Larry Katzenstein & Section 344 of the Protecting Americans from Tax Hikes Act of 2015
“Anyone in the charitable community who has been paying attention – and probably even many who haven’t been – by now knows that the IRA charitable rollover has been made permanent by section 112 of the Protecting Americans from Tax Hikes Act of 2015 signed by the President on December 18. But even the most attentive observer may not have noticed one of the other charitable provisions, the sleeper in section 344 of the Act.”
Larry Katzenstein provides members with his commentary on Section 344 of the Protecting Americans from Tax Hikes Act of 2015.
Lawrence P. Katzenstein, a partner is St. Louis law firm Thompson Coburn LLP, is a nationally known authority on estate planning and planned giving, a frequent speaker around the country to professional groups and serves as outside counsel to planned giving programs at charitable organizations nationwide. He appears annually on several American Law Institute estate planning programs, and has spoken at many other national tax institutes, including the Notre Dame Tax Institute, the University of Miami Heckerling Estate Planning Institute and the Southern Federal Tax Institute. Mr. Katzenstein has served as an adjunct professor at the Washington University School of Law where he has taught both estate and gift taxation and fiduciary income taxation. A former chair of the American Bar Association Tax Section Fiduciary Income Tax Committee, he is active in several Tax Section and American College of Trust and Estate Counsel (ACTEC) charitable planning committees. He is listed in Best Lawyers in America® 2015 (Copyright 2014 by Woodward/White, Inc., of Aiken, S.C.) in the field of Trusts and Estates. Mr. Katzenstein was named the St. Louis Non-Profit/Charities Lawyer of the Year in 2011 and 2015, and the St. Louis Trusts and Estates Lawyer of the Year in 2010 and 2013 by Best Lawyers in America®. He was nationally ranked in the 2009-2015 editions of Chambers USA for Wealth Management. He has served as a member of the advisory board of the National Center on Philanthropy and the Law at New York University. Mr. Katzenstein is also the creator of Tiger Tables actuarial software, which is widely used around the country by tax lawyers and accountants as well as the Internal Revenue Service. He received his undergraduate degree from Washington University in St. Louis and his law degree from Harvard.
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
· Dan Evans: The Valuation of Terminating NIMCRUTs After Section 344 of the Protecting Americans from Tax Hikes Act of 2015
Now, here is Larry Katzenstein’s commentary:
COMMENT:
Anyone in the charitable community who has been paying attention – and probably even many who haven’t been – by now knows that the IRA charitable rollover has been made permanent by section 112 of the Protecting Americans from Tax Hikes Act of 2015 signed by the President on December 18. But even the most attentive observer may not have noticed one of the other charitable provisions, the sleeper in section 344 of the Act. That brief section, in its entirety, is as follows:
SEC. 344. CLARIFICATION OF VALUATION RULE FOR EARLY
TERMINATION OF CERTAIN CHARITABLE REMAINDER UNITRUSTS.
(a) IN GENERAL.—Section 664(e) is amended—
(1) by adding at the end the following: ‘‘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.’’, and
(2) by striking ‘‘FOR PURPOSES OF CHARITABLE CONTRIBUTION’’ in the heading thereof and inserting ‘‘OF INTERESTS’’.
(b) EFFECTIVE DATE.—The amendment made by this section shall apply to terminations of trusts occurring after the date of the enactment of this Act.
What is this section trying to accomplish? First, some background. A standard charitable remainder unitrust pays a fixed percentage of trust assets, as revalued at least annually, to the income beneficiary or beneficiaries. Internal Revenue Code section 664(d)(3) permits a variation on the unitrust theme, allowing a charitable remainder unitrust to pay the income beneficiary the lesser of trust fiduciary accounting income or the unitrust amount. An income-only unitrust may also provide – or not provide – that if in later years trust income exceeds the unitrust amount for the year, deficiencies can be made up for prior years when income was less than the unitrust amount. (The makeup payment can never exceed the unitrust percentage payment for the year.) These are the well-known NICRUT and NIMCRUT. In calculating the actuarial value of the charitable interest in an income-only charitable remainder unitrust, Code section 664(e) says that the income-only feature is ignored:
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.
The Senate report to the 1969 Tax Reform Act described the Senate amendment allowing an income-only unitrust, and stated that the amount of a charitable contribution deduction would be computed ignoring the income-only feature:
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.
Although the Code provision mentions only value of the charitable remainder, it should follow that the income interest would be similarly valued. The Tax Court’s recent decision in Estate of Schaefer (145 T.C. No. 4, decided July 28, 2015) is consistent with this, holding that for purposes of calculating the 10% actuarial remainder test of section 664 the income-only feature is ignored.
