Tax Court Issues Opinion on Valuing Remainder Interest in NIMCRUT for Purposes of 10% Remainder Interest Requirement

Tax Court Issues Opinion on Valuing Remainder Interest in NIMCRUT for Purposes of 10% Remainder Interest Requirement

Article posted in Charitable Remainder Trust on 8 September 2015| comments
audience: National Publication, Richard L. Fox, Esq. | last updated: 9 September 2015
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Summary

Author Richard Fox explores the implications of a recent Tax Court Case, Estate of Schaefer, on the calculation of the 10% Remainder Interest qualification necessary when establishing Charitable Remainder Trusts.

By: Richard L. Fox, Esq.

Background on 10% Remainder Interest Requirement for Charitable Remainder Trusts

The present value of the remainder interest for both a charitable remainder annuity (CRAT) and charitable remainder unitrust (CRUT) must be at least equal to 10% of the initial net fair market value of the property transferred to the trust.  IRC §§ 664(d)(1)(D) (annuity trusts), 664(d)(2)(D) (unitrusts). The 10% minimum remainder interest rule was added by the Taxpayer Relief Act of 1997, which also imposed the rule that the annual annuity or unitrust payment cannot exceed 50%.  These new requirements were added as a result of Congressional concerns that charitable remainder trusts (“CRTs”) were being inappropriately utilized for noncharitable purposes. The applicable IRC § 7520 interest rate is used to determine whether the 10% threshold has been met. Where the actuarial value of the interest of the charitable remainder interest is less than the minimum 10% requirement, the trust will not qualify as a CRT under IRC § 664. This means that not only does the donor not obtain a charitable income, gift or estate tax deduction for the transfer of property to the trust, but also that the trust is not a tax-exempt trust for its own income tax purposes.

NICRUTs and NIMCRUTs

Unlike a CRAT, a CRUT may contain a net income limitation, either with or without a provision for subsequent “make-up” payments.  Under a net income CRUT (NICRUT), the annual unitrust payment is limited to the lesser of (1) a fixed percentage of the net FMV of the assets of the trust revalued on an annual basis, i.e., the standard unitrust payment, or (2) the amount of the trust income. Where this limitation applies, there is no subsequent “make-up” payment in future years in the event that the income of the trust should subsequently exceed the standard unitrust payment amount, notwithstanding that the prior year payouts were limited to the income of the trust (because it was less than the standard unitrust payout amount). Rather, in such a case, the payment will be limited to the standard unitrust payment amount, even where the trust income is greater and payments in prior years were limited to income.

Just as in the case of a NICRUT, the unitrust payment for a CRUT with a make-up provision, or NIMCRUT, is limited to the lesser of (1) a fixed percentage of the net FMV of the assets of the trust revalued on an annual basis, i.e., the standard unitrust payment amount, or (2) the amount of the trust income. However, a NIMCRUT contains a “make-up provision” providing that for any year for which the income of the trust is less than the standard unitrust payment, such deficiency is to be made up in subsequent years to the extent that the income of the trust exceeds the standard unitrust payment amount in such years.

