NIMCRUT's Charitable Remainder Interest Must Be Valued Using Stated Payout Percentage Without Reduction Based on Possible Limts Due to Net Income

Sometimes it takes a while for the Tax Court to issue a decision on an issue that you might have thought would have been addressed previously.  Such is true with regard to the issue of valuing net income makeup charitable remainder unitrusts (NIMCRUTs) created under IRC §664.  In the case of Estate of Schaefer v. Commissioner, 145 TC No. 4, the Tax Court addressed this issue.

Under IRC §664, added to the law in 1969, a taxpayer is allowed to claim a charitable deduction for the current discounted value of principal that would go to a charity at the termination of either a charitable reminder annuity trust (CRAT) or a charitable remainder unitrust (CRUT).  Such a trust generally provides for either a fixed payout per year to an income beneficiary (CRAT) or a payout based on a fixed percentage of the trust’s value each year (CRUT). 

The CRUT can contain a provision that limits the payout to the lesser of the fixed percentage or the trust’s income for the year (a net income CRUT).  Such a net income CRUT may contain a “make-up” provision that will allow that if the payout is limited based on the trust’s income in a particular year, that payout can be increased up to the amount of income in a future year until the shortfall is recovered (a net income make-up CRUT or NIMCRUT).

The value deemed to go to the charity is computed by valuing the income and remainder interests using discounting rules provided IRC §664(e).  For a CRUT the value is computed on the basis that an amount equal to the greater of 5 percent of the value of trust assets or the payout percentage is distributed each year.  However no charitable deduction will be allowed if the value passing to charity, computed under these rules, is less than 10% of the assets transferred to the trust.

In this case the trusts in question were NIMCRUTs that provided the annual payout would be the lesser of a fixed percentage (10% for one and 11% for the other) of the fair value of the net assets of the trust, valued annually.  That payout would be reduced in a year if trust income fell below those levels, with the underpayment carried forward to be potentially distributed in a later year when trust income was above those levels.

These trusts had been valued for estate tax purposes using a payout rate that was less than the stated rates in the trust, using the §7520 rates as a “stand-in” for the trust’s annual net income.  The IRS contended that the proper value was using the stated rates for annual payouts, a position consistent with Revenue Procedure 2005‑54.  If the IRS’s position was correct the remainder interest would fall below 10% and thus no charitable deduction would be allowed (in this case the charitable deduction was being claimed for transfer tax and not income tax purposes).

The Tax Court concluded that the text of the Internal Revenue Code did not clearly indicate which method should be used to value the interest, so the Court looked at the legislative history of the section.  The original House bill did not contain a provision for a limitation based on net income—that was added by the Senate.

The Court found while the statute wasn’t clear on the issue, the Senate Committee Report.  The Court noted:

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 (emphasis added). 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.

However the Court notes that the IRS regulations do not make the issue clear.  As the Court noted:

The regulations are less clear. The regulation addressing how to value the remainder interest in a CRUT, section 1.664­4(a)(3), Income Tax Regs., contains an explicit cross-reference to distributions determined under section 1.664-3(a)(1)(i)(a), Income Tax Regs. But NIMCRUT distributions are described under an exception to that regulation. Id. subdiv. (i)(b).

Given this the Tax Court decides to turn to the Revenue Procedure described above and a 1972 revenue procedure (Rev. Rul. 72-395) that provided example language for such a trust for guidance.  The Court notes that such rulings do not bind the Court, but that they are owed some deference.  In this case the Court finds the rulings consistent with the legislative history and that they stand the test of having “‘power to persuade’ by looking to “the thoroughness evident in its consideration, the validity of its reasoning, [and] its consistency with earlier and later pronouncements’”.

The Court concludes:

Particularly in the light of the legislative history previously discussed, we find the Commissioner's guidance to be persuasive. Both pieces of guidance are thoroughly reasoned, providing examples and explanations based on the applicable provisions. Additionally, the guidance has withstood the test of time. Rev. Rul. 72-395, supra, has been in effect for over four decades without any change to the provision before us. Further, Rev. Proc. 2005-54, supra, reaffirmed that reasoning when it was published some 30 years later. The Commissioner's position also has remained consistent and has been the subject of little litigation.

Thus the Court concluded that the CRUTs in question failed the 10% test and no charitable deduction was allowable.