by Ted Batson Jr. and Greg Baker
Many clients feel a great sense of satisfaction upon the creation of a charitable remainder trust (CRT). After the newness wears off, however, some CRT income and remainder beneficiaries wish to terminate their trusts.
Perhaps the CRT's value has dropped to the point that the continued payment of income distributions to the income beneficiary is in danger of exhausting the CRT so that the charitable organization will receive nothing (e.g., from a charitable remainder annuity trust).
The organization may have initiated a new program that the income beneficiary would like to fund now rather than after his or her death. Or, the income beneficiary may be experiencing an unexpected cash flow crunch and need access to his or her portion of the CRT's value.
When is it generally advisable to keep the CRT intact and when might termination be an option? What will the Internal Revenue Service's perspective be if an early termination occurs? Should professional advisors counsel donors and the charitable organization they have a relationship with to stay the course?
In every case, it is important to consider the as-yet unsettled nature of the law regarding early terminations and weigh the advantages and costs of requesting a private letter ruling specific to a client's facts and circumstances.
Administration of a CRT is often more art than science. At any moment in time there may be unresolved issues with the investment portfolio, distributions to the income beneficiaries may be in arrears or beneficiaries may have been overpaid, or tax filings may not be current. Before entering into a termination transaction, the administration of the CRT should be cleaned up and any unresolved issues resolved.
Where an actuarial split is contemplated, the divisibility of the underlying trust assets must be considered. Where the trust holds unmarketable assets that are not easily divisible, the result of the termination may place the income and remainder beneficiaries in a worse position.
CRT terminations generally take one of two forms: (1) the assignment of the income interest to the charitable remainder beneficiaries (an "assignment termination"); or (2) division of the trust assets between the income and remainder beneficiaries based upon the actuarial present value of their respective interests (an "actuarial split").
Not every CRT is a candidate for an early termination. The trust's governing instrument must be examined to verify that the income beneficiary is not expressly prohibited from assigning his or her income interest and that the settlor did not expressly prohibit an early termination.
What is the effect of an early termination on the CRT's qualified status under IRC §664?
Over the years, the IRS has issued more than 15 private letter rulings related to CRT terminations. In one of the earliest rulings regarding an assignment termination (PLR 7949035), the Service concluded (without analysis) that the assignment of the entire income interest to the remainder beneficiary and subsequent termination of the trust would not cause the trust to retroactively fail to qualify as a CRT within the meaning of IRC §664. The determining factor was that the assignment of the income interest was permitted under state law.
In later rulings regarding actuarial splits, the Service continued to rely on a finding that the contemplated termination was a valid transaction under state law (see PLRs 200208039, 200304025 and 200324035).
Necessity of a Court Proceeding. In all states, a court of competent jurisdiction can be called upon to rule on an early termination proceeding. In some states, however, nonjudicial methods for dealing with trust matters are available. Where these methods are available, it is often quicker and more cost-effective to terminate a trust.
Consent of All Beneficiaries. In most states, an essential element to a state law termination proceeding is the consent of all beneficiaries—regardless of whether they vested. For example, it may be required that the children of the donor, who possess a survivorship income interest that is subject to a testamentary power of revocation held by the donor, consent to the termination.
If the charitable remainder beneficiaries were irrevocably named in the governing document, ascertaining those charitable organizations from which the trustee must obtain consent is relatively straightforward.
If the original charitable remainder beneficiaries were named revocably, however, questions may arise as to whether any or all of the charitable organizations were ever revoked and others substituted. Some states require that a prescribed method be followed when changing trust beneficiaries. Therefore, the trustee should verify that proper procedures were followed in the event that a change in charitable remainder beneficiaries was performed.
If the donor is still living, these issues can be easily resolved by requesting that the donor issue a notice revoking all previously named charitable organizations and fixing irrevocably those charitable organizations that are to be parties to the termination proceeding. Otherwise, a careful review of the trust file must be made to ascertain that the correct charitable organizations are identified and notified, and their consent obtained.
Role of the State Attorney General. In most states, the Attorney General serves as the protector for charitable organizations. In this role, the Attorney General may often be a required party to a transaction involving the early termination of a charitable trust (for example, if the CRT does not specify a charitable remainder beneficiary). In other states, the Attorney General's participation may be optional. In either instance, the IRS has shown a preference for having the Attorney General as a consenting signatory to the termination (see PLRs 200127023 and 200208039).
Will the assignment termination result in the charitable organization possessing current access to the trust principal?
Where an assignment termination in favor of an organization is contemplated, often a prime motivator is providing the charitable organization with current access to trust principal. As an irrevocable split-interest trust with a defined term, however, there is an expectation that the trust will continue in existence to the end of the trust term.
At least two methods exist to ensure that the charitable organization will have current access to the trust principal. In PLR 7949035, this dilemma was resolved by petitioning a local court for a declaratory judgment terminating the trust and directing that the trust funds be distributed to the charitable beneficiary.
A second resolution to this dilemma is found in a state trust law concept known as the doctrine of merger. The doctrine of merger holds that where a trust beneficiary is the owner of both an income interest and a remainder interest in a trust, the two interests merge, and the beneficiary has a present right to the trust principal (see PLRs 8311063, 9550026 and 200140027).
