Dan Evans & the Valuation of Terminating NIMCRUTs
“It is sometimes advantageous for a donor to terminate a charitable remainder unitrust (‘CRUT’) prematurely, usually by transferring the retained unitrust interest to the charitable remainderman and so ‘collapsing’ the trust. Because of a technical change made by Congress to the valuation rules for NIMCRUTs (net income with makeup charitable remainder unitrust), early terminations of NIMCRUTs can produce larger income tax deductions, and the larger charitable deductions might produce income tax reductions greater than the present value of the income from the NIMCRUT.”
In his commentary, Dan Evans tells us how the change to the valuation rules happened, and how NIMCRUT beneficiaries may take advantage of the new valuation rules. Members should note that the following authors have also commented on this important development for LISI, and their newsletters are hyperlinked:
· Richard L. Fox and Jonathan G. Blattmachr: Protecting Americans from Tax Hikes (“Path”) Act of 2015 Amends IRC § 664(e) to Disregard Net Income Limitation upon Early Termination of NICRUTs and NIMCRUTs; Long-Awaited Change Negates IRS Ruling Position
· Larry Katzenstein: Section 344 of the Protecting Americans from Tax Hikes Act of 2015
Daniel B. Evans is NumberCruncher’s Chief Technical Advisor. Dan practices law in Glenside, Pennsylvania in the areas of estate planning, estate and trust administration, and related tax planning for closely-held businesses. He is a fellow of the American College of Trust and Estate Counsel, is active in the Pennsylvania and Philadelphia Bar Associations, and has written and spoken extensively on estate planning and legal technology. He served for 13 years as the "Probate-Technology Editor of Probate and Property magazine, published by the Section of Real Property, Probate, and Trust Law of the American Bar Association. Dan is a Co-Author of THE NEW BOOK OF TRUSTS (610 924 0515) and is the author of WILLS, TRUSTS, AND TECHNOLOGY: AN ESTATE LAWYER'S GUIDE TO AUTOMATION and HOW TO BUILD AND MANAGE AN ESTATES PRACTICE, both published jointly by the Real Property, Probate and Trust Law and Law Practice Management Sections of the ABA. Most recently, he received the 2014 Distinguished Estate Planner award from the Philadelphia Estate Planning Council. His complete resume, and many of his writings, can be found at http://resources.evans-legal.com
Here is Dan’s commentary:
EXECUTIVE SUMMARY:
IRC section 664 allows a charitable remainder unitrust to distribute income only, but directs that the charitable remainder must be valued based on the percentage payout, without regard to the net income limitation. In private letter rulings, the IRS had held that, upon the early termination of the trust, the unitrust interest should be valued based on either the percentage payout rate or the income rate under IRC section 7520, whichever was less. These rulings were adverse to taxpayers, and Congress has now amended IRC section 664 to direct that the valuation of interests upon terminations of unitrusts should be based on the same rules that apply to the initial valuation of the remainder interests. Because current income yields are so much lower than the 5% minimum required payout rate, the new valuation rule greatly increases the charitable deduction that may be possible for the early termination of charitable remainder unitrusts with net income limitations, so much so that the benefit of the charitable deduction could exceed the net present value of the income interest that being given up.
FACTS:
In the usual charitable remainder unitrust (“CRUT”), the donor retains the right to receive a stated percentage of the value of the trust assets each year, based on annual revaluations of the trust assets, and IRC section 664(d)(2)(A) states that the payout rate may not be less than 5%. However, there is an exception in IRC section 664(d)(3), which allows a trust document to direct that the distributions be limited to the net income actually received by the trust, even if less than the percentage distribution otherwise required, with distributions of income in later years in excess of the percentage distribution to the extent that the total of the previous income distributions is less than the total previous percentage distributions. Limited by net income in this way, the total distributions from the trust could be less than the percentage distributions, but never more. This kind of CRUT is usually known as a “net income with makeups charitable remainder unitrust,” or “NIMCRUT.” (By regulations, the IRS has also allowed CRUT documents to allow the trust to “flip” between being a NIMCRUT and a regular CRUT upon the occurrence of an event specified in the document. See Treas. Reg. § 1.664-3(a)(1)(i)(c).)
Although the non-charitable distributions from a NIMCRUT could end up being less than percentage distributions, and so the charitable remainder could be more, the donor is not entitled to any increased charitable deduction for creating a NIMCRUT. IRC section 664(e) expressly states that “For purposes of determining the amount of any charitable contribution, the remainder interest of a charitable remainder annuity trust or charitable remainder unitrust shall be computed on the basis that an amount equal to 5 percent of the net fair market value of its assets (or a greater amount, if required under the terms of the trust instrument) is to be distributed each year.” So, when valuing the charitable remainder in a NIMCRUT, the net income limitation is ignored.
