A SECOND BITE OF THE APPLE: COMMUTING THE UNDERPRODUCTIVE CRT
by Russell A. Willis III, J.D., LL.M.
Editor’s Note: This article is based on a presentation to the 2003 National Conference on Planned Giving.
rents. An arrearage of about $20,000 accumulated in his makeup account. The trust instrument characterizes post-contribution gain as income, so in the year in which the property was sold for $1.2 million, Richard received a unitrust payment of about $116k— eight percent of corpus, plus the $20,000 arrearage. The following year, however, the net proceeds of the sale of the real property having been reinvested in a portfolio of stocks and bonds yielding only about 1.5 percent, the payment to Richard dropped to under $17,000. Over the next two years, he accumulated an arrearage of nearly $140,000. When the Treasury adopted regulations a few years back permitting net income makeup trusts to be "flipped" to straight unitrusts, Richard decided to take advantage of that opportunity. For the past four years, he has been receiving straight unitrust payments of eight percent of corpus, most of it taxed as pre-contribution gain, but with the recent decline in the stock market, the amount of the unitrust payout has been trending downward dramatically. Jane, the planned giving director in the development office at the university which is designated to receive the trust remainder, has been in frequent contact with Richard over the years, and is sympathetic with the frustration Richard has been experiencing. In the present investment climate, not only is the unitrust payout to Richard, even at eight percent, not meeting his expectations, but the prospective remainder to the university is dwindling. At one of their occasional luncheon meetings, Jane suggests to Richard that he might look into the possibility of commuting the unexpired unitrust interest, accelerating the remainder to the university. She mentions that this transaction could take any of several forms: either Richard and the university could each receive the present value of their respective interests in the trust,
Journal of Gift Planning
A flurry of recent private letter rulings suggests that there has been an upsurge of interest among donors and their advisors in a transaction in which the holder of the lead annuity or unitrust interest in a charitable remainder trust surrenders a portion or all of that interest to the charitable remainderman, either outright or in exchange for a gift annuity. Gift planners in both the private and the nonprofit sectors need to be aware not only of how this transaction works, but also of how various factors—recent market declines, anticipated changes in marginal income tax rates, shortened life expectancies, etc.—may make the transaction attractive both to individual donors and to recipient organizations. For the nonprofit planner, this is a matter of donor cultivation and stewardship of existing planned gifts. For the private sector planner, it is a matter of providing informed advice to the client in light of changed circumstances. This article details the mechanics of this transaction, exploring both the cash flow and the income tax and capital gains tax consequences, and illustrating the calculations that must be made to determine whether the transaction will be attractive or advantageous to the donor and/or to the recipient organization. A VIGNETTE About eight years ago, Richard set up a net income makeup charitable remainder unitrust. He contributed commercial real property then valued at $1 million to the trust. He reserved a unitrust payment to himself for life in the amount of the lesser of current income or eight percent of corpus, revalued annually. The remainder at his death is to be paid to a named charity, the university from which he received his undergraduate degree. During the first year, until the real property was sold, Richard received income of about $60,000, or six percent, from net
5
or Richard could surrender his unitrust interest as an outright gift to the university, or in exchange for a charitable gift annuity. Richard asks whether Jane can put some numbers to this. A few days later, Jane sends Richard some numbers. When he created the trust eight years ago, Richard was 62 years old. The transfer generated a charitable contributions deduction for income tax purposes of about $278,000, which Richard was able to carry forward for five years. Now that the value of the trust corpus has dropped to $700,000, the present value of Richard's unexpired unitrust interest is valued at about $433,000. If he and the university were to agree to commute Richard's interest in the trust, the university would receive about $267,000 outright, and Richard would receive about $433,000, on which he would likely recognize long-term capital gain (this tax consequence is a matter of some uncertainty). He could reinvest the net proceeds in whatever manner he might choose. If he were simply to surrender the unexpired unitrust interest to the university, he would be able to claim another income tax charitable contributions deduction of $433,000 (which might actually be more than he could absorb in five years of carryforwards). If he were to surrender the unitrust interest in exchange for a gift annuity, under the current ACGA rates he might expect to receive an annuity of only about $28,000 —about half the $56,000 he received last year in unitrust payouts, but the annuity would not be subject to fluctuation. He would be able to claim an income tax charitable contributions deduction of about $133,000, and about $18,000 of the annuity payout for the next 15.5 years would be treated as long-term capital gain, while the balance would be treated as ordinary income. Jane also provides numbers showing similar, albeit more modest, results if Richard were either to commute or to surrender only a portion of his unitrust interest, as by reducing the amount of the unitrust payout to five percent (the minimum required to maintain the trust's exempt status, and perhaps a rate which might be expected to allow the trust corpus to grow when the market rebounds). Over the next few weeks, Richard meets with his estate planning lawyer, his tax accountant and his investment advisor, singly and in combination, to discuss these ideas. Jane is invited to attend a
6
Journal of Gift Planning
