Summer 1999 Newsletter
RECENT IRS REGULATIONS PROVIDE PLANNING OPPORTUNITIES FOR EXISTING CHARITABLE REMAINDER UNITRUSTS
By David L. Lundy
The IRS recently announced that it will extend the deadline for reformation of existing charitable remainder unitrusts (CRUTs) to take advantage of new regulations that permit an income CRUT to convert to the fixed percentage method for calculating payments to the non-charitable beneficiary. Clients who are receiving beneficiary payments based on the net income earned by a CRUT should be informed of this one-time opportunity to change the payment method to a fixed percentage of the annual value of trust assets. Under final regulations effective December 10, 1998, a net income method CRUT may now provide that it will convert to the fixed percentage method as of a specified date or event. The new regulations permit reformation of existing CRUTs to provide for a conversion from the net income method to the fixed percentage method of calculating beneficiary payments. The regulations require that proceedings to reform the trust be commenced by June 8, 1999. However, the IRS announced on May 21, 1999, that it will amend the regulations to permit reformation if an action is brought by June 30, 2000.
As defined in IRC § 664(d)(2)(A), a CRUT is a trust that provides for the distribution of a fixed percentage of the net fair market value of its assets, valued annually (the "fixed percentage method"). The fixed percentage must be at least 5 percent and not more than 50 percent of the value of trust assets. Distributions must be paid at least once a year to one or more persons (at least one of which is not a charitable organization) for a term of not more than 20 years, or for the lives of individual beneficiaries. Following termination of the payments, the remainder interest in the trust must be transferred to, or for the use of, a charitable organization, or retained by the trust for such. use.1 As of the date that property is contributed to the trust, the value of the charitable remainder interest in such property must be at least 10 percent of the property's net fair market value.2
Section 664 contains an exception to the requirement that trust beneficiaries be paid a fixed percentage of the net fair market value of trust assets. The beneficiaries may be paid the amount of trust income for any year, if such amount is less than the fixed percentage designated for the trust (the "net income method").3 The trust instrument also may provide for payment of trust income in excess of the fixed percentage, to the extent that the aggregate of amounts paid in prior years was less than amounts that would have been paid using the fixed percentage method (the "net income with make-up method").4
Before proposing the new regulations, the IRS took the position that the initial method selected for the calculation of beneficiary payments could not be changed during the term of the trust. This limited the flexibility needed by clients who contributed assets that were not readily marketable and produced little income. If a grantor contributed undeveloped real estate to a CRUT, for example, it would not be possible to make payments under the fixed percentage method until the real estate was sold. One of the net income methods could be selected for the trust so that distributions of any income could be made annually as required by the regulations. Once the property was sold, however, the grantor may have preferred receiving a fixed percentage of the reinvested trust assets each year without regard to the amount of income being generated.
In PLR 9506015, real estate was used to fund a CRUT that provided for beneficiary payments of the lesser of annual net income or 8 percent of the net fair market value of trust assets, valued annually. The trust agreement also contained a make-up provision. The grantors intended to provide in the instrument that the net income with make-up method would be replaced by the fixed percentage method following sale of the real estate. They requested a private letter ruling while their petition for court reformation was pending. The IRS stated that a change in payment methods would disqualify the trust, causing it to lose its tax-exempt status.
As a result of changes made by the Tax Reform Act of 1969, a remainder interest in property transferred in trust to a charitable organization qualifies for the charitable deduction for federal income, gift, and estate tax purposes only if the trust is a charitable remainder annuity trust described in section 664(d)( 1) of the Code, a charitable remainder unitrust described in section 664(d)(2) or a pooled income fund described in section 642(c)(5). The purpose of these changes was to remove any incentive to manipulate trust investments for the benefit of non charitable income beneficiaries to the detriment of the charitable remainder beneficiaries.
Pursuant to section 664(d) of the Code, the amount payable to non charitable beneficiaries from a qualified charitable remainder unitrust must be computed using one of three methods as selected by the terms of the trust's governing instrument. Those methods are the fixed percentage method, the income exception method, or the income exception with make-up method. To prevent possible manipulation of trust assets to the detriment of the charitable remainder interest, the trust's governing instrument must select one of those methods and that selected method must be used during the entire term of the trust. The governing instrument may not provide for a change in the method of computing the unitrust amount during the term of the trust. In addition, the governing instrument may not be reformed to provide for a change in the method of computing the unitrust amount without adversely affecting the qualification of the trust under section 664.5
A trust that makes beneficiary payments using one of the net income methods, and subsequently converts to the fixed percentage method of payment, generally is referred to as a "flip-CRUT." The IRS changed its position against flip provisions when it published proposed regulations in 1997.
The final regulations, which are effective December 10, 1998, permit the creation of flip CRUTs in which the change from the net income method to the fixed percentage method "is triggered on a specific date or by a single event whose occurrence is not discretionary with, or within the control of, the trustees or any other persons."6 Such events are defined to include the sale of unmarketable assets, or marriage, divorce, death, or the birth of a child with respect to any individual.7 "Unmarketable assets" are assets that are not "cash, cash equivalents, or other assets that can be readily sold or exchanged for cash or cash equivalents."8 Examples include real property, closely held stock, and an unregistered security for which there is no available exemption permitting public sale.
