Source: http://toledo.pgdc.com/pgdc/charitable-lead-trust
Timestamp: 2018-02-17 21:03:32
Document Index: 99430840

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Charitable Lead Trust | Toledo Community Foundation
PGDC → National Publication
Technical Report posted in Charitable Lead Trust by Marty McKeever on 3 May 2003| comments
audience: National Publication | last updated: 30 July 2013
Charitable lead trusts ("CLTs") are designed to provide income payments to at least one qualified charitable organization for a period measured by a fixed term of years, the lives of one or more individuals, or a combination of the two; after which, trust assets are paid to either the grantor or to one or more noncharitable beneficiaries named in the trust instrument. This comprehensive paper provides a complete technical overview of charitable lead trusts; how charitable deductions are determined for income, gift, estate and generation-skipping transfer tax purposes; the taxation of charitable lead trusts; income tax considerations for grantors and beneficiaries; and private foundation excise tax rules.
Taxation of Charitable Lead Trusts
Income Tax Considerations for Grantors and Beneficiaries
Transfer Tax Considerations
Private Foundation Excise Tax Rules
Charitable lead trusts ("CLTs") are designed to provide income payments to at least one qualified charitable organization for a period measured by a fixed term of years, the lives of one or more individuals, or a combination of the two; after which, trust assets are paid to either the grantor or to one or more noncharitable beneficiaries named in the trust instrument.1 Also referred to as a "charitable income trust," the term "charitable lead trust" is used more commonly because the payment of the income interest to charity leads or precedes the payment of the remainder interest.
In theory, charitable lead trusts can be thought of as the inverse of charitable remainder trusts. In practice, however, many of the rules that govern the operation and taxation of charitable lead trusts differ significantly from those for charitable remainder trusts. For example, CLTs are not tax-exempt entities as are charitable remainder trusts. The rules governing charitable remainder trusts are designed to protect the charitable remainder interest, whereas the rules governing charitable lead trusts protect the charitable income interest. When appropriate, we will compare and contrast these two vehicles.
Prior to 1969, an individual could establish a trust that would make payments to charity for a period of years, exclude the income earned by the trust during its operating life from his or her own income, claim a current income tax charitable contribution deduction for the present value of the income stream passing to charity, and, at the end of the term, receive the remainder interest.
Congress concluded, however, that allowing donors to exclude trust income and receive a charitable deduction gave them a double tax benefit. In response, the Tax Reform Act of 1969 mandated that in order for a gift of an income interest to charity to be deductible for income tax purposes, the income earned by the trust would have to be taxable to the grantor. Further, the income paid to charity would have to take the form of a guaranteed annuity or unitrust interest, and be payable at least annually.
After the 1969 Tax Reform Act, planners quickly concluded that if the trust was drafted so the grantor was not considered the owner of the trust's income, no charitable income tax deduction would be available. However, neither would the grantor be treated as the owner of the trust's income for income tax purposes. This exclusion of income was equivalent to a 100% income tax deduction. Further, even though the charitable income tax deduction was unavailable, such trusts could qualify for the gift and estate tax charitable deductions provided the lead interest consisted of a guaranteed annuity or unitrust amount.2 This type of trust came to be known as the "nongrantor" or "statutory" lead trust and would prove very useful for donors who desired to transfer assets to successor generations of the their family with little or no transfer tax cost.
The design of charitable lead trusts in use today is based on two main themes: 1) whether the trust income is considered owned by the grantor and therefore produces an income tax charitable deduction, and 2) whether the remainder interest reverts to the grantor or is paid to third parties such as members of the grantor's family.
There are four basic types of charitable lead trusts arising out of these themes:
Qualified reversionary grantor trust
Qualified nonreversionary grantor trust
Qualified nonreversionary nongrantor trust
Nonqualified reversionary nongrantor trust
Each type of trust produces different tax benefits that can be matched with the donor's personal and philanthropic planning objectives. Following is a more detailed description of these trusts and how they are typically utilized:
Qualified Reversionary Grantor Charitable Lead Trusts
Qualified reversionary grantor charitable lead trusts are created during the life of the donor for the purpose of paying an income interest to charity for a term defined in the trust instrument; after which, the remainder interest reverts to the grantor.
Donors creating grantor CLTs receive a charitable contribution income tax deduction in the year the trust is created for an amount equal to the net present value of the income interest passing to charity. In order to qualify for income tax deduction purposes, the grantor must treated as the owner of the trust's income under the grantor trust rules of IRC §§671 - 678. Accordingly, all income produced by the trust during the trust term, including amounts distributed to charity, is taxable to the grantor. On conclusion of the measuring term, the trust assets revert to the grantor or to the grantor's estate.
Qualified grantor lead trusts are particularly useful for donors who desire to make a multi-year charitable pledge and accelerate the charitable deductions, that would otherwise be produced over the pledge period, into the first year.3
Example 1: Mrs. Green is considering a $50,000 annual pledge to $include:c_donee$ for a period of five years. In the absence of a charitable lead trust, she can claim a charitable contribution income tax deduction for the payments to charity in each year they are actually made. As an alternative, Mrs. Green transfers $1,000,000 in tax-exempt bonds to a grantor charitable lead annuity trust. The trust is designed to pay $50,000 per year to charity for a period of five years; after which, the trust will terminate and return its assets back to Mrs. Green.
Under this scenario, Mrs. Green will receive a charitable contribution deduction equal to the present value of the income interest being transferred to charity. The total amount to be distributed to charity over the five-year period is $250,000. The present value of the income interest is calculated to be $205,524. The deduction can be used by the grantor subject to the percentage limitation and reduction rules of IRC §170.4
As mentioned previously, in order for the present value of the income interest to be deductible by the grantor for income tax purposes, the grantor must be treated as the owner of the trust. In other words, even though income is being paid to charity, it is considered as having been received by the grantor for income tax purposes.
In the context of this example, Mrs. Green will receive a charitable income tax deduction in the amount of $205,524 in year one. All income earned by the trust, including capital gains and amounts paid to charity, will be considered earned by and, therefore, included in Mrs. Green's gross income just as if the trust does not exist. However, because Mrs. Green transferred tax-exempt securities to the trust, however, she will not be required to include the interest from the bonds in her gross income. However, any gains from the sale or redemption of the bonds is produced will be taxable to Mrs. Green.
Qualified Nonreversionary Nongrantor Charitable Lead Trusts
Qualified nonreversionary nongrantor charitable lead trusts are the most common form and are created for the purposes of paying an income interest to charity for a defined measuring term with the remainder interest transferred to one or more noncharitable beneficiaries named in the trust instrument. The grantor's children and grandchildren are the most frequently named beneficiaries of these types of trusts.
As its name suggests, a nongrantor trust does not qualify under grantor trust rules; accordingly, the grantor does not receive a charitable income tax deduction; however, none of the income produced by the trust is taxable to the grantor. A qualified nongrantor CLT is taxed as a complex trust.
If the nongrantor trust is created on an inter vivos basis, the grantor receives a gift tax charitable deduction in an amount equal to the net present value of annuity or unitrust income interest payable to charity. If the trust is created on a testamentary basis, the settlor's estate receives an estate tax charitable deduction, also based on the net present value of the income interest. Depending on the combination of measuring term and income amount payable to charity, it is possible to produce a charitable gift or estate tax deduction that equals the amount transferred thereby creating a gift and estate tax-free transfer.
Example 2: Mrs. Peterson has an estate valued at $10 million. She is very committed to the mission of $include:c_donee$ and provides it with significant annual financial gifts. She is also interested in transferring assets to her children in the most tax-efficient manner possible.
Mrs. Peterson will transfer a $2,000,000 apartment complex to a charitable lead annuity trust. The trust will pay a $140,000 annuity amount to $include:c_donee$ for a period of fifteen years, ten months; after which, the trust assets will be distributed to the her children. Based on this scenario, Mrs. Peterson will receive a charitable contribution gift tax deduction in an amount of $1,375,000. The net taxable gift is $625,000 and can be offset by Mrs. Peterson's unified gift and estate tax credit. As a result, the children will receive the property, including any appreciation that occurs over the trust period; completely gift and estate tax free.
As will be discussed, nonreversionary nongrantor CLTs can also be used to leverage the generation-skipping transfer tax exemption for transfers to grandchildren and other skip persons. The benefits of wealth transfer can be amplified by funding the trust with assets that qualify for valuation discounts such as units in family limited partnerships and other types of minority fractional interests in property.
Qualified Nonreversionary Grantor Lead Trusts
The qualified nonreversionary grantor lead trust is a more recently approved variation that produces both income and gift tax deductions. Simply stated, it similar to a nongrantor nonreversionary lead trust in that it qualifies for a charitable gift tax deduction; however, it contains an intentional drafting defect (i.e., a right held by the grantor or nonadverse party to the grantor to reacquire trust property by substituting other property of equivalent value) that causes the grantor to be considered as the owner of the trust's income. This latter component also qualifies the transfer for charitable income tax deduction purposes.
Provided the grantor does not retain any rights that would otherwise cause the gift to be considered incomplete for gift tax purposes, the taxable transfer to the heirs becomes complete when the trust is established. Further, assuming the grantor retains no estate tax interests or strings, no portion of the trust is includible in the grantor's estate.
Example 3: The facts are same as in Example 1 except that Mrs. Green would like her son to be the remainder beneficiary. If Mrs. Green is treated as the income tax owner under the grantor trust rules, she will be entitled to a charitable income tax deduction for the present value of the income stream to charity -- $205,524. If the trust is a qualified charitable lead trust, she will also be entitled to a charitable gift tax deduction in the same amount for the present value of the income stream to charity. However, the present value of the son's remainder interest will be a taxable gift to her for gift tax purposes. The amount of the gift is determined by subtracting the present value of the income interest from the fair market value of the property transferred to the trust ($1,000,000 - $205,524 = $794,476). The trust assets should not be includable in her gross estate if she retains no applicable power or right.
See Ltr. Ruls. 9224029 and 9247024 for reference.
Nonqualified Nongrantor Reversionary Lead Trust
In order to qualify for income, gift, and estate tax deduction purposes, a charitable lead trust must pay a guaranteed annuity or unitrust amount. Nonqualified charitable lead trusts are designed to violate this rule and, therefore, produce no income, gift, or estate tax deductions. Gift and estate tax deductions are immaterial because the trust will revert to the grantor. The trust will, however, be able to claim gift tax deductions for income amounts transferred to charity as they occur.
What is important to these types of trusts is fact that although no income tax deduction is available, neither is any of the trust's income taxable to the grantor. These trusts are taxable as complex trusts for which they can claim a deduction against their taxable income for amount distributed to charity.
Example 4: Mr. Smith owns a portfolio of corporate bonds. He desires to make a gift of income to charity and reduce his personal income taxes. Mr. Smith will transfer $500,000 in bonds to a charitable lead annuity trust. The trust will pay $35,000 annually to charity for a period of ten years; after which, the remainder interest will revert to Mr. Smith. The present value of the annuity interest is immaterial because no deduction is created. However, Mr. Smith will not have to include the interest income produced by the bonds on his personal tax return. Depending on the other elements of his income tax structure, an exclusion of this amount may drop Mr. Smith into a lower marginal income tax bracket.
When compared to a reversionary grantor trust, Mr. Smith will also benefit from avoiding the compliance and percentage limitation issues associated with claiming the charitable contribution income tax deduction.
It is possible for a CLT to provide for payment of the lead or income interest to both charitable and non-charitable beneficiaries.back
IRC §§2055(e)(2)(B) and 2522(c)(2)(B)back
As discussed supra, it is possible that using a charitable lead annuity trust to satisfy a legally-binding charitable pledge could have undesired consequences; we refer here to a non-binding charitable pledge.back
Gifts of an income interest via a charitable lead trust are considered gifts "for the use of" rather than "to" charity. If the income is payable to a 50%-type charitable organization (a public charity as described in IRC §170(b)(1)(A)), the deduction is subject to the 30% limitation. If the income is payable to a 30%-type organization (a private nonoperating foundation), the deduction is subject to the 20% limitation. Any excess deduction can be carried forward an additional five years.back
The following requirements apply to all qualified grantor and nongrantor charitable lead trusts:
Unlike charitable remainder trusts and pooled income funds, for which model trust forms are provided in the Revenue Rulings and Procedures, the IRS has not published any model trust forms or other definitive guidance regarding the mandatory governing provisions required for charitable lead trusts to qualify for income, gift, and estate tax deduction purposes. Establishing a qualified charitable lead trust is, therefore, accomplished by reference to a series of published and private rulings. Given the highly technical nature of these vehicles and lack of clear authority, donors may wish to receive an advance ruling.1
Drafters are cautioned against including a provision that would return assets to the donor if the desired tax benefits were not achieved. Such provisions have been held to disqualify charitable remainder trusts based on the possibility that payments other than the annuity or unitrust amount could be paid for the benefit of a noncharitable beneficiary.2 As an alternative, donors can be protected by including a provision in the trust instrument that permits the trustee to amend the trust for the sole purpose of ensuring the trust qualifies for income, gift, and estate tax deduction purposes.3
Requirement of Annuity Trust or Unitrust
Anyone desiring to create a charitable lead trust that is qualified for income, gift, or estate tax deduction purposes must choose between annuity trust and unitrust formats. A trust is qualified only if it is irrevocable and the income interest payable to charity is either an annuity trust or unitrust in every respect. No blending is allowed.4
Charitable Lead Annuity Trust Defined
A charitable lead annuity trust is a trust from which a sum certain, determinable with certainty at the time the trust is created, is to be paid, not less often than annually, to one or more qualified charitable organizations as described in IRC §170(c) for a period that is measured by a term of years or the life of one or more individuals who are living at the time the trust is created.
The annuity amount may be stated as a fixed percentage of the initial net fair market value of the trust assets, as a fixed sum, or by a formula that is intended to produce a specific tax result. Furthermore, unlike charitable remainder annuity trusts, the annuity amount may be changed during the term of the trust. The regulations provide that a specified annuity amount is paid for a specified term, or for the life of an individual; after which, the annuity may change to another specified amount for the remainder of the trust term. The new amount cannot, however, be redetermined by reference to a fluctuating index, such as the cost of living index, that is referenced at the time of the change. The new amount can, however, be expressed in terms of a fraction or percentage of the cost of living index in effect on the date of transfer.5
In the event that trust income is insufficient to meet the annual annuity amount, the trustee must invade corpus.
Charitable Lead Unitrust Defined
A charitable lead unitrust is a trust from which a fixed percentage of the net fair market value of its assets, valued at least annually, is to be paid, not less often than annually, to one or more organizations described in IRC §170(c) for a period that is measured a term of years or the life of one or more individuals who are living at the time the trust is created.
