Trust Language Doomed Estate's Deduction for Transfer of CRAT Interest to Charity

(Parker Tax Publishing April 2023)

The Tax Court held that an estate was not entitled to a deduction under Code Sec. 2055(a) for the transfer of a remainder interest in a trust to a charitable organization because the trust instrument did not provide that a "sum certain" was to be paid at least annually to the income beneficiaries of the trust and therefore, the trust was not a charitable remainder annuity trust (CRAT). The court also found that an amendment to the trust did not qualify for the exception for judicial reformations because the amendment was executed beyond the 90-day period following the due date for the estate tax return and was instituted by the co-trustees alone, rather than by a court. Estate of Block v. Comm'r, T.C. Memo. 2023-30.

Background

Susan Block died on October 21, 2015. Her will provided for the transfer of her residuary estate to the Susan Rubin Block Revocable Trust (Trust).

The Trust instrument provided for a subtrust, the Harriet Katz Trust (Katz Trust), to be funded upon Block's death. The Katz Trust would exist for the benefit of Block's sister, Harriet Katz (Harriet), and then for the benefit of Harriet's spouse, I.W. Katz, should he survive Harriet. Article 4 of the Katz Trust provides that upon the death of both Harriet and I.W., the property remaining in the trust will be distributed to the Jewish Community Foundation of Greater Hartford, Inc. (Foundation), a charitable organization.

Article 4.1 of the Trust instrument states that the Katz Trust was intended to be a charitable remainder annuity trust (CRAT) within the meaning of Code Sec. 664(d)(1) and Rev. Proc. 2003-57 and that "the terms of this Section shall be construed to give maximum effect to such intent." Article 4.1(A) of the Katz Trust directed that an "annuity amount" be paid to Harriet during her life in an amount "equal to the greater of: (a) all net income, or (b) the sum of Fifty Thousand Dollars ($50,000), at least annually."

After the IRS initiated an examination of the Block estate's Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, in August 2017, the co-trustees executed an amendment to the Trust instrument (First Amendment) with an effective date of October 21, 2015 (Block's date of death). The First Amendment's stated purpose was to revise Article 4.1(A) to provide that the trustees shall pay from the Katz Trust to Harriet for her life, and to I.W. should he survive Harriet, "an annuity amount equal to the sum of Fifty Thousand Dollars ($50,000), at least annually." The First Amendment removed "all net income" from the determination of the annuity amount. The Katz Trust has paid $50,000 each year to Harriet from 2015 through at least 2019.

On its estate tax return, Block's estate deducted from the value of the gross estate the present value of the charitable remainder interest of the Katz Trust, which the estate calculated on the basis of an annuity amount of $50,000 and the actuarial life expectancies of Harriet and I.W. The IRS disallowed the entirety of the estate's claimed charitable deduction in connection with the Katz Trust. To date, the co-trustees of the Trust have not commenced any judicial proceeding to reform any provisions of the Trust instrument.

Code Sec. 2055(a) generally allows a deduction from the value of a decedent's gross estate for transfers for charitable purposes. However, Congress attached special conditions in the case of charitable bequests in the form of split-interest transfers. Such a transfer occurs where an interest in property passes to a charitable beneficiary while an interest in the same property also passes to a noncharitable beneficiary for less than full and adequate consideration. Code Sec. 2055(e)(2)(A) disallows a deduction for the charitable remainder portion of a split interest transfer unless (1) the remainder passes in trust and (2) the trust is a charitable remainder annuity trust (CRAT), a charitable remainder unitrust (CRUT), or a pooled income fund (PIF). Congress imposed the Code Sec. 2055(e)(2)(A) requirement for split-interest remainders in order to remove the incentive to favor the income beneficiary over the remainder beneficiary by means of manipulating the trust's investments. Thus, the annual payout to the noncharitable income beneficiaries must be a fixed dollar amount (in the case of a CRAT) or a fixed percentage of the value of the trust assets (in the case of a CRUT).

