Introduction
The Tax Reform Act of 1969 first established the rules for creating charitable remainder trusts (CRTs), including a required minimum 5% payout each year. The Taxpayer Relief Act of 1997 added two additional criteria for a 50% maximum annual payout and a 10% minimum deduction test that applies to both charitable remainder unitrusts (CRUTs) and charitable remainder annuity trusts (CRATs). Sec. 664(d). If a CRT failed either of these requirements, it would not qualify as a charitable remainder trust.
CRATs are also subject to an additional test, the 5% probability test, designed to protect the charitable remainder. Until recently, this test did not pose a problem for individuals looking to establish a CRAT. But now, with lower applicable federal rates, it has become more difficult for CRATs to satisfy this test. On August 8, the Internal Revenue Service (IRS or Service) issued Rev. Proc. 2016-42, which created an alternative to the 5% probability test. This alternative creates a new way for a CRAT to qualify even if it does not satisfy the 5% probability test.
The 5% Probability Test
The 5% probability test came about because the IRS was concerned that CRATs would not leave a sufficient remainder for charities. Because CRATs pay a fixed annuity amount to beneficiaries each year, it was possible that a CRAT could pay more than it earns each year, eventually exhausting the trust corpus. This would then leave the charities named as remainder beneficiaries with nothing.
In order to reduce the risk of exhaustion, and ensure that CRAT charitable beneficiaries ultimately derived some benefit, the Service issued Rev. Rul. 77-374. This ruling specified an additional test for charitable remainder annuity trusts payable for one or more lives. In addition to passing the Sec. 664(d)(1)(A) 5% minimum payout and 50% maximum payout tests, Rev. Rul. 77-374 specifies that annuity trusts must also pass a 5% probability test.
The 5% probability test is used to ensure that there will be a remainder for the charity. If the annuity, with adjustment for the payment frequency, exceeds the annualized earning rate under the Sec. 7520 applicable federal rate (AFR), then the trust corpus may diminish over time. In order to pay the annuity, the trustee would have to pay out all income and also invade principal.
If the invasion of principal were to continue for a significant period of time, the annuity principal could diminish to zero. The rate of principal reduction would increase each year, since the annuity earnings decline as the principal declines. Thus, there would be greater invasions of principal each year to pay the annuity amount.
Therefore, under the 5% probability test, if there is a 5% or greater probability using the selected AFR that the trust beneficiary will live long enough for the trust to be exhausted, then the trust will fail to qualify as a CRAT.
The 5% Probability Test Has Posed a Problem in Recent Years
Over the past several years, low AFRs have made it challenging for individuals to create CRATs that are capable of passing the 5% probability test. This is because the 5% probability test assumes that the earnings rate on trust assets is equal to the selected AFR.
When AFRs were above 5%, it was almost a certainty that a donor could create a one or two life CRAT capable of passing the 5% probability test, assuming the minimum 5% payout was selected. Since 2008, however, the AFR has been lower than 5.0%, reaching a nadir of 1.0% several times in 2012 and 2013. The most recent AFRs have also been below 2.0%.
With a low AFR, it is incredibly difficult for one or two life CRATs to pass the 5% probability test, even if the minimum 5% annuity payout is selected. This is because a CRAT paying out the minimum 5% annuity would still be paying out more than the assumed earnings rate, reflected in the AFR. Consequently, under the 5% probability test, a trust paying out more than it earns could eventually exhaust.
Example 1
Phillip and Elizabeth are ages 75 and 74, respectively. Recently they have been talking with their attorney, Stan, about establishing a $1,000,000 two-life CRAT. At the time that Phillip and Elizabeth are thinking of establishing the CRAT, the AFR is 1.4%. With this low AFR, even assuming the minimum 5% payout, the probability that Phillip and Elizabeth's CRAT will exhaust is 8.59%. In order for them to create a CRAT that would have a probability of exhaustion less than 5%, they would both need to be at least age 77. As such, for Phillip and Elizabeth to create a CRAT they would need to create a term of years CRAT limited to a maximum term of 20 years. Alternatively, they could create a two-life CRUT.