Are income tax and gift tax charitable deductions available following an assignment termination?
The assignment of an income interest in a CRT is a gift of a capital asset (see PLR 200127023 and Rev. Rul. 72-243).
A CRT income interest, however, is a partial interest in property. IRC §170(f)(3)(A) denies a charitable income tax deduction for the contribution of less than a taxpayer's entire interest in property. The regulations under section 170 further clarify, however, that if the partial interest transferred is the donor's entire interest in property, and the partial interest was not created to circumvent the rules of IRC §170(f)(2) and (f)(3)(A), then an income tax charitable deduction will be allowed.
The Service has consistently concluded that a CRT income interest represents an income beneficiary's entire interest in the trust property (Rev. Rul. 86-60). With respect to the question of whether the interest was created to circumvent the partial interest rules, the IRS looks to the facts and circumstances surrounding each case.
Critical facts include: the years that have passed since the initial funding of the trust, the attestation by the donor that the motivation for the creation of the trust was poor investment performance, or the creation of the trust by a settlor other than the income beneficiary.
The amount of the income tax deduction is computed using the formula prescribed in the regulations for computing the present value of an income and remainder interest in a trust. Please note that, if any of the underlying assets are not cash or marketable securities, a qualified appraisal will be required [Treas. Reg. 1.170A-13(c)(3)]. Because an income interest in a CRT is neither cash nor a marketable security, many practitioners feel the charitable contribution substantiation rules require that the computation of the present value of the income interest must follow the qualified appraisal rules.
Of great importance to the donor of an income interest is whether the contributed interest will also qualify for a gift tax charitable deduction. This is because a gift that fails to qualify for a gift tax charitable deduction will result in either the use of the donor's gift tax exclusion amount or even a gift tax. When asked to examine this question, the IRS has consistently determined that a gift tax charitable deduction is allowed in an assignment termination (see Rev. Rul. 86-60 and PLR 7949035).
Is an actuarial split a prohibited act of self-dealing under IRC §4941?
IRC §4947(a)(2) provides that IRC §4941 (regarding self-dealing) applies to a CRT. In most instances, the income beneficiary that surrenders his or her income interest in a CRT in return for a distribution of trust assets is a disqualified person as defined in IRC §4946.
The transfer of trust assets to a disqualified person is, by definition, an act of self-dealing. IRC §4947(a)(2)(A), however, provides an exception for amounts payable to a noncharitable beneficiary under the terms of the trust.
Two key questions to be answered:
In PLR 200152018, the IRS approved the assignment of an income interest in exchange for a charitable gift annuity issued by the charitable remainder beneficiary. This transaction preserved an income stream for the income beneficiary and allowed an additional income and gift tax charitable deduction. Most importantly, the income beneficiary was permitted to defer the recognition of the capital gain on the exchange by recognizing a portion with each annuity payment.
Given the Service's favorable ruling with respect to the exchange of a CRT income interest for a charitable gift annuity, one must consider other similar options. For example, could an income interest be used to fund a new albeit smaller CRT with terms that are different (and presumably less objectionable) than the original CRT?
The early termination of a CRT is not a transaction to enter into lightly. With appropriate counsel, attention to detail and a willingness to play by the rules, however, early terminations can effectively address the needs of some clients and result in a successful conclusion.
Please call Jeff W. Anderson, J.D. at 423-439-5352, or e-mail us at firstname.lastname@example.org , for more information.
About the Authors
Ted R. Batson Jr., MBA, CPA, is Vice President of Professional Services for Renaissance Inc., the nation's leading third-party administrator of charitable gifts. Since his employment in 1993, Batson has developed a wealth of practical, hands-on experience in dealing with complex issues related to the creative use of unmarketable and unusual assets to fund charitable gifts. He routinely consults with the more than 2,000 attorneys, CPAs and financial service professionals who look to Renaissance for case assistance.
Batson has spoken to numerous groups regarding charitable planning and has been published in several professional publications. Batson is a member of the American Institute of Certified Public Accountants (AICPA) and the Indiana CPA Society. He is a graduate of Asbury College (BA in computer science) and Indiana University (MBA in accounting).
As Renaissance's Vice President of Legal Services, Greg Baker works directly with clients' attorneys, other advisors and Renaissance staff regarding interpretations of federal and state laws applicable to charitable accounts; charitable gift, investment, retirement, estate and tax planning; and the wide array of assets held by affluent clients.
He has consulted on more than 13,000 charitable remainder trusts, 700 charitable lead trusts and countless private foundations, supporting organizations and charitable gift annuities.
Baker is a member of the advisory board for the CAP program at the American College, the Indiana Bar, Indiana State Bar Assoc., National Committee on Planned Giving, and Society of Financial Service Professionals. He is a graduate of Wabash College and Indiana University School of Law at Indianapolis.
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The information in this publication is not intended as legal advice. For legal advice, please consult an attorney. Figures cited in examples are for hypothetical purposes only and are subject to change. References to income tax apply to federal taxes only. Federal estate tax, state income/estate taxes or state law may impact your results.