Tax-Wise Charitable Remainder Trust Planning

When it comes to charitable remainder trusts (CRTs), Groucho Marx’s line from the 1930 movie Duck Soup is instructive: “Why, a four-year-old child could understand this report. Run out and find me a four-year-old child.  I can’t make head or tail out of it.”1

This is the third article in our three-part series about charitable trusts. Our first article covered ugly tax schemes that caused trouble for donors and their advisors,2 and our second article discussed charitable remainder unitrusts (CRUTs) and charitable remainder annuity trusts (CRATs).3 To wrap up the series, we’ll explain the gift and estate tax rules and how to qualify for the CRAT and CRUT safe harbors. And how to fix up muck ups.  

Gift Tax Rules 

The income tax rules (previously covered) are always first on the list. Not knowing the gift tax values can do in clients (and advisors).  

Most clients need only worry about federal gift tax returns, but for those lucky enough to live in Connecticut, a state gift tax return might also be needed. Always check whether state and local tax rules apply.  

CRUTs and CRATs.  If your client has a one-life CRUT or CRAT for the donor’s life, the value of the charitable remainder interest in the qualified trust isn’t subject to gift tax. However, the donor must report the remainder gift (regardless of its size because it’s a future interest) on a federal gift tax return.4 The donor then takes an off-setting gift tax charitable deduction.5  

One-life CRUTs and CRATs for the benefit of someone other than the donor are treated differently. That donor makes two gifts: one to the beneficiary (the value of the life interest) and one to the charity (the value of the remainder interest).

Gift to life beneficiary. Say adonor makes a gift to the life beneficiary of the value of the life interest. That interest is a present interest, so it qualifies for the annual gift tax exclusion. If that interest’s value exceeds the annual gift tax exclusion and the “tentative” tax on the gift isn’t offset by the unified transfer tax credit, some gift tax will be due.6 The rules for determining the life beneficiary’s interest when the beneficiary is the donor’s spouse are similar, but with one positive exception: As long as the trust doesn’t have any non-spouse beneficiaries, the U.S. citizen spouse’s life interest qualifies for the automatic unlimited gift tax marital deduction (no election needed).7 

Suppose the second life beneficiary’s interest follows the donor’s life interest. The donor can avoid making a gift to the survivor by providing in the inter vivos trust the right (exercisable only by will) to revoke the survivor’s life interest. If the donor exercises that right, the trust terminates on the donor’s death. The trust principal is then delivered to the charity. The donor doesn’t have to exercise that right in their will. Merely retaining the right avoids the donor making a completed gift to the survivor beneficiary.8 

As long as a CRUT or CRAT doesn’t have any non-spouse beneficiaries, a U.S. citizen spouse’s future interest in a CRUT or CRAT qualifies for the automatic unlimited gift tax marital deduction (no election needed).9 Alternatively, you can avoid gift tax concerns by having the donor reserve the right in the inter vivos trust to revoke the surviving spouse’s life interest by will. 

Two-life CRUT or CRAT funded with joint, tenancy in common or community property, and donors are spouses. The trust should provide for payments to the donors jointly for life and then to the survivor for life. The charitable remainder interest is reportable (regardless of size because it’s a future interest) on the federal gift tax return, then it’s deductible as a charitable contribution, resulting in a wash. For example, an actuarially older spouse makes a gift to an actuarially younger spouse of the difference in value of their survivorship interests. As long the trust doesn’t have any non-spouse beneficiaries, the gift qualifies for the automatic unlimited gift tax marital deduction (no election need be made) for U.S. citizens.10 It’s unnecessary for gift tax purposes (although it can’t hurt) for the spouses to reserve the right to revoke, as outlined above. But the taxpayers may want to retain the right to revoke and actually revoke it if there’s a divorce. If the spouses are divorced, the gift won’t qualify for the estate tax marital deduction. A divorce settlement agreement should deal with this issue. 

Revoking a beneficiary’s interest. Although it’s retained in an inter vivos CRT, the right to revoke should be exercisable only by will. If the right is exercisable during the donor’s life, the trust will be disqualified. The right to revoke shouldn’t be retained unless the donor is a trust beneficiary. For example, in a trust providing payments to the donor’s son for life, with the remainder passing to charity, the trust could be disqualified if the donor retains the right to revoke the son’s interest. Why? The trust would potentially be measured by the donor’s life instead of the son’s life.11 Absent a retained right, the son’s interest wouldn’t be includible in the donor’s gross estate. But apparently, a non-beneficiary donor can keep a testamentary right to revoke a beneficiary’s interest in a term-of-years trust. The Internal Revenue Service approved one such trust in Private Letter Ruling 8949061 (Dec. 8, 1989). Remember, PLRs are “authority” only for the recipient. 

