IRS revenue procedure reopens the door to long-term charitable remainder annuity trusts

18 August 16

by Paul M. Roy, Of Counsel, and Eric Fischer, Associate

On August 9, 2016, the Internal Revenue Service issued Revenue Procedure 2016-42, which permits long-term Charitable Remainder Annuity Trusts ("CRATs") to avoid the application of the often fatal "probability of exhaustion" test. Prevailing low interest rates have made lifetime CRAT planning difficult (if not impossible) in recent years. The new guidance reopens the door to this planning technique, which allows donors to receive a fixed dollar annuity from a charitable remainder trust rather than a unitrust payment.

Background
 

A CRAT is a type of split-interest trust in which the assets of the trust are divided between charitable and non-charitable beneficiaries. During the trust term, which can last either for a fixed period up to 20 years or for the lifetime of one or more individuals, annuity payments are made to non-charitable beneficiaries (often the donor and/or the donor's spouse). At the end of the trust term, the remaining trust assets are paid to charity. Because the CRAT itself is exempt from income tax, donors often choose to contribute highly appreciated assets like artwork, real estate or stock to a CRAT, thereby allowing them to defer federal income taxes until they receive annuity payments during the trust term. As an additional benefit, donors are allowed to take an income tax deduction equal to the actuarial present value of the remainder interest that will pass to charity.

The "Probability of Exhaustion Test"

Among the many technical requirements that must be satisfied for a CRAT is passage of the probability of exhaustion test. The probability of exhaustion test states that if there is a greater than 5% probability that all of the CRAT's assets will be paid out to the non-charitable annuity recipients, the CRAT will fail. Ultimately, the mathematical formula used to test the CRAT is influenced by two variables: (i) the length of the trust term, and (ii) an assumed interest rate prescribed by the IRS (the so-called "7520 rate"). For fixed-term CRATs, this test rarely presents an issue, but for one- or two-life CRATs, prevailing low interest rates have made qualification challenging or impossible. At current rates, the probability of exhaustion test eliminates the possibility of lifetime CRATs for anyone under the age of 74.

Charitable remainder unitrusts ("CRUTs") have been a viable alternative for donors who were unable to contribute property to a CRAT. Unlike a CRAT, which provides a fixed dollar annual payment each year, the non-charitable beneficiaries of a CRUT receive a unitrust payment equal to a percentage of the CRUT's assets. Many donors are uncomfortable with the uncertainty of receiving a unitrust payment, which varies depending on the value of assets in the trust.

A New Safe Harbor

Revenue Procedure 2016-42 reopens the door to long-term CRAT planning for donors under age 74 by providing a safe harbor provision that can be included in CRAT instruments. The provision triggers the early termination of the CRAT and an immediate distribution of all trust assets to the charitable remainder beneficiary if the total value of the CRAT's assets falls below a certain level. That level is equal to 10% of the initial value of the CRAT, multiplied by a discount factor. CRATs that include the new provision are not subject to the probability of exhaustion test.

Like the test itself, the early termination provision relies on the 7520 rate in effect at the time the CRAT is created to determine the discount factor. So long as the investments inside the CRAT are able to outperform the 7520 rate in effect at the time the CRAT is created (currently 1.4%), the early termination provision would not be triggered. Accordingly, while the early termination provision may be concerning in concept, its application should favor those CRATs created while interest rates remain low.

A Near-Term Planning Opportunity

The new guidance is especially favorable to CRATs created while interest rates remain low, so interested donors should consider establishing a CRAT while favorable interest rates prevail. The new safe harbor is available to all CRATs created after August 8, 2016.

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