Annual Valuation
The net fair market value of the trust assets may be determined on any one date during the taxable year of the trust. It also may be determined by taking the average of valuations made on more than one date during the taxable year of the trust, so long as the same valuation date or dates and valuation methods are used each year.6 In the event the trust instrument fails to stipulate a specific valuation date, the trustee must select a date or dates and apply them consistently throughout the life of the trust. This selection must also be reported on the initial Form 1041.
Multiple valuation dates, while helping to balance payout fluctuations, are usually impractical from an administrative standpoint. Therefore, the majority of unitrust instruments provide for one valuation date. If an additional contribution is made on a non-valuation date, the property is valued on the date of contribution and the unitrust amount is adjusted to reflect the unitrust amount attributable to the additional contribution for the balance of the trust's taxable (calendar) year.7
To enable the trustee to plan for required distributions and to easily determine the value of publicly traded securities held by the trust, most trust instruments designate the first business day of each calendar year as the annual valuation date. Designating an annual valuation date after a required payment date requires the trustee to estimate the future value of trust assets in order to determine the unitrust amount and, therefore, is not generally recommended.
No Net Income Option
A net income option permits a trustee to pay the lesser of the full unitrust amount and trust income (as defined in IRC §643(b) and the regulations thereunder). As envisioned by Congress, the net income option was intended to relieve trustees of charitable remainder unitrusts from having to distribute trust corpus in years in which the trust failed to produce income in amount sufficient to satisfy the unitrust amount.8 This provision was intended to protect the charitable remainder interest. With respect to a qualified charitable lead unitrust, a net income option is unavailable because it could reduce the income payments to charity and thereby overvalue the present value of the income interest.9
The net income option is available, however, for nonqualified nongrantor charitable lead unitrusts because such trusts are not required to provide a guaranteed unitrust amount.10
Use of Formula Annuity and Unitrust Rates
For purposes of satisfying the "ascertainable with certainty" payment requirement, the trust may include a provision that permits the annuity or unitrust rate to be established by formula contained within the trust instrument or testator's will. The purpose of such arrangements is to enable the trust to accomplish defined tax planning objectives and otherwise maintain the trust's qualification for federal tax purposes (e.g., to avoid violating prohibitions against excess business holdings).
No Minimum or Maximum Annuity or Payout Rate
Unlike charitable remainder trusts, which require a minimum rate of 5% and a maximum rate of 50%, there are no minimum or maximum annuity or unitrust payout rates applicable to charitable lead trusts. Furthermore, the five-percent probability test, applicable to charitable remainder annuity trusts does not apply to charitable lead annuity trusts.11
Measuring Terms
The annuity or unitrust amount must be paid, not less often than annually, for a period that is measured by a specified term or for the life or lives of an individual or individuals, each of whom must be living at the date of transfer and can be ascertained at such date.12 The annual payment from both types of trusts can be paid in one installment or can be paid in equal installments semi-annually, quarterly, monthly, or weekly.13
If the trust term is measured by the life or lives of one or more individuals, those individuals must be living at the date of transfer and can be ascertained at such date. The regulations also provide that a trust can be measured by the life of an individual followed by a term of years.14
Unlike charitable remainder trusts, which impose a twenty-year maximum term on trusts that are measured solely by a term of years, there is no maximum number of years a charitable lead trust can operate for federal tax purposes. Charitable lead trusts are, however, required to comply with local law, which may include a rule against perpetuities.
Anti "Ghoul" Trust Regulations
In early 2000, the IRS became aware of a scheme whereby charitable lead trusts were marketed to wealthy estate owners as "packages" which included the name of a seriously ill (but not "terminally ill") individual and access to the individual's medical records. Under the plan, wealthy so-called "donors" would establish a nonreversionary charitable lead trust typically naming their heirs as remaindermen. However, instead of the trust being measured by a term of years, which is standard practice to pinpoint the charitable deduction, the trust was measured by the life of the seriously ill individual, for which the individual was paid a fee.
As long as the individual was not "terminally ill" as defined in the regulations at the time the trust was created, the present value of the charitable income interest could be calculated using the normal mortality tables. Reg. §25.7520-3(b)(3) describes a terminally ill person as follows:
an individual who is known to have an incurable illness or other deteriorating physical condition is considered terminally ill if there is at least a 50 percent probability that the individual will die within 1 year. However, if the individual survives for eighteen months or longer after the date the gift is completed, that individual shall be presumed to have not been terminally ill at the date the gift was completed unless the contrary is established by clear and convincing evidence.
Thus, if the measuring individual survived at least 18 months or longer after the trust was created, he or she would not be deemed to have been terminally ill at the time the trust was created and, therefore, could use the normal mortality tables in valuing the charitable interest. For example, if the individual was 40 years old, the use of a moderate annuity or payout rate would produce up to a 100% gift or estate tax charitable deduction thereby eliminating all transfer taxes. In application, however, the measuring individual could die eighteen months and one day following the creation of the trust with the same tax results. The philanthropic results, however, would be quite different and a clear abuse of the charitable lead trust.
On April 5, 2000, Treasury issued Proposed Regulations which provided that only one or more of the donor, the donor's spouse and a lineal ancestor of all the remainder beneficiaries could be used as the measuring lives for a charitable lead trust.
In addition, the Proposed Regulations provided that an interest payable for a term of years could qualify as a guaranteed annuity or unitrust interest even if the trust included a "rule against perpetuities" savings clause (described in the next section). However, such savings clause would have to use a vesting period of 21 years after the deaths of people who are selected as measuring lives to maximize rather than limit the term of the charitable lead trust. In the explanation of this provision, the IRS stated, "For example, a guaranteed annuity or unitrust interest that will terminate on the earlier of 30 years or 21 years after the death of the last survivor of the descendants of any grandparent of the donor living on the date of the creation of the interest will be treated as payable for a specified term of years."
In January of 2001, Treasury issued final Regulations that expand the class of permissible measuring lives over the class permitted by the Proposed Regulations and include a probability test. As finalized, the Regulations permit the measuring lives to include someone who, with respect to all of the noncharitable remainder beneficiaries, is either a lineal ancestor or a spouse of a lineal ancestor of the noncharitable remainder beneficiaries. The final Regulations provide that a trust will satisfy the requirement that all noncharitable remainder beneficiaries are lineal descendants of the individual who is the measuring life, or that individual's spouse, if there is less than a 15% probability that individuals who are not lineal descendants will receive any trust corpus, as computed on the date of transfer to the trust. The probability is calculated taking into account the interests of all individuals living at that time.
The final regulations apply to transfers to charitable lead trusts made on or after April 4, 2000, or in the case of the estate tax provision, to transfers made to charitable lead trusts under wills and revocable trusts where the decedent dies on or after April 4, 2000. An exception to this effective date applies for wills and revocable trusts executed on or before April 4, 2000, if the decedent dies on or before July 3, 2001 and has not republished his or her will or amended his or her revocable trust. A second exception applies for decedents under mental disabilities on April 4, 2000, who cannot change the disposition of their property, so long as they do not regain competency to dispose of such property prior to their deaths or so long as they die before the later of (i) 90 days after the date on which they first regain competence or (ii) July 3, 2001, without having revised their wills or amended their revocable trusts.
For further detailed reading on this subject and full text of the regulations, see:
Ghoul Charitable Lead Trust Proposed Regulations
Final Ghoul Charitable Lead Trust Regulations
Perpetuities Savings Clauses
In 1981, the Service approved a charitable lead trust that included a clause that would terminate the trust prior to its stated measuring term in order to comply with the state's rule against perpetuities.15 The Service did not comment specifically on this provision and may have approved it because, based on the facts (i.e., there were 33 measuring lives for purposes of the clause), the probability of using the clause was so remote as to be negligible.
This issue has subsequently been clarified in Ltr. Rul. 9721006. In the request for ruling, the grantor proposed to create an inter vivos charitable lead trust with a measuring term that would extend 25 years after his death. In order to comply with the state's rule against perpetuities, however, if all three named remainder beneficiaries died within the 25 period, the trust would terminate upon the earlier of 21 years after the death of the last surviving remainder beneficiary or 25 years.
The IRS approved the arrangement stating that the computation of the present value of the lead interest should incorporate this contingency.
Qualified Contingencies
Contrast the perpetuities savings clause with a "qualified contingency " that would cause a charitable lead trust to terminate upon satisfaction of a condition subsequent named in the governing instrument. Qualified contingencies are permitted in charitable remainder trusts because they potentially accelerate the payment of the charitable interest.16 Conversely, the use of such provisions in charitable lead trusts could deny charity of its interest and, for this reason, is not permitted.
The rulings applicable to charitable remainder trusts provide several additional measuring term options. Under the first option, the trust makes payments for the longer of a guaranteed term of years or the lives of one or more individuals, measured concurrently.17 Under a second option, the trust makes payment for the shorter of a term of years or the lives of one or more individuals, measured concurrently. And under a third option, the trust makes payments for the lives of one or more individuals. Upon death, the trust continues to make payments for a period measured by the lives of one or more new individuals, or a fixed term of years, whichever is less.
Although these alternatives are not mentioned in the regulations applicable to charitable lead trusts, they all permit the measuring term to be ascertainable with certainty at the time the trust is created. There is no apparent conflict that should preclude their application to a charitable lead trust.
Can contributions be made to a charitable lead trust after the initial contribution? With respect to charitable remainder trusts, additional contributions to unitrusts are expressly permitted. Conversely, additional contributions to charitable remainder annuity trusts are specifically prohibited.18
In the case of charitable lead trusts, there are no restrictions that prohibit additional contributions to either an annuity trust or unitrust. There are several important distinctions, however:
Additional Contributions to Annuity Trusts
In order for a transfer to a charitable lead annuity trust to qualify for income, gift, or estate tax deduction purposes, the annuity amount must be "determinable with certainty" at the time the trust is created.19 The increased annuity amount arising from an additional contribution violates this rule. Therefore, any additional contributions will not produce any additional income, gift, or estate tax deductions. This failure will not disqualify the deduction produced by the initial contribution, however.
Additional Contributions to Unitrusts
Because payments from a charitable lead unitrust do not have to be determinable with certainty at the time the trust is created, additional contributions will qualify for income, gift, and estate tax deduction purposes. The Service has ruled privately that a charitable lead unitrust that contained a provision that expressly provided for additional contributions was qualified and that additional contributions would qualify for gift tax purposes.20
The governing trust instrument of a qualified annuity trust or unitrust may provide that trust income which exceeds the amount required to pay the annuity or unitrust amount shall or may, at the discretion of the trustee, be paid to or for the use of a charitable organization.
In the case of a nongrantor trust, the settlor is not entitled to any additional deduction arising from the excess payment.21 However, the trust is permitted a charitable income tax deduction for an amount equal to the excess payment.22 In the case of a grantor trust, the grantor is entitled to an additional charitable income tax deduction equal in amount to the excess payment subject to the percentage limitations for individual contributions.23
Commuting the Charitable Income Interest
Can the trustee of a charitable lead trust use trust income or principal to prepay future annuity or unitrust payments to charity in order to commute the trust prior to the expiration of the measuring term specified in the trust instrument? Not if the grantor desires a charitable gift tax deduction.
Rev. Rul. 88-27 holds that a commutation power violates the requirement that charitable lead trusts provide a guaranteed annuity or unitrust interest that is determinable at the time the trust is created. Accordingly, no gift tax charitable deduction is allowed for the transfer to charity.24
In Crown v. Commissioner, the trustee of a nongrantor charitable lead annuity trust made payments of excess income to charity and claimed income tax deductions under IRC §642(c)(1) for the amount of the excess payments. The trustee did commute future payments, however.25 The IRS disallowed the deductions for excess payments and imposed tax deficiencies and understatement penalties for a three-year period. The Service disallowed the deductions stating that it was doing so because the excess payments were not paid under the terms of the governing instrument. In order for the payments to be deductible under Section 642(c), they would first have to be deductible for gift tax purposes under IRC §2522(c)(2)(B) thereby validating them as being paid under the terms of the trust; and for that, commutation would be required. The court agreed. The trust then argued that the excess payments were deductible under IRC §661(a)(2) because they had been permanently set aside for charitable purposes. The court, however, rejected the argument noting that Reg. §1.663(a)-2 precludes a deduction under IRC §661(a) for amounts paid or set aside for charitable purposes and that such amounts are deductible only to the extent permitted under IRC §642(c).26
Terminating a Charitable Lead Trust
Can a grantor terminate an existing charitable lead annuity trust by transferring the rights to the remainder interest to the charitable income recipient? Rev. Rul. 75-307 addresses whether a grantor realizes gain or loss under IRC §1001 or income under IRC §677.
A taxpayer created a reversionary grantor lead trust with a measuring term of ten years. Any income in excess of the guaranteed annuity amount was to be distributed back to the grantor. Although the trust contained no commutation provision, state law permitted the trust to be revoked with the consent of all persons having a beneficial interest therein.
The specific questions to be resolved in the ruling were 1) whether the grantor would recognize any gain or loss on the accelerated termination of the trust, and 2) whether upon such accelerated termination, any of the income subsequently earned on the assets of the trust in excess of the guaranteed annuity would be realized by the taxpayer.
With respect to the first question, the ruling cited Rev. Rul. 57-506 which held that a donation of a remainder interest to a charitable foundation did not give rise to taxable income or realized gain to the donor because no economic benefit inured to the donor.27 With respect to the second question, the ruling cited the U.S. Supreme Court decision in Blair v. Commissioner. That ruling held that when a taxpayer assigns both his income and reversionary interest, the taxpayer ceases to be treated as the owner of the income interest and, therefore, is not taxable on the subsequent income earned by the trust.28
Permissible Income Recipients
In order to be qualified for income, gift, and estate tax purposes, a charitable lead trust must provide income to at least one charitable income recipient each year. Although most charitable lead trusts name one or more charitable organizations, the trust instrument is not required to do so.29 The power to designate charitable income recipients can be given to the trustee who can select one or more charities and sprinkle income among them on a discretionary basis provided the full annuity or unitrust amount is paid.30
As with charitable remainder trusts, the trust instrument should always include a provision that 1) names one or more alternate charities to which income will be paid in the event a named organization fails to qualify, or 2) in the absence of naming a specific organization, authorizes the trustee to select one or more qualified organizations. Such a retained power will not cause the transfer to be incomplete for gift tax purposes.31
It is important to note that if a grantor, who serves as trustee, reserves the power to select income recipients, such a retained power will cause the transfer to be incomplete for gift tax purposes and cause the trust to be includible in the grantor's estate.32 This problem can be avoided by not retaining the power, having the a person other than the grantor serve as trustee, or by providing for an independent special trustee whose sole purpose it is to select charitable income recipients.33 In separate rulings, the Service held that having a child of the grantor serve as co-trustee would not cause the trust to be includible in the estate of the grantor;34 nor would using precatory language in the governing instrument that requests the trustee to consult with the grantor's children in connection with the selection of charitable income recipients.35
Power to Designate Use of Income Payments
A grantor can designate the specific use to which the charitable recipient places the income payments. Because distributions from charitable lead trusts occur over a period of years, they are ideally suited to fund the annual operating expenses of specific programs maintained by the charity. Distributions can also be dedicated to the organization's endowment fund, if one is maintained by the organization, or can be unrestricted.