Estate Tax Rules 

Here’s a review of several common situations involving estate tax and marital deduction rules:

Donor is the sole beneficiary of an inter vivos CRUT or CRAT. The value of the trust assets at the donor’s death (or at the alternate valuation date) is includible in the donor’s gross estate when the donor retains a life interest in the trust. The estate deducts the value of the trust assets as a charitable contribution, resulting in a wash.12 But the value of the trust assets isn’t includible in the donor’s gross estate when the donor creates an inter vivos CRUT or CRAT for a beneficiary other than the donor.13

For two-life inter vivos CRATs and CRUTs funded with the donor’s separate property with payments to the donor for life and then to a non-spouse second beneficiary for life, the value of the trust assets at the donor’s death (or alternate valuation date) is includible in the donor’s gross estate whether or not the second beneficiary survives the donor.14 If the second beneficiary doesn’t survive the donor, the amount includible in the gross estate will be deducted as a charitable contribution—again, resulting in a wash.15 If the second beneficiary survives the donor, the donor will deduct the value of the charitable remainder as a charitable contribution. In effect, only the value of the survivor beneficiary’s life interest is subject to tax. If an alternate valuation date is elected, in computing the value of the charitable remainder, the donor must use the value of the assets at the alternate valuation date, but the donor must use the age of the survivor beneficiary (at the nearest birthday) as of the date of the donor’s death.16

Two-life inter vivos CRUT or CRAT funded with jointly owned property when donors who are beneficiaries are spouses. Only half of jointly held property owned by spouses is includible in the estate of the first spouse to die, regardless of who furnished the consideration.17 The estate of the first spouse to die gets an estate tax charitable deduction for the remainder interest in half the property includible in the gross estate and automatically gets (without an election) a marital deduction for the value of the surviving U.S. citizen spouse’s life interest in half the joint property includible in the gross estate, as long as the trust doesn’t have any non-spouse beneficiaries.18 

CRUTs or CRATs created by donor’s will for benefit of U.S. citizen spouse. The estate receives an estate tax marital deduction (no election) for the value of the surviving spouse’s life interest and an estate tax charitable deduction for the value of the charity’s remainder interest. Thus, the entire value of the trust assets isn’t subject to tax.19 The estate tax marital deduction for the spouse’s life interest is allowable only if the spouse is the sole beneficiary.20 For example, a remainder trust created by the donor’s will providing payments to spouse for life, and then to son for life, wouldn’t qualify for the estate tax marital deduction. The charitable remainder interest would still qualify for the estate tax charitable deduction. In PLR 200204022
(Jan. 25, 2002), a disclaimer saved the marital deduction, but at a price. The non-spouse beneficiaries had to give up income.

Safe Harbors

The IRS gives sample CRAT and CRUT forms. Specifically, we’ll review two revenue procedures that provide some well-drafted samples, along with annotations, which are a complete course in themselves.21 A trust instrument that contains substantive provisions in addition to those provided in the revenue procedures discussed below (other than properly integrated alternative provisions from the revenue procedure or provisions necessary to establish a valid trust under applicable local law that are consistent with the applicable federal tax requirements) or that omits any of the provisions of the revenue procedures (unless an alternative provision is properly integrated) “will not necessarily be disqualified, but neither will that trust be assured of qualification under the provisions of this revenue procedure.”22

Revenue Procedure 2005-52 provides that previously, the IRS issued sample trust instruments for certain types of CRUTs. The IRS updated the previously issued samples and issued new samples for additional types of CRUTs. Section 4 of Rev. Proc. 2005-52 presents a sample declaration of trust for an inter vivos CRUT with one measuring life that’s created by an individual who’s a U.S. citizen or resident. Section 5 provides annotations to the provisions of the sample trust. Section 6 offers samples of several substitute clauses concerning: the payment of part of the unitrust amount to an organization described in Section 170(c); a qualified contingency; the last unitrust payment to the recipient; the restriction of the charitable remainderman to a public charity; a retained right to substitute the charitable remainderman; a power of appointment to designate the charitable remainderman; the net income method of calculating the unitrust amount; the net income with make-up method of calculating the unitrust amount; and a combination of methods for calculating the unitrust amount.23 