number of these meetings, and not only does she enjoy several excellent lunches in very comfortable settings, but she makes promising contacts with Richard's advisors, each of whom has some kind of relationship to the university, either directly or through family and/or clients, and each of whom can be cultivated not only as a prospective donor, but as a source of leads and as a resource in structuring other planned gift transactions in the future. And in fact, after these discussions have run their course, Richard does decide to surrender a substantial portion of his unitrust interest as an outright gift to the university. THE RECENT LETTER RULINGS The foregoing vignette describes one of the more typical scenarios in which the parties in interest in a charitable remainder trust, i.e., the holder(s) of the term or life interest(s) and the remaindermen, may want to explore the potential benefits to each of accelerating the remainder. Recent stock market losses have been reflected in reduced unitrust payouts, while fixed annuity payouts are further eroding already decimated principal balances. Shrinking endowments and other financial pressures are driving charities to look for additional sources of current revenue. At the same time, the "section 7520" rates by which split interests are valued for tax purposes are at historic lows, which means that the unexpired lead interest in an annuity trust, and to a much lesser degree in a unitrust with a quarterly or more frequent payout, will be assigned a somewhat higher value in calculating the income and transfer tax consequences of such a transfer. The attention of the planned giving community was at least momentarily focused on this transaction when the Service released PLR 200152018 (09/26/01) late in December of 2001. Two similar rulings soon followed. 1. PLR 200152018 (09/26/01) Some years earlier, the taxpayer had created a straight five percent unitrust for his life, with the remainder to a named charity. It was represented that the decedent had not initially created the trust for the purpose of evading the partial interest
rules of Code section 170(f)(3)(A). The taxpayer proposed to surrender his unitrust interest to the remaindermen in exchange for a gift annuity payable for his life from the charity's general funds. The annuity would be payable only to the taxpayer, and it would be nonassignable, or assignable only to the charity. It was evidently assumed that under applicable state law, the transfer of the unitrust interest to the remainderman would have the effect of accelerating the remainder. The Service ruled: (a) that the taxpayer would be entitled to claim a charitable contributions deduction for both income and gift tax purposes in the amount by which the present value of the unitrust interest that he would be surrendering exceeded the present value of the gift annuity he would be receiving in exchange, (b) that because a sale of the taxpayer's unitrust interest would have resulted in long-term capital gain, there would be no reduction in the amount allowable as a charitable contributions deduction per Code section 170(e)(1), and the amount of the deduction that he could take in a given year would be subject to a limitation of thirty percent of his adjusted gross income, (c) that the taxpayer would not recognize undistributed capital gains accumulated in prior years as a consequence of the transfer, and (d) that the transaction would be treated as a bargain sale under Code section 1011(b), i.e., that the taxpayer would recognize long-term capital gain in the amount of the present value of the gift annuity ratably over the period of years measured by the expected return multiple under the annuity contract, but only from that portion of the annuity payout that was treated as a return of his investment in the contract. Note: for purposes of calculating gain, the taxpayer's basis in his unitrust interest was to be treated as zero pursuant to Code section 1001(e)—more on this later. Related note: the text of the ruling does not include any analysis
to support the conclusion that the taxpayer would not recognize undistributed capital gains accumulated in prior years, but see the discussion of PLR 9550026 (09/18/95), below. Two other rulings released early in 2002, PLRs 200205008 (10/23/01) and 200207026 (10/23/01) are discussed below. These recent private letter rulings derive in large part from Rev. Rul. 86-60, 1986-1 C.B. 302, in which the Service ruled that a transfer to the designated remainderman of the unexpired annuity interest in a charitable remainder annuity trust would qualify for a charitable contributions deduction for both income tax and gift tax purposes. 2. Rev. Rul. 86-60, 1986-1 C.B. 302 The ruling considered two related situations. In the first ("situation 1"), the taxpayer had created the trust, reserving a lifetime annuity for herself, with the remainder over to a designated charity, and then four years later she assigned the unexpired annuity to the remainderman. It was assumed that the taxpayer had not initially created the trust (thereby dividing her interest in the trust corpus) for the purpose of evading the partial interest rules of Code section 170(f)(3)(A)—and this was key to the ruling, in that the taxpayer was treated as having transferred her entire interest in the trust to the charity, without regard to the fact that she had earlier owned other interests in the same property. Therefore, the Service ruled, the transfer qualified for a charitable contributions deduction for both income and gift tax purposes. The method of calculating the amount of the deduction was not discussed. In the second situation ("situation 2"), the annuity was to have continued for the life of the taxpayer's spouse, if he survived her. Both the taxpayer and her spouse transferred their respective
Journal of Gift Planning
7