Under Code Sec. 2055(e)(3)(A), if a trust initially fails to qualify as a CRAT or a CRUT, the settlor's estate still may take a charitable deduction if there is a "qualified reformation" of the trust. Code Sec. 2055(e)(3)(C) provides that a qualified reformation cannot occur unless the remainder interest is a "reformable interest" under Code Sec. 2055(e)(3)(B), meaning that in the pre-reform trust (1) the remainder interest is exclusively charitable and (2) all payments to the noncharitable beneficiaries are "expressed either in specified dollar amounts or a fixed percentage of the fair market value of the property." Under Code Sec. 2055(e)(3)(C)(iii), there is an exception to the "specified dollar or fixed percentage" requirement: An initially nonfixed interest will be excused if, within 90 days after the due date for the estate tax return, a judicial proceeding is commenced that results in the trust qualifying as a CRAT or a CRUT, retroactive to the date of the decedent's death. In such a case, the remainder is deemed a reformable interest just so long as the pre-reform trust designated it as exclusively charitable.

Code Sec. 664(d)(1) generally defines a CRAT as a trust with certain characteristics, one of which is that a "sum certain" is to be paid, at least annually, to the income beneficiaries. Reg. Sec. 1.664-2(a)(1)(ii) defines "sum certain" as a stated dollar amount which is the same either as to each recipient or as to the total amount payable for each year of the annuity period.

The estate argued that the First Amendment effected a qualified reformation or, alternatively, that the estate substantially complied with the judicial reformation exception in Code Sec. 2055(e)(3)(C)(iii). The estate also contended that Rev. Proc. 2003-57 and Rev. Proc. 2003-59 allow a trustee to act alone, without court involvement, to amend the terms of a trust at any time to ensure it both qualifies as a CRAT and retroactively qualifies for an estate tax charitable deduction. The estate pointed to a sample provision in each of the revenue procedures that does not specify a time limit for amending the trust or require judicial intervention. Further, the estate argued that the Katz Trust qualified as a CRAT from the beginning because Article 4.1(A) for an "annuity amount" equal to the greater of all net income or $50,000 at least annually and contained language stating that the Katz Trust was intended to be CRAT and that the trust should be construed to give maximum effect to that intent.

Analysis

The Tax Court held that Article 4.1(A) of the Trust instrument, as it stood on the date of Block's death, was not limited to a specific dollar amount and therefore violated the requirement of Code Sec. 664 that the annuity of a CRAT be a "sum certain." Consequently, the court found that the Katz Trust did not qualify as a CRAT at the time of Block's death (nor as a CRUT or a PIF), and the charitable remainder of the Katz Trust was not a reformable interest under the default rules - that is, before considering the exception for judicial reformations.

The court explained that, since the First Amendment could not have effected a qualified reformation, the only remaining possibility was a judicial reformation. However, the court determined that the judicial reformation exception clearly did not apply because (1) the First Amendment was executed far beyond the 90-day period following the due date for the estate tax return and (2) the amendment was instituted by the co-trustees along, rather than by a court. The court declined the estate's request to deem the it to have substantially complied with the exception after finding that Congress clearly provided that the rules for qualified reformations are to be strictly construed in order to prevent abuse of the charitable deduction. The court also rejected the estate's argument that Rev. Proc. 2003-57 and Rev. Proc. 2003-59 permit a trustee to amend the terms of a trust at any time, without court involvement, to ensure it both qualifies as a CRAT and retroactively qualifies for an estate tax charitable deduction. The court found that the procedures do not permit corrections for "major, obvious defects" such as a provision that allows annual payments to the income beneficiary in the amount equal to the greater of all net income or $50,000. Major defects, the court found, require a judicial proceeding to be commenced before an IRS audit might begin.

The court was not persuaded by the estate's argument that Katz Trust was a CRAT from the beginning. The court understood the estate to be arguing that the "all net income" provision of Article 4.1(A) was void ab initio, so that no qualified reformation - let alone a judicial proceeding - was necessary for the Katz Trust to be a CRAT. The court reasoned that even if the phrase "all net income" was ineffectual under state law, that did not mean the trust was a CRAT from the beginning. That determination, the court found, depended on the proper construction of Code Sec. 664(d)(1)(A), which provides that a CRAT is (among other things) a trust "from which a sum certain . . . is to be paid, not less often than annually, to one or more persons." In the court's view, this provision could lead to two interpretations, either (1) the trust's governing instrument unambiguously provides for a sum-certain annuity or (2) the governing instrument once properly construed (such that any and all ambiguities are resolved in accordance with applicable state law) provides for a sum-certain annuity. The court concluded that the first interpretation accords much more soundly with Congress' intent, which was to deny both income and estate tax charitable deductions for remainder interests unless the amount going annually to the noncharitable beneficiaries is certain and unmanipulable.

For a discussion of charitable deductions with respect to split-interest transfers, see Parker Tax ¶227.730.

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.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com