By Russell A. Willis III, J.D., LL.M.
The charitable remainder trust, and its many variations, remains a valuable tool for the charitably minded. Often the settlor of a charitable remainder trust, however, will want to provide an annuity or unitrust benefit for someone other than him- or herself—a spouse, child, sibling or parent. Complications may arise if the annuity or unitrust interest is not immediate, if it otherwise does not qualify for a marital deduction, or if the present value of the income stream exceeds the gift tax annual exclusion.
The following vignette explores the gift and estate tax issues that can arise in connection with designing a charitable remainder trust from which someone other than the settlor is to receive an annuity or unitrust payout.
Industrialist and philanthropist Oliver W. has asked you to assist him in designing a trust that will provide a reliable stream of income for his adopted daughter, Annie B., for 20 years, with the remainder to benefit his alma mater, the School of Hard Knocks, a 501(c)(3) organization. While discussing this idea with you, Oliver also mentions that he is considering marrying his longtime personal assistant, Grace F., and suggests that he may want to set up a similar plan for her—possibly for her life, rather than for a term of years. Oliver is 62 years old, Annie is 18 and Grace is 34.
You begin by acquainting Oliver with the basic principles of charitable remainder trusts: the fixed annuity or a variable unitrust payout; 5 percent or more; net income with or without makeup; the income tax deduction for the charitable remainder; present value at least 10 percent; and so on.
A Plan to Provide for Annie
The next step is putting some numbers together for Annie’s circumstances. You suggest a 20-year trust1 funded with $100,000 of marketable securities, paying $5,000 per year to Annie for the lesser of her life or 20 years, and generating a charitable contributions deduction of a little more than $22,000.
“However,” you caution, “by the same math, the present value of the annuity to Annie is almost $78,000. And although the gift to her of an ‘income’ interest is a present interest gift, eligible for the $13,000 annual exclusion,2 everything above that amount would be a taxable gift, reducing your $1 million lifetime exemption.”
Oliver asks, “Is there a way around that?”
“Yes,” you say. “You could reserve a power to revoke the annuity, which you could exercise only in your will.3 The result would be that the annuity would be a completed gift to Annie only as it is actually paid out.”
“Exercise only in my will. I know you want to tell me the logic of that rule.”
“Yes, it has to do with whether the trust is a ‘grantor’ trust for income tax purposes.”
“Nevermind that,” Oliver says. “What about setting up something similar for Grace?”
Oliver presents a general idea of what he wants to accomplish: “I want something that will provide for her lifetime, with some protection against inflation. And would it make a difference if I married her?”
“It could,” you say, “if we set up the trust in such a way as to qualify for a gift tax marital deduction. Ordinarily, if a trust that pays out something other than the entire net income to a spouse—here, a unitrust amount—and the remainder goes to a third party, it would not qualify for the marital deduction. There is, however, a specific exception in the tax code for charitable remainder trusts.4
“Again, to put some numbers to it, the present value of the charitable remainder after a 5 percent unitrust for Grace’s life would be nearly $15,000,5 and the present value of the payout to her would be more than $85,000, but you would not need to worry about the annual exclusion or the lifetime credit because of the marital deduction.”
Oliver appears to be calculating something. “The idea being,” he says finally, “that the tax people expect her to live a certain number of years.”
“Forty-three and a half,” you confirm.
“But if she doesn’t, Hard Knocks gets its money early, and I don’t get any further tax benefit. What would happen if we made the unitrust payable to me after Grace’s death?”
“That’s an interesting idea,” you admit. “The arrangement actually would qualify for the gift tax marital deduction under the exception I just mentioned.” A smile of self-satisfaction flickers across Oliver’s face.
“Of course,” you continue, “the present value of the remainder, the income tax deduction, would be slightly less, more like $13,314.6 The actuarial likelihood that you will outlive Grace is not very high. Though if you did survive her, you could accelerate the remainder to Hard Knocks and take an income tax deduction for the then-present value of your unexpired unitrust interest.”
The QTIP Alternative
“Another approach,” you offer, “would be simply to make this a type of income trust, called a QTIP (qualified terminable interest property) trust, with no charitable deduction at all for now. You could authorize the trustee to distribute principal to Grace if she needed it. Assuming Grace survived you, the contingent income interest to you would simply lapse, or if you survived, the remainder to Hard Knocks at your death would be deductible in your estate. Or…”
Oliver holds up his hand. “One thing at a time. Why wouldn’t there be a charitable deduction now?”
“It is because this would not be in the form of an annuity or unitrust.” And you give him a brief history of the 1969 legislation that closed down the former abusive practice of setting up a trust that paid income to an individual beneficiary with a remainder to charity, claiming a deduction for the present value of the remainder, but then investing the trust entirely in high yield, zero growth assets.
Oliver nods. “All right,” he says. “The QTIP will pay income to Grace for her life and offer discretionary distributions of principal, but I receive no charitable deduction at the front end. Plus the QTIP pays a contingent income interest to me if I survive her. Suppose she dies before I do, but I have no need for the income. Can I claim a deduction for accelerating the remainder to Hard Knocks?”