interests in the trust to the remainderman. Again, the fact that the taxpayer had not (it was assumed) initially created the trust for the purpose of evading the partial interest rules was key, because in this circumstance the transfer of the taxpayer's annuity interest, standing alone, would not otherwise have qualified for the charitable contributions deduction, in that she had also made a transfer for private (i.e., noncharitable) purposes: the annuity to her spouse, if he survived her. The transfer by the spouse of his annuity interest to the remainderman qualified, though it was not in the form of a charitable lead annuity trust, because it was the only interest in the property he had ever had. Several private letter rulings issued over the next few years treated some of the variations suggested by the generic situations described in Rev. Rul. 86-60. 3. PLR 8805024 (11/05/87) In 1975, the taxpayer had created a straight five percent unitrust for his life, and for the life of his wife, should she survive him, reserving to himself a testamentary power to revoke her interest. The remainder was payable to a named charity. It was represented that the taxpayer had not initially created the trust for the purpose of evading the partial interest rules. The taxpayer and his wife proposed to surrender a portion of their respective unitrust interests to the remainderman. In arriving at its ruling, the Service assumed that state law would effect a merger of the surrendered interests with a proportionate share of the remainder, resulting in an outright distribution to the charity. The Service ruled: (a) that the taxpayer would be entitled to claim a charitable contributions deduction for both income and gift tax purposes in the amount of the present value of the portion of his unitrust interest that he was surrendering, (b) that the taxpayer's wife, whose interest was both contingent on her surviving the taxpayer and also subject to defeasance by him, would not be entitled to claim a deduction, and
8
Journal of Gift Planning
(c) that the trust would continue to qualify as a unitrust under Code section 664(d)(2), in that the unitrust payout to the taxpayer (and later, to his wife) would be five percent of the remaining corpus. Note: there is some slippage here, in that the charitable contributions deduction which the taxpayer presumably claimed on income and gift tax returns for the year in which the trust was created would have been calculated with reference to the then life expectancies of both himself and his wife, while the deduction arising from the present transaction is calculated with reference to the taxpayer's life expectancy alone. 4. PLR 9529032 (04/28/95) In 1993, the taxpayer had created a net income unitrust without makeup, paying to himself and to his wife, in equal shares, the lesser of current income or 10 percent of the trust corpus, revalued annually. At the death of either the taxpayer or his wife, the entire unitrust amount was to be paid to the survivor. The taxpayer had reserved a power, exercisable during his life, to designate the charitable remaindermen. In default of such designation, the remainder was to be distributed to a named foundation. The taxpayer and his wife proposed to surrender their respective interests to a named charity. It was represented that under applicable state law, this transfer, in combination with the taxpayer's exercise of his power to designate the remainderman, would have the effect of accelerating the remainder. The Service ruled: (a) that the taxpayer was entitled to claim a charitable contributions deduction for gift tax purposes (for some reason, a ruling was not requested on the question of a deduction for income tax purposes) in the full amount of the value of the trust corpus, and (b) that his wife was entitled to claim a deduction in the amount of the present value of her unitrust interest. Note: the ruling makes reference by analogy to Rev. Rul. 77275, 1997-2 C.B. 346, in which the Service had ruled that where a taxpayer had reserved a power to designate annually the income distributees of a charitable lead income trust, the gift to
charity was incomplete, for gift tax purposes, until the designation was made. 5. PLR 9550026 (09/18/95) Some years previously, the taxpayers had created a net income unitrust without makeup, paying themselves in equal shares the lesser of current income or nine percent of the trust corpus, revalued annually. At the death of either taxpayer, the entire unitrust amount was to be paid to the survivor, except that each had reserved a testamentary power to revoke that portion of the survivor's unitrust interest attributable to his or her own community interest in the property transferred to the trust. The remainder at the death of the survivor was to be paid to a named charity. Again, it was represented that the taxpayers had not initially created the trust for the purpose of evading the partial interest rules. The taxpayer and his wife proposed each to disclaim their respective contingent unitrust interests following the death of the other, and to surrender 20 percent of their respective current interests to the remainderman. It was implicitly assumed that under applicable state law, this transfer would have the effect of accelerating that portion of the remainder. The Service ruled: (a) that the taxpayers would be entitled to claim a charitable contributions deduction for both income and gift tax purposes in the amount of the present value of 20 percent of a straight nine percent unitrust interest, without reduction for the net income limitation, (b) that the transfer would not adversely affect the trust's qualification under Code section 664(d)(2), and (c) that the taxpayers would not recognize undistributed capital gains accumulated in prior years as a consequence of the transfer. Note: in support of this last element of the ruling, the Service cited Palmer vs. Commissioner, 62 T.C. 684 (1974), affirmed on other grounds, 523 F.2d 1308 (8th Cir. 1975), acq. in part, nonacq. in part, 1978-1 C.B. 2, and Rev. Rul. 78-197, 1978-1 C.B. 83, for the proposition that a taxpayer will not ordinarily recognize gain on the transfer of appreciated property to a charity, unless there is a pending sale which the recipient will be legally obligated to close. 6. PLR 9721014 (02/19/97) The facts are essentially identical to those given in "situation 2" in Rev. Rul. 86-60, except that a unitrust, rather than an annuity trust, was involved, and the remainder was payable to the trustee of an endowment fund. In 1986, the taxpayers had created a net income unitrust with makeup trust, paying themselves in equal shares the lesser of current income or five percent of the trust corpus, revalued annually, with arrearages to be made up in years in which current income exceeded five percent. At the death of either taxpayer, the entire unitrust amount was to be paid to the survivor, except that each had reserved a testamentary power to revoke that portion of the survivor's unitrust interest attributable to his or her own community interest in the property transferred to the trust. The remainder at the death of the survivor was to be paid to a third party trustee, to be held for the benefit of a named charity. Again, it was represented that the taxpayers had not initially created the trust for the purpose of evading the partial interest rules.