Rev. Proc. 2003-53 deals with CRATs. Like Rev. Proc. 2005-52, this revenue procedure updates previously issued samples and provides new samples for additional types of CRATs. It also includes annotations and alternate sample provisions. Section 4  presents a sample declaration of trust for an inter vivos CRAT with one measuring life that’s created by an individual who’s a U.S. citizen or resident, and the annotations to the provisions of the sample trust are found in Section 5. Section 6 provides samples of alternate provisions concerning: the statement of the annuity amount as a specific dollar amount; the payment of part of the annuity to an organization described in Section 170(c); a qualified contingency; the last annuity payment to the recipient; the restriction of the charitable remainderman to a public charity; a retained right to substitute the charitable remainderman; and a power of appointment to designate the charitable remainderman.24

The trust forms are very helpful, but you can’t just fill in the blanks of the sample. You must first determine: the type of property ownership; whether the donor or donors will also be beneficiaries; who the donors are; whether the funding asset is marketable; the nature of the charitable remainder organization; that the payout is neither less than 5% nor more than 50%; compliance with the 10% minimum remainder interest requirement; and when to add or substitute an alternative provision. 

Use the IRS specimens as your guide. In many cases, you’ll want to mix and match and make your own modifications. To get the whole ball of tax (all the specimens, alternative provisions and annotations), see Rev. Proc. 2005-52 through Rev. Proc. 2005-59.

To avoid the torpedoes when qualifying CRUTs and CRATs for safe harbor protection:

The donor must be one individual or, if two individuals are the donors, they must be married;

The IRC requirements not relating to the provisions of the governing instrument must also be met; 

The trust must operate in a manner consistent with the terms of the trust instrument; 

The trust must be a valid trust under applicable local law; and 

The trust instrument must be substantially similar to the IRS’ sample in the applicable revenue procedure or properly integrate one or more alternative provisions from the revenue procedure.

It’s not enough to have all the required governing provisions. Even if a trust is exactly the same as an IRS safe harbor specimen, it must actually operate as a CRT and do what the trust instrument specifies. Otherwise, income, gift and estate tax charitable deductions will be denied; all capital gains will be taxable; and the gift and estate tax marital deductions will be lost. Other than that, not to worry.  

You may want to look away from your computer screen. The following may be shocking: The U.S. Court of Appeals for the Eleventh Circuit held that an inter vivos CRAT’s failure to comply with the required annual payment regulations during the donor’s lifetime resulted in a complete loss of the estate tax charitable deduction—even though substantial sums would go to charity. The loss of the charitable deduction cost the estate $2,654,976.25 Although the case dealt with a CRAT, the same rule applies to CRUTs.

Making (and Fixing) Mistakes

Throughout this and our two previous Trusts & Estates articles, we discussed how to properly use CRTs not only to achieve the most favorable tax treatment but also to provide the most benefit to charity. Sometimes, even with the best intentions, practitioners mess up. CRTs don’t always go as planned. When the unexpected happens, sometimes you can save them.

Scrivener’s error. Lucy and Ricky wanted to create a net income with make-up CRUT (NIM-CRUT), funding it with highly appreciated stock. Unfortunately, due to a lack of communication among their financial planner, their attorney and the charity’s planned giving director (who assisted the financial planner), the couple mistakenly created a standard charitable remainder trust (STAN-CRUT). The couple had filed all tax returns as if the trust were a NIM-CRUT. Lucy and Ricky soon discovered the scrivener’s (lawyer’s) error and wanted to reform the trust under state law. The reformation’s sole purpose was to convert a STAN-CRUT into a NIM-CRUT.

The IRS ruled that,provided a state court concludes that a scrivener’s error occurred and the modification is made under state law, the proposed reformation altering the payment method won’t violate IRC Section 664 and won’t disqualify the trust. The IRS based its conclusion on the landmark case, Commissioner v. Estate of Bosch,26 holding the decision of a state’s highest court on an underlying substantive rule of state law controls when applied to a federal matter.27 

Prohibited contribution returned—CRUT saved. You can’t make additional contributions to a CRAT. You can, however, make additional contributions to a CRUT if the governing instrument permits and gives a formula for determining the payments in any year of additional contributions.

