Sample CRAT Provision Provides Alternative for Satisfying Probability of Exhaustion Test

(Parker Tax Publishing August 2016)

The IRS has issued a revenue procedure containing a sample provision that can be included in the governing instrument of a charitable remainder annuity trust (CRAT) that would exempt the trust from the "probability of exhaustion" test. Rev. Proc. 2016-42.

Background

Under Code Sec. 664(d)(1), a charitable remainder annuity trust (CRAT) is a type of charitable remainder trust that pays out a certain percentage of the initial net fair market value of the trust's property to one or more persons for a term of years, and once the payments cease, transfers the remainder of the interest in the property to a charitable organization. The percentage cannot be less than five percent or more than 50 percent of the property's value, the annuity payments cannot continue for more than 20 years, and the remainder interest must be at least 10 percent of the initial value of the trust's property. Charitable remainder trusts are generally exempt from income tax.

The estate of the taxpayer who created the CRAT can take a charitable contribution deduction for the fair market value of the remainder interest. No charitable deduction is allowed, however, if the transfer of the remainder interest depends on the performance of some act or the happening of a precedent event in order for the transfer to be effective (i.e., a conditional gift), unless the possibility that the charitable transfer will not become effective is so remote as to be negligible.

Under Rev. Rul. 70-452, if there is a greater than 5 percent probability that the payments from a charitable remainder trust will defeat the charity's interest by exhausting the trust assets by the end of the trust term, then the possibility that the charitable transfer will not become effective is not so remote as to be negligible (the "probability of exhaustion" test). Rev. Rul. 77-374 applies the probability of exhaustion test to CRATs, and provides that if the probability that the life beneficiary or beneficiaries will survive exhaustion of the CRAT assets is greater than 5 percent, then the charitable remainder interest of the CRAT does not qualify for an income, gift, or estate tax charitable deduction and the CRAT is not exempt from income tax under.

The probability of exhaustion is calculated first by applying the Code Sec, 7520 assumed rate of return on CRAT assets against the amount of the annuity payment to determine when the CRAT assets will be exhausted. Then, a mortality table is used to determine the probability that the income beneficiary or beneficiaries will survive exhaustion of the CRAT assets. If the Code Sec. 7520 rate at creation of the trust is equal to or greater than the percentage used to determine the annuity payment, then exhaustion will never occur under the test.

The IRS noted that low interest rates in recent years have greatly limited use of a CRAT as an effective charitable-giving vehicle. For example, in May of 2016, the Code Sec. 7520 rate was 1.8 percent. At this interest rate, the sole life beneficiary of a CRAT that provides for the payment of the minimum allowable annuity (equal to 5 percent of the initial value of the trust assets) must be at least 72 years old at the creation of the trust for the trust to satisfy the probability of exhaustion test. The Code Sec. 7520 rate has not exceeded the minimum 5 percent annuity payout rate since December of 2007, which has necessitated testing for the probability of exhaustion for every CRAT created since that time.

Sample CRAT Provision

The sample provision in Rev. Proc. 2016-42 provides an alternative to satisfying the probability of exhaustion test. Specifically, the provision provides for early termination of the trust (and thus the end of the ability to make any more annuity payments) on the date immediately before the date on which any annuity payment amount would result in the value of the trust corpus being less than 10 percent of the value of the initial trust corpus.

The following is the sample provision designed to be used in an inter vivos CRAT for one measuring life:

"The first day of the annuity period shall be the date the property is transferred to the trust and the last day of the annuity period shall be the date of the Recipient's death or, if earlier, the date of the contingent termination. The date of the contingent termination is the date immediately preceding the payment date of any annuity payment if, after making that payment, the value of the trust corpus, when multiplied by the specified discount factor, would be less than 10 percent of the value of the initial trust corpus. The specified discount factor is equal to [1 / (1 + i)]^ t, where t is the time from inception of the trust to the date of the annuity payment, expressed in years and fractions of a year, and is the interest rate determined by the Internal Revenue Service for purposes of section 7520 of the Internal Revenue Code of 1986, as amended (section 7250 rate), that was used to determine the value of the charitable remainder at the inception of the trust. The section 7520 rate used to determine the value of the charitable remainder at the inception of the trust is the section 7520 rate in effect for [insert the month and year], which is [insert the applicable section 7520 rate]."

The sample provision is treated as a qualified contingency for purpose of Code Sec. 664(f), meaning that the inclusion of the exact language of the provision will not cause the trust to fail to qualify as a charitable remainder trust.

Practice Tip: A CRAT that contains a substantive provision similar but not identical to the sample provision will not necessarily be disqualified, but such a provision is not assured of treatment as a qualified contingency under Code Sec. 664(f).

Rev. Proc. 2016-42 generally applies to trusts created after August 8, 2016.

For a discussion of charitable remainder annuity trusts, see Parker Tax ¶57,110.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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