Journal of Gift Planning
9
The taxpayer and his wife proposed each to surrender their respective interests in the trust to the remainderman. It was represented that under applicable state law, this transfer would have the effect of accelerating the remainder. The Service ruled that the taxpayers would be entitled to claim a charitable contributions deduction for both income and gift tax purposes in the amount of the present value of their interests in the trust. The method of calculating this value was not discussed. No other rulings were requested. 7. PLR 200010035 (12/10/99) The two taxpayers, evidently husband and wife, had created a charitable remainder annuity trust in 1988, paying each of them an equal share of an annuity in the amount of seven percent of the initial net fair market value of the property transferred to the trust. At the death of the first taxpayer, the entire annuity was to be paid to the survivor. The remainder at the death of the survivor was to be paid to a private foundation the taxpayers had set up and funded at the same time they created the trust. In the interim, the value of the corpus of the trust had nearly doubled, while the foundation was running short of money to fund its operations. The taxpayers proposed to petition a local court to modify the trust to provide that trust income in excess of the amount required to pay the annuity would be distributed to the foundation, and that the trustees would have discretion to distribute principal to the foundation, provided that the principal of the trust would not be reduced below the amount in which it had initially been funded, and provided further that in the case of distributions in kind, the adjusted basis of the property distributed would be fairly representative of the adjusted basis of all property available for distribution on the date of payment. The Service ruled: (a) that the proposed modification would not adversely affect the trust's qualification under Code section 664(d)(1), nor the tax-exempt status of either the trust or the foundation,
(b) that neither taxpayer would recognize taxable income or capital gain as a result of the transaction, (c) that the transaction would not subject either taxpayer to liability for gift tax, and (d) that the transaction would not constitute an act of selfdealing by either taxpayer, the trust, or the foundation (the taxpayers were also co-trustees of the annuity trust and managers of the private foundation). The Service also ruled that the transaction would not constitute a termination of either the trust or the foundation for purposes of Code section 507(c), which imposes an excise tax on such terminations. 8. PLR 200140027 (06/29/01) Some years previously, the taxpayer had created a straight five percent unitrust for his life, and for the life of his wife, should she survive him, reserving to himself a testamentary power to revoke her interest. He had also reserved a power, exercisable during his life, to redesignate the charitable remaindermen. In the interim, his wife had died. Again, it was represented that the taxpayer had not initially created the trust for the purpose of evading the partial interest rules. The taxpayer proposed to divide the trust into two separate unitrusts, 85 percent to one and 15 percent to the other, to irrevocably designate a particular charity as remainderman of the smaller trust, and to surrender his unitrust interest in the smaller trust to that charity. The allocation of assets as between the two trusts was to be fairly representative of the relative basis of assets in the trust as originally constituted, with accruals. It was represented that under applicable state law, the assignment of the taxpayer's unitrust interest in the smaller trust to the remainderman would have the effect of accelerating the remainder. The Service ruled: (a) that the taxpayer would be entitled to claim a charitable contributions deduction for both income and gift tax purposes in the amount of the present value of his unitrust interest in the
10
Journal of Gift Planning
smaller trust and (b) that the larger trust would continue to qualify as a unitrust under Code section 664(d)(2)—which at least arguably would not have been the case had the taxpayer instead designated a remainderman as to 15 percent of the entire trust and assigned 15 percent of his unitrust interest to that remainderman, as the remaining unitrust payout would the have been only 4.25 percent of the corpus of the trust as originally constituted. 9. PLR 200205008 (10/23/01) The taxpayer's husband, since deceased, had created a net income makeup unitrust for their lives, with a portion of the remainder at the death of the survivor in specified shares to two named charities and the balance to charities to be selected. Again, it was represented that the decedent had not initially created the trust for the purpose of evading the partial interest rules. The surviving spouse proposed to surrender a portion of her unitrust interest to one of the two named remaindermen. It was represented that under applicable state law, this would have the effect of accelerating a corresponding portion of the remainder to that charity, though as acknowledged in this ruling, this representation was not strictly necessary, as the situation falls within the second situation described in Rev. Rul. 86-60, i.e., the surviving spouse was proposing to convey outright a portion of the only interest she had ever had in the trust. It was further represented that the other named remainderman would consent to this transfer. The Service ruled: (a) that the taxpayer would be entitled to claim a charitable contributions deduction for both income and gift tax purposes in the amount of the present value of the portion of her unitrust interest that she was surrendering, i.e., the lesser of the present value of that portion of the specified percentage payout or of that portion of the income of the trust for her life, and (b) that the balance of the trust would continue to qualify as a unitrust under Code section 664(d)(2).
The ruling notes that section 1.664-3(a)(4) of the regulations provides that a unitrust instrument may require or permit the trustee in its discretion to distribute amounts other than the unitrust amount to qualified charities, provided that in the case of distributions in kind, the adjusted basis of the property distributed is fairly representative of the adjusted basis of all property available for distribution on the date of payment. The published text of the ruling does not recite either the amount of the percentage unitrust payout or the proportion of her unitrust interest that the surviving spouse proposed to surrender to the remainderman, so it is impossible to determine whether this transfer might have reduced the unitrust payout to less than five percent of the corpus of the trust as it existed prior to the transfer. One cannot, of course, rely on private letter rulings as precedent, but this does seem to imply that a formal partition of the trust, as was proposed in PLR 200140027 (06/29/01), above, may not be necessary. 10. PLR 200207026 (10/23/01) A reiteration nearly verbatim of PLR 200205008 (10/23/01), apparently to the same taxpayer. Evidently the earlier version of the letter had omitted to specify one of the percentage amounts involved. Another wrinkle: A question that none of the earlier rulings had addressed was whether the settlor would recognize income or capital gain if she and the remainderman each simply took distribution of the present value of their respective interests. This was the subject of a ruling released in April of last year. 11. PLR 200314021 (12/24/02) Some years previously, the taxpayer had set up what was apparently a net income makeup unitrust, to which he conveyed stock in a closely held corporation. After the stock was sold, there was a judicial proceeding to modify the trust to a straight 12 percent unitrust. The taxpayer retained a power, exercisable during his life, to redesignate the charitable remaindermen. He