If a restriction is desired, it can be accomplished by making specific provision in the governing instrument or by granting the trustee the power to designate the use. As with a retained power to designate charitable recipients, in the absence of clear authority, planners are cautioned that a power retained by the grantor to designate the use of income distributions may cause the trust to be included in the grantor's estate.
Noncharitable Income Recipients
In similar fashion to charitable remainder trusts, which permit the trust to include one or more charitable income recipients, charitable lead trusts are permitted to include one or more noncharitable income recipients. The Service has ruled that the portion of the income interest payable to charity will qualify for gift tax deduction purposes.36 The trust instrument must provide that no preference in the priority of distributions can be made for noncharitable purposes.37 Furthermore, trust assets must be segregated between charitable and noncharitable income recipients. From an administrative standpoint, this latter requirement may cause these arrangements to be impractical. Planners may wish to consider using separate trusts.
The Service announced in Rev. Proc. 88-50 that is will issue advance rulings to living taxpayers on estate tax matters; however, advance rulings will be issued only if there is an executed will, trust instrument, deed of conveyance, or contract or if the individual on whose behalf the ruling is requested states in writing, under penalty of perjury, that such individual has a present intention to execute the will, trust instrument, deed of conveyance, or contract. A copy of such executed or proposed document must be included in the request. See also Rev. Proc. 98-3 for a listing of areas in which the Service will not rule.back
Rev. Rul. 76-309, 1976-2 C.B. 196back
IRC §2055(e)(3)back
IRC §§170(f)(2); 2055(e)(2)(B); 2522(c)(2)(B). Reg. §§1.170A-6(2)(i) and (ii); 20.2055-2(e)(2)(vi) and (vii); 25.2522(c)-3(c). Rev. Rul. 77-300, 1977-2 C.B. 332back
Reg. §170A-6(c)(2)(i)(A)back
Reg. §1.664-3(a)(1)(iv)back
Reg. §1.664-3(b)back
Reg. §1.664-3(a)(1)(i)(b)back
Rev. Rul. 77-300, 1977-2 C.B. 352; Ltr. Rul. 7918102back
IRC §170(b)(1)(F); Ltr. Rul. 9742006back
Ltr. Rul. 9431051back
Reg. §1.170A-6(c)(2)(i)(A) and (ii)(A); 20.2055-2(e)(2)(vi)(a) and (vii)(a); 25.2522(c)-3(c)(2)(vi)(a) and (vii)(a)back
Id. and Reg. §20.2031-7(d)back
Ltr. Rul. 8104213back
IRC §664(f)back
Ltr. Rul. 9331043back
Reg. §1.664-2(b)back
Reg. §§1.170A-6(c)(2)(i); 20.2055-2(e)(2)(vi)(a); 25.2522(c)-3(c)(2)(vi)(a).back
Ltr. Rul. 8043077back
Rev. Rul. 78-183, 1978-1 C.B. 302; Reg. §§1.170A-6(c)(2)(i)(C); 1.170A-6(c)(2)(ii)(C)back
IRC §642(c)(1)back
Reg. §1.170A-6(d)(2)(ii)back
Rev. Rul. 88-27, 1988-1 C.B. 331; Ltr. Rul. 9734057back
Rebecca K. Crown Income Charitable Fund, et al v. C.I.R., 98 T.C. 276back
Rebecca K. Crown Income Charitable Fund, et al v. Commissioner, 93-2 USTC (7th Circuit)back
Rev. Rul. 57-506, 1957-2 C.B. 65back
Rev. Rul. 75-307, 1975-2 C.B. 256; Blair v. Commissioner, 300 U.S. 5 (1937)back
Rev. Rul. 78-101, 1978-1 C.B. 301; Ltr. Rul. 9331015back
Ltr. Ruls. 80511059 and 9331015back
Reg. §25.2511-2back
Rev. Rul. 77-275, 1977-2 C.B. 346; IRC §2036back
Ltr. Rul. 9735012; 9629009; 8112039back
Ltr. Rul. 9748009back
Ltr. Rul. 9304020back
Rev. Rul. 77-327, 1977-2 C.B. 353back
Rev. Rul. 77-327, 1977-2 C.B. 353; Reg. §§1.170A-6(c)(2)(i)(E) and (ii)(D); 25.2522(c)-3(c)(2)(vi)(f) and (vii)(e); 20.2055-2(e)(2)(vi)(f) and (vii)(e); Ltr. Rul. 8828047back
The deductible portion of a transfer to a qualified charitable lead trust for income, gift, and estate tax purposes is based on the present value of the annuity or unitrust income interest. The computation uses an interest rate assumption for the purpose of discounting the annuity or unitrust interest. A lower the discount assumption produces a higher charitable deduction.
Prior to October of 1983, the discount rate used for purposes of valuing annuities, life estates, and remainder interests was fixed at six percent. During the high inflation years of the late seventies and early eighties, nongrantor nonreversionary charitable lead annuity trusts became very popular because the annuity interest was discounted at a six percent rate when the trust could be invested in fixed income instruments with yields approaching twenty percent. The use of a fixed resulted in an overvaluation of the annuity interest because it bore no relation to current economic conditions. In response to this disparity, Congress modified the discount rate to ten percent for trusts created after November 30, 1983; however, the use of any static rate would ultimately prove to favor one interest or the other depending on the prevailing economy. The Tax Act of 1988 remedied this by implementing the floating rate system that is in use today
This present value of the annuity or unitrust interest is calculated by using an interest rate (rounded to the nearest 2/10ths of 1 percent) equal to 120 percent of the Federal midterm rate in effect under IRC §1274(d)(1) for the month in which the valuation date falls and actuarial tables found in IRS Pub. 1457. The steps involved in the computations are prescribed in the regulations. 1 As an alternative, the taxpayer may elect to use such federal midterm rate for either of the two months preceding the month in which the valuation date falls.
As a result of these changes, the use of charitable lead trusts rises and falls depending with prevailing interest rates.
Sample Term of Years Annuity Trust Deduction Computation
Mr. and Mrs. Smith transfer $1,000,000 to a charitable lead annuity trust on January 1, 1998. The trust will pay an $80,000 annuity amount at the end of each year for a period of six years and six months. The Applicable Federal Midterm Rate in effect for the month of January is 7.4%.
A. Input Assumptions:
Date of transfer . . . . . . . . . . . . . . . . . . . . . .   01/01/1998
Fair market value of property transferred. . . . . . . . . . 1,000,000.00
Annual annuity rate. . . . . . . . . . . . . . . . . . . . .         8.00%
Payment sequence . . . . . . . . . . . . . . . . . . . . . .     Annually
Is payment at beginning or end of payment period . . . . . .    Beginning
This calculation uses a hypothetical future discount rate of         7.40%
The mortality table is based on the census taken in. . . . .         1980
The trust will last for 6 years, 6 months and 0 days.
B. Calculation of Gift Tax Deduction for Non-Grantor Trust:
1. Fair market value of property transferred. . . . . . . . 1,000,000.00
2. Annual annuity rate. . . . . . . . . . . . . . . . . . .         8.00%
3. Annuity amount payable on an annual basis. . . . . . . .    80,000.00
4. Interpolation of factor for present worth of an annuity
for a term certain (based on Table B)
(a) Present worth of annuity at 6 years. . . . . . . . .       4.7082
(b) Present worth of annuity at 7 years. . . . . . . . .       5.3149
(c) Difference between factors (Line 4(b) - Line 4(a)) .       0.6067
(d) Difference per month (Line 4(c) / twelve). . . . . .  0.050558333
(e) Adjustment for 6 months. . . . . . . . . . . . . . .       0.3034
(f) Present worth of annuity (Line 4(a) + Line 4(e)) . .       5.0116
5. Line 3 annuity amount times Line 4(f) factor . . . . . .   400,928.00
6. Adjustment factor for payment sequence and beginning or
end of period (from Table K) . . . . . . . . . . . . . .       1.0740
7. Present value of annuity interest (Line 5 * Line 6). . .   430,596.67
8. Gift tax deduction (lesser of Line 1 and Line 7) . . . .   430,596.67
9. Present value of remainder interest = remainder subject
to gift tax (Line 1 - Line 8). . . . . . . . . . . . . .   569,403.33
Sample Term of Years Unitrust Deduction Computation
Mr. and Mrs. Smith transfer $1,000,000 to a charitable lead unitrust on January 1, 1998. The trust will pay an 8% unitrust amount at the end of each year for a period of six years and six months. The Applicable Federal Midterm Rate in effect for the month of January is 7.4%.
Unitrust payout rate . . . . . . . . . . . . . . . . . . . .         8.00%
Number of months between the valuation date and the first
payout for the first full taxable year of the trust. . .           12
B. Calculation of Present Value of Remainder Interest Factor:
(Interpolation of Table D factor)
1. Factor from Table F based on the periodic payment period
and the number of months between the valuation date and
the first payment. . . . . . . . . . . . . . . . . . . .     0.931099
2. Adjusted payout rate (Table F factor * payout rate). . .     7.448792%
3. The nearest usable payout rate less than the Line 2 rate     7.400000%
4. Line 2 minus Line 3. . . . . . . . . . . . . . . . . . .     0.048792%
5. Line 4 divided by .20 percent. . . . . . . . . . . . . .     0.243960
6. Interpolation of Table D factor at the Line 3 rate
(a) Table D factor at 6 years. . . . . . . . . . . . . .     0.630472
(b) Table D factor at 7 years. . . . . . . . . . . . . .     0.583817
(c) Difference between factors (Line 6(a) - Line 6(b)) .     0.046655
(d) Difference per month (Line 6(c) / twelve). . . . . .  0.003887917
(e) Adjustment for 6 months. . . . . . . . . . . . . . .     0.023328
(f) Table D factor (Line 6(a) - Line 6(e)) . . . . . . .     0.607145
7. Interpolation of Table D factor at the rate .20 percent
higher than the Line 3 rate
(a) Table D factor at 6 years. . . . . . . . . . . . . .     0.622346
(b) Table D factor at 7 years. . . . . . . . . . . . . .     0.575048
(c) Difference between factors (Line 7(a) - Line 7(b)) .     0.047298
(d) Difference per month (Line 7(c) / twelve). . . . . .    0.0039415
(e) Adjustment for 6 months. . . . . . . . . . . . . . .     0.023649
(f) Table D factor (Line 7(a) - Line 7(e)) . . . . . . .     0.598697
8. Line 6(f) minus Line 7(f). . . . . . . . . . . . . . . .     0.008447
9. Line 8 times Line 5 (interpolation adjustment) . . . . .     0.002061
10. Present value of remainder interest factor
(Line 6(f) - Line 9) . . . . . . . . . . . . . . . . . .     0.605084
C. Calculation of Gift Tax Deduction for Non-Grantor Trust:
2. Present value of remainder interest in unitrust factor
(from section B) . . . . . . . . . . . . . . . . . . . .     0.605084
3. Present value of remainder interest = remainder subject
to gift tax (Line 1 * Line 2). . . . . . . . . . . . . .   605,083.50
4. Present value of unitrust interest = the gift tax
deduction (Line 1 - Line 3). . . . . . . . . . . . . . .   394,916.50
Sample Life Term Annuity Deduction Computation
Mr. and Mrs. Smith transfer $1,000,000 to a charitable lead annuity trust on January 1, 1998. The trust will pay an $80,000 annuity amount at the end of each year for a period measured by Mr. and Mrs. Smith's joint lives. The Applicable Federal Midterm Rate in effect for the month of January is 7.4%. Mr. Smith is age 80 and Mrs. Smith is 78.
Mr.'s nearest age on the date of the gift is . . . . . . . .           70
Mrs.'s nearest age on the date of the gift is. . . . . . . .           70
4. Factor for present worth of a multiple life annuity
(a) Factor from Table R(2) (for remainder interest). . .      0.31679
(b) 1.00000 minus Line 4(a) (factor for life estate) . .      0.68321
(c) Line 4(b) divided by AFR (factor for annuity). . . .       9.2326
5. Line 3 annuity amount times Line 4(c) factor . . . . . .   738,608.00
6. Adjustment factor for payment sequence (from Table K). .       1.0000
7. Adjusted annuity value (Line 5 * Line 6) . . . . . . . .   738,608.00
8. Amount of first annuity payment if payment is made at
beginning of payment sequence (otherwise 0). . . . . . .    80,000.00
9. Present value of annuity interest (Line 7 + Line 8). . .   818,608.00
10. Gift tax deduction (lesser of Line 1 and Line 9) . . . .   818,608.00
11. Present value of remainder interest = remainder subject
to gift tax (Line 1 - Line 10) . . . . . . . . . . . . .   181,392.00
Sample Life Term Unitrust Deduction Computation
Mr. and Mrs. Smith transfer $1,000,000 to a charitable lead unitrust on January 1, 1998. The trust will pay an 8% unitrust amount at the end of each year for a period measured by Mr. and Mrs. Smith's joint lives. The Applicable Federal Midterm Rate in effect for the month of January is 7.4%. Mr. Smith is age 80 and Mrs. Smith is 78.
(Interpolation of Table U factor)
6. Factor from Table U at the Line 3 rate . . . . . . . . .     0.292680
7. Factor from Table U at the rate .20 percent higher
than the Line 3 rate . . . . . . . . . . . . . . . . . .     0.283800
8. Line 6 minus Line 7. . . . . . . . . . . . . . . . . . .     0.008880
9. Line 8 times Line 5 (interpolation adjustment) . . . . .     0.002170
(Line 6 - Line 9). . . . . . . . . . . . . . . . . . . .     0.290510
(from section B) . . . . . . . . . . . . . . . . . . . .     0.290510
to gift tax (Line 1 * Line 2). . . . . . . . . . . . . .   290,510.00
deduction (Line 1 - Line 3). . . . . . . . . . . . . . .   709,490.00
Situations in Which IRS May Depart from Mortality Tables
The IRS is not bound to abide by the actuarial tables in cases where the individual upon whose life the measuring term of the trust is based is considered by medical evidence to be terminally ill at the time the trust is created. Technical Advice Memorandum 9504004 involved a transfer to two charitable lead unitrusts that were measured by the life of a woman who had advanced cancer and who survived less than three weeks following the creation of the trust. The Service substituted the woman's actual life expectancy.