The change in payment method must occur at the beginning of the taxable year following the year in which the specific date or triggering event occurs.9 Following the change, any "make-up" amount that has not been paid is forfeited.10 When the trust converts to the fixed percentage method, it must use the same percentage that was designated for the trust as the maximum amount payable under the net income method.11
Net income method CRUTs, including those with make-up provisions, may be reformed under the new regulations to permit conversion to the fixed percentage method.12 Such reformations also are permitted for trusts with existing flip provisions that do not comply with the final regulations. The event that triggers conversion under the reformed instrument may not occur in a year prior to the year in which the court orders reformation, unless the governing instrument of a trust prior to reformation already provided for beneficiary payments under an impermissible combination of methods, and the triggering event occurred prior to reformation. The regulations require that the trustee begin legal proceedings to reform the trust by June 8, 1999. In its recent notice, however, the IRS announced that it will amend the regulations to extend the deadline to June 30, 2000.13 The amendment will be effective December 10, 1998.
The IRS notice states that the term "legal proceedings" includes non-judicial reformations that are valid under state law, but such reformations must be completed by June 30, 2000.
The Virginia Code provides for non-judicial reformation of charitable remainder trusts to conform such trusts to requirements for exemption from federal taxes. Section 55-29.1 provides that
the trustee or trustees of such trust, with the concurrence of the creator of the trust (if then living and able to give such consent) and the Attorney General, may, without resort to any court, unless such amendment is inconsistent with an express provision of such trust's governing instrument, amend the terms of such trust to bring such trust into or continue such trust in conformity with requirements for exemption of such trust, or any interest therein, from federal taxes.14
If an existing flip provision does not comply with Treasury regulations, the Virginia statute might be interpreted to permit amendment of the trust instrument without court intervention because such amendment would bring the trust into conformity with the requirements for tax exemption. The statute also requires, however, that any amendment not be inconsistent with an express provision of the trust. An amendment that permits a proper flip provision could be deemed inconsistent with the existing terms of a trust, depending on the nature of the improper provision.
A net income method CRUT that complies with all requirements for tax exemption also may seek reformation to add a flip provision to its governing instrument. Section 55-29.1 permits non-judicial reformation "to bring such trust into or continue such trust in conformity with" the requirements for tax exemption. In this case, the purpose of the reformation is to provide the income beneficiary with a desired payment option; reformation is not being undertaken to maintain the exempt status of the trust. Another problem with non-judicial reformation in this context is that a flip-provision amendment could be deemed inconsistent - under § 55-29.1 - with the net income method contained in the trust's governing instrument.
Practitioners who are concerned about the effectiveness of a non-judicial reformation should consider bringing an action under Va. Code § 55-19.4. The statute authorizes a Virginia circuit court to modify a trust in any manner, on a showing of good cause.15 The court must find, however, that such action will not adversely affect the interests of any beneficiary.16 "Good cause" may be shown by evidence of changes in federal tax laws which, if modification were made, would materially benefit the trust or the interests of the trustor or any beneficiary.17
If a net income method CRUT is reformed to allow conversion to the fixed percentage method, the non-charitable income beneficiary may benefit financially to the extent that trust income falls short of the fixed percentage designated for the trust. In such case, there may be. a corresponding financial detriment to the charitable remainder man. In an action to reform, good cause may be shown if there will be a "material benefit" to the income beneficiary. The court may question whether such benefit, once established, will prevent a finding under § 55-19.4(B) of no adverse effect on the charitable interest.
The new regulations provide flexibility for clients who want to establish a net income method CRUT funded with unmarketable assets, and retain the ability to receive payments based on the fixed percentage method once those assets have been sold. The regulations also provide a one-time opportunity for beneficiaries of existing CRUTs' to add a flip provision to the governing instrument of the trust.
If reformation of an existing trust is desired, practitioners should consider whether a court-ordered modification would be appropriate. The limited application of § 55-29.1 suggests that judicial involvement may be necessary in most cases. In an action to reform under § 55-19.4, a material benefit must be shown, together with the absence of any detriment that could be caused by the proposed reformation. The action should include the Attorney General on behalf of the charitable interest.
DAVID L. LUNDY is an associate with the Roanoke law firm of Gentry Locke Rakes & Moore. He received his J. D., cum laude, from Washington and Lee University, and an L.L.M. in taxation from the College of William and Mary. Mr. Lundy completed judicial clerkships with Judge Julian J. Jacobs of the u.s. Tax Court, Judge Robert H. Hodges, Jr. of the U.S. Court of Federal Claims, and Judge Jackson L. Kiser of the U.S. District Court for the Western District of Virginia. He is a member of the bar in Virginia and New York and practices primarily in the areas of taxation and trusts and estates.
1 IRC § 664(d)(2)(C).
2 IRC § 664(d)(2)(D).
3 IRC § 664(d)(3)(A).
4 IRC § 664(d)(3)(B); Treas. Reg. § 1.6643(a)(I)(i)(b).
5 PLR 9506015 (citations omitted). See also PLR 9516040 (same conclusion based on Treas. Reg. § 1.664-3(a)(4), which provides that the trust may not be subject to a power to invade, alter, amend, or revoke for the benefit of a non-charitable beneficiary); and PLR 9522021 (reformation permitting change in payment method would be self-dealing under IRC § 4941 because it could transfer assets from the charitable remainder man to the income beneficiary).
6 Treas. Reg. § 1.664-3(a)(I)(i)(c)(1).
7 Treas. Reg. § 1.664-3(a)(1)(i)(d).
8 Treas. Reg. § 1.664-1(a)(7)(ii).
9Treas. Reg. § 1.664-3(a)(1)(i)(c)(2).
10 See Treas. Reg. § 1.664-3(a)(1)(i)(c)(3).
11 Treas. Reg. § 1.664-3(a)(I)(i)(c).
12 Treas. Reg. § 1.664-3(a)(1)(i)(t)(3).
13 Notice 99-31 dated May 21, 1999.
14 Va. Code § 55-29.1.
15Va. Code § 55-19.4(A).
16 Va. Code § 55-19.4(B).
17 Va. Code § 55-19.4(D)(I).