continued on page 39
Journal of Gift Planning
11
Russell A. Willis continued from page 11
had exercised this power to designate a foundation created by himself and his wife. The taxpayer proposed to petition a local court to terminate the trust, distributing to himself and to the foundation the present value of their respective interests, as determined using the then current section 7520 rate. It was represented that there was no reason to believe that the taxpayer had a life expectancy that was less than average for a person his age. The Service ruled that the transaction would be, in effect, a sale by the taxpayer of his unitrust interest to the remainderman, on which he would recognize long-term capital gain in the amount that he was to receive in the transaction, i.e., the taxpayer's basis in his unitrust interest was to be treated as zero pursuant to Code section 1001(e). Clearly this is not the result the taxpayer was looking for. A similar conclusion had been mentioned in passing, though the taxpayer had not requested a ruling on the issue, in a ruling released in January. 12. PLR 200304025 (10/23/02) Some years previously, the taxpayers, husband and wife, had set up a net income makeup unitrust paying the lesser of current income or five percent of corpus, revalued annually, for their lives, with the remainder at the death of the survivor to a named private foundation. The taxpayers had divided the trust into two separate unitrusts, allocating assets equally between the two trusts in a manner that was represented to be fairly representative of the relative basis of assets in the trust as originally constituted, and they proposed to commute their unitrust interests in one of these trusts. It was represented that no deficiency had accrued in the makeup account. It was further represented that under applicable state law, the commutation of the unitrust interests would have the effect of accelerating the remainder. And it was represented that there was no reason to believe that either taxpayer had a life expectancy that was less than average for a person his or her age. The Service ruled: (a) that the partition of the original trust into two smaller trusts had not adversely affected the qualification of any of the trusts under Code section 664(d)(1), (b) that the proposed commutation of the taxpayers' unitrust
interests in one of the trusts would not constitute an act of selfdealing by either taxpayer, and (c) that the transaction would not constitute a termination of either the trust or the foundation for purposes of Code section 507(c). The ruling was conditioned on the assumption that the transaction would be accomplished through a judicial proceeding to which the state attorney general was a party. Although the taxpayers had not requested a ruling on the question, the Service also ruled that the transaction would be a sale by the taxpayers of their unitrust interests, on which they would recognize long-term capital gain in the amount that they were to receive in the transaction. Unfortunately, the regulations under Code section 1001(e) do state that the holder of a term interest in a trust (including a life interest) has a basis of zero in that interest, rather than a pro-rated basis derived from the settlor's basis in the underlying assets prior to their transfer to the trust. However, it might be pointed
Journal of Gift Planning
39
out that the legislative history of Code section 1001(e) makes specific reference to the life or term interest having been "acquired by gift, bequest, inheritance, or transfer in trust," which of course would make for a somewhat more rational rule. But the regulatory interpretation of the statute does not include this limitation. The correctness of the regulation has not been litigated, but it would be an adventurous taxpayer who would report a pro-rated basis in the retained unitrust interest, and a correspondingly reduced capital gain, on the strength of the legislative history and in the face of the regulation and these two rulings. WHERE THIS LEAVES US Keeping in mind that private letter rulings may not be relied on as precedent, it seems reasonably clear that (a) assuming the trust was not initially created for the purpose of evading the partial interest rules of Code section 170(f)(3)(A), and (b) assuming that where the transaction involves only a portion of the trust, the allocation of assets as between the portion surrendered or distributed and the portion remaining in trust is fairly representative of the relative basis of assets in the trust as originally constituted, with accruals, and (c) assuming there is no reason to believe that the life expectancy of the holder of the annuity or unitrust interest at the time of the surrender or distribution is less than average for a person of the same age, then (d) the holder of an annuity or unitrust interest in a charitable remainder trust may surrender a portion or all of that interest to a designated remainderman outright, (e) if the surrendered interest is not contingent, the taxpayer may claim a charitable contributions deduction for income tax purposes in the amount of the present value of the surrendered interest, determined using the "section 7520" rate in effect at the time of the surrender (but query whether in the case of an annuity trust the deduction should be limited to the lesser of the present value of the unexpired annuity or the current principal balance of the trust—a point on which, it will be remembered,
40
Journal of Gift Planning
Rev. Rul. 86-60 is unclear), (f) if the annuity or unitrust interest is surrendered in exchange for a gift annuity, the taxpayer will recognize long-term capital gain under the "bargain sale" rules of Code section 1101(b) in the amount of the present value of the gift annuity, ratably over the period of years measured by the expected return multiple under the annuity contract, from that portion of the annuity payout that is treated as a return of the taxpayer's investment in the contract, i.e., the present value of the surrendered annuity or unitrust interest, determined using the "section 7520" rate in effect at the time of the transfer, (g) if instead the holder of the annuity or unitrust interest takes distribution of the present value of that interest, or of a portion of that interest, and the remainderman takes distribution of the present value of the remainder, or of a corresponding portion of the remainder, determined using the "section 7520" rate in effect at the time of the transfer, the taxpayer will probably recognize long-term capital gain in the full amount that he or she receives, without pro-rating his or her basis in the unitrust interest, even if he or she was the settlor of the trust, and (h) where the interest surrendered to the remainderman or distributed to the holder is in a net income makeup unitrust, the value of that interest for purposes of the charitable contributions deduction and/or capital gain recognition will be the lesser of the present value of the specified percentage payout or the income of the trust, or of that portion of the trust surrendered or transferred, for the unexpired term, determined using the "section 7520" rate in effect at the time of the surrender or transfer. It seems sensible to suppose, further, that... (i) the holder of an annuity or unitrust interest might enter into an arrangement under which the amount of the annuity or unitrust payout is reduced, (but not below five percent of corpus in the case of a unitrust), in order to allow the trust principal to grow for the benefit of the remainderman, and claim a charitable contributions deduction for income tax purposes in the amount of the present value of the foregone annuity or unitrust payments.