IRC §7520; Reg. §20.2031-7(d)(2)back
Unlike charitable remainder trusts and pooled income funds, charitable income trusts are not conditionally exempt from income taxes; rather, they or their grantors are taxable from inception. Nongrantor charitable lead trusts are taxable as complex trusts. Conversely, grantor charitable lead trusts are not taxed on their income because the grantor is treated as the owner of the trust's income and is, therefore, responsible for the payment of all income taxes arising therefrom.
Taxation of Nongrantor Charitable Lead Trusts
Because both qualified and nonqualified nongrantor charitable lead trusts can retain income in excess of amounts they are required to distribute to charity, they are characterized for federal income tax purposes as complex trusts.1
Deductions for Amounts Paid to Charity
IRC §642(c) provides that a nongrantor charitable lead trust is allowed as a deduction in computing its taxable income any amount of its gross income, without limitation, that pursuant to the terms of the governing instrument is, during the taxable year, paid for charitable purposes. The deduction is provided in lieu of the deduction allowed by IRC §170(a), relating to the deduction for charitable contributions. Because the deduction under IRC §642(c)(1) is limited to amounts of gross income, no deduction is allowed for a distribution of an amount of principal except to the extent that 1) the amount distributed was included in the gross income of trust and 2) provided that no deduction was allowed for any previous taxable year for the amount distributed.
Set Aside Deduction No Long Available
For trusts created prior to October 10, 1969, income amounts exceeding the annual annuity or unitrust amount could be permanently set for charitable purposes free from tax. For trusts created after that date, however, any trust income in excess of allowable deductions is taxable to the trust at rates applicable to trusts and estates.2
Election to Treat Contributions as Paid in Preceding Taxable Year
If a charitable contribution is paid after the close of the taxable year and on or before the last day of the year following the close of such taxable year, the trustee or administrator may elect to treat the contribution as paid in the previous taxable year.3 The trustee makes the election by filing a statement with the tax return for the year in which the contribution is being considered paid.4
Capital gains generated within a nongrantor charitable lead trust are allocated either to income or corpus according to the terms of governing instrument. In the absence of a provision in the trust instrument, capital gains are allocated in accordance with local law. Most states allocate capital gains to corpus; accordingly, in the event gains are allocated to corpus and not distributable as income, such gains are taxable to the trust.
With respect to the payment of capital gains tax, former IRC §644(a) provided that any gains realized by the trust on assets sold within two years of their contribution by a living donor are taxed at the marginal tax rate that would have applied if the donor had sold the property. The provision did not apply to testamentary trusts presumably because assets funding such trusts received a stepped-up cost basis in the estate of the testator.5 Former IRC §644 was repealed effective August 5, 1997.
Taxation of In-Kind Distributions
Rev. Rul. 83-75 holds that the distribution by a trust of appreciated securities in satisfaction of its obligation to pay a fixed annuity to a charitable organization results in taxable gain to the trust. Such amounts are treated for trust tax purposes as if the trustee had sold the property and distributed the sales proceeds. Any gain or loss arising from such distributions is realized by the trust.6 The trust is entitled to a charitable deduction under IRC §642(c) in an amount equal to the amount of gain recognized upon distribution.7 The Service has also ruled privately that a proposed in-kind distribution would not violate the private foundation excise tax rules. If the property to be distributed would result in a loss if sold by the trust, it may be advisable to sell the property, recognize the loss, and distribute the proceeds. Otherwise, the trust may not be able to deduct the loss pursuant to the rules described in IRC §267 relating to losses, expenses, and interest with respect to transactions between related taxpayers.
The presence of unrelated business income in charitable lead trusts does not carry the same ominous tax consequences that apply to charitable remainder trusts. With respect to charitable remainder trusts, unrelated business taxable is subject to a 100 percent excise tax. Conversely, nongrantor charitable lead trusts are taxable as complex trusts from inception; therefore, the tax consequences of unrelated business taxable income are not so problematic.
With respect to nongrantor charitable lead trusts, amounts distributed to charity that otherwise qualify for deduction under IRC §642(c) are not deductible to the extent that such amounts are allocable to unrelated business income (as described in IRC §512) realized by the trust during the taxable year.8 Unrelated business income typically arises from certain business activities, leases, mineral exploration carried on by the trust, and possibly including income produced by debt-financed property. Unrelated business income can also arise indirectly from the ownership by the trust of pass-through entities such as partnerships over which the trustee may have no control over operations and the resulting tax character of income produced by the enterprise.
Although the deduction for distributions of UBI is disallowed under IRC §681, section 512(b)(11) provides partial mitigation. Specifically, this section permits the trust to deduct payments of UBI actually made to charity subject to the percentage limitation rules applicable to individual taxpayers. Accordingly, if the distributions consist of cash payable to a public charity as described in IRC §170(b)(1)(A), the trust can deduct distributions of UBI to the extent of 50% of the trust's contribution base.9 If the payments are made to a private non-operating foundation, the percentage limitation is 30%.
Debt-Financed Income
Unlike charitable remainder trusts, for which the presence of debt-encumbered property can cause disqualification, the ownership of debt-encumbered property by charitable lead trusts may cause the trust to have unrelated business income.
If a charitable lead trust has any debt-financed property, the income from such property is considered unrelated debt-financed income subject to unrelated business income tax rules as described above. Debt-financed property includes property that had "acquisition indebtedness" at anytime during the tax year or within 12-months of disposition of the property. In this context, the term "income" is not limited to recurring income but applies as well to gains from the disposition of property.10
The term "acquisition indebtedness" generally means the outstanding amount of principal indebtedness incurred prior, during, or after acquiring or improving the property.11 Further, where property is acquired subject to indebtedness, the indebtedness is considered as an indebtedness of the organization incurred in acquiring the property even though the organization does not assume or agree to pay such indebtedness.12
Five-and-Five Exception
Where a charitable lead trust acquires mortgaged property by gift, the debt secured by the mortgage will not be treated as acquisition indebtedness during the ten years following the date of acquisition as long as:
the mortgage was placed on the property more than five years prior to the gift, and
the property was held by the trustor for more than five years prior to the gift.
This exception is inapplicable, however, if the trust assumes any part of the debt secured by the mortgage.13
The Service has ruled privately that a transfer of real property subject to a nonrecourse indebtedness, that was placed on the property more than 10-years prior, was not considered property subject to acquisition indebtedness, did not constitute an act of self-dealing, was not a jeopardizing investment, and was not an excess business holding.14
In the same ruling, the Service held that in addition to the deduction of standard expenses normally associated with real property ownership, such as depreciation, amortization of leasehold, commissions, management fees, accounting and legal fees, the trust could also deduct the interest paid on the mortgage. Furthermore, interest and amortization of principal on the loan would not be considered payments for a private purpose.
This ruling suggests that a charitable lead trust may be able to own debt-encumbered property and make payments on the loan without having unrelated business income provided the loan is nonrecourse and meets the previously mentioned holding period requirements.
Other Related Concerns
Although the five-and-five exception seemingly clears the way for funding a charitable lead trust with debt-encumbered property, there is at least one other consideration. As mentioned in the discussion of private foundation excise taxes supra, a prohibited act of self-dealing will occur if property is transferred to a charitable lead trust that is subject to a mortgage or similar lien which a disqualified person placed on the property within the 10-year period ending on the date of the transfer. This rule effectively increases the five-and-five year rule to ten years.
Establishment of Tier System
Unlike charitable remainder trusts, for which income distributions are considered made according to a prescribed four-tier system, distributions from charitable lead trusts are not subject to any specified ordering system. In the absence of specific provisions in the governing instrument, or unless local law requires a different apportionment, amounts paid for the charitable purposes specified in IRC §642(c) are ratably apportioned among each class of items of income entering into the computation of the distributable net income.15
From a tax planning standpoint, it may be wise to deviate from the statutory pro rata allocation scheme in favor of an ordering system that prioritizes the distribution of income that would otherwise be taxed within the trust at the highest rates. The following system accomplishes this objective:
First, as ordinary income, to the extent of the trust's ordinary income for the taxable year;
Second, as short-term capital gains, to the extent of the trust's realized net short-term capital gains for the taxable year;
Third, as intermediate-term capital gains, to the extent of the trust's realized net intermediate-term capital gains for the taxable year;
Forth, as long-term capital gains, to the extent of the trust's realized net long-term capital gains for the taxable year;
Fifth, as unrelated business taxable income, to extent of the trust's unrelated business taxable income for the taxable year;
Sixth, as other (tax-exempt) income (including income excluded under part III, subchapter B, chapter 1, subtitle A of the Code) to the extent of the trust's other income for the taxable year; and
Finally, as corpus, defined as the net fair market value of the trust assets less the total undistributed income (but not loss) in each of the above categories.16
Caution: The Service has issued recent private letter rulings that provide conflicting results with respect to the ability to deviate from the pro rata allocation scheme. For example, Ltr. Rul. 9750020 states --
Although section 1.642(c)-3(b)(2) does not specifically provide that an allocation of income in a trust instrument must have economic effect, we believe that an allocation of income items to a charity should generally be made on a pro-rata basis. A specific allocation will only be allowed when trust provisions have an economic effect on Trust's distributions independent of tax consequences.
Ltr. Rul. 9716023 permitted a deviation from the pro rata allocation scheme without comment, however.
Allocating Trust Expenses
The governing instrument of both grantor and nongrantor charitable lead trusts should allocate expenses, such as trustee fees, to income. In the absence of a specific provision, such expenses could, under local law, be allocable in part or whole to corpus thereby preventing such amounts from being deducted from the taxable income of the trust. Trust expenses should, however, never be allocable against the annuity or unitrust amount. The Service has ruled that allocating trustee fees against the unitrust amount of a charitable remainder unitrust would disqualify the trust.17 Although the Service has not ruled on the application of this practice to charitable lead trusts, its holding would seemingly apply to charitable lead trusts as well because a reduction in the annuity or unitrust amount would violate the guaranteed annuity or unitrust requirement.
Nongrantor charitable lead trusts are subject to the alternative minimum tax to the extent the AMT exceeds the regular income tax liability. State AMT rules may also apply.
Taxation of Grantor Trusts and Grantors
Prior to the Tax Reform Act of 1969, an individual could establish a reversionary charitable lead trust, claim a current charitable income tax deduction for the present value of the income interest, and exclude the income earned by the trust from his or her personal income. The result was a double tax benefit. Further, absent clear requirements regarding the income amount payable to charity, the trust assets were frequently invested in such a way as to maximize the remainder interest while minimizing the income that were actually distributed to charity. As a result the claimed income tax deduction often bore no relationship to the amount actually conveyed to charity.
To eliminate these abuses, Congress enacted IRC §170(f). This section provides that no income tax charitable deduction is allowed for the value of any income interest in trust transferred to charity unless the interest is in the form of a guaranteed annuity or unitrust. The law further requires the grantor to be treated as the owner of the income interest subject the grantor trust rules as described in IRC §§671 - 678.
In application, grantors are taxed on the income produced by the trust as if the trust does not exist and can claim deductions and tax credits associated with such income. No additional deduction is available for the annual amounts distributed by the trust to charity, however.
Grantor Trust Rules
The grantor trust provisions tax the income of a charitable lead trust to the grantor even though the grantor is not an income beneficiary.18 Sections 673 through 678 define the circumstances under which income of a trust is taxed to a grantor or other person. In general, the grantor will be treated as owner of the income interest if:
the grantor has retained a reversionary interest in the trust, within specified limits (section 673);
the grantor or a nonadverse party has certain powers over the beneficial interests under the trust (section 674);
certain administrative powers over the trust exist under which the grantor can or does benefit (section 675);
the grantor or a nonadverse party has a power to revoke the trust or return the corpus to the grantor (section 676); or
the grantor or a nonadverse party has the power to distribute income to or for the benefit of the grantor or the grantor's spouse (section 677).
Under section 678, income of a trust is taxed to a person other than the grantor to the extent that he has the sole power to vest corpus or income in himself.
Following is a brief overview of the grantor trust rules as they apply to charitable lead trusts. Due to their complexity and numerous exceptions, advisors are urged to review the relevant Code and regulation sections in detail prior to reliance on any of the following commentary.
Five Percent Reversion Rule
IRC §673 provides that a grantor will be treated as the owner of any portion of a trust in which he or she has a reversionary interest in either the corpus or the income therefrom, if, as of the inception of the trust, the present value of the remainder interest exceeds five percent of the value of such portion.
Power to Control Beneficial Enjoyment
IRC §674 provides that, in general, a grantor will be treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of trust corpus or income is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party. Adverse parties include any person having a substantial beneficial interest in the trust that would be adversely affected by the exercise or nonexercise of a power that he or she possesses respecting the trust. For this purpose, a person having a general power of appointment over the trust property shall be deemed to have a beneficial interest in the trust. The term "nonadverse party" means any person who is not an adverse party.19
Eight exceptions to this rule are also provided in this section. For instance, the power to determine the beneficial enjoyment of the corpus or income, if the income or corpus is irrevocably payable for a charitable purpose, will not cause grantor trust status. In addition, the power to allocate between receipts and disbursements between income and corpus will not cause the application of the grantor trust rules. There are also certain powers that if retained by an independent trustee will not cause the application of the grantor trust rules.
The power to withhold income temporarily or to distribute corpus under certain circumstances are also excepted. However, retaining certain excepted powers may, for other reasons, cause disqualification of the charitable lead trust. For example, the power to withhold income or alter the amount of income distributable to a charitable income recipient would violate the guaranteed annuity or unitrust amount requirement.
Administrative Powers
IRC §675 provides that a grantor shall be treated as the owner of any portion of a trust in respect of which he or she:
retains the right to sell trust assets for less than adequate and full consideration;
retains the right to borrow trust corpus or income without adequate interest or security;
or exercises certain "administrative powers" in a nonfiduciary capacity.
Administrative powers that cause the grantor to be treated as owner of the trust include:
a power to vote or direct the voting of stock or other securities of a corporation in which the holdings of the grantor and the trust are significant from the viewpoint of voting control;
a power to control the investment of the trust funds either by directing investments or reinvestments, or by vetoing proposed investments or reinvestments, to the extent that the trust funds consist of stocks or securities of corporations in which the holdings of the grantor and the trust are significant from the viewpoint of voting control; or
a power to reacquire the trust corpus by substituting other property of an equivalent value.
Obviously, the exercise of some of these powers would, in the context of a charitable lead trust, implicate a breach of the trustee's fiduciary duty, as well as implicate the self-dealing rules.