The Rev. Proc. 2016-42 Solution
Fortunately for individuals like Phillip and Elizabeth, the IRS has recently provided an alternative that will allow for the establishment of a CRAT even if it does not meet the 5% probability test. In Rev. Proc. 2016-42, the IRS approved a qualified contingency.
Section 664(f) provides that the duration of a charitable remainder trust may be shortened by a qualified contingency. This contingency could be based on an objective occurrence, such as marriage, divorce or a similarly defined event. If the specified event takes place, then the trust may be terminated and the remainder transferred at that time to charity. Since the event is generally contingent, there is no increase in the income tax deduction, regardless of the nature of the event.
In Rev. Proc. 2016-42, the Service indicated that through the use of a qualified contingency, the 5% probability test will be disregarded for qualification purposes. The specific qualified contingency is a provision included by the trust drafter. The provision will effectively terminate the trust if, at some later date, the trust value, as discounted using the funding AFR, will be less than 10% following the next payment. This provision may be called the "10% Termination Test."
In application, this provision requires that at the beginning of each payment the trustee subtract the next payment from the current trust value. The remaining balance of the trust is then discounted at the interest rate in effect when the trust was created. If this calculation results in a discounted trust value less than 10% of the initial trust value, then the trust terminates and its remaining assets are distributed to the charitable remaindermen.
Example 2
Let's return to the example of Phillip and Elizabeth. With Rev. Proc. 2016-42 in hand, their attorney, Stan, includes the qualified contingency of Rev. Proc. 2016-42 in the CRAT document. Because of the inclusion of the contingency, the Service will disregard the 5% probability test in determining whether Phillip and Elizabeth's trust is qualified. Therefore, they are entitled to receive an income tax deduction for creating the $1,000,000 two-life CRAT.
Before each payment, the trustee of Phillip and Elizabeth's CRAT will need to apply the qualified contingency formula to determine whether the trust must terminate. At the start of year 15, both Philip and Elizabeth are still alive and the trust's value has fallen to $245,000. The trust pays an $85,000 annual annuity payment. The original AFR when they established their trust was 1.4%. The qualified contingency will not cause the trust to terminate so long as the discounted value does not fall below 10% of the initial trust value. The calculations below show (1) the 10% initial trust value and (2) the discounted value in year 15 using the qualified contingency formula.
- $1,000,000 x 10% = $100,000
- ($245,000 - $85,000) x [1 / (1 + .014)]^{15}
$160,000 x (1/1.014)^{15}
$160,000 x .986193^{15}
$160,000 x .811762 = $129,882
The discounted value of $129,882 at the start of year 15 is still more than $100,000, 10% of the initial trust value. Therefore, the qualified contingency will not cause Phillip and Elizabeth's trust to terminate in year 15.
Even though the qualified contingency of Rev. Proc. 2016-42 allows the 5% probability test to be disregarded, practitioners and their clients should be aware of two important caveats. First, clients need to be aware that the possibility exists that the qualified contingency may cause the trust to terminate before their deaths. This is because the qualified contingency is not concerned with the current value of the trust, but the discounted value of the trust following the next scheduled payment.
Second, CRATs still need to pass the 10% minimum deduction test. Consequently, practitioners will need to first determine whether inclusion of the Rev. Proc. 2016-42 qualified contingency is necessary. If it is, then they will also need to ensure that the CRAT passes the 10% minimum deduction test.