IDENTIFYING LIKELY PROSPECTS As suggested in the vignette with which we opened this discussion, the most likely prospects for this transaction are the life (or term) beneficiaries—generally, the settlors—of (a) unitrusts with high stated percentage payouts and depressed principal values, (b) low yield NIMCRUTs with no "flip" provisions, or with no immediate prospect of a "flip" occurring, in which arrearages have accumulated that are unlikely ever to be paid out, and (c) annuity trusts with high payouts that are decimating corpus. Some of these plans were "oversold" several years ago by aggressive investment managers, often in conjunction with "replacement" life insurance trusts, and the settlors or other life or term beneficiaries have become disillusioned. In many of these cases, the settlor has reserved a power to designate (or redesignate) the remainder beneficiaries, and while this obviously provides an additional incentive to a charity whose remainder is entirely speculative to "close" the transaction, it may also provide some interesting opportunities in the setting of gift annuity rates (more on this in a moment). Recent stock market declines are reflected in reduced unitrust payouts, while fixed annuity payouts are eroding principal balances, and shrinking endowments and other, similar pressures are driving charities to look for additional sources of current revenue. At the same time, the "section 7520" rates by which split interests are valued for tax purposes are at historic lows, which means that the unexpired lead interest in an annuity trust (and to a much lesser degree, in a unitrust with a quarterly or more frequent payout) will be assigned a somewhat higher value in calculating the income and transfer tax consequences of such a transfer. If the "section 7520" rates rebound in coming months, the present value of a gift annuity given in exchange for the surrender of a portion or all of an unexpired annuity or unitrust interest will drop, thereby increasing the amount of the potential charitable contributions deduction, but also increasing that
portion of each annuity payment that will be treated as ordinary income rather than as long-term gain. Clearly, there is a rather complex balance to be struck here. A taxpayer who is expecting to fall into a lower marginal income tax bracket in subsequent years may want to claim a more substantial charitable contributions deduction in the current year. Finally, although the most recent letter rulings make it clear that the viability of this transaction will depend on there being no reason to believe that the holder of the current annuity or unitrust interest has a shortened life expectancy, the same should not apply to a following interest which is contingent on surviving the holder of the current interest and/or defeasible by the settlor, because this interest is not being taken into account in valuing the exchange, cf., PLR 8805024 (11/05/87), item 3 above. Thus, where circumstances have emerged to shorten the life expectancy of the spouse or a child of the settlor whose following interest in the annuity or unitrust is contingent and/or defeasible, it may be desirable for the settlor to accelerate all or part of the remainder gift and claim an additional income tax charitable contributions deduction. DETAILS: THE CALCULATIONS To illustrate the calculations involved in presenting this transaction to a client or to a prospective donor, let us walk through the specifics of the "Dick and Jane" vignette with which we began. a. "section 7520" rates The current "section 7520" rate, that is, the interest rate assumption under which annuities, life and term income interests, and remainder and reversionary interests are valued, is set at 120 percent of the annual mid-term "applicable federal rate" for the month in which the valuation date falls. These rates are available from a variety of sources, most reliably online at: www.irs.gov/taxpros/lists/0,,id=98042,00.html In valuing a gift to charity, the "section 7520" rates for the month in which the gift is made, and for the two preceding
Journal of Gift Planning
41
months, are available, and some attention must be given to which yields the most advantageous results. Because the revenue ruling setting forth the rates for the coming month is issued a few days before the end of the preceding month, it is actually possible to choose among the rates for four months in timing the closing of a pending transaction. In July of last year, the "section 7520" rate hit an historic low of 3.0 percent. The rate for June was 3.6 percent, and the rate for May was 3.8 percent. If we assume that the transaction between Richard and the university closed in July, we have these three rates to choose from in valuing the interests transferred. (Because the "section 7520" rate for April was also 3.6 percent, there was no advantage to be gained in closing the transaction in June.) b. life expectancies (per tables) Life expectancies are derived from Table 90CM, using 1990 census data. This table was published as part of T.D. 8819 (04/29/99), which appeared in 1999-20 I.R.B. 20 (05/17/99), and is available online at: www.irs.gov/pub/irs-irbs/irb99-20.pdf According to this table, of 71,357 persons alive at age 70, such as Richard in our example, more than half will still be alive at age 83, and somewhat fewer than half at age 84, which tells us that for tax valuation purposes, at least, Richard has a life expectancy, for purposes of valuing both his unexpired unitrust interest and a replacement gift annuity of somewhere between 13 and 14 years. c. present value of unexpired lead interest Table 90CM has been incorporated into the updated tables of valuation factors for remainder, income, and annuity factors collected in Publication 1457 (the "Aleph" volume) and for unitrust remainder factors collected in Publication 1458 (the "Beth" volume). These publications, each running about 800 pages, include factors for one and two lives and for terms certain up to 20 years. While it is useful to understand the methodologies set forth in the first few pages of each of these publications for calculating such factors as the value of an annuity for the life of a survivor as between two persons, or for a life plus a term of years, there are a number of software products on the market that incorporate all but the most obscure scenarios.