Planning Opportunity: The Service has ruled that a power that permits a nonadverse party to acquire trust property by substituting other property of equivalent value will cause the trust to be treated as a grantor trust, but will not cause the trust to be included in the grantor's estate (i.e., also known as a "defective" grantor lead trust).20 Care must be exercised in this regard, because the Service has been unwilling to rule affirmatively that Section 675(4)(C) applies. Instead, the Service is delaying any conclusion under the grantor trust rules until it can evaluate the facts to determine whether the individual with the substitution right is in fact acting in a non-fiduciary capacity.
IRC §676 provides that a grantor shall be treated as the owner of any portion of a trust where at any time the power to revest in the grantor title to such portion is exercisable by the grantor or a non-adverse party, or both. A power of revocation will disqualify a charitable lead trust, because it violates the irrevocability and annuity or unitrust payment requirements on which the charitable contribution deduction is based.
Income for Benefit of Grantor
IRC §677 provides that a grantor shall be treated as the owner of the trust if income, without the approval of any adverse party, can be:
distributed to, held, or accumulated for the benefit of the grantor or the grantor's spouse; or
applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor's spouse (except policies owned by charity)
The exercise of these powers would cause the grantor trust rules to apply; however, care must be taken to ensure that such a power does not disqualify the charitable lead trust, such as the annuity or unitrust payment requirement.
Planning Opportunity: Grantors may be able to leverage the amount passing to their heirs by having a nonreversionary charitable lead trust purchase a cash value type insurance policy on the life of the grantor or grantors (e.g., a survivorship policy on the husband and wife). Provided the transfer is considered complete for gift tax purposes, the death benefit will not be includible in the grantor's estate. Care must be exercised prior to implementing this type of planning and all issues must be considered.
Person other than Grantor Treated as Substantial Owner
IRC §678 provides that a person other than the grantor shall be treated as the owner of the trust if:
such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself, or
such person has previously partially released or otherwise modified such a power and after the release or modification retains such control as would, within the principles of sections 671 to 677, inclusive, subject a grantor of a trust to treatment as the owner thereof.
This section essentially causes someone other than the grantor to be treated as the grantor for income tax purposes. Such a power to invade corpus or income would disqualify a charitable lead trust.
Tax and Information Return Requirements
Filing Requirements for Nongrantor Charitable Lead Trusts
All qualified and nonqualified nongrantor charitable lead trusts are required to file Form 1041 U.S. Income Tax Return for Estates and Trusts. Accompanying the return is a Schedule K-1 that reports the income beneficiaries' share of income, deductions and credits. Also required are Forms 1041A - U.S. Information Return Trust Accumulation of Charitable Amounts, and Form 5227 - Split-Interest Trust Information Return
Filing Requirements for Grantor Charitable Lead Trusts
Prior to 1996, all grantor charitable lead trusts were required to file Form 1041. For tax years beginning on or after January 1, 1996, however, the regulations eliminate the requirement to file Form 1041 provided the trustee satisfies alternate reporting requirements.
Form 1041 Requirements
If the trustee elects to file Form 1041, all items of income, deduction, and credit attributable to the trust are not reported on the form itself, but are shown on a separate statement attached to the form.21
>Alternate Reporting Requirements
Provided the grantor or other person who is treated as the owner of the trust are persons other than those described in Reg. §1.671-4(b)(6)22 or (7)23, the trustee may, but is not required to, report by one of the following alternate methods:
The trustee must either --
furnish the name and taxpayer identification number (TIN) of the grantor or other person treated as the owner of the trust, and the address of the trust, to all payors during the taxable year, or
furnish the name, TIN, and address of the trust to all payors during the taxable year.
Unless the grantor or other person is the trustee or co-trustee, the trustee must also furnish each grantor or other person treated as owner of the trust with a statement that --
shows all items of income, deduction, and credit for the taxable year;
identifies the payor of each item of income;
shows the information necessary to take the items into account in computing the grantor's or other person's taxable income; and
informs them that the items of income, deduction and credit and other information shown on the statement must be included in computing the taxable income and credits of the grantor or other person on the income tax return of the grantor or other person.
If these requirements are met, trustee is not required to file any type of return with the Internal Revenue Service. 24 If, however, there is a breach of the private foundation excise tax rules and excise taxes are to be paid, the trustee must file Form 4970.
Form W-9 and Backup Withholding Requirements
If the trustee elects to furnish the name and taxpayer identification number (TIN) of the grantor or other person treated as the owner of the trust, and the address of the trust, to all payors, the grantor or other person must provide a complete Form W-9 to the trustee, and the trustee must give the name and TIN shown on that Form W-9 to all payors.
In addition, if the Form W-9 indicates that the grantor or other person is subject to backup withholding, the trustee must notify all payors of reportable interest and dividend payments of the requirement to backup withhold. If the Form W-9 indicates that the grantor or other person is not subject to backup withholding, the trustee does not have to notify the payors that backup withholding is not required.
The trustee should not give the Form W-9, or a copy thereof, to a payor because the Form W-9 contains the address of the grantor or other person and requires the trustee to furnish the address of the trust to all payors and not the address of the grantor or other person. The trustee acts as the agent of the grantor or other person for purposes of furnishing to the payors the information required. Thus, a payor may rely on the name and TIN provided to the payor by the trustee, and, if given, on the trustee's statement that the grantor is subject to backup withholding.25
Form 1099 Requirement
If the trustee elects not to furnish the names of the grantor or other persons treated as owners of the trust directly to the payors (as described in option (2) above), the trustee must file Form 1099 showing the trust as the payor and each grantor or other person treated as an owner of the trust as the payee.
Changing Reporting Methods
The regulations provide instructions for changing from filing Form 1041 to one of the previously described alternative reporting methods and vice versa, and from changing between the two alternate methods. Those instructions are provided in Reg. §1.671-4(g).
Effective for tax years beginning after December 31, 1986, inter vivos nongrantor charitable lead trusts are required to make estimated tax payments in the same manner applicable to individual taxpayers.26 Testamentary charitable lead trusts are not required to make estimated tax payments until the third taxable year following the date of death.27
IRS tax and information returns applicable to charitable lead trusts can be found in the Advisor Resources - IRS Forms and Instructions section of this site.
IRC §651(a); Reg. §1.651(a)-4back
IRC §642(c)(2); Reg. §1.642(c)-2(b)(2)back
Ltr. Ruls. 9446019, 9447011, and 9447011 granted extensions of time to make the election.back
IRC §644(e)(1) (prior law)back
See also Ltr. Rul. 9201029 revoking Ltr. Rul. 8931029back
Ltr. Rul. 9005059back
Reg. §1.681(a)-2(b)back
Contribution base is defined as adjusted gross income without regard to NOL carryback into the contribution year.back
Reg. §1.514(b)-1(a)back
IRC §512(c)(1)back
IRC §514(c)(2)(A)back
IRC §514(c)(2)(B)back
Ltr. Rul. 7808067back
Reg. 1.661(b)-2back
See Ltr. Ruls. 9048044; 9604015; 9604016back
Rev. Rul. 74-19, 1974-1 C.B. 155back
Reg. §1.671(a)back
IRC §672(a)back
Ltr. Rul. 9713017; 9642039back
Reg. §1.671-4(a)back
(6)(i) A common trust fund as defined in section 584(a); (ii) A trust that has its situs or any of its assets located outside the United States; (iii) A trust that is a qualified subchapter S trust as defined in section 1361(d)(3); (iv) A trust all of which is treated as owned by one grantor or one other person whose taxable year is a fiscal year; (v) A trust all of which is treated as owned by one grantor or one other person who is not a United States person; or (vi) A trust all of which is treated as owned by two or more grantors or other persons, one of whom is not a United States person.back
(7)(A) At least one grantor or one other person who is treated as an owner of the trust is a person who is not an exempt recipient for information reporting purposes; and (B) The trustee reports without regard to whether any of the grantors or other persons treated as owners of the trust are exempt recipients for information reporting purposes.back
Reg. §1.671-4(b)(3)(ii)back
Reg. §1.671-4(e)(1)back
IRC §6654(1)back
IRC §6654(1)(2)back
For purposes of the income tax charitable deduction, transfers to grantor charitable lead trusts are considered gifts "for the use of" charity rather than gifts "to" charity. If the trust makes payments to a public charity, the deduction can be used against up to 30% of the grantor's contribution base with a five year carryover of any excess deduction. If the trust provides income to a private non-operating foundation, the percentage limitation is reduced to 20%. Any deduction exceeding the amount deductible in the year of contribution can be carried forward up to five additional years.
Deduction Cannot Exceed Value of Trust
Based on the combination of the trust's payout or annuity rate and the measuring term, it is possible for the present value of the remainder interest to exceed the fair market value of the trust assets. The amount that may be deducted for income tax purposes, however, cannot exceed 100 percent of the fair market value of the property transferred to the trust and upon which the deduction is calculated.1
Furthermore, if by reason of all the conditions and circumstances surrounding a transfer of an income interest in property it appears that the charity may not receive the beneficial enjoyment of the interest, a deduction will be allowed only for the minimum amount it is evident the charity will receive. The application of this rule is illustrated by the examples found in the regulations that illustrate scenarios that result in the present value of the income stream exceeding the fair market value of the amount transferred.2
If for any reason the grantor ceases at any time before the termination of the trust to be treated as the owner of the income interest for purposes of applying IRC §671 (e.g., the grantor dies during the trust term or releases certain grantor trust powers), the grantor is considered as having received, on the date he or she ceases to be so treated, an amount of income equal to 1) the amount of any deduction that was allowed under IRC §170 for the contribution reduced by 2) the discounted value of all amounts that were required to be, and actually were, paid with respect to such interest under the terms of trust to the charitable organization before the time at which the grantor ceases to be treated as the owner of the interest.3
The discounted value of the amounts paid is computed by treating each payment as a contribution of a remainder interest after a term of years and valuing the payment as of the date of contribution of the income interest by the donor. The method of determining the present value is the same as for income, gift, and estate tax purposes.4
Application of Bargain Sale Rules to Transfers of Debt-Encumbered Property
Does the transfer of debt-encumbered property to a charitable lead trust cause the grantor to realize gain under the bargain sale rules? IRC §1011(b) provides --
If a deduction is allowable under section 170 (relating to charitable contributions) by reason of a sale, then the adjusted basis for determining the gain from such sale shall be that portion of the adjusted basis which bears the same ratio to the adjusted basis as the amount realized bears to the fair market value of the property.
Although the regulations provide that a transfer of debt encumbered property to charity in exchange for a charitable gift annuity requires the donor to treat the indebtedness as an amount realized for purposes of the bargain sale rules, no guidance is given regarding a contribution of an income interest such as occurs with a charitable lead trust.5
In the case of a transfer to a nongrantor charitable lead trust, no deduction is allowed under IRC §170. We conclude, therefore, the bargain sale rules should not apply to such transfers. With respect to transfers to grantor lead trusts for which a deduction under IRC §170 is produced, such transfers would, if based solely on these criteria, seem to trigger the bargain sale rule. Gifts of an income interest are, however, distinguishable from both outright gifts and gifts of a remainder interest.
When debt-encumbered property is transferred by outright gift to charity, the donor is relieved of the obligation. Such relief is considered income. The same theory holds true with a gift of a remainder interest to charity. Although there is an intervening income interest, the debt is ultimately transferred to charity.
In the case of a grantor lead trust, the grantor is treated as owner of the income interest. Furthermore, the trust corpus (remainder interest) and, therefore, the indebtedness is never transferred to charity. Provided the trust takes the property "subject to" and does not "assume" the indebtedness, it would seem plausible that the transfer would not be considered a bargain sale. The IRS has not, however, issued any public or private rulings on this issue.
Income Tax Considerations for Remainder Beneficiaries
Generally, the noncharitable remainder beneficiaries of nonreversionary nongrantor charitable lead trusts are not subject to any income tax liability during the operating term of the trust because they are not considered an owner of the income interest. However, the noncharitable remainder beneficiary's income tax structure is relevant upon termination and distribution of the remainder interest.
Nongrantor charitable lead trusts were subject to the "throwback tax" rules as described in IRC §§665 - 667. The throwback tax was created to create income tax parity between nongrantor trusts and the remainder beneficiaries for whom they accumulated assets. A nongrantor trust pays income tax on its excess income (i.e., income exceeding the amount it is required to distribute to charity and for which it receives a deduction under IRC §642(c)).
Under the throwback tax rules, a tax is imposed upon termination of the trust in an amount equal to the increase in income tax, if any, that the remainder beneficiary would have paid on the accumulated trust income had the remainder beneficiary received the income in the year in which it was actually earned by the trust. The tax is payable from the remainder interest.
The throwback rules have been modified pursuant to The Taxpayer Relief Act of 1997. Effective for taxable years beginning after August 5, 1997, these rules no longer apply to distributions from domestic trusts created after February 29, 1984, if such trusts have never been foreign trusts.
Reg. §1.170A-6(c)(3)(i)and (ii)back
Reg. §1.170A-6(c)(3)(iii)back
Reg. §1.170A-6(c)(4)back
Reg. §20.2031-7back
Reg. §1.1011-2(a)(4)(I)back
Transfers to a charitable lead trust consist of two components: 1) a contribution of an income interest to charitable and, potentially, noncharitable recipients, and 2) the payment of a remainder interest to a noncharitable beneficiary.
Gifts of Income Interests to Charity
Gifts of an income interest to charity via a qualified charitable lead trust qualify for unlimited gift and estate tax deductions for the present value of the charitable income interest.1 If the trust is created during the life of the grantor, the transfer will qualify for the unlimited gift tax charitable deduction provided the transfer is considered complete for gift tax purposes.
The regulations provide that a transfer will not be considered complete if the grantor retains the right to change the disposition of the trust property. In the context of a charitable lead trust, this would include the right to designate the charitable income recipients or to change noncharitable remainder beneficiaries.
Reg. §25.2511-2 of the Gift Tax Regulations provides, in part, as follows:
(b) As to any property, or part thereof or interest therein, of which the donor has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or for the benefit of another, the gift is complete. But if upon a transfer of property (whether in trust or otherwise) the donor reserves any power over its disposition, the gift may be wholly incomplete, or may be partially complete and partially incomplete, depending upon all the facts in the particular case. Accordingly, in every case of a transfer of property subject to a reserved power, the terms of the power must be examined and its scope determined.
(c) A gift is incomplete in every instance in which a donor reserves the power to revest the beneficial title to the property in himself. A gift is also incomplete if and to the extent that a reserved power gives the donor the power to name new beneficiaries or to change the interests of the beneficiaries as between themselves unless the power is a fiduciary power limited by a fixed or ascertainable standard.