Calculation of Charitable Deduction for NICRUTs and NIMCRUTs

IRC § 664(e) (“Valuation for purposes of charitable contribution”) provides that for “purposes of determining the amount of any charitable contribution, the remainder interest of a charitable remainder annuity trust or charitable remainder unitrust shall be computed on the basis that an amount equal to 5 percent of the net fair market value of its assets (or a greater amount, if required under the terms of the trust instrument) is to be distributed each year.”   While IRC § 664(e) is not the model of clarity in the context of a NICRUT or NIMCRUT, the treasury regulations regarding the available deduction for a contribution to a NICRUT or NIMCRUT, which are designed to ensure that the charitable deduction is not inflated, require the assumption that a NICRUT and NIMCRUT will distribute to the noncharitable beneficiary an amount based on the stated unitrust percentage distribution rate of the NICRUT and NIMCRUT, notwithstanding that the noncharitable beneficiary's actual distributions may be less (and charitable remainder beneficiary's payment more) due to the presence of the net fiduciary accounting income limitation.  Regs. 1.664-4(a)(3) and 1.664-3(a)(1)(i)(a).  The IRS believes that the noncharitable beneficiaries of a NICRUT and NIMCRUT have a “potential right” to receive amounts in excess of net income, “a right that is dependent on the happening of events which are not so remote as to be negligible”[1] and, therefore, for purposes of computing the charitable income tax deduction, the “charitable remainder interest must be minimized to reflect amounts that reasonably may be paid to the beneficiaries.”[2]  For purposes of determining the amount of the charitable contribution, the remainder interest is computed on the basis that an amount equal to the fixed percentage unitrust amount is to be distributed each year, without regard to the possibility that a smaller amount of trust income may be the amount distributed.

New Tax Court Case Addresses Calculation of 10% Remainder Interest Rule in the Case of a NIMCRUT

In Estate of Schaefer, 145 T.C. No. 4 (July 28, 2015), during his lifetime, the decedent established two irrevocable charitable remainder trusts.  The decedent was the beneficiary during his lifetime and, upon his death, one of his sons became the beneficiary of one trust and the other son became the beneficiary of the other.  Each trust was designed so that one of the decedent’s sons would receive distributions during his life or a term of years, with the remainder going to charity. The trust instruments directed the trustees to distribute the lesser of: (1) each trust’s annual income; or (2) a fixed percentage (for one trust, the fixed percentage was 10% and for the other trust it was 11%).  If the trust income exceeded the fixed percentage, the trustee was directed to make additional distributions to make up for previous years when the trust income did not yield enough to satisfy a distribution of the fixed percentage. Thus, the trusts were NIMCRUTs.

Because the decedent was a beneficiary of the NIMCRUTs during his, the NIMCRUT was included in the decedent’s gross estate. The estate claimed it was entitled to an estate tax charitable deduction for the values of the charitable remainder interests of the two irrevocable trusts.  The IRS determined that the estate was not entitled to the deduction because the value of the remainder interest for each trust did not equal 10% of the net fair market value of the property contributed to the trust at the time of contribution.  The IRS based its calculation assuming distributions would equal the fixed percentage of the NIMCRUT’s assets, without regard to the net income limitation. The estate disagreed, and countered that the distributions were to be determined using the expected net income according to the applicable IRC § 7520 rate so long as the rate is above 5%.

The Tax Court found that IRC § 664(e) and the regulations thereunder were ambiguous in determining how to value a remainder interest in a NIMCRUT.  The court then looked to the legislative history regarding net income CRUTs and quoted the following Senate report language:

A second modification of the annuity trust and unitrust rules made by the committee provides that the charitable remainder trust must be required by the trust instrument to distribute each year 5 percent of the net fair market value of its assets (valued annually in the case of a unitrust and valued at the time of the contribution in the case of an annuity trust) or the amount of the trust income, whichever is lower. In valuing the amount of a charitable contributions deduction in the case of a remainder interest given to charity in the form of an annuity trust or a unitrust, it is to be computed on the basis that the income beneficiary of the trust will receive each year the higher of 5 percent of the net fair market value of the trust assets or the payment provided for in the trust instrument.

S. Rept. No. 91-552, supra at 89-90, 1969-3 C.B. at 481. The court stated that the “Senate report makes clear that where there is a net income provision, the distribution amount or rate set forth in the trust instrument is to be used for valuation purposes even though distributions may be limited by net income.” The court also found that the guidance issued by the IRS on this issue is “wholly consistent” with this legislative history, citing Rev. Rul. 72-395, sec. 7.01, 1972-2 C.B. at 349-350, and Rev. Proc. 2005-54, sec. 6.09, 2005-2 C.B. at 363, which specifically indicate that  for purposes of determining the amount of the charitable contribution, the remainder interest is computed on the basis that an amount equal to the fixed percentage unitrust amount is to be distributed each year, without regard to the possibility that a smaller or larger amount of trust income may be the amount distributed.  The court noted that it was not bound by IRS rulings or procedures, but stated that “we do owe them the appropriate level of deference.”

