16-Oct-16
New Life for Charitable Remainder Annuity Trusts
Last month the IRS surprised us with a gift when it published Rev. Proc. 2016-42. This is welcome news for older clients who want to adopt a charitable remainder annuity trust (CRAT). It is also good news for those tax exempt entities that rely on CRATs for part of their planned giving campaigns. The surprise deals with a relaxation of what is called the CRAT 5% exhaustion test.
By way of brief background, the transfer of assets to a CRAT will not provide any tax advantages associated with funding a CRAT, it will not be a qualified CRAT, unless it meets several technical restrictions. One of the most technical of those restrictions is that when assets are transferred by a taxpayer to a CRAT, there can be more than a 5% probability that the CRAT will become exhausted (from the lifetime annuity payments to the taxpayer) before the tax exempt entity receives the remainder interest in the CRAT, i.e. after the life annuitant dies. If there is a greater than 5% probability that the tax exempt entity will receive nothing, then the trust is not a qualified CRAT.
This 5% exhaustion test creates problems for those taxpayers who want to create a CRAT in light of the historically low prevailing interest rates. The 5% probability test that the charity will actually get something is calculated by using the life expectancy of the CRAT’s life-annuitant(s) and the IRC 7520 applicable federal midterm rate of interest for the month when assets are transferred by the taxpayer to the CRAT.
This month the federal applicable midterm rate is 1.4%. With that low interest rate used to calculate the 5% exhaustion test, for example, a married couple both age 76 could not create a qualified CRAT and satisfy the 5% test because their combined 16 year life expectancy would cause the CRAT’s corpus to be exhausted from the annual annuity payments before the survivor’s death, i.e. there was less than a 5% chance the charity remainder holder would receive anything from the CRAT. Or, a 74 year old taxpayer who created a CRAT for his/her own lifetime could not create a qualified CRAT since he/she would have a 13 year life expectancy. In either situation, the taxpayer would be denied the opportunity to create and benefit from a CRAT.
Thus, even when folks are eager to create and fund CRATs to fulfill their planned giving objectives and gain the lifetime tax benefits from funding a CRAT [an immediate charitable income tax deduction; the ability to sell appreciated assets ‘inside’ the CRAT and not immediately recognize the capital gain arising on sale] they could not do so because the CRAT flunked the 5% exhaustion test, which frustrates both the taxpayer and the tax exempt organization.
With its new Revenue Procedure the IRS will now permit a CRAT to be treated as a qualified CRAT for income tax purposes even if it fails the 5% exhaustion test. To qualify the CRAT instrument must now contain ‘magic language’ that provides that the CRAT will terminate prior to the death of the annuitant-beneficiary should the value of the CRAT’s corpus drop below 10% of the value of the amount originally contributed to the CRAT, with that below 10% amount immediately distributed to the tax exempt entity.
As noted above, in the absence of this new Revenue Procedure a single person age 74 could not create a tax qualified CRAT due to the 5% exhaustion test. Assume that a 74 year old taxpayer wants to fund a CRAT with $1.0 million of appreciated securities. In the past, creating a CRAT was a no-go due to the 5% exhaustion test. Now, the 74 year old taxpayer can proceed to create and fund the CRAT. If the CRAT’s terms require a 5% annual annuity paid to the taxpayer, and the corpus of the CRAT earns an average of 4% a year during the taxpayer’s lifetime, there would still be $834,000 in the CRAT at the end of the taxpayer’s normal life expectancy. Even if the taxpayer lived to be 100, there would still be about $555,000 that would be paid to the tax exempt organization at the taxpayer’s death.
The obvious risk to a taxpayer who wants to proceed with a CRAT in this low interest-low investment return environment is that the CRAT may have to prematurely terminate due to the ‘magic language’ while the taxpayer is still alive, and perhaps dependent upon the annuity payments to sustain their lifestyle. But instead of facing a ‘no-go from the get-go’, the taxpayer can now go forward with the CRAT, obtain the present income tax charitable deduction, diversify their appreciated portfolio without immediately paying capital gains taxes, and know that their philanthropic objectives will be carried out. The risk of a premature termination of the CRAT may be a risk that most philanthropic taxpayers are willing to assume.
To conclude, if you know of clients who have considered funding a CRAT in the past but were turned down due to the 5% exhaustion test, now is a good time to revisit this opportunity with them.