Many people have charitable desires which can be met either by outright gifts to charities or gifts in trust for a charity’s benefit. For a taxpayer to receive a charitable deduction for gifts to a trust, the trust must meet stringent guidelines established by the Internal Revenue Service (“IRS”). The IRS has recently clarified that certain language added to a charitable remainder annuity trust (“CRAT”) will help meet one of those requirements.
A CRAT is a trust which pays an annuity to one of more non charitable beneficiaries (for a term of years not more than 20 or the life of an individual recipient at the time the CRAT is created) and then, at the end of the term of years or death, the remainder is paid to the charity. The IRS requires that the annuity is not less than 5% nor more than 50% of the fair market value of the property funding of the CRAT. For example, if $1,000,000 is transferred to a CRAT, then the annuity can not be less than $50,000 nor more than $500,000.
The IRS also requires that IF the charitable transfer is dependent upon an act for the transfer to become effective, the charitable deduction is only allowed if the possibility of such an act preventing a charitable transfer is “so remote as to be negligible”.
Further, if there is a greater than 5% probability that payment of the annuity will exhaust the trust assets prior to distribution to the charity, then such possibility is deemed to NOT be “so remote to be negligible” (the “probability of exhaustion” test) and the taxpayer could not receive a charitable deduction for assets transferred to such a CRAT.
Without going into the specifics, the calculation for the 5% probability of exhaustion test uses the current Section 7520 interest rate, the annuity amount and the mortality table for the income beneficiary. Currently , because the Section 7520 interest rate is so low, the income beneficiary would have to be 72 years old to satisfy the probability of exhaustion test in a CRAT created today.
Revenue Procedure 2016-42 provides relief in providing language to add to a CRAT that will help ameliorate that issue and permit a CRAT to have younger annuity beneficiaries.
ADVICE: Prior to creating a CRAT be sure to include the proposed language. Also review prior revenue procedures to review IRS recommended language for a CRAT.
WORD OF THE WEEK: Annuity is a financial term which means a series of payments of a set size and frequency. If $1,000,000 was transferred to a CRAT and the donor received an annuity of $20,000 a year the $20,000 is considered the annuity amount. This is to be distinguished from the product, an “annuity”. An annuity is a contract sold by a company designed to provide payments to the holder at specified intervals, usually after retirement and the holder is taxed only when they start taking distributions. Annuities are tax deferred which means that the earnings from the investments in the annuity are not taxed until withdrawal.
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