A charitable remainder annuity trust (“CRAT”) can be a powerful estate planning tool for taxpayers who wish to make charitable contributions but also desire to provide a current income stream to themselves or to other noncharitable beneficiaries. Here’s how it works. First, a taxpayer transfers assets to an irrevocable trust. During the term of trust, fixed annual payments are made to the transferor or to the chosen noncharitable beneficiaries. At the end of the trust term, the assets remaining in trust pass to a designated charity. The transferor is entitled to a charitable deduction in the year the trust is funded in the amount of the fair market value of the property placed in trust reduced by the present value of the annuity to be paid from the trust.
Various technical requirements must be met for a trust to qualify as a CRAT. First, the annuity must be paid for a term not to exceed 20 years, or for the life of the individual(s) to whom the annuity is paid. Second, the annual payments must be in an amount that is at least 5% but not more than 50% of the initial fair market value of the assets transferred to the CRAT. In addition, the value of the remainder interest, as determined at the creation of the CRAT, must be at least 10% of the initial fair market value of all property placed in trust. Finally, when the CRAT terminates, the remaining trust property must pass to or for the use of a charitable organization or other qualified remainder beneficiary.
In addition to the payout and remainder value requirements, a CRAT measured by the term of one or more lifetimes must also satisfy the “probability of exhaustion” test. Under this test, if there is a greater than 5% probability that distributions to the income beneficiaries will defeat the charity’s interests by exhausting the principal of the CRAT, the transferor is not permitted to take a charitable contribution deduction upon the transfer of assets to the trust. Whether the test has been satisfied is determined by calculating how many years it will take to exhaust the principal of the trust, given the applicable Internal Revenue Service (“IRS”) discount rate and the payout rate under the terms of the CRAT. If, in accordance with published mortality tables, there is a greater than 5% chance that one or more income beneficiaries will survive past the expected depletion date, the trust has failed the probability of exhaustion test.
New rules set forth by the IRS will allow certain trusts that do not satisfy the probability of exhaustion test to nonetheless qualify for favorable tax treatment. In Revenue Procedure 2016-41, the IRS has set forth a sample provision that, if included in the governing instrument, can be used as an alternative to satisfying the probability of exhaustion test. The sample provision would trigger early termination of the CRAT on the date immediately before the date on which any annuity payment would be made, if such payment would cause the discounted value of the trust principal to be less than 10% of the value of the initial trust principal. This new rule is intended in part to ensure that the charitable remainder beneficiary receives a benefit that is proportionate to the charitable deduction allowed to the transferor upon creation of the trust.
Current low interest rates have made it difficult to meet the requirements of a CRAT. For example, at the May 2016 published §7520 discount rate of 1.8%, the sole life beneficiary of a CRAT that provides for payment of the minimum allowable annuity (5% of the initial 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. In recent years, CRATs have thus taken a backseat to other estate planning techniques. In light of Revenue Procedure 2016-41 and expected interest rate hikes in the not-too-distant future, taxpayers with charitable inclinations may once again wish to consider a CRAT to achieve their objectives.