In Revenue Procedure 2016-42 the IRS gave sample language that can be included in the governing instrument of a Charitable Annuity Trust (CRAT) providing for annuity payments payable for one or more measuring lives followed by the distribution of trust assets to one or more charitable remaindermen that can allow the trust to escape the “probability of exhaustion” testing found in Revenue Ruling 70-452.
Charitable remainder trusts, as defined in IRC §664, provide one of the few methods that allow for a charitable deduction of a partial interest to a charity for either income tax or estate tax purposes. The trusts provide for a payout to an income beneficiary for a period of time (can be a fixed number of years or for life) and then, following the end of that term, the balance remaining in the trust being paid to a charitable organization. A deduction is allowed for the discounted value of the expected balance to be paid to the charity at the time the trust is formed.
However a trust does not qualify for this treatment if there is more than a remote possibility that the charitable interest will end up getting nothing, as the income payments exhaust the trust principal. Revenue Ruling 70-452 dealt with this situation, as the new Revenue Procedure describes:
Rev. Rul. 70-452 applies these rules to a split-interest charitable remainder trust. Rev. Rul. 70-452 holds that, if there is a greater than 5 percent probability that payment of the annuity will defeat the charity's interest by exhausting the trust assets by the end of the trust term, then the possibility that the charitable transfer will not become effective is not so remote as to be negligible. This determination is referred to as the “probability of exhaustion test.” Rev. Rul. 77-374 applies the probability of exhaustion test to a CRAT. The probability of exhaustion is calculated first by applying the § 7520 assumed rate of return on CRAT assets (§ 7250 rate) against the amount of the annuity payment to determine when the CRAT assets will be exhausted. Then, a mortality table (Mortality Table 2000CM, found in § 2031-7(d)(7)) is used to determine the probability that the income beneficiary or beneficiaries will survive exhaustion of the CRAT assets. If the probability that the life beneficiary or beneficiaries will survive exhaustion of the CRAT assets is greater than 5 percent, then the charitable remainder interest of the CRAT does not qualify for an income, gift, or estate tax charitable deduction and the CRAT is not exempt from income tax under § 664(c). If the § 7520 rate at creation of the trust is equal to or greater than the percentage used to determine the annuity payment, then exhaustion will never occur under this test.
As the Revenue Procedure goes on to note, extremely low interest rates in recent years have made it very difficult for a CRAT to pass this test. As the procedure notes:
For example, in May of 2016, the § 7520 rate was 1.8 percent. At this interest rate, the sole life beneficiary of a CRAT that provides for the payment of the minimum allowable annuity (equal to 5 percent of the initial FMV of the trust assets) must be at least 72 years old at the creation of the trust for the trust to satisfy the probability of exhaustion test. The § 7520 rate has not exceeded the minimum 5 percent annuity payout rate since December of 2007, which has necessitated testing for the probability of exhaustion for every CRAT created since that time.
The IRS is providing a “fail-safe” provision that would terminate the trust and pay the balance to charity if the annuity payment would cause the value of trust corpus, multiplied by a discount factor, to be less than 10% of the initial value of the trust principal. The inclusion of this provision would qualify as a “qualified contingency” per §664(f) that would not disqualify the CRAT even though terminating the payments earlier than the normal term of the trust
The sample language for a single life CRAT is provided as follows:
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].
The procedure goes on to describe modifications to be made to the above language in the case of a testamentary CRAT, how to use this language along with the same CRAT language found in Revenue Procedure 2003-57 and for CRATs paying consecutively for two measuring lives.
The procedure goes on to provide a detailed example of how this rule would apply in practice:
On January 1, Year 1, Donor transfers property valued at $1,000,000 to Trust, an inter vivos trust providing for an annuity payment of $50,000 (5 percent of the value of the initial trust corpus) on December 31 of each year to S for S's life followed by the distribution of trust assets to Charity. Trust includes the precise language of the sample provision in section 5 of this revenue procedure providing for an early termination contingency and specifies the § 7520 rate in effect for January, Year 1, which is 3 percent. But for the early termination provision, Trust meets all of the requirements of § 664(d)(1). In accordance with this revenue procedure, the IRS will treat the early termination contingency as a qualified contingency under § 664(f). Therefore, the early termination provision does not cause Trust to fail to qualify as a CRAT under § 664. In addition, Trust qualifies as a CRAT regardless of whether it passes the probability of exhaustion test on January 1, Year 1.
Each year, prior to payment of the annuity to S, the trustee performs the calculations required to determine if Trust will terminate early in accordance with the terms of the qualified contingency. In each year from Year 1 through Year 17, the trustee determines that the value of the trust corpus, minus the $50,000 annual payment, and then multiplied by the specified discount factor, is greater than 10 percent of the initial trust corpus. The value of the trust corpus as of December 30 in Year 18 is $210,000. Only in Year 18 does the value of the trust corpus as of December 30, when reduced by the annuity payment and multiplied by the specified discount factor, fall below 10 percent of the value of the initial trust corpus. The calculations required to determine if Trust will terminate early in Year 18 are as follows:
1. $1,000,000 x 10% -= $100,000
2. ($210,000 - 50,000) X (1/(1+.03)]^18
$160,000 x [1/(1+.03)]^18
$160,000 X 0.97087418^18
$160,000 X 0.587397 = $93,984
Because the value of the trust corpus ($210,000), when reduced by the annuity payment ($50,000) and then multiplied by the specified discount factor (0.587397), is less than 10 percent of the value of the initial trust corpus ($100,000), Trust terminates on December 30, Year 18, and the principal and income remaining in Trust (including the annuity payment for Year 18 that otherwise would have been payable to S) then must be distributed to Charity.
The Revenue Procedure is effective for trusts created on or after August 8, 2016.