Section §25.2522(c)-3(c) of the regulations provides, in part, as follows:
(c) Transfers of partial interests in property--(1) Disallowance of deduction. If a donor transfers an interest in property after July 31, 1969, for charitable purposes and an interest in the same property is retained by the donor, or is transferred or has been transferred for private purposes after such date (for less than an adequate and full consideration in money or money's worth), no deduction is allowed under section 2522 for the value of the interest which is transferred or has been transferred for charitable purposes unless the interest in property is a deductible interest described in subparagraph (2) of this paragraph. The principles that are used in applying section 2523 and the regulations thereunder shall apply for purposes of determining under this subparagraph whether an interest in property is retained by the donor, or is transferred or has been transferred by the donor. If, however, as of the date of the gift, a retention of an interest by a donor, or a transfer for a private purpose, is dependent upon the performance of some act or the happening of a precedent event in order that it may become effective, an interest in property will be considered retained by the donor, or transferred for a private purpose, unless the possibility of occurrence of such act or event is so remote as to be negligible. The application of this subparagraph may be illustrated by the following examples, in each of which it is assumed that the property interest which is transferred for private purposes is not transferred for an adequate and full consideration in money or money's worth.
Rev. Rul. 77-275 addressed a situation whereby a grantor established a reversionary grantor lead trust and retained the power to designate, from time to time, the income beneficiary of the trust. IRS ruled that this power was not a fiduciary power limited by a fixed or ascertainable standard. On the contrary, it extended to the entire trust income; therefore, the gift of the income interest in the trust was incomplete, in view of section 25.2511-2(c) of the regulations, quoted above. Gift tax deductions for transfers of income to charity would be available as income was paid. Further, because the trust assets were to revert to the grantor, there were no further gift tax consequences with respect to the noncharitable remainder interest.
A gift or estate tax can, however, be generated on the value of the remainder interest if it is transferred to someone other than the grantor. Additional gift or estate tax can be generated if the trust includes a noncharitable income recipient that is other than the grantor.
Gifts of Remainder Interests to Noncharitable Beneficiaries
In the previous case, the effect of the loss of the gift tax charitable deduction is benign because the remainder interest was to revert to the grantor. If, however, the remainder interest is payable to other individuals, the consequences can be significant.
If the remainder interest of a qualified charitable lead trust is paid to someone other than the grantor, the grantor has made a gift of a remainder interest to that individual when the trust is created. The computation of the present value of the remainder interest is illustrated in Section III.
Availability of Annual Gift Tax Exclusion
The $10,000 annual gift tax exclusion is not available to offset completed gifts of a remainder interest because such transfers are considered gifts of a future interest for which the exclusion is not available.
Testamentary Power to Revoke Remainder Beneficiary's Interest
A grantor can forestall the recognition of a taxable transfer to a noncharitable remainder beneficiary by reserving the power in the trust instrument to revoke the beneficiary's remainder interest, thereby making the transfer incomplete for gift tax purposes. Following the guidance applicable to charitable remainder trusts, this power must be exercisable solely by the grantor's will. 2
Estate Tax Consequences when Right of Revocation is Unexercised
Continuing with the rationale applied to charitable remainder trusts, if a grantor, who retains a right of revocation, fails to exercise that right, the entire value of the trust is includible the grantor's gross estate under IRC §2038(a). The present value of the charitable remainder interest is calculated based on the fair market value of the trust and remaining trust measuring term on the date of the grantor's death. The present value of the income interest qualifies for the estate tax charitable deduction under IRC §2055(a).3
Estate Tax Consequences when Right of Revocation is Absent
If the grantor does not reserve the right to revoke the noncharitable remainder beneficiary's interest, and does not retain any other power as to the dominion and control of the trust that would otherwise cause it to be includible in the grantor's estate, the gift of the remainder interest is considered complete when the trust is created.
Planning Considerations Regarding Rights of Revocation
Should a grantor reserve the right to revoke the noncharitable remainder beneficiary's interest? If the trust assets are expected to appreciate in value net of trust distributions, a reserved right of revocation might not be a good idea because a larger amount will be subject to estate taxation in the grantor's estate and will be offset by a smaller charitable estate tax deduction. The tax effect may further be exacerbated by a larger generation skipping transfer tax if the remainder beneficiary is more than one generation removed from the grantor. In the event, however, the transfer would result in the current payment of a large gift tax, delaying the estate tax until other estate assets, such as life insurance, are available to pay the tax may be preferable or necessary.
Estate Tax Consequences
There are several fact patterns that cause the corpus of a charitable lead trust to be included in the donor's estate:
Reversionary Trusts
If the trust is designed to revert to the grantor, and he or she dies during the measuring term of the trust, the fair market value of the trust corpus will be included in the grantor's estate under IRC §2036(a). The grantor's estate will receive a charitable estate tax deduction based on the present value of the remaining income interest payable under the terms of the trust instrument.
Nonreversionary Trusts
If a nonreversionary trust is created during the life of the grantor, as previously discussed, it will not be includible in the grantor's estate unless he or she retains rights in the trust instrument that otherwise cause the trust to be included. For example, if the grantor retains the power, as trustee, to designate the income or remainder beneficiaries, the corpus of the trust will be included in the grantor's estate if he or she dies during the trust term.4
If a nonreversionary lead trust that is established on a testamentary basis, the donor's estate is entitled to an estate tax charitable deduction for the present value of the income interest passing to charity based on the net fair market value of the trust assets on the date of death.
The federal estate tax system was created to tax the transfer of wealth from one generation to the next. Where there is a will (or trust), however, there is a way to avoid wealth transfer taxes. As originally implemented, the federal estate tax system did not anticipate a very simple strategy that could eliminate estate taxes -- simply encourage taxpayers to transfer a portion of their estate directly to their grandchildren or successor generations thereby skipping gift and estate taxation at the intervening levels. Properly implemented, the strategy could more than halve the total estate taxes paid by a family over time.
Congress, recognizing that a significant leak had sprung in the estate tax system moved to limit the flow by creating the Generating Skipping Transfer Tax ("GSTT"). Originally enacted with the Tax Reform Act of 1976, the original legislation proved unworkable which lead to its repeal and revision with the Tax Reform Act of 1986.
A complete discussion of the GSTT is beyond the scope of this text. Following is a brief discussion of the effect of the tax on transfers to the beneficiaries of nonreversionary nongrantor and grantor charitable lead trusts.
Generation Skipping Transfers Defined
For purposes of transfers to charitable trusts, a generation skipping transfer occurs any time an inter vivos or testamentary transfer is made to a trust that names a remainder beneficiary who is a natural person assigned to a generation which is two or more generations below the generation of the grantor. Such persons are referred to as "skip persons."5
Skip Persons
Skip persons generally include the natural, half-blood, and adopted grandchildren and successor generation lineal descendants of the grantor and grantor's spouse (or former spouse).6 If a person is not a lineal descendant, they will be assigned to the grantor's generation if they were born not more than 12-1/2 years after the date of the birth of the grantor. If they were born more than 12-1/2 years but not more than 37-1/2 years after the date of the birth of the grantor, they are assigned to the first generation younger than the grantor, with similar rules for a new generation every 25 years.7 Persons that are married or have at any time been married to the grantor are assigned to the same generation regardless of their age. Likewise, any persons married to any lineal descendant skip person are assigned to that descendant's generation regardless of their age. All other persons not included within this definition are considered "non-skip persons."
The Taxpayer Relief Act of 1997 imposed an important modification to the generation assignment rules. Beginning in 1998, if a grandparent makes a transfer to a grandchild, whose parent is dead at the time the transfer is completed for gift or estate tax purposes, the grandchild is no longer considered a skip person; the grandchild is stepped-up one generation by virtue of his or her parent's death. This exception applies only for 1) transfers involving lineal descendents, and 2) transfers to collateral heirs (e.g., grandnieces and grandnephews) provided the grantor has no living lineal descendants at the time of transfer. 8
Timing of Tax
The GSTT is not triggered at the time a charitable lead trust is created because it does not satisfy the definition of a direct skip, taxable termination, or taxable distribution as defined in IRC §2612. A taxable termination does occur and the tax is triggered at the conclusion of the measuring term of the trust when the remainder interest is distributed to the skip person. If no specific charity is named to receive the annual payments, but someone is instead given the power to name the charitable recipient each year, a taxable distribution results at the termination of the lead interest.
$1,000,000 Exemption
Every individual (grantor) is provided a lifetime exemption of $1,000,000 against taxable generation skipping transfers.9 Gift splitting between married couples is also permitted; accordingly a married couple can together assign $2,000,000 towards a generation skipping transfer. Beginning in 1999, the $1,000,000 exemption amount will be indexed for inflation.
Method of Allocating Exemption
The GSTT exemption can be allocated by the grantor or the grantor's executor at any time from the date of the transfer (for inter vivos transfers) through the date for filing the grantor's federal estate tax return (including any extensions for filing that have been actually granted). If no estate tax return is otherwise required to be filed, the GSTT exemption may be allocated at any time through the date a federal estate tax return would have been due (including any extensions actually granted).10
Allocating the GSTT exemption to inter vivos transfers is made on Form 709. The allocation must clearly identify the trust to which the allocation is being made, the amount of GSTT exemption allocated to it, and if the allocation is late or if an inclusion ratio greater than zero is claimed, the value of the trust assets at the effective date of the allocation. The statement should also provide the inclusion ratio after the allocation.11 Allocating the GST exemption to testamentary transfers and inter vivos transfers (for which no allocation was made during the grantor's life) is made on Form 706.
Effect of Exemption on Computation of Inclusion Ratio
As will be discussed in the next section, the GSTT exemption allocation amount is used to calculate the portion of the remainder interest that is subject to the GSTT. This portion is referred to as the "inclusion ratio."
The original rules imposed by TRA '86 provided that the inclusion ratio was determined by dividing the allocated exemption (numerator) by the fair market value of the trust assets (determined on the date the exemption is allocated) reduced by any state death taxes allocable to the trust and the amount of the charitable contribution gift or estate tax deduction resulting from the transfer (denominator). The resulting fraction is then subtracted from one to produce the inclusion ratio.
With respect to charitable lead unitrusts, because the payment to charitable income recipients is based on a fixed percentage of the annual value of the trust assets, a dramatic increase in the value of the trust assets will benefit both the charitable income recipients and the noncharitable remaindermen. Accordingly, the computation of the inclusion ratio for transfers to charitable lead unitrusts remains undisturbed as provided above.
In the case of charitable lead annuity trusts, however, because the annual annuity amount paid to the charitable income recipients is fixed at the time the trust is created, any increase in trust value will inure entirely to benefit of the noncharitable remaindermen. Accordingly, it was possible for grantors to greatly leverage the GSTT exemption to the point where the net proceeds of trust would exceed those that the remaindermen would have received had the trust not contained any charitable component.
In an attempt to eliminate the potential differential benefit provided by the annuity trust format, Congress modified the computation of the inclusion ratio for charitable lead annuity trusts, effective for contributions after October 13, 1987.
The computation of the inclusion ratio is modified in two ways: 1) instead of using the fair market value of the property on the date the exemption is allocated in the denominator of the computation, the fair market value of the trust assets immediately after termination of the lead interest is used; and 2) the GSTT exemption amount is compounded annually for the measuring term of the trust using the same applicable federal midterm rate used for purposes of calculating the charitable contribution gift or estate tax deduction.12
Although the compounding of the exemption amount can produce a large denominator, the increase will be offset if the trust assets appreciate substantially in value over the compounding rate.
Allocation Rules
For inter vivos transfers to charitable lead unitrusts, if the exemption is allocated via a gift tax return that is filed on a timely basis, the fair market value of the property on the date it was transferred to the trust is used in the denominator of the inclusion ratio computation. If the exemption is allocated via a gift tax return that is not filed on a timely basis, the fair market value of the trust assets on the date the gift tax return is filed is used in the denominator of the inclusion ratio computation. As an alternative, the grantor can use the fair market value of the trust assets on the first day of the month during which a late allocation is made.13
If the grantor fails to make an allocation during life, the grantor's executor can make the election on the grantor's federal estate tax return.14 For this purpose, the fair market value of the trust assets on the date of death is used in the denominator of the inclusion ratio computation.
With respect to charitable lead annuity trusts, the fair market value of the property immediately preceding the distribution of remainder interest is always used in the denominator of the inclusion ratio computation regardless of when the exemption is allocated. Accordingly, the timing of the allocation of the exemption has no effect on the value of the trust assets for computation purposes. As will be discussed, however, waiting to make an allocation may influence the amount of exemption that is allocated.
Allocations of the GSTT exemption for transfers to testamentary charitable lead unitrusts and annuity trusts must be made on the testator's federal estate tax return.
Exemption Allocation Irrevocable
With exceptions discussed below, the exemption allocation is irrevocable once it is made. Thus, if a taxpayer allocates excess exemption, such excess is lost and cannot be allocated to other gifts. Conversely, any portion of the exemption that has not been allocated at the time of the taxpayer's death is first allocated to any transfers that were considered direct skips with any remaining exemption applied pro rata to trusts that may have taxable terminations or taxable distributions.
Also with respect to charitable lead unitrusts, an allocation of GSTT exemption to a trust is void to the extent the amount allocated exceeds the amount necessary to obtain an inclusion ratio of zero. An allocation is also void if it is made with respect to a trust that has no "GSTT potential" with respect to the grantor making the allocation, at the time of the allocation. For this purpose, a trust has GSTT potential even if the possibility of a GSTT is so remote as to be negligible.15 These exceptions do not apply, as discussed below, to charitable lead annuity trusts.
When to Allocate the Exemption Amount for Inter Vivos Transfers
The determination of the inclusion ratio applicable to transfers to inter vivos charitable lead unitrusts can be determined with certainty when the trust is created. Accordingly, there may be no compelling reason why a grantor would want to delay the allocation of exemption and potentially generate a less favorable tax result.
With respect to transfers to charitable lead annuity trusts, grantors should seriously consider delaying the allocation until immediately prior to the trust's termination. Although the timing of exemption allocation has no effect on the valuation date for purposes of the inclusion ratio computation, it does, however, irrevocably establish the amount of the exemption that is being allocated. Because the computation of the inclusion ratio for charitable lead annuity trusts is based on the value of the trust immediately prior to distribution to remaindermen, it is preferable to make the allocation as close as possible to that time when the trust value on which the inclusion ratio computation will be based is known. Otherwise, if the trust outperforms investment projections, an unplanned GSTT may be triggered. Conversely, if the trust under-performs, a portion of the GSTT exemption that was allocated to offset a larger projected transfer will go unused with no ability to reallocate the unused portion to other transfers. If the grantor dies during the trust term, having failed to make an allocation, the grantor's executor will make the election via the grantor's federal estate tax return. This provides some ability to plan.
Planning for Testamentary Transfers
With respect to testamentary transfers, the GSTT exemption must be allocated no later than when the testator's estate tax return is filed (including extensions). For charitable lead unitrusts, this is not problematic because the inclusion ratio can be locked in at the time the trust is created. For charitable lead annuity trusts, however, the uncertainty of future trust value and its effect on the GSTT computation reduce planning to that of making an educated guess. Cash flow modeling, therefore, becomes particularly important to the planning of a testamentary charitable lead annuity trusts.