But suppose that the income beneficiary and the charitable remainder beneficiary decide to whack up and terminate the trust, with the income beneficiary getting assets equal the actuarial value of the income interest and the charitable remainder beneficiary getting assets equal to the actuarial value of the remainder interest. Do we take into account the income-only feature in that situation? One’s first reaction might be no – don’t we have to be consistent in how we value these interests, and if the income-only feature is ignored for purposes of calculating the charitable deduction shouldn’t it be ignored for all purposes? On the other hand, if the trust provides for, say, payment of the lesser of fiduciary accounting income or a 10% unitrust amount, isn’t ignoring the income-only feature in our current low interest environment going to mean that a lot more is going to pass out to the income beneficiary on division than the beneficiary could ever expect to receive if the trust were not terminated, and isn’t that self-dealing under Code section 4941?
The Service has addressed this issue in several private letter rulings. In the earlier rulings,[i] the Service approved division of income-only unitrusts without requiring that the income-only feature be taken into account in allocating trust assets. But in more recent rulings[ii] the Service ruled that division of the trusts without taking into account the income-only feature would be self-dealing. Instead, the Service required that trust be divided as if the unitrust payout percentage were equal to the 7520 rate in effect at the time of the division. Here is what the Service had to say in Private Letter Ruling 201325018:
One reasonable method not resulting in a greater allocation of assets to Husband and Wife than appropriate is the following: The computation of the remainder interest is found using a special factor as indicated in § 1.7520-3(b)(1)(ii). The special remainder factor is found by using the methodology stated in § 1.664-4 for computing the factor for a remainder interest in a unitrust, with the following modification: where § 1.664-4(a)(3) of the regulations provides an assumption that the trust's stated payout percentage is to be paid out each year, instead the assumed payout shall be that of a fixed percentage which is equal to the lesser of the trust's stated payout percentage or the § 7520 rate for the month of termination. The special factor for the non-charitable payout interest is 1 minus the special remainder factor…In this case, the income beneficiaries are not expected to receive more than they would during the full term of Trust under the above-described methodology for valuing their interests in a charitable remainder trust with a net income make-up feature.
We have it on good authority that the purpose of Section 344 of the Act was to reverse the position the Service took in these later PLRs. But there are several odd things about the Act as it was written. Note first that the provision is called a “clarification.” If so, why does the “clarification” apply only to terminations of trusts occurring after the date of enactment? But even more important, the amendment to section 664 doesn’t fix the perceived problem! It says nothing at all about self-dealing – no amendment was made to Code section 4941.
Just because the income interest is “valued” without taking into account the income-only feature, it doesn’t necessarily follow that a division which results in the income beneficiary getting substantially more on the division than would otherwise be paid out is not self-dealing. And how can the charity and the trustee ever consent to such a division without violating their respective fiduciary duties? If the trust can only be divided by court order, shouldn’t the state attorney general object? The numbers can be significant.
Take for example a $1,000,000 unitrust providing for quarterly payments to a 70 year old income beneficiary of the lesser of a 10% unitrust amount or trust income. Suppose further that in the month of division the 7520 rate is 2.0 %--the current December rate. If we ignore the income only feature on division, the income beneficiary would receive $694,350. If instead we use the IRS methodology in the PLRs to avoid self-dealing, the income beneficiary would receive only $238,810. Even the IRS solution in the PLRs is a tad too generous because it allowed division assuming a 2% unitrust payment, not a 2% fiduciary accounting income payment, which is all the income beneficiary was entitled to. The actuarial value for a 70 years old of a straight income interest of 2% is only $237,400.
It is difficult to see how a division of a net-income CRUT which results in the income beneficiary’s receiving far more he or she could ever dream of receiving otherwise could not be self-dealing and the amendment to section 664 just doesn’t address this. This amendment to section 664 is not good for charities and one hopes that trustees and charitable remainder beneficiaries will do their duty when interest rates are low and resist divisions which so grossly overpay the income beneficiary absent some pretty unusual circumstances.
There is another situation in which the Act applies, namely the transfer of an income-only unitrust interest by the income beneficiary to the charitable remainder beneficiary causing termination of the trust. The Act would apply in this case as well although here no new ground is broken. Although in PLR 200205008 the Service limited the deduction for the gift of an income interest in a net income unitrust to the lesser of the unitrust value or the value of the income interest, that appears to be an aberration as PLRs 200524014 and 200808018 say just the opposite.
HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!
Larry Katzenstein
CITE AS:
LISI Charitable Planning Newsletter #241 (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.
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