Example 3
Returning to the example of Phillip and Elizabeth and their intention to create a $1,000,000 CRAT, assume they want a 9% or $90,000 annual annuity payment for their joint lives. Although this CRAT would otherwise fail the 5% probability test, their attorney, Stan, bypasses that problem through the use of Rev. Proc. 2016-42's qualified contingency. However, Stan knows that the CRAT still needs to pass the 10% minimum remainder test. Thus, he calculates that the remainder interest would be valued at $92,755, less than 10% of the trust's initial $1,000,000 value. Consequently, although the qualified contingency would allow the CRAT to qualify, the 10% minimum deduction test would not. In order for the CRAT to qualify, Phillip and Elizabeth would have to agree to a lower annual annuity amount. In this instance, Stan calculates that an 8.5% or $85,000 annual annuity would produce a $106,072 remainder, which passes the 10% test.
Rev. Proc. 2016-42's Qualified Contingency
Section 5 of Rev. Proc. 2016-42 contains the sample language for the qualified contingency that allows a CRAT to qualify despite otherwise failing the 5% probability test. Although the IRS does not require that its recommended language be copied verbatim, Sec. 4.01 of the revenue procedure indicates that a trust containing a provision substantially similar, but not identical to, the one stated cannot be guaranteed of satisfying the IRS's requirements.
Section 5 contains the standard language for a qualified contingency in an inter vivos trust along with three other variations for testamentary CRATs, CRATs created using the IRS's recommended trust language and two-life CRATs. In the sample provision below, the underlined portions are the sections where the IRS specifically includes variations within the revenue procedure.
10% Termination Test Mandatory Trust Provisions
Below is the qualified contingency language that should be included in a one-life inter vivos annuity trust.
The first day of the annuity period shall be the date the property is transferred to the trust and the last day of the annuity period shall be the date of the Recipient's death or, if earlier, the date of the contingent termination. The date of the contingent termination is the date immediately preceding the payment date of any annuity payment if, after making that payment, the value of the trust corpus, when multiplied by the specified discount factor, would be less than 10 percent of the value of the initial trust corpus. The specified discount factor is equal to [1 / (1 + i)]^t, where t is the time from inception of the trust to the date of the annuity payment, expressed in years and fractions of a year, and i is the interest rate determined by the Internal Revenue Service for purposes of section 7520 of the Internal Revenue Code of 1986, as amended (section 7250 rate), that was used to determine the value of the charitable remainder at the inception of the trust. The section 7520 rate used to determine the value of the charitable remainder at the inception of the trust is the section 7520 rate in effect for [insert the month and year], which is [insert the applicable section 7520 rate].
In a testamentary CRAT, the initial sentence phrase "the property is transferred to the trust" in this sample language must be replaced with "of my death." If the annuity is payable consecutively for two measuring lives, the initial sentence phrase "the Recipient's death" must be replaced with "the death of the survivor of the Initial Recipient and the Successor Recipient(s)."
Due to the risk that the AFR at death may be lower than when a will or trust is drafted, there is a risk that a testamentary annuity trust may fail the 5% probability test. Inclusion of the Rev. Proc. 2016-42 qualified contingency is now a solution for situations where a testamentary CRAT may otherwise fail the 5% probability test.
If the inter vivos or testamentary CRAT is created using the sample form provided in Rev. Proc. 2003-53, 2003-2 C.B. 230, or Rev. Proc. 2003-57, 2003-2 C.B. 257, respectively, the insertion of this sample provision in the appropriate locations will satisfy the requirements of a qualified contingency.
Conclusion
Thanks to Rev. Proc. 2016-42, charitable remainder annuity trusts have been given new life. Through the use of a qualified contingency, CRATs can now qualify for a deduction even if they otherwise would fail to qualify under the 5% probability test. Practitioners should make sure that clients are aware of the possibility that the qualified contingency could cause the CRAT to terminate sooner than expected. In addition, all CRATs must still pass the 10% minimum deduction test. Though deviation from the specific language mentioned in Rev. Proc. 2016-42 is allowed, practitioners should be aware that the IRS does not guarantee such deviation will suffice. In the end, Rev. Proc. 2016-42 should once again make one or two life CRATs a possibility for individuals interested in the benefits CRATs provide.