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Thursday September 2, 2010
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October - 2004
Gifting an Income Interest in a Charitable Remainder Trust
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When a donor establishes a charitable remainder trust he or she is relinquishing all rights in the contributed asset. In exchange, he or she receives the right to a unitrust or annuity trust payment for one or more lives or for a term of years.
At some point during the trust term, the donor may decide that he or she no longer needs the unitrust or annuity trust payments. The donor may at that point transfer to charity his or her right to receive future trust payments. After this transfer, the entire value of the trust may be distributed to the remainder charity early. If the donor chooses to transfer an income interest to charity, then he or she has made another gift to the charity.
How is the amount of this new gift determined?
When the charitable remainder trust was first established, the donor's gift was the present value of the remainder interest in that trust. Often, that number is simply referred to as the charitable deduction for the charitable remainder trust. The donor, on the other hand, currently owns an income interest in the trust. If the donor chooses to give his or her income interest to charity and forgo future trust payments, then the new gift is the present value of the donor's income interest.
The calculation for either the present value of the remainder interest in the trust or the present value of the income interest in the trust is the same. In fact, the present value of the remainder interest plus the present value of the income interest will always equal the value of the property on which the calculation is being done. For example, if the donor is contributing a $100,000 asset to a charitable remainder unitrust and the charitable deduction is $40,000, that $40,000 represents the present value of the remainder interest. Therefore, the present value of the income interest has to be $60,000. The $60,000 represents today's value of the future payments the donor can expect to receive over the term of the trust.
How to Perform the Calculation
Of course the present value of the remainder interest and the present value of the income interest are going to depend on the terms of the trust. One of the relevant factors for the calculation includes the gift date. The gift date will dictate what Section 7520 rate (the rate of the month) is permissible to use for the charitable deduction calculation. According to IRC Sec. 7520 the current month's rate or one of the two prior month's rates can be used so long as a charitable deduction is allowable. Thus, in the case where the donor is creating the charitable remainder trust or giving up his or her right to receive payments from the trust there are three rates that can possibly be used.
When the highest Section 7520 rate is used for the calculation, the present value of the remainder interest will be maximized. Thus, it is best to use the highest Section 7520 rate when the trust is first established because it will maximize the charitable deduction for the donor. However, if the donor is relinquishing his or her rights to the charitable remainder trust payments, using the lowest 7520 rate will maximize the present value of the income interest, which is what the new charitable deduction will be.
Other factors relevant for the calculation are the remaining term of the trust, the current fair market value of the trust if it is a unitrust, the original value of the trust if it is an annuity trust, the payment frequency and the trust payout percent. Determining the remaining term of the trust is done by simply typing in the birth date of the donor if it is a lifetime trust. If the trust is for a term of years then the remaining number of months and years in the trust must be calculated and entered into the software used to calculate the deduction.
The current fair market value of the trust on the date of termination is used in the calculation if the trust is a charitable remainder unitrust. That is because the payments from the trust are always based on the fair market value of the trust each year. If the trust is an annuity trust, then the original value of the trust is always used, because the future payments from the trust are based on that original value. Annuity trust payments do not fluctuate with trust performance.
The Steps
Therefore, the steps to determine the amount of the new deduction when a donor decided to relinquish his or her payments from a unitrust or annuity trust is as follows.
The unitrust:
First enter the date on which the income interest will be gifted. This is the date the trustee of the charitable remainder trust receives the donor's letter to irrevocably transfer and assign his or her income interest to the charitable remainderman.
Second, enter the birth date(s) of the income beneficiaries if the trust is for a lifetime or the remaining term of years if the trust was for a term of years.
Third, enter the current fair market value of the trust as of the "new" gift date.
Fourth, enter the payment frequency as stated in the trust document.
Last, enter the payout percent that is also in the trust document.
Once all the steps are completed, print out the charitable deduction worksheet. The number at the bottom gives the present value of the remainder interest in the unitrust. This is what the donor has already given away and has already received a charitable deduction for. Subtract the present value of the remainder interest from the fair market value of the trust. The result is the present value of the income interest. This is the donor's new charitable income tax deduction for relinquishing his or her right to future unitrust payments.
Example:
Ms. Jones, age 81, created a 5% payout unitrust on January 31, 2000. Ms. Jones initially funded the trust with $150,000 and as of October 1, 2004 the trust is valued at $200,000. Ms. Jones has been receiving her quarterly payments, but has decided that she no longer needs her unitrust payments and would like the charity to be able to use the trust funds immediately rather than wait until she passes away. On October 1, 2004 the charitable remainderman of Ms. Jones' unitrust receives a letter indicating her wishes to terminate the unitrust and distribute the entire trust to the charity. Ms. Jones would like to know if she can take a charitable deduction for ending her trust early and if so how much is the deduction.
To determine the new deduction for Ms. Jones using the Crescendo Software, open up Program 40 - Unitrust One - Eight Lives. Select One Life. For the gift date enter 10/01/2004. Choosing the lowest rate of the month, select October 4.4. Enter Ms. Jones name and age of 81. For the trust amount enter the fair market value on October 1, 2004 of $200,000. Enter 5% for the payout and select quarterly payments. Go to "Answers" and select "Deduction 1." The present value of the remainder interest should be $139,266. If $139,266 is subtracted from $200,000 the difference is $60,734. The new deduction that Ms. Jones can claim is $60,734, the present value of the income interest that Ms. Jones has irrevocably given to charity.