            On the basis of the legislative history and administrative guidance, the court held that in determining the value of the remainder interest for purposes of the 10% requirement, “the estate must use an annual distribution amount of 11% or 10% of the net fair market value of the trust assets when valuing the remainder interests” of each trust, without regard to the income limitation otherwise applicable. Because the value of the remainder interest using this methodology was less than 10%, the court upheld the IRS determination that the estate tax charitable contribution deduction was not allowable.

Comments: It is interesting that the Tax Court found that regulations in this area to be ambiguous, as it has been generally consensus among practitioners that the combination of Regs. 1.664-4(a)(3) and 1.664-3(a)(1)(i)(a) require the net income limitation for a NICRUT or NIMCRUT to be disregarded in determining the value of the charitable remainder interest.   In any event, the decision of the court in this case is in line with the thinking. 

Query:  The 10% minimum remainder interest requirement is found at IRC §§ 664(d)(1)(D) (for annuity trusts), 664(d)(2)(D) (for unitrusts), both of which require that “the value (determined under section 7520) of [the] remainder interest is at least 10 percent of the initial net fair market value of all property placed in the trust.”   In determining such value, the Tax Court relied upon IRC § 664(e), which, on its face, only applies to determining the value of the remainder interest for “purposes of determining the amount of any charitable contribution.”  Query whether a “charitable deduction” valuation methodology, designed to ensure that the value of the charitable deduction is not inflated, necessarily should be applied for purposes of the 10% minimum remainder interest requirement.  As discussed below, in determining the value of the remainder interest upon the early termination of a NIMCRUT, the IRS disregards the fixed percentage payout where it is greater than the IRC § 7520 rate, and generally bases its calculation of the value of the remainder interest on the assumption that the noncharitable beneficiary’s annual payment will be limited to net income. 

Valuation Issues Upon Early Termination of NIMCRUT

In the context of the early termination of a NICRUT or NIMCRUT, an interesting issue arises regarding how the net income limitation affects the valuation of the term interest. There are a number of private letter rulings addressing this issue in the context of the early termination of a NIMCRUT.  Given that the payout by a NIMCRUT and NICRUT is limited to net fiduciary accounting income (subject to a makeup payment in the case of a NIMCRUT), special consideration must be given in determining the appropriate amount of the distribution to a noncharitable beneficiary, because an overpayment to a noncharitable beneficiary in this context, according to the IRS, will result in an act of self-dealing under IRC § 4941.  The IRS rulings provide that the appropriate calculation of the actuarial value of noncharitable interests in a NIMCRUT, taking into account the net income provisions, requires the use of a reasonable method for the calculation that does not inappropriately inflate the value of noncharitable interests to the detriment of the charitable remainder beneficiary. These rulings have stated that “one reasonable method to calculate the actuarial value of the income and remainder interests” upon the early termination of a NIMCRUT is to use the lesser of the stated percentage distribution rate of the NIMCRUT or the Section 7520 rate in effect for the month of termination, with the Section 7520 rate representing the deemed rate of income to be earned by the trust.

Using this approach in the current near-record low Section 7520 rate environment has the effect of dramatically reducing the value of the term interest in a NIMCRUT, thereby resulting in a much lesser distribution to the noncharitable beneficiary upon an early termination than if the net income limitation were not considered.  In Ltr. Rul. 201325021, for example, the distribution of funds to the noncharitable beneficiaries upon the early termination of a NIMCRUT, which was to occur in either March or April 2013, was based on the Section 7520 rate of 1.40% in effect for those months, substantially less than the unitrust payout percentage provided under the trust. The IRS ruled favorably on the IRC § 4941 self-dealing issue, stating that as a result of this methodology, “the income beneficiaries are not expected to receive more than they would during the full term of Trust under the above-described methodology for valuing their interests in a charitable remainder trust with a net income make-up feature.”

