trusts, there are certain acts that a trustee is prohibited from performing. Sec. 4947 and Reg. 1.664-1(b). For instance, the trust document must include provisions prohibiting certain activities, most notably acts of self-dealing. If an act of self-dealing is found, then the trustee could be subject to harsh tax penalties. Sec. 4941. Self-trustees are especially susceptible to engaging in acts of self-dealing, since most self-trustees are not well versed in this area of law and attempt to maximize utmost control over the trust property.
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