Gift Planning Tips

A Lifeline for Charitable Remainder Annuity Trusts

Section 7520 rates have been below 5% since the beginning of 2008, currently hovering at 1.4%. That’s bad news for donors wishing to fund charitable remainder annuity trusts. Not only are annuity trusts subject to the same 10% remainder requirement as charitable remainder unitrusts [Code §§664(d)(1)(D), (d)(2)(D)], they are also subject to a 5% probability test [Rev. Ruls. 70-452 and 77-374]. No deduction is allowed for a charitable remainder annuity trust if the probability exceeds 5% that a noncharitable beneficiary of the trust will survive the exhaustion of the trust fund. An annuity trust for which a deduction is not available is not a qualified charitable remainder trust [Letter Ruling 9532006].

The 5% probability test is not really an issue when §7520 rates exceed 5% and the trust provides for a 5% payout, but the lower the rates, the more difficult it is for annuity trusts to qualify. For example, a one-life annuity trust paying the minimum 5% (assuming quarterly payments and a 1.4% §7520 rate) does not qualify for a donor age 74, although the charitable deduction of 47% easily satisfies the 10% remainder requirement. For a two-life annuity trust, both income beneficiaries would have to be at least age 77 to pass the 5% test.

Recently released Revenue Procedure 2016-42 offers a possible solution for younger donors seeking the fixed payments of an annuity trust. Annuity trusts created on or after August 8 that include the exact language of the sample provision will not be subject to the 5% probability test. The provision calls for the early termination of the annuity trust and an outright distribution of trust assets to the charitable remainderman prior to the date on which an annuity payment would be made, if that payment would result in the value of the trust corpus falling below 10% of the value of the initial trust corpus. The early termination is considered a qualified contingency under Code §664(f). Language is included for both inter vivos and testamentary annuity trusts, and an example is given.

Should donors be concerned about their annuity trusts ending early? While that is a possibility, trustees are likely to be able to get returns higher than what is presumed under current §7520 rates. Therefore, it may not be necessary to dip into corpus to the point where the 10% remainder value is reached. Trustees will be required to perform an annual computation using a discount factor to determine whether that year’s required payments will cause the corpus to drop below 10% of the initial value of the trust corpus.

Plan Early for Savings on Medicare

The Medicare surcharge for high-income clients may be increasing, starting in 2018, but there are steps that can be taken to reduce the burden, some of which also allow clients to assist favorite charities. Beginning in 2018, the annual premium for Parts B and D is estimated to be about $1,493 per person for single individuals with modified adjusted gross income (MAGI) of $85,000 or less or couples with MAGI of $170,000 or less. Above those amounts, surcharges begin to apply, reaching a top of $4,775. The income thresholds are not indexed for inflation, meaning that an increasing number of recipients may be subject to the surcharges in the coming years.

Because surcharges are based on income earned two years prior, clients need to begin planning in 2016 to reduce their income. MAGI is adjusted gross income plus tax-exempt interest. Boosting itemized deductions will not affect this number. What can a client do?

  • Convert to a Roth IRA, which does not require minimum distributions after age 70½. All qualified distributions are tax free. Clients would owe income tax in the year of the conversion, however.
  • Clients who are still working should contribute the maximum amount possible to 401(k)s and IRAs, thereby lowering AGI.
  • Pay attention to capital gains and losses. While capital gains will add to a client’s AGI, losses can offset gains plus up to $3,000 of other income each year.
  • Make charitable gifts of appreciated securities. Although the deduction itself will not lower MAGI, the capital gains that would be recognized if the shares were sold is avoided.
  • For those age 70½ or older, qualified charitable distributions from IRAs — up to $100,000 annually — can take the place of required minimum distributions that would normally add to AGI.

Customizing Trusts to Meet Clients’ Needs

Testamentary charitable remainder trusts are typically established to provide financial security for a surviving family member or other individual. But that general goal can be refined to meet particular needs.

Special needs beneficiaries — A charitable remainder trust can make payments to a noncharitable trust for the life of an individual who is “financially disabled” (Rev. Rul. 2002-20). The IRS has indicated that such arrangements are appropriate where the income beneficiary, by reason of a medically determinable physical or mental impairment, is unable to manage his or her own financial affairs. The trustee of the noncharitable trust could have broad discretion as to how much income or principal would be paid to the beneficiary, and could take into account government benefits to which the beneficiary may be entitled.

Ruling from the grave — Code §664(f)(2) permits charitable remainder trusts to terminate early upon the happening of specified contingencies. The contingency is disregarded in valuing the charitable remainder. One of the most famous examples of a qualified contingency in a testamentary charitable remainder trust was contained in the will of billionaire hotelier Leona Helmsley. Charitable remainder trusts established for two of her grandchildren provided that the trusts would end early if the grandchildren failed to visit the grave of their father at least once annually for the rest of their lives.

Charity to the Rescue for Blended Families

Brides and grooms in second marriages often face the dual goals of providing for a surviving spouse while still having assets eventually pass to children from a first marriage or to a favorite charity. The QTIP trust allows a husband or wife to reserve all the income — along with some invasion of principal — for the survivor, knowing that, at the survivor’s death, assets can pass to the children of the first spouse to die [Code §2056(b)(7)]. The QTIP can also be used to pass assets to charity at the surviving spouse’s death. The entire value of the trust qualifies for the marital deduction in the estate of the first spouse to die (assuming the first spouse’s estate is subject to tax), and at the surviving spouse’s death, the value is included in his or her gross estate. If charity is the remainder beneficiary, the charitable deduction will shelter the estate from tax.

Another option is a charitable remainder trust for the surviving spouse. Normally, a remainder trust would not qualify for the estate tax marital deduction, since the surviving spouse is not entitled to all income for life, but rather just the stated trust percentage. However, Code §2056(b)(8) provides for a hybrid trust that does qualify for the marital deduction and also the charitable deduction. The surviving spouse must be the only noncharitable beneficiary [Code §2056(b)(8)(A)], so the trust cannot pay income to children following the death of the surviving spouse, prior to the charitable remainderman. This may not be a problem where the estate is not subject to tax, although the remainder trust with children added might not yield the required 10% charitable remainder [Code §§664(d)(1)(D), (d)(2)(D)]. However, the IRS has ruled favorably where a QTIP trust was to distribute assets to a charitable remainder trust benefitting the decedent’s children, at the death of the surviving spouse (Letter Ruling 9122029).

A surviving spouse can also be given a life estate in a home or farm, with the property passing to charity at his or her death [Code §170(f)(3)(B)(i)]. The survivor must have the right not only to occupy the property, but also to rent the home or farm and receive the income for life [Reg. §20.2056(b)-7(h)].


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