The IRS ruling's approach to valuing the noncharitable term interest upon the early termination of a NIMCRUT directly contrasts with the valuation method required under applicable Treasury regulations for computing the charitable income tax deduction upon the creation of a NIMCRUT (or a NICRUT) and the decision of the Tax Court in  Estate of Schaefer, both as discussed above.  The IRS's valuation approach has been subject to criticism because for purposes of computing the charitable deduction upon its creation, the net income limitation is simply ignored in valuing the charitable remainder interest. In a letter to the IRS dated 4//4/08, the Committee on Estate and Gift Taxation of the New York City Bar Association urged the adoption of a “consistent approach to valuation of the income interest when the NIMCRUT is created and upon early termination protects all parties” and, accordingly, asserted that the IRS should similarly ignore the net income limitation in determining payouts to noncharitable beneficiaries upon the early termination of a NIMCRUT.  The letter concludes that “we urge you to issue a published ruling confirming that the proper method for valuing the income interest and the remainder interest of a NIMCRUT that is being terminated early is the same method that is used to value those interests when a NIMCRUT is created.” No such published ruling has ever been issued.

Clearly, the IRS is taking an inconsistent approach in this matter. For charitable income tax purposes, the IRS assumes that, regardless of the net income limitation, the noncharitable beneficiary of a NIMCRUT will receive the full amount of the payments based on the stated unitrust payout percentage, thereby minimizing the charitable deduction. For self-dealing purposes, however, it assumes that only the fiduciary accounting net income (based on the Section 7520 rate in the month of termination) will be paid to the noncharitable beneficiary, thereby minimizing the payout to the noncharitable beneficiary.

While the valuation methods applied by the IRS upon the creation of a NIMCRUT and its early termination are indeed inconsistent, the philosophy used in applying different methods arguably is consistent, in that the methods are, respectively, aimed at preventing an inflated charitable income tax deduction upon creation and an inflated distribution to noncharitable beneficiaries upon an early termination. Query, too, whether a charitable remainder beneficiary, or the state attorney general or court having jurisdiction over the NIMCRUT, would agree that the net income limitation under a NIMCRUT should be ignored in computing the payout to a charity simply because tax regulations ignore the limitation for purposes of computing a settlor's charitable income tax deduction. Because of their varying payout structures, different valuation methods arguably should be applied upon an early termination of a CRUT containing a net income limitation, depending on whether it is a NICRUT, a NIMCRUT, or a FLIP CRUT, adding even more complexity to this issue. The calculation method used by the IRS in private letter rulings in the context of NIMCRUT early terminations was labeled as “one reasonable method,” an indication that the IRS may consider other calculation methods to be reasonable. Because the IRS will no longer issue private letter rulings on early terminations of CRTs, obtaining a ruling on another possible valuation method is, however, no longer possible.

Of course, the valuation issue raised on the early termination of a NIMCRUT can be avoided by the noncharitable beneficiary selling the term interest to an unrelated third-party, rather than participating in an early termination transaction, whereby the two parties to the sale transaction can set the price as they may ultimately agree. This transaction would not be subject to the self-dealing rules of Section 4941, as the payout does not come from the CRT or from a charity in which the noncharitable beneficiary is a disqualified person, but from a third-party, in which case the amount ultimately passing to the charitable remainder beneficiary will not be affected.



[1] Note that in the context of the charitable income tax deduction, if a transfer for charitable purposes may be defeated by the performance of some act or the happening of some event, no deduction is allowable unless the possibility that such act or event will occur is “so remote as to be negligible.” Reg. 1.170A-1(e).

[2] See Ltr. Ruls. 201325018—201325021.

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