Formula Allocations
Allocation of the GSTT exemption can be made by formula. For example, the allocation may be expressed in terms of the amount necessary to produce an inclusion ratio of zero. However, formula allocations made with respect to charitable lead annuity trusts are not valid except to the extent they are dependent on values as finally determined for federal estate or gift tax purposes.
Calculating the Generation Skipping Transfer Tax
The generation skipping transfer tax is calculated by multiplying the fair market value of the property transferred to the trust (on the date such transfer becomes complete for gift or estate tax purposes) by the "applicable rate." The applicable rate is obtained by multiplying the maximum federal estate tax rate of 55% by the "inclusion ratio." The inclusion ratio calculates the portion of the remainder interest that is subject to the GSTT.
GSTT Computation for Charitable Lead Unitrusts
The GSTT with respect to transfers to charitable lead unitrusts can be determined with certainty when the trust is created. The GSTT can also be eliminated altogether by designing the trust in such a way that the inclusion ration equals zero. This can be accomplished by varying the funding amount, measuring term, payout rate, and GSTT exemption allocation. As previously mentioned, with testamentary transfers, these variables can be established by formula in the testator's will to achieve the desired tax result.
The GSTT can be determined with certainty when the trust is created. It is determined by multiplying the amount transferred to the trust by the "applicable rate" as calculated using the following formula:
Where: A = FMV of property transferred to trust on date transfer is complete for gift or estate tax purposes
E = Amount of GST exemption allocated to trust
F = Fair market value of trust property on date of GST exemption allocation
T = Amount of federal estate and state death taxes paid from trust
C = Charitable gift or estate tax deduction created by contribution Inclusion Ratio = (1 - (E / (F - T -C))
Example 1: Grandparents transferred $5,000,000 to a charitable lead unitrust naming their granddaughter as remainder beneficiary. Using the gift-splitting election, the grandparents allocated their entire $2,000,000 GST exemption to the transfer. The transfer produced a charitable gift tax deduction of $2,000,000. There were no federal or state death taxes recoverable from the trust. The computation is as follows: Inclusion Ratio = (1 - ($2,000,000 / ($5,000,000 - $0 - $2,000,000))
= .667 Applicable Rate (AR) = .667 x .55 = .367 GSTT = A x AR = $1,835,000
GSTT Computation for Charitable Lead Annuity Trusts
Because charitable lead annuity trusts pay a fixed annuity amount regardless of the annual value of the trust, it is possible for grantors to leverage the GSTT exclusion to the point where the net proceeds of the trust exceed the net after gift or estate tax amount the heirs would have received if the trust had not contained any charitable component. Thus, effective for transfers to charitable lead annuity trusts after October 13, 1987, the computation of the inclusion ratio is modified in two ways: 1) instead of using the fair market value of the property on the date it is originally transferred to the trust in the denominator of the computation, the fair market value of the trust assets immediately after termination of the lead interest is used; and 2) the GST exemption amount is compounded annually for the measuring term of the trust using the same applicable federal midterm rate used for purposes of calculating the charitable contribution gift or estate tax deduction.16
E = Amount of GSTT exemption allocated to trust
R = Applicable federal midterm rate on date of contribution
M = Measuring term of trust (with months converted to decimal)
F = FMV of trust property on the effective date of GST exemption allocation
D = FMV of trust property on date of distribution to remaindermen
C = Charitable gift or estate tax deduction created by contribution Inclusion Ratio = (1 - ((E x (1+R)M) / (D - T -C))
Example 2: Grandparents transferred $5,000,000 to a charitable lead annuity trust naming their granddaughter, a skip person, as the remainder beneficiary. Using the gift-splitting election, the grandparents allocated their entire $2,000,000 GSTT exemption to the transfer. The transfer produced a charitable gift tax deduction of $2,000,000. There were no federal or state death taxes recoverable from the trust. The trust had a measuring term of ten years and had appreciated to $7,000,000 when it terminated. The AFMR at the time of the contribution was 7.0%. The computation is as follows: Inclusion Ratio = (1 - ($2,000,000 x 1.96715) / ($7,000,000-$0 -$2,000,000))
= (1 -($3,934,300 / $5,000,000)
= 21.3% Applicable Rate (AR) = 21.3% x 55% = 11.7% GST = A x AR = $5,000,000 * 11.7% = $586,134
GSTT Calculator
For your convenience, you may download a simple Microsoft Excel spreadsheet that calculates the generation skipping transfer tax attributable to transfers to charitable lead unitrusts and annuity trusts as illustrated in the previous section.
Liability for the Tax
Unless otherwise directed pursuant to the governing instrument, the liability for payment of the GSTT pursuant to a taxable termination is the responsibility of the trustee and is paid from the remainder interest prior to distribution to the remaindermen.17
Planning with Qualified Terminable Interest Property
The Economic Recovery Tax Act of 1981 introduced the concept of qualified terminable interest property as a method whereby a decedent spouse can preserve the estate tax marital deduction for a transfer of property to a surviving spouse while retaining control of the ultimate distribution of the property.
Because a charitable lead trust does not provide an income interest to the surviving spouse, it cannot qualify as a QTIP trust. A charitable lead trust can make an ideal remainder beneficiary of a QTIP trust, however. For example, a testator transfers property in trust to his surviving spouse via a QTIP election. She receives all of the income from the trust for her life; after which, the remainder interest is transferred to a charitable lead trust. After payment of the charitable lead interest, the remainder interest is transferred to the testator's children or grandchildren. For federal estate tax purposes, the value of the QTIP trust is includible in the estate of the surviving spouse with a charitable contribution estate tax deduction available to reduce the taxable estate.
If the remainder interest of the charitable lead trust is payable to the testator's grandchildren (or other skip persons), an interesting problem can arise. If the transfer is of an amount that requires the use of both grandparents' GSTT exclusion, the first grandparent's GSTT exemption will be unavailable because it was not claimed on his federal estate tax return. Enter the "reverse QTIP election."
Under Reg. §26.2652-2 the person making the QTIP election may elect to treat the property as if the QTIP election had not been made (reverse QTIP election). An election under this section is irrevocable and is not effective unless it is made with respect to all of the property in the trust to which the QTIP election applies. If the property transferred to the QTIP exceeds the testator's GSTT exclusion amount of $1,000,000, the QTIP trust can be treated as separate (taxable and non-taxable) trusts with the exclusion amount allocated to the taxable trust in an amount necessary to reduce the inclusion ratio to zero.18
Can the surviving spouse be given a limited power of appointment to redirect the remainder interest of the QTIP trust from the charitable lead trust to a named individual such as the testator's child or grandchild? The Service has ruled favorably with respect to the application of such a power to a transfer to a charitable remainder trust.19 We see no reason why such a retained power would not also apply to a charitable lead trust.
Payment of Estate Taxes
Revenue Ruling 82-128, that specifically prohibits the payment of federal estate taxes attributable to a charitable remainder trust from trust corpus, does not apply to charitable lead trusts. However, the governing instrument of a nonreversionary charitable lead trust should include a similar provision. Otherwise, a testamentary trust that is burdened with the payment of estate taxes will create an interrelated estate tax computation that will reduce the amount of the charitable interest.
As an alternative, it is recommended that the amount transferred to a testamentary charitable lead trust be planned in such a way as to create no estate tax or to provide for other estate assets to pay the tax.
Provision Requiring Payment of Estate Taxes by Successor Income Recipient Permitted
A donor proposed to include a provision in a charitable remainder trust that, in the event the trust became liable for death taxes attributable to a successor income recipient, the recipient's interest would continue or take effect only if the recipient furnished the funds for payment of all taxes attributable to the recipient's interest. Finally, the trust provided that, if the recipient failed to furnish all such funds, such recipient would be deemed to have predeceased the donor.
Because there can be no invasion of the trust's assets to pay federal estate or state death taxes upon the grantor's death, and thus no interference with the charity's remainder interest, the Service ruled the trust will be qualified under IRC §664(d)(2)(B).20 It is possible that the result would be similar for a charitable lead trust; however, caution is advisable in this regard.
How is the amount of the estate tax charitable deduction computed in the case of a transfer to a charitable remainder unitrust if, under applicable state law, federal estate taxes with respect to the trust are to be apportioned entirely to trust principal?
An individual died in 1991. At the time of her death, she was the life income beneficiary of a marital trust created by her husband that was includible in her gross estate.21 Upon her death, the trust corpus was to be distributed to a charitable remainder unitrust that named the decedent's son as life income recipient with the remainder to a designated charity.
Under IRC §2207A and the decedent's will, the marital trust is burdened with the estate taxes generated by the inclusion of the marital trust in the decedent's gross estate. The trust instrument contains no provision regarding the apportionment of federal estate taxes to be paid by the trust. The applicable state apportionment statute provides that, if both a present interest and a future interest in property are involved, a tax shall be apportioned entirely to principal. This shall be the case even if the future interest qualifies for an estate tax charitable deduction, even if the holder of the present interest also has rights in the principal, and even if the principal is otherwise exempt from apportionment.
On the federal estate tax return, the estate claimed a charitable deduction for the present value of the charitable remainder interest. The deduction was computed by determining the net amount passing to the unitrust (before payment of estate taxes), subtracting from that amount the federal estate taxes payable with respect to the unitrust, and multiplying the difference by the appropriate unitrust remainder factor.
On audit of the return, the district office took the position that, pursuant to the estate's methodology, because the estate tax liability was paid off the top of trust corpus, the lifetime recipient's unitrust interest (which is the lesser of trust income or percentage of the value of the trust) was necessarily reduced proportionately. Thus, the estate's method for apportioning the estate tax effectively placed the burden of a portion of the estate tax liability generated by the unitrust on the interest of the lifetime unitrust recipient.
The district office argued this approach conflicted with the state's statute that specifically provides that any estate tax is to be apportioned "entirely to the principal." The district office contended that, under the statute, the unitrust/income recipient is exonerated from paying any tax, and that the entire tax burden is borne by the beneficiary of the trust principal--the charitable remainderman. This result could be obtained (even though the taxes are paid currently) if, for example, the lifetime recipient received an additional payment each month (i.e., from the charitable remainderman) to compensate for the reduced unitrust/income payment resulting from the tax payment. The charitable deduction would be computed by subtracting the value of the unitrust interest from the value of the trust corpus and from the amount so obtained, and then subtracting the estate taxes allocable to the trust. The balance is the amount of the charitable deduction.
Fortunately for the charitable remainderman, the Service ruled in technical advice that the estate's approach in computing the allowable charitable deduction is correct.22 It is possible that the Service may take a similar approach with charitable lead trusts, but caution should be exercised.
Interrelated Estate Tax Computations
In determining the taxable estate of a decedent, a deduction is allowed for qualified gifts to charity. If the value of the property to be transferred to charity is burdened with the payment of any death taxes, the amount of the charitable deduction is reduced by the amount used to pay the taxes. In essence, the computation of the estate tax is dependent on the charitable deduction, which is dependent on the estate tax. The computation therefore chases its own tail. The computation of death taxes attributable to a charitable interest requires an interrelated computation. Formulas and examples of interrelated computations are provided in IRS Publication 904.
With respect to planning a testamentary charitable lead trust, the interrelated computation can be avoided altogether by providing for a specific amount to fund the trust and allocating any death taxes attributable to the noncharitable remainder interest to other estate assets. Funding a charitable lead trust on a residuary basis or apportioning estate taxes to the amount used to fund the trust will trigger the interrelated computation, which may cause a significant reduction in the amount of the charitable interest.
Example: Mr. Jones' adjusted gross estate is valued at $5,000,000. His estate plan provides for the payment of specific bequests in the amount of $1,000,000 with the remainder of his estate, net of estate taxes and miscellaneous deductions, to be paid to a charitable lead trust for the benefit of family members. The following computation calculates the amount of estate tax due and the amount transferred to a charitable lead trust.
E = Adjusted Gross Estate $5,000,000
D = Estate Deductions $250,000
f = Charitable Lead Trust Deduction Factor .25000
S = Specific Bequests to Non-Charitable Recipients $1,000,000 The estate tax and residuary funding amount can be calculated as follows:23
Step 1 Calculate the estimated range of the taxable estate:
R = (E-D) - ((E-D-S) x f)
R = $3,812,500
Step 2 Select the a slope and b intercept corresponding to R from the following table:
Taxable Estate a
Slope b
$600,000 - $700,000 .37 -222,000
$750,000 - $1,000,000 .39 -237,000
$1,000,000 - $1,250,000 .41 -257,000
$1,250,000 - $1,500,000 .43 -282,000
$1,500,000 - $2,000,000 .45 -312,000
$2,000,000 - $2,500,000 .49 -392,000
$2,500,000 - $3,000,000 .53 -492,000
$3,000,000 - $10,000,000 .55 -552,000
$10,000,000 - $21,040,000 .60 -1,052,000
Step 3 Once the a and b parameters are identified, the following formula can be used to calculate the estate tax:
X = (aT - afT + afS + b) / (1- af)
X = $1,791,159 where:
T = (E-D)
Step 4 Calculate the amount to be transferred to the charitable lead trust:
Adjusted Gross Estate $5,000,000
Less: Estate Deductions $250,000
Less: Specific Bequests $1,000,000
Less: Estate Tax $1,791,159
Equals: Amount to Charitable Lead Trust $1,958,841
IRC §§2522(c)(2)(B) and 2055(e)(2)(B); Regs. §§25.2522(c)-3(d) and 20.2055-2(f)back
Reg. §§1.664-2(a)(4); 1.664-3(a)(4)back
Lober v. United States, 346 U.S. 335 (1953)back
Ltr. Rul. 9737023back
IRC §2613(a)(1)back
IRC §2651(b)back
IRC §2651(e); See also Ltr. Rul. 9123052back
IRC §2631back
Reg. §26.2632-1(a)back
Reg. §26.2632-1(b)(2)(i)back
IRC §2642(e); Reg. §26.2642-3(a); Technical and Miscellaneous Revenue Act of 1988back
Reg. §26.2642-2(a)back
Reg. §26.2642-2(b)back
IRC §2603(a)(2)back
Reg. §26.2654-1(b)(1); See Ltr. Ruls. 9803013 and 9738018 for examples of the IRS granting extensions of time to make the reverse QTIP election to accommodate the allocation of the GSTT exclusion to transfers involving charitable lead trusts. See also Ltr. Ruls. 9501038 and 9123052back
Ltr. Rul. 9144016back
Ltr. Rul. 9512016back
IRC §2044back
TAM 9419006back
Formula provided by Stanley L. Klein, Ph.D.back
Qualified grantor and nongrantor charitable lead trusts are not technically private foundations; however, because they are considered split-interest trusts, they are required to include provisions that prohibit them from violating certain of the private foundation excise tax rules.1 Following is a brief overview of these rules:
All qualified charitable lead trusts are subject to private foundation excise taxes imposed on acts of self-dealing between the foundation manager (i.e., the trustee) and a disqualified person.
