Three Strikes and You're In! Service Reverses Earlier Revocation of CRT Termination Ruling
Summary
by Marc D. Hoffman
Editor-in-Chief
Planned Giving Design Center
Background
On October 30, 2005, the IRS issued Ltr. Rul. 200525014 in which it granted permission for the early termination of a charitable remainder unitrust. Such terminations and division of trust assets between the income recipients and remainderman, each according the value of their interests, have become fairly common.
As with previous rulings, the Service ruled the early termination would not constitute an act of self-dealing under Section 4941(a)(1) of the Code by the trustee or by either donor with respect to the trust, nor by either donor with respect to the remainderman, nor by any foundation manager; and it would not constitute a termination of foundation status under Section 507(a) of the Code.
Stop the Bus
So far, so good; however, on January 9, 2006, the Service issued Ltr. Rul. 200614032 in which it revoked its previous ruling without explanation.
Practitioners speculated as to the reason for the Service's change of heart — most notably Leimberg Information Services commentator Lawrence P. Katzenstein, of Thompson Coburn LLP. In an article published by Leimberg last week, Mr. Katzenstein speculated (quite creatively in our opinion) that the source of IRS's angst may have been based on the fact this particular charitable remainder unitrust was a net income unitrust bearing a 15% payout rate. Why might that be material?
Net income unitrusts are limited to distributing the lesser of the unitrust amount (i.e., 15% x FMV) and trust accounting income (as defined in the trust instrument and under state law). Based on these restrictions, many net income unitrusts are limited to distributing, for example, interest, dividends, rents, and royalties. Unless otherwise explicitly defined as income and permitted under state law, these trusts cannot distribute net capital gains. And, they can never distribute trust principal in satisfaction of the unitrust amount. Therefore, from a trust management standpoint, total return investing often gives way to trying to maximize distributable income.
In recent years, interest rates have been low, making it difficult for net income unitrusts to meet even more modest payouts of 5% to 8%, not to mention 15%! So it is understandable how some trustors could have become weary of this type of arrangement.1 In the present case, we don't know if this trust included capital gains as income or the trustors' motivations for terminating it.
The key to Mr. Katzenstein's analysis is based on how one divides the income and remainder interests at the time of termination. Commutation amounts are determined by calculating the net present value of income and remainder interests on the date of termination in the same manner used for income, gift and estate tax purposes. Variables include the fair market value, payout rate, payment frequency, number and ages of income recipients (if the trust is measured by lives) or the remaining term, and the charitable federal midterm rate ("CFMR") under Section 7520 in effect for the month of termination (no two month lookback option is allowed).
What is interesting about a charitable remainder unitrust as compared to an annuity trust is that in the case of the unitrust, the CFMR has very little effect on the outcome of the computation. It is the payout rate that drives the calculation. The CFMR affects only the adjustment factor for payment frequency and has a negligible effect on the overall computation. The higher the payout rate, the greater the present value of the income recipient's income interest as a percentage of trust assets.
Mr. Katzenstein then calculated present values for a hypothetical 65-year-old income recipient using the April CFMR of 5.6% as the trust's payout rate (representing a current market rate of interest) verses the 15% payout rate actually used in the computation. Had the commutation been based on a payout rate of 5.6%, the income recipient would have received 56% of the trust's assets. Using 15%, they would be entitled to 84%.
Was there Abuse?
Was the IRS concerned the income recipients were receiving too much for their interest in relation to the income amounts they were actually receiving from the trust? We don't think so because in the absence of a net income provision, the majority of the trust's assets would have already been distributed to the income recipients.
It's also important to note the presence of a net income provision has no effect on the present value computation. The donor's original income tax deduction was based on the same 15% payout rate (regardless of what in investment markets were doing at that time) and, therefore, was very small in relation to the amount contributed. If this trust was creatd before late 1997 (when the 10% minimum remainder interest qualification requirement became law), the trustors' deduction could have been negligible.
Combine a very small initial income tax deduction with the Service's current position that 100% of the lump-sum commutation amount being distributed to the income recipients is taxable to them as capital gains and we don't see the formula for abuse. 2 Neither did Mr. Katzenstein.
New Info
On April 21, 2006, subsequent to Mr. Katzenstein's article, the IRS released a third ruling that illuminated the reason for its previous revocation. Ltr. Rul. 200616035 permitted the termination based on "additional information" having been submitted by the taxpayers. What had changed? Recall, the original ruling stated the remainderman was a private foundation. The new ruling states the following:
The charitable remainderman of B was E, an organization recognized as an exempt organization under section 501(c)(3) of the Code and as a private foundation.
You have informed us that in accordance with the powers held by A under the trust agreement, A has changed the charitable remaindermen from E to F, G, H, I, J, and K. F through K are all organizations described in section 501(c)(3) of the Code and are publicly supported organizations [emphasis added] under section 509(a).
This latest ruling also made a point of stating the termination would take the form of a sale of the income recipients' income interests to the charitable remaindermen. Whether there is actually a sale or the parties are merely splitting up their chips based on mutual agreement is debatable and may fall into the category of legal fiction; however, we can see how this distinction would be material to the Service's revocation of the original ruling.
In this case the income recipients were the creators of the trust. As such, they were substantial contributors and, therefore, disqualified persons for purposes of the private foundation excise tax rules with respect to the charitable remainder trust. However, what is not known from the information presented is if the income recipients were also disqualified persons with respect to the private foundation to which they were selling their income interests.
If the income recipients created the private foundation, were otherwise substantial contributors to the foundation, or foundation managers, they would be disqualified persons. Therefore, a sale of assets (such as their income interests) to the private foundation would be a prohibited act of self-dealing under section 4941(d)(1). Had that been overlooked in the original ruling? Maybe so.
Good "Strategery"
Fortunately, this particular charitable remainder unitrust included an optional provision that permitted the trustors to substitute the charitable remainderman. By simply switching the remainderman to one or more publicly supported charities, the income recipients would no longer be disqualified persons with respect to the remainderman and the self-dealing issue would go away. This seems plausible to us.
Open Question
Was the revocation of the earlier ruling based on the fact the remainderman was merely a private foundation and the Service was concerned about possible self-dealing OR because the income recipients were also disqualified persons with respect to this specific private foundation?
Although the Service could not comment to us on this question, a representative did state that more letter rulings on CRT terminations are on the way. Stay tuned.
For further reading, see our commentary regarding Ltr. Rul. 200208039.back
See Ltr. Ruls. 200127023 and 200441024 regarding the taxation of commutations.back
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