But how is the retained unitrust interest to be valued if the donor should later decide to renounce or assign the unitrust interest and allow the entire trust to pass to charity? Is the net income limitation take into account in that case?
This issue was apparently first addressed by the IRS in private letter rulings beginning in 2007, and the IRS took the position that the unitrust interest being given up to charity should be valued based on either the payout rate provided by the document or the discount rate in effect under IRC section 7520 in effect at the time of the gift, whichever is less. See, e.g., PLRs 200920136 and 201325019.
This IRS position has been effectively reversed by Congress. Section 344 of the Protecting Americans from Tax Hikes Act of 2015, which is Division Q of the Consolidated Appropriations Act of 2015, H.R. 2029, P.L. 114-113 (12/18/2015), has amended IRC section 664(e) by addition the following additional sentence:
In the case of the early termination of a trust which is a charitable remainder unitrust by reason of subsection (d)(3), the valuation of interests in such trust for purposes of this section shall be made under rules similar to the rules of the preceding sentence.
Section 344 of the act also made a conforming change to the title of IRC section 644(e ), and provided that the amendment is effective for terminations of trusts occurring after the date of the enactment, which was December 18th.
COMMENT:
Although the IRS position on valuing the retained unitrust interest in a NIMCRUT based on the lesser of the stated payout rate or the current 7520 rate made a certain amount of sense, because the non-charitable distributions were limited to net income and the 7520 rate is intended to represent current income yields, the position effectively whipsawed the donor/beneficiaries of NIMCRUTs by denying them a full charitable deduction for the entire value of the property passing to charity. Congress has now eliminated this disparity between NIMCRUTs and regular CRUTs.
To illustrate the problem created by the IRS position, assume that a 60 year old donor creates a NIMCRUT with the minimum required 5% payout to the donor during the donor’s lifetime. If the distributions are annual and immediately following each valuation, then the charitable deduction for the present value of the remainder will be 37.656% of the value of the assets transferred to the NIMCRUT because the valuation is based on the 5% payout without regard to the actual (or possible) income of the trust.
If the donor should change his mind within a short time, and decide to give the unitrust interest to charity as well, and if the unitrust interest is valued in the same way as the charitable remainder, which is based on the stated payout rate without regard to the income limitation, then the factor for the unitrust interest will be one minus the remainder factor, or 62.344% in the example above. So the donor will have gotten a charitable deduction for 100% of the value of the property in the NIMCRUT. However, if the unitrust interest is valued based on a payout equal to a 7520 rate of 2.2% (which will be the rate in January 2016), then the value will be only 36.560% of the value of the property in the trust. So donor will have lost 25.784% of the charitable deduction (62.344% minus 36.560%) even if there is no change in ages, interest rates, or property values from the initial gift to the NIMCRUT to the gift of the unitrust interest and termination of the NIMCRUT.
(Note to NumberCruncher users: NumberCruncher will not let you enter a payout rate of less than 5% for a CRUT, but will allow payouts of less than 5% for a charitable lead annuity trust, or CLUT. So the value of the unitrust interest at 2.2% can be calculated as a CLUT.)
This same problem would not exist for a regular CRUT, so taxpayers creating NIMCRUTs were very much at a disadvantage in how they would be treated in the event of a premature termination of their trusts. Fortunately, Congress has now eliminated that disadvantage.
And, although Congress may have intended only to eliminate the disadvantage suffered by NIMCRUTs under the IRS valuation position, it might have also created a new incentive for charitable gifts of unitrust interests in NIMCRUTs. In the example given above, if the value of the NIMCRUT were $1,000,000, then the 60 year old donor could claim a charitable deduction of $623,440 for giving up the 5% payout. If the donor is in the top 39.6% federal income tax bracket, that deduction will save $246,882 in tax. Meanwhile, if the trust is only earning income of (and distributing) 2%, then (according to NumberCruncher), the present value of that income interest is only $334,660, which is only $168,669 after applying the same 39.6% income tax rate. Which means that the donor could get an income tax deduction that is worth more than the income being given up.
Conclusion
With current low income yields, the beneficiaries of NIMCRUTs could very well decide that the charitable deduction for terminating the trust is worth more than the income from the trust, so the advisors to those beneficiaries should be looking at the possible advantages of early terminations.
HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!
Dan Evans
CITE AS:
LISI Charitable Planning Newsletter #242 (January 6, 2016) at http://www.leimbergservices.com Copyright 2016 Leimberg Information Services, Inc. (LISI) Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Written Permission.
CITES:
Section 344 of the Protecting Americans from Tax Hikes Act of 2015, which is Division Q of the Consolidated Appropriations Act of 2015, H.R. 2029, P.L. 114-113 (12/18/2015); IRC section 664; PLRs 200920136 and 201325019.