The annuity trust:
First enter the date on which the income interest will be gifted. This is the date the trustee of the charitable remainder trust receives in writing the donor's wishes to irrevocably transfer and assign his or her income interest to the charitable remainderman.
Second, enter the birth date(s) of the income beneficiaries if the trust is for a lifetime or the remaining term of years if the trust was for a term of years.
Third, enter the original value of the trust.
Fourth, enter the payment frequency as stated in the trust document.
Last, enter the payout percent that is also in the trust document.
Once all the steps are completed, print out the charitable deduction worksheet. The number on line E represents the present value of the future annuity payments. This is the donor's new charitable income tax deduction for relinquishing his or her rights to future annuity trust payments.
Example:
If Ms. Jones had an annuity trust in the above example instead of a unitrust, open Program 47 - Annuity Trust One or Two Lives. Select One Life. Enter the gift date as 10/01/2004. Select the October rate of 4.4%. Enter Ms. Jones age as 81. Enter the original trust value of $150,000. Enter a 5% payout rate with quarterly payments. Click on "Answers" and then on "Deduction 1." Line E on the worksheet shows the present value of the annuity at $31,302. This is Ms. Jones deduction for irrevocably giving up her income interest in the charitable remainder annuity trust.
Sample Language
The following is sample language that the donor can send to the trustee of the charitable remainder trust to transfer his or her interest in the future payments to charity. It is advisable to have the donor consult with their own professional advisor.
December 31, 2004
Dear Trustee,
On February 2, 1998, I funded the Mrs. Smith Charitable Remainder Unitrust, a one-life unitrust in the amount of $100,000. Under the trust terms, I was to receive a quarterly unitrust payment of 6% of the fair market value of the trust as determined every January 1.
As of December 31, 2004, I hereby irrevocably assign my entire interest in the Mrs. Smith Charitable Remainder Unitrust to ABC Charity. In assigning my interest, I understand that I will no longer be entitled to or receive any further unitrust payments from the Mrs. Smith Charitable Remainder Unitrust.
Sincerely,
Mrs. Smith
The Authority
When a unitrust is created, the donors retain the right to an income interest and the charity receives irrevocably the remainder interest. This income interest retained by donors is a property right under state law and thus should be transferable like any other property rights. The Service in several Private Letter Rulings (9550026, 9721014, 200124010, 200140027, 200208039, 200205008) has allowed donors to either transfer their income interest to the remainder recipient or even cash out of the charitable remainder trust.
When the income interest is irrevocably transferred, there will be a charitable deduction under Sec. 170 of the Code for the value of the income interest gifted. This is an appreciated-type gift deductible to 30% of AGI in most instances. Since the charity now owns both the income and the remainder interest, under the doctrine of merger, the trust no longer exists and should terminate under state law.
Cashing Out
It may also be possible that the donor simply wishes to terminate the trust and cash out his or her interest. There have been several Private Letter Rulings that have allowed such a transaction. In this case, the calculation is the same as described above except for one change. Because the donor is not making another charitable gift by giving the income interest to charity, the rate of the month used for the calculation must be the rate that corresponds with the date the donor decides to terminate the trust. One of the prior two months rates cannot be used because no charitable deduction is allowable. Once the calculation is performed, the present value of the remainder interest is what the charity would receive when the trust is terminated and the balance, the present value of the income interest, is the part that the donor would receive in the cash out.
One other item to note is that the donor will recognize gain on the cash out. Because the value of the income interest is considered an appreciated property type gift in which the donor has a zero cost basis, the donor will pay capital gains tax on the full value of the amount received. See PLR 200152018
Other Considerations
In some cases, most commonly with an annuity trust, the value of the trust principal may be substantially lower that the original trust principal. In this case it may be possible for the present value of the income interest (i.e. the donor's portion) to exceed the total value of the trust. While there is no authority for the following suggestion, it is possible that the new deduction is equivalent to the current value of the trust when the present value of the income interest exceeds the current fair market value and the donor is irrevocably giving his or her income interest to charity. Another more conservative approach is to run the present value calculation on the current value of the trust rather than the original value. Again there is no authority here and thus, it is advisable for the donor to see his or her own legal advisor on the matter.
Another possible step to take in terminating a charitable remainder trust early is to petition the probate court of the state under which the trust is formed. Going through the probate court may be necessary in some states as a means to terminating an irrevocable trust. During the process, it is important to have all parties consent to the early termination and seek the court's approval. In most cases, especially where the income interest will be paid to the charity, the court will not have an objection. Whether or not this step needs to be taken is a matter of local law. Therefore, if early termination of a trust is considered, it is wise to find out what the law in your area requires.
One other recommended step to take in terminating a charitable remainder trust early is to notify the State Attorney General of the early termination. The State Attorney General in most jurisdictions oversees all charitable trusts created under that particular state's trust law.
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September - 2004 - ABC's of Actuarial Valuations
Part 2: Applicable Federal Rates and Mortality Tables
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August - 2004 - ABC's of Actuarial Valuations
Part 1: Present Value and Future Value Basics
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| July - 2004 - Navigating the FLIP
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| June - 2004 - Basic GST for Planned Giving
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