In one case, thedonors (husband and wife) funded their CRUT with securities. They were the trustees and income beneficiaries. Later, they made an additional stock contribution to the trust, and the stock was sold.Just one problem:The CRUT’s governing instrument prohibited additional contributions. Soon after the second contribution, the donors realized their mistake. The trust’s custodians, at the donors’ direction, identified and maintained records of the proceeds of the second contribution. The husband and wife didn’t take a charitable deduction for the second contribution, and it wasn’t used to calculate their CRUT payments.

The donors, as trustees, proposed to return the proceeds of the second contribution to themselves,  as donors. They would amend their individual tax returns to report any capital gains and dividend income generated by the second contribution while it was in the unitrust.

The IRS ruled thatthe second contribution of stock would be ignored for federal tax purposes and wouldn’t disqualify the trust as a CRUT, provided that the donors amend their tax returns to report any capital gains and dividend income generated by the second contribution of stock while it was in the trust’s account.28 

Comment.It’s comforting that the IRS let the donors make amends for their error. But the IRS and the courts aren’t always so forgiving. Compare this ruling with the Tax Court’s decision in Atkinson v. Comm’r,29 in which a perfectly drawn CRAT was disqualified because it was imperfectly operated. Even minor infractions may do you in.

CRT with multiple muck-ups not reformable. Fixing a defective CRT to get income, gift and estate tax charitable deductions and avoid tax on the trust’s sale of appreciated assets generally involves two steps: (1) reforming the trust by deleting improper provisions and adding missing ones; and (2) getting the IRS to go along with the reformation (an approving IRS letter ruling or no challenge from the IRS on an audit).

While the first step isn’t always a gimme, courts are generally liberal in approving reformations to save charitable gifts and attendant deductions. And a trip to the court house to reform a trust can often be avoided if the trust instrument gives the trustee the power to amend the trust to comply with the requirements of Section 664, the regulations thereunder and any other Treasury or IRS requirements for CRTs. A draftsperson who drew a defective CRT may have omitted such a provision. Some states allow reformation with the consent of all the parties (the state attorney general may be a necessary party).

The second step—getting the IRS to go along with a reformation—is the tougher one. The IRC imposes not-always-achievable requirements and not-always-meetable deadlines.

Let’s look at a New York Surrogate’s Court case that describes a trust that gives new meaning to the expression “every mistake in the book.” Surrogate C. Raymond Radigan’s opinion is concise, so we’ll let him tell about the trust and why he wouldn’t allow a reformation:

This is a petition brought by the trustees of an irrevocable lifetime trust to reform the instrument to qualify as a charitable remainder trust.

It is clear from the title of the instrument, ‘The Rita Antun Irrevocable Charitable Remainder Trust-1997’ and the references therein to IRC 664 that the intent of the grantor was to create a charitable remainder trust recognized as such by the Internal Revenue Service. The document fails to carry out that intent. The petition indicates that instrument does not qualify as a charitable remainder trust because it:

1. Permits a beneficiary or member of his family to occupy real estate owned by the trust rent-free;

2. Provides for payment of income to be made to the non-charitable beneficiaries from the trust in the trustee’s discretion;

3. Permits additional contributions to be made to the trust without, if the trust was intended to be a unitrust, providing a mechanism for the computation of the unitrust amount with respect to the addition;

4. Provides for an improper method of computing the commissions of the trustee;

5. Provides the trustees with various powers to operate a business and to purchase assets and to make loans to the trust.

Additionally, the instrument fails to contain language required by the Internal Revenue Code, as amended, which:

1. Provides for a sum certain to be paid to the non-charitable beneficiaries at least annually, expressed as either a stated dollar amount or as a percentage of the fair market value of the property placed in the trust (i.e., an annuity interest or a unitrust interest, with or without a full net income limitation provision);

2. Provides language in the trust instrument addressing the computation of the annuity or unitrust amount to be paid to the non-charitable beneficiaries in a short taxable year of the trust;

3. Names as the non-charitable beneficiaries only those persons to be used as measuring lives for the term of the trust;

4. Provides language in the trust instrument to address a potential incorrect valuation of the net fair market value of the trust assets;

5. Provides language in the trust instrument prohibiting additional contributions to the trust if the trust was to be an annuity trust, or prohibiting additions or permitting additional contributions with a mechanism to compute the unitrust amount in the event of additions, if the trust was to be a unitrust;

6. Provides the trustee with the power to designate charities to receive the remainder of the trust in the event that the named charities did not qualify at the termination of the trust as organizations to which contributions qualify for income and gift tax deductions under the Code.