42
Journal of Gift Planning
These two publications are available online at: www.irs.ustreas.gov/pub/irs-pdf/p1457.pdf and www.irs.ustreas.gov/pub/irs-pdf/p1458.pdf According to the Table U(1) appearing on page five of Publication 1458, the present value of the remainder after a straight eight percent unitrust over the life of a person aged 70 years is .38132. If the value of the trust corpus in our example is $700,000, then the present value of the remainder should be about $266,924, and the present value of Richard's unexpired unitrust interest should be about $433,076. Of course, these rough figures disregard the fact that the unitrust payout is to be made quarterly and the fact that the gift might be closed partway through a quarter. Factors taking these matters into account in adjusting the remainder value are included in Publication 1458, but conducting these calculations by hand can be quite cumbersome. This is where the software comes in. The illustrations presented in this paper were generated using a version of PhilanthroCalc software that can be accessed online at the Planned Giving Design Center, which is maintained at: www.pgdc.com/usa Taking into account the quarterly payment to Richard of the unitrust amount, the present value of the remainder is actually closer to $269,000 or $270,000, depending which "section 7520" rate is employed (a higher interest rate assumption will very slightly increase the remainder value of a unitrust from which payments are made quarterly, because amounts not yet distributed to the lead beneficiary until the end of the next quarter continue to grow inside the trust). d. ACGA annuity rates The American Council on Gift Annuities sets recommended gift annuity payout rates based on its own analysis of mortality tables, rates of return on balanced portfolios of cash, stocks and bonds, and estimated expenses of maintaining a gift annuity program. The rates assume a residuum at the end of the annuitant's life of 50 percent. The current rates, which were adopted on May 12 of last year, are available online at: www.acga-web.org/ratesjuly03.html
The suggested gift annuity rate for a single annuitant aged 70 years is 6.5 percent. Thus, in our example, Richard might surrender his entire unexpired unitrust interest, valued at $433,076, to the university in exchange for an annuity of 6.5 percent, or $28,149.94 per year. According to Table S(3.0), which appears on page 5 of Publication 1457, the multiplier for the present value of an annuity over the life of a person aged 70 years in a 3.0 percent interest rate environment is 10.6773, which means that the present value of an annuity of $28,149.94 payable to Richard in our example is $300,565.35, or about $132,510.65 less than he is paying for it. Under the "bargain sale" rules, Richard would be able to claim the difference as a charitable contributions deduction for income tax purposes. If we were to use the 3.6 percent "section 7520" rate from June, the annuity multiplier would drop to 10.1715, yielding a present value of the gift annuity over Richard's life expectancy of $286,327.11, and if we were to use the 3.8 percent rate from May, the multiplier would drop to 10.0117, yielding a present value of $281,828.75. In other words, the higher the "section 7520" rate, the lower the present value of the annuity, and thus the lower the amount of capital gain Richard will recognize on the exchange of his unitrust interest. Again, these rough figures disregard the fact that the gift annuity might be paid quarterly. e. comparison of gift annuity payout to projected payout under existing trust Again, in our example, prior to the surrender of his unitrust interest in exchange for a gift annuity, Richard was receiving a payout of eight percent on a principal value of $700,000, or about $56,000 per year, most of it taxed as pre-contribution gain. Using the ACGA rate of 6.5 percent, the gift annuity will pay him about $28,000 per year. A portion of this will be treated as long-term capital gain on the exchange of the unitrust interest, and a portion will be treated as ordinary income. This allocation is determined with reference to "expected return multiples," which are set forth in Table V, at section 1.72-9 of the regulations. The expected return multiple for a person aged 70 years is 16.0, which is two or three years longer than the life
expectancy as determined from Table 90CM. This discrepancy has the effect of spreading out the recovery of the capital gain, thereby slightly increasing the percentage of each annuity payment that is characterized as ordinary income. f. the effect of the "section 7520" rates Using the lower "section 7520" rate to value the interests exchanged in the transaction would slightly increase the value allocated to the unexpired unitrust interest, thereby increasing the amount of gain that Richard would recognize over the term of the gift annuity. This may actually be desirable, because almost every nickel that is not characterized as gain will be characterized as ordinary income. On the other hand, while the lower interest rate assumption would also slightly increase the amount of the annuity payout, this would be at a rather substantial expense to the amount of the income tax charitable contributions deduction. Specifically, (1) if the July 3.0 percent rate is used, the present value of Richard's unexpired unitrust interest would be $430,647, the annuity payout at 6.5 percent would be $27,992.06, of which $8,984.05 would be treated as ordinary income, and Richard could claim an income tax charitable contributions deduction of $128,419.53, whereas (2) if the June 3.6 percent rate is used, the present value of the unitrust interest would drop to $430,171, the annuity payout would drop to $27,961.12, of which $9,834.40 would be taxed as ordinary income (quite a bit more than if the transaction were valued at the July rate), and Richard could claim a deduction of $141,956.16, and (3) if the May 3.8 percent rate is used, the present value of the unitrust interest would be $430,017, the annuity payout would be $27,951.10, of which $10,103.17 would be taxed as ordinary income, and the deduction would rise to $146,234.97. g. deviating from the ACGA rates Where the issuance of annuity contracts constitutes a "substantial part" of the activities of an otherwise exempt organization, this would be treated as an unrelated trade or business, resulting in the loss of the organization's exempt status, were it
Journal of Gift Planning
43