Acts of self-dealing generally include a sale, exchange or lease, loan or other credit (except a loan that bears no interest), furnishing goods, services or use of trust property, or payment of compensation, income or use of assets, between a private foundation (charitable remainder trust) and a disqualified person.2
With respect to a charitable lead trust, a disqualified person is a:
substantial contributor (a person who contributes more than $5,000 or the creator of the trust); 3
trustee (foundation manager);
person who owns more than 20% of:
-voting power of a corporation,
-profit interest in a partnership, or
-the beneficial interest of a trust or unincorporated enterprise, where the entity is a substantial contributor to the trust;
spouse, ancestors, children, grandchildren, great grandchildren, and their spouses, of persons previously described; or
corporation, partnership, trust, estate or enterprise of which more than 35% of the total ownership, and the rights thereof, are owned by persons previously described.
Taxes Imposed on Acts of Self-Dealing
An initial tax of five percent of the amount involved is imposed on the disqualified person even though he may not have knowingly committed a prohibited act.4 An additional tax of two and one-half percent is levied on the trustee who willfully participates in an act of self-dealing knowing it was such an act unless he has reasonable cause.5
If the act of self-dealing is not corrected during the taxable period or correction period, an additional tax of 200% of the amount involved is imposed on the disqualified person and a tax of 50% (to a limit of $10,000) is imposed on the trustee if the trustee refuses to agree to all or part of the correction.6
Administration of Estate Assets
The Service has ruled privately that a sale of estate assets by a fiduciary preceding and pursuant to the funding of a testamentary charitable lead trust is not an act of self-dealing.7 In a separate ruling, the Service held that a non-pro rata distribution of estate properties between charitable and noncharitable trusts did not constitute an act of self-dealing by the executors.8
Special Exception for Disqualified Corporations
Recall from the discussion of closely-held stock, a transaction between a charitable remainder trust and a corporation that is a disqualified person (e.g., a redemption) is not an act of self-dealing if the offer to purchase stock is made to all shareholders and on the same terms.9 In a separate ruling, the IRS stated that the retention by the trustee of a charitable remainder trust of a majority interest in a closely-held corporation is not a transaction that constitutes a prohibited act of self-dealing under IRC §4941.10
In a situation where a parent corporation owned subsidiary corporations involved separately in securities sales, lending, and trust services, transactions between the charitable remaindermen of charitable remainder trusts (for which the trust companies served as trustee) and the other related firms were not deemed prohibited acts of self-dealing. The Service stated, "these rules do not run upstream and thus the corporate parent of a foundation manager [trustee] is not a disqualified person with respect to the private foundation [charitable trust] merely by reason of stock ownership in the manager."11
Merger of Corporations Owned by Charitable Remainder Trust and Income Recipient Not Self-Dealing
A charitable remainder unitrust owned stock in two corporations. The income recipient of the unitrust was a shareholder, officer, and director of one of the corporations. The corporations proposed to merge; however, would the transaction be a prohibited act of direct or indirect self-dealing?
IRC §4941(d)(2)(F) provides that any transaction between a private foundation and a corporation which is a disqualified person (as defined in IRC §4946(a)), pursuant to any liquidation, merger, redemption, recapitalization, or other corporate adjustment, organization, or reorganization, shall not be an act of self-dealing if all of the securities of the same class as that held by the foundation are subject to the same terms and such terms provide for receipt by the foundation of no less than fair market value.
Section 53.4941(d)-3(d)(1) of the regulations states that all of the securities are not subject to the same terms "unless, pursuant to such transaction, the corporation makes a bona fide offer on a uniform basis to the foundation and every other person who holds such securities."
The merger transaction would include a bona-fide offer made on a uniform basis with all holders of stock receiving the same number of shares of the acquiring corporation's stock. Thus, all the securities of the same class would be subject to the same terms. The Service approved the transaction.12
Application of Self-Dealing Rules to Employee Stock Ownership Plans
The definition of disqualified person includes any person who is an owner of more than twenty percent of the total combined voting power of a corporation that is a substantial contributor to a private foundation.13
The phrase combined voting power means the voting power represented by holdings of voting stock, actual or constructive, but does not include voting rights held only as a director or trustee.14
An Employee Stock Ownership Plan's stock is subject to the direction of the individuals on whose behalf the shares have been allocated and to whom the beneficial interest in the shares has passed. Therefore, to the extent the ESOP trust has any voting power with respect to the corporation's stock, it is merely the voting power of a trustee. Thus, although the ESOP trust may hold legal title to any amount of stock that exceeds twenty percent of the total combined voting power of the corporation, it is not treated as the owner of the stock, for purposes of IRC §4946(a)(1)(C).
Rev. Rul. 81-76 holds that an ESOP as described in IRC §4975(e) is not treated as the owner of stock in a corporation where the stock is allocated to participating employees and, thus, is not a disqualified person.15
Transfers of Debt-Encumbered Property and Self-Dealing
Qualified charitable lead trusts can, under certain circumstances, receive contributions of debt-encumbered property. The Code provides that the transfer of real or personal property by a disqualified person to a charitable lead trust shall be treated as a sale or exchange if the property is subject to a mortgage or similar lien which the trust assumes or if it is subject to a mortgage or similar lien which a disqualified person placed on the property within the ten-year period ending on the date of the transfer.16 This exception does not apply, however, if the trust pays any part of the indebtedness.17 Other portions of this text deal with the unrelated business income tax issues associated with the receipt by the trust of debt-financed income.
Trust Established in Satisfaction of Irrevocable Charitable Pledge or In Exchange for Recognition Ruled Self-Dealing
An individual made a legally binding pledge in 1987 to an educational institution that was a public charity. Upon receipt of a portion of the pledge the educational institution was obligated to rename itself after the individual, which it did. There remained a large balance left to contribute to the institution in satisfaction of the pledge.
The individual then proposed to create a charitable remainder trust that named the institution as the recipient of its remainder interest. When the remainder interest was distributed to the institution at the termination of the charitable remainder trust, the fair market value of the assets distributed would be applied against the individual's remaining irrevocable pledge balance. The individual proposed to amend and restate his irrevocable pledge agreement with the institution to include the charitable remainder trust as a legal party to the agreement.
In a 1992 private ruling, the Service held that the pledge agreement by the individual and his charitable remainder trust in consideration for the educational institution's name change to a name containing part of the individual's name did not constitute an act of self-dealing between the trust and the disqualified person. Further, the benefit to the individual, public acknowledgment and recognition, was ruled to be incidental and tenuous under the regulations and previously cited revenue rulings.18
In substantiation of the holding, the Service cited Revenue Ruling 73-407 which provides that a contribution by a private foundation to a public charity made on the condition that the public charity change its name to that of a substantial contributor to the foundation and agree not to change its name again for 100 years does not constitute an act of self-dealing under IRC§4941(d)(1)(E). 19
In Ltr. Rul. 9714010, the Service revoked Ltr. Rul. 9233053, citing Reg. §53.4941(d)-2(f)(1) which provides that if a private foundation makes a grant or other payment which satisfies the legal obligation of a disqualified person, such grant or payment shall ordinarily constitute an act of self-dealing. An agreement, whereby the remainder interest in the trust is credited toward a legally enforceable pledge, results in a use of trust assets for the benefit of the grantor and, therefore, is an act of self-dealing. The regulation contains an exception to the general rule for payments in satisfaction of pledges made on or before April 16, 1973, so long as the disqualified person obtained no other substantial benefit. In the present case, the pledge occurred in 1986.
In its explanation, the Service stated that it had relied inappropriately on the more general provisions of Reg. §53.4941(d)-2(f)(2), concerning incidental or tenuous benefits as received by a disqualified person as cited by Rev. Rul. 73-407. Moreover, the ruling's reliance on Rev. Rul. 77-160 was also misplaced because that ruling does not concern a legally enforceable pledge.
The donor's request for relief under IRC §7805(b), which permits the donor to rely upon the findings of the original ruling, was granted.
Although these rulings dealt with the use of a charitable remainder trust, we see no reason why the same logic should not apply to a grantor or nongrantor charitable lead trust. The Service has not ruled on this theory; however, given the otherwise obvious planning compatibility of using a charitable lead trust to satisfy an existing pledge, donors and advisors are strongly urged to proceed with caution and may be well advised to obtain an advance ruling.
Interest-Free Loan from Disqualified Person to Trust Permissible
The lending of money by a disqualified person to a private foundation is not a prohibited act of self-dealing as long as the loan is without interest or other charge and the proceeds are used exclusively for purposes described in IRC §501(c)(3). Furthermore, the imputed interest rules of IRC §7872 do not apply.20 A loan may cause the trust to have acquisition indebtedness, however.
Reasonable Compensation to Disqualified Person Not Self-Dealing
The payment of compensation from a private foundation to a disqualified person for personal services necessary to carrying on the tax-exempt purposes of a private foundation is a permitted exception to the self-dealing rules provided such compensation is not excessive.21
Excess Business Holdings
The excess business holdings rules of IRC §4943 can present special challenges to the planning opportunities involving family owned business interests. The Code provides that a charitable lead trust is not subject to the excess business holdings rules unless the present value of the charitable income interest exceeds 60 percent of the aggregate fair market value of all trusts assets on the date of creation.22 For nongrantor lead trusts, the cost of avoiding the excess business holdings rules requires subjecting at least 40 percent of the trust assets to gift or estate tax.
In the event a charitable lead trust is subject to the excess business holdings rules, it is subject to the percentage limitation rules that follow:
20% Rule for Corporate and Partnership Holdings
A charitable lead trust's corporate or partnership holdings will not be considered excessive provided such holdings do not exceed 20 percent of the voting stock or profits interest, reduced by the percentage of the voting stock or profits interest owned by all disqualified persons.
In any case in which all disqualified persons together do not own more than 20 percent of the voting stock of an incorporated business enterprise, nonvoting stock or capital interest held by the trust shall also be treated as permitted holdings.
35% Rule Where Third Party Controls Enterprise
Notwithstanding the previous paragraphs, a charitable lead trust's business holdings will not be considered excessive if the trust and all disqualified persons together do not own more than 35 percent of the voting stock of an incorporated business enterprise or profits interest of a partnership, and it is established that effective control of the corporation or partnership vests with one or more persons who are not disqualified persons with respect to the foundation.
2% De Minimis Rule
A charitable lead trust will not have excess business holdings in any corporation in which it (together with all other private foundations which are described in IRC §4946(a)(1)(H)) owns not more than two percent of the voting stock and not more than two percent in value of all outstanding shares of all classes of stock.
Treatment of Sole Proprietorships
The percentage limitation rules discussed above do not apply to interests in a sole proprietorship. Any holdings in a sole proprietorship are considered excess for purposes of the excess business holdings rules.
Five Year Rule for Disposition of Excess Business Holdings
The term "excess business holdings" means the amount of stock or other interest in the enterprise which the trust would have to dispose of to a person other than a disqualified person in order for the remaining holdings of the trust in such enterprise to be permitted holdings. When a charitable lead trust is determined to have excess business holdings, the trustee is allowed five years to dispose of such excess holdings prior to imposition of a tax. Upon showing good cause, the terms of which are enumerated in the Code, the IRS may grant an additional five-year extension.23
Penalties for Failure to Dispose of Excess Business Holdings
In the event the trustee of a charitable lead trust fails to dispose of excess business holdings in the manner prescribed above, there shall be imposed on the excess business holdings of the trust a tax equal to five percent of the value of such holdings.
The tax is imposed on the last day of the trust's tax year based on the greatest amount of excess holdings at any time during the taxable year. If the excess business holding is not disposed of by the close of the tax year, an additional tax equal to 200 percent of such excess business holding is imposed.
Jeopardizing Investments
Charitable lead trusts may also be subject to private foundation excise taxes on jeopardizing investments. The Code provides that a charitable lead trust is not subject to the rules prohibiting jeopardizing investments unless the present value of the charitable income interest exceeds 60 percent of the aggregate fair market value of all trusts assets on the date of creation.24 If applicable, an excise tax is imposed on the trustee that invests in a manner that would jeopardize the trust's tax-exempt purpose (i.e., providing an income interest to an IRC §170(c) organization.
No category of investments is treated as a per se violation. However, the Service will closely scrutinize trading on margin (which will also cause debt-financed income), trading in commodity futures, investments in working interests in oil and gas wells, calls, puts, straddles, warrants, and selling short.25
Even though a violation of the rule might not cause an excise tax, a trustee that fails to exercise ordinary business care and prudence in balancing the competing interests of the income recipient and remainderman may become subject to liability.
Private Foundation Expenditures
Private foundation expenditures as described in IRC §4945 are not relevant to charitable lead trusts because such trusts are prevented from making payments to anyone other than charitable organizations or the noncharitable remaindermen. Therefore, a trustee would never make political contributions, grants to individuals, or donations to private foundations as contemplated in this section.
An exception to the private foundation expenditure rules exists for payments for full and adequate consideration (e.g., trustee, administrative, investment management fees, etc.).26
IRC §§4947(a)(2) and 508(e)back
IRC §4941(d)(1)back
IRC §507(d)(2)back
IRC §4941(a); Reg. §53.4941(a)-1(a)back
IRC §4941(a)(2)back
IRC §4941(b)(2)back
Ltr. Rul. 8942054back
Ltr. Rul. 9438045back
IRC §4941(d)(2)(F); Ltr. Rul. 9015055back
Ltr. Rul. 9210005; See also Ltr. Rul. 9721035back
Ltr. Rul. 9451069back
Ltr. Ruls. 9734015; 9734016; 9734017; 9734018; 9734019back
IRC §4946(a)(1)(C)back
Reg. §53.4946-1(a)(5)back
Rev. Rul. 81-76, 1981-1 C.B. 516, See also Ltr. Rul. 9542040back
IRC §4941(d)(2)(A)back
Ltr. Rul. 9241064; See discussion regarding application of the debt-financed income rules of IRC §514(c)(2)(B).back
Ltr. Rul. 9233053back
Rev. Rul. 73-407, 1973-2 C.B. 383back
IRC §4941(d)(2)(B)back
IRC §4941(d)(2)(E)back
IRC §4947(b)(3)(A)back
IRC §§4943(c)(6) and (c)(7)back
Reg. §53.4944-1(a)(2)back
Reg. §1.664-2(a)(4)back
7520 Rates: February 2.8% January 2.6% December 2.6%