The petition seeks the court’s indulgence to remedy the instrument’s short comings by reformation. The court is aware that courts often reform instruments to preserve a charitable deduction or other tax benefit, and has done so itself.

What is sought here, however, is not the reformation of one or two provisions of the instrument, but a wholesale rewriting of the instrument. An expressed desire to create a charitable remainder trust will not suffice to create one and the court is not authorized to draft a new instrument under the guise of reformation. 

The petition is denied. This decision constitutes the order of the court.30

Final Thoughts

We end with the good, the bad and the ugly.

The good: Properly drawn and administered CRTs give donors the satisfaction of making important charitable gifts, a lifetime (or term-of-years) income stream and significant tax benefits. 

The bad and the ugly: Conversely, the result of a poorly drawn—or perfectly drawn but improperly administered—trust is the loss of income, gift and estate tax charitable deductions, as well as the trust’s tax exemption. Sometimes a muck-up can be fixed up by a reformation, but don’t bet the ranch on it. 

That said, though seemingly fraught with peril, CRTs are, nonetheless, effective mechanisms to benefit worthy causes while achieving favorable tax results. At the heart of it all is a donor’s charitable intent and advisors who know their stuff. As the Tax Code grows ever more complex, taxpayers need a cohesive and competent team to guide them through. We hope our three articles have helped you gain a better understanding of these powerful tools to benefit charities and your clients and how to use them. And if you still don’t get it, you can always try to find a four-year-old child. 

Endnotes

1. Duck Soup, Paramount, 1933.

2. Conrad Teitell, Heather J. Rhoades and Brianna L. Marquis, “The Ugly Side of Charitable Remainder Trusts,” Trusts & Estates (October 2023).

3. Conrad Teitell, Heather J. Rhoades and Brianna L. Marquis, “Issues Regarding Charitable Remainder Trusts,” Trusts & Estates (November 2023).

4. Internal Revenue Code Section 6019.

5. IRC Section 2522(c)(2)(A); Treasury Regulations Section 25.2522(c)-3(c)(2)(iv) and 1.664-4.

6. IRC Section 2503(a); Treas. Regs. Section 25.2503-3(b).

7. IRC Section 2523(g).

8. Ibid., Revenue Ruling 79-243; Treas. Regs. Sections 1.664-3(a)(4) and 25.2511-2(c).

9. See supra note 7.

10. Ibid.

11. Treas. Regs. Sections 1.664-2(a)(5), -3(a)(5).

12. IRC Sections 2036 and 2055(e)(1)(B); Treas. Regs. Section 1.664-4.

13. IRC Section 2035(d).

14. Section 2036.

15. IRC Section 2055(e)(1)(B); Treas. Regs. Section 20.2031-7.

16. IRC Section 2032(b)(2).

17. IRC Section 2040(b).

18. Sections 2055(e)(2)(A) and 2056(b)(8).

19. Ibid.

20. See Private Letter Ruling 8730004 (April 15, 1987), Rev. Proc. 2003-53 (Aug. 4, 2003).

21. Rev. Proc. 2005-52 (Aug. 22, 2005) (charitable remainder unitrusts); Rev. Proc. 2003-53 (Aug. 4, 2003) (charitable remainder annuity trusts).

22. Rev. Proc. 2005-53 (Aug. 4, 2005).

23. Rev. Proc. 2005-52 (Aug. 22, 2005).

24. See supra note 21. 

25. Estate of Atkinson v. Commissioner, 309 F.3d 1290 (11th Cir. 2002), cert. denied, 124 S. Ct. 388 (2003).

26. Comm’r v. Estate of Bosch, 387 U.S. 456 (1967).

27. PLR 200218008 (May 3, 2002).

28. PLR 200052026 (Dec. 29, 2000).

29. Atkinson v. Comm’r,  U.S. Tax Ct. No. 20968-97 (Oct. 16, 2002).

30. Matter of Antun, NYLJ, Dec. 14, 2000, at p. 34 (N.Y. Surr. Ct.).