not for an exception in Code Section 501(m)(5) for gift annuities. That exception applies only if the annuity contracts conform to the requirements of Code Section 514(c)(5) regarding "unrelated debt-financed income" in the form of "acquisition indebtedness." For our present purposes, this means that the present value of the annuity cannot be more than 90 percent of the value of the property received by the charity in the exchange. If we consider for a moment the possibility of deviating from the ACGA rates in the specific context of this transaction—after all, Richard is accelerating the remainder, reducing by nearly half the amount of his current payout, and accepting about a third of that as ordinary income rather than long-term gain—we are looking at the following limits: (1) using the July figures, based on the 3.0 percent "section 7520" rate, 90 percent of $430,647 (the present value of the unitrust interest) is $387,582.30. Assuming an adjusted annuity multiplier of 10.7969, the largest annuity allowable under Code Section 514(c)(5) would be $35,897.55, or about 8.3 percent. Richard would recognize gain of $387,582.30 in the transaction, spread over 15.9 years, so that only $11,367.48 of each year's annuity would be characterized as ordinary income. His income tax charitable contributions deduction would be $43,064.96 (i.e., 10 percent of the value transferred—we are running up against the limits of the software here). (2) using the June figures, based on the 3.6 percent "section 7520" rate, 90 percent of $430,171 is $387,153.90. Assuming an adjusted annuity multiplier of 10.3077, the largest annuity allowable would be $37,559.68, or about 8.7 percent. Richard would recognize gain of $387,153.90, again spread over 15.9 years, so that about $13,075.60 of each year's annuity would be characterized as ordinary income. His charitable contributions deduction would be about $43,017.40 (again, roughly 10 percent of the value transferred). (3) using the May figures, based on the 3.8 percent "section 7520" rate, 90 percent of $430,017 is $387,015.30. Assuming an adjusted annuity multiplier of 10.1528, the largest annuity allowable would be $38,199.07, or nearly 8.9 percent. Richard
44
Journal of Gift Planning
would recognize gain of $387,015.30, again spread over 15.9 years, so that about $13,930.95 of each year's annuity would be characterized as ordinary income. His deduction would be $43,002.11. A similar, possibly more attractive result might be achieved by having Richard surrender his unexpired unitrust interest in exchange for a unitrust interest in a freshly created trust with a somewhat lower payout rate. The question of deviating from ACGA rates would not come into play. While this transaction has not yet been the subject of any letter rulings, the same principles would seem to apply. This technique might be particularly attractive in a situation in which the settlor is locked into a NIMCRUT that has accumulated a considerable deficiency and which continues to make payouts considerably below the stated percentage. h. taking this a step further If Richard had reserved a power to designate the remaindermen of the unitrust, then the acceleration of the remainder would itself be a gift to the university—see PLR 9529032 (04/28/95), item 4 above—though it would not generate an additional income tax deduction. Query whether a gift annuity given in exchange for this transfer would run afoul of the 90 percent limitation imposed by Code Section 514(c)(5). Note that regulation 1.514(c)-1 defines the limitation in terms of "the value of the prior owner's equity" in the property received (an embellishment of the statute, which does not use the word "equity"). Note also that for income tax purposes, Richard not only has no basis in the remainder, he has no property interest in it at all (unless some value were to be ascribed to his reserved power to designate the remaindermen). i. the "more modest" results The method of calculating the results if Richard were to surrender only a portion of his unitrust interest is identical to that described above. If instead Richard were to agree to reduce the amount of his unitrust payout from eight percent to five, the present value of the three percent spread would be calculated by subtracting the remainder value of a five percent unitrust from that of an eight percent unitrust, etc.
j. charitable contributions deduction Because Richard's interest in the unitrust is considered a capital asset on which he would report long-term gain in an exchange, any deduction he might claim will be limited to 30 percent of his adjusted gross income, and any unused excess would be eligible for carryforward for up to five years. DETAILS: THE LEGALITIES The legal mechanics of how this transaction is to be closed are very state law specific. In general, whether the transaction is to be accomplished by private agreement or through a "friendly" judicial proceeding to modify or terminate the trust, all interested parties, including the holders of contingent interests (albeit perhaps not the holders of interests defeasible through the exercise of a power reserved by the settlor) must be represented. Where the identities or shares of the charitable remaindermen are indefinite, either because the settlor has reserved a power to designate the remaindermen or because a similar power has been granted to the trustee or to one or more individual beneficiaries, it will almost certainly be necessary to join the state attorney general in a judicial modification or termination proceeding. RELATED TRANSACTION: SURRENDER OF LEAD TRUST REMAINDER Code Section 2522(c)(2)(B) requires that the charitable interest in a lead trust be in the form of a guaranteed annuity or unitrust interest. Regulation 25.2522(c)-3(c)(2)(vi)(a) requires, in the case of a charitable lead annuity trust, that the exact amount of the annuity be ascertainable at the date the trust is created. (There is no parallel language in the regulation governing charitable lead unitrusts.) The Treasury has ruled that the
statute and regulatory requirements preclude the use of commutation or prepayment provisions in charitable lead annuity trusts, if prepayment is to be made on a discounted basis. (Rev. Rul. 88-27, 1988-1 C.B. 331) And in a private letter ruling, the Service came to the same conclusion with respect to a proposed commutation and prepayment by agreement. (PLR 9734057, 05/28/97) However, in another letter ruling—PLR 9844027 (08/05/98)—the Service approved the prepayment of the future stream of annuity payments in full, without discount. Clearly, this ruling can literally apply only to an annuity trust for a term of years. But query whether it might be possible to commute the lead interest in a unitrust, whether for a term of years or for the life or lives of one or more individuals.
Russell A. Willis III maintains a private consulting practice in Creve Coeur (St. Louis), Missouri, with an emphasis in charitable planned gift design. He is a former chair of the Steering Committee of the Probate and Trust Law Section of the Bar Association of Metropolitan St. Louis. For a number of years, he served on the Trust Law Revision Subcommittee of the Probate and Trust Law Committee of the Missouri Bar. In addition, Mr. Willis has taught courses in future interests and tax-driven estate planning as an adjunct member of the faculty of the St. Louis University School of Law. Mr. Willis holds a J.D. from the St. Louis University School of Law. He received an LL.M. in Taxation Law from Washington University School of Law.