“I can see an argument for that position,” you say cautiously, “but there might be a question under what is called the ‘partial interest rule.’7 Certainly you could disclaim the income interest, which would have the effect of trading a marital deduction for a charitable deduction in Grace’s estate, assuming her estate was taxable. Or you could simply turn the income over to Hard Knocks as it came in, which could work out to be a wash and would spread the deductions out over your lifetime, rather than taking the deduction in one year with a five-year carryforward.”
Oliver seems momentarily distracted. “If Grace’s estate were taxable,” he muses, “that would be, what, something over $3.5 million?”
“This year, yes,” you say. “Estate taxes are repealed in 2010, but in 2011 are reinstated at the $1 million level, unless Congress makes some changes.”
Circumstances That Require Further Consideration
Thinking ahead, you begin, “You know, Oliver,…”
“Yes,” he says. “We might not still be married when this all comes down.”
You continue, “If we set this up as a QTIP, we could make any provision for discretionary distributions of principal conditional on her remaining married to you. Contrarily, if we set this up as a net income unitrust with makeup, we could have it flip to a straight unitrust in the event of your divorce, trapping any accrued deficits in the trust.”
“But could we provide that in the event of divorce the unitrust payout goes instead to Annie?” Oliver asks.
“That would disqualify the trust for the gift tax marital deduction,”8 you note. “Also, the present value of the remainder after two lives, with Annie being as young as she is, would be nowhere near the required 10 percent. What we could do, though, is limit the trust to a term of 20 years and have you reserve a testamentary power to revoke the unitrust payout to either beneficiary, so that, again, the gift would be complete only as the distributions were actually paid out to either Grace or Annie.”
“Let’s stay with the idea of creating an income stream for Grace for her lifetime,” Oliver says. “Presumably my lawyers will put together some elaborate prenuptial agreement, providing some reasonably substantial benefit to Grace in exchange for her waiving claims to something even more substantial. Could this trust, whether it is a charitable remainder trust or a QTIP, be set up as a part of that agreement?”
“It could,” you say, “provided the transfer is made after the marriage is formalized. You cannot claim a gift tax marital deduction for a transfer to someone who is not yet your spouse. The U.S. Treasury has adopted a regulation9 saying that a transfer in exchange for a waiver of marital rights at the outset of a marriage is not ‘consideration’ in money’s worth. Whereas if you entered a similar arrangement after you were married, such as a divorce settlement within two years before or one year after the decree, it would be a taxable exchange.”10
Oliver glances at his watch and leaps to his feet. “Anything else I need to know?”
Review Objectives and Outcomes
“We have talked about having you reserve a testamentary power to revoke someone’s annuity or unitrust interest in order to make the gift incomplete for tax purposes,” you remind him. “In those scenarios, if you died holding that power, or within three years of relinquishing the power,11 the unexpired annuity or unitrust interest would be included in your gross estate for estate tax purposes, even though it would be payable to Grace or to Annie.12 If it did not qualify for the marital deduction, it would generate an estate tax. You would need to make a provision in the trust document or in your will for paying the incremental tax from assets other than the charitable trust itself.13 You might even require that the recipient pay the tax as a condition of receiving the annuity or unitrust payout.”14
Oliver growls. “Anything else?”
“Is Grace an American citizen?” you ask.
Oliver drops back into his chair. “Why do you ask?”
You reply, “It would make a difference in how we would have to structure anything we wanted to qualify for the marital deduction for gift or estate tax purposes. A gift in trust for a non-citizen spouse that would qualify for the marital deduction only if a QTIP election were made would not be eligible for the same unlimited marital deduction as a similar gift to a citizen.15 Instead, you would be limited to $13,000 per year. The trust instrument could include provisions that permit the trustee, at your death, to hold back from any distribution of principal an amount equivalent to what would have been the incremental tax in your estate had a marital deduction not been allowed.16 The idea with this strategy, Oliver, is to protect against the noncitizen spouse expatriating assets that would otherwise be taxable at her death.
“In any event,” you conclude, “it can be done with a charitable remainder trust because no QTIP election is required. The IRS has approved the arrangement privately.17 But the marital deduction would be limited to $133,000.”
Oliver stands again and strides to the door. “Put something on paper,” he says.
Please call Tim Enstice at 757-962-8213, or e-mail us at [email protected], for more information.
1 Based on fixed annual payments and a 2.4 percent charitable midterm federal rate.
2 Code Section 2503(b).
3 Reg. 1.664-2(a)(4) and -3(a)(4).
4 Code Section 2523(g)(1). There is a similar exception at Code Section 2056(b)(8) for estate tax purposes.
5 See note 1.
6 See note 1.
7 Code Section 170(f)(3).
8 Code Section 2056(b)(1).
9 Reg. 25.2512-8.
10 Code Section 2516.
11 Code Section 2035(a)(1).
12 Code Section 2038(a)(1).
13 13Rev. Rul. 82-128, 1982-2 C.B. 71.
14 14PLR 9512016.
15 Reg. 25.2523(i)-1(d), example 4.
16 Code Section 2056A(a)(2).
17 17PLR 9244013