II. CHARITABLE REMAINDER AND CHARITABLE LEAD TRUSTS BRYAN E. KEENAN GORDON, FOURNARIS, & MAMMARELLA P.A. WILMINGTON, DELAWARE

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1 II. CHARITABLE REMAINDER AND CHARITABLE LEAD TRUSTS BRYAN E. KEENAN WILMINGTON, DELAWARE

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3 II. CHARITABLE REMAINDER AND CHARITABLE LEAD TRUSTS A client s estate plan and charitable objectives may be advanced by giving a partial interest in property to a charity. The interest may be either a remainder interest or an income interest. The following table summarizes the different interests in charitable remainder and charitable lead (or income) trusts. Income Remainder Charitable Remainder Trust Non-Charity Charity Charitable Lead Trust Charity Non-Charity A charitable contribution deduction, whether for income, gift or estate tax purposes, does not necessary follow a gift of a partial interest in property in trust for the benefit of a charity. 1 Qualifying for the charitable contribution deduction requires following a host of statutory requirements. 1 E.g., Treas. Reg A-6(a)(1).

4 A. Charitable Remainder Trusts 1. Overview and Definition Generally, a charitable remainder in trust is not eligible for the income, gift or estate tax purposes unless the trust is a charitable remainder annuity trust or charitable remainder unitrust described in Section 664 of the Code. 2 A charitable remainder trust is an irrevocable trust that provides for a specified distribution, at least annually, to one or more beneficiaries, at least one of which is not a charity, for life or for a term of years, with an irrevocable remainder interest to be held for the benefit of, or paid over to, one or more charities Types Charitable remainder trusts are divided into two classes, charitable remainder annuity trusts and charitable remainder unitrusts. An annuity trust pays a fixed dollar amount to the income beneficiary each year, while a unitrust pays a fixed percentage of the value of the trust corpus to the income beneficiary each year. Charitable remainder trusts may be either inter vivos or testamentary. 2 Code 170(f)(2) (A) (income tax), 2055(e)(2),(estate tax), 2522(c)(2) (gift tax). 3 Treas. Reg (a)(1)(i).

5 3. Qualification and Requirements General. A. Trust must be valid under local law. 4 B. Trust must be irrevocable. 5 C. At least one noncharitable income recipient Interests of two or more noncharitable income recipients may be concurrent or successive Individuals must be living at time of trust creation. 8 a. Includes class gifts. 9 (1) Exception where period is term of years Payments may be made to and for the benefit of the income beneficiary Treas. Reg (a)(1)(i); Rev. Procs , 89-21, and E.g., Treas. Reg (a)(1)(i). 6 Code 664(d)(1)(A), (2)(A); Treas. Reg (a)(1)(i), (a)(3)(i), (a)(3)(i). 7 Rev. Procs , and Code 664(d)(1)(A), (2)(A); Treas. Reg (a)(3)(i), (a)(3)(i). 9 Treas. Reg (a)(3)(i), (a)(3)(i). 10 Treas. Reg (a)(3)(i), (a)(3)(i).

6 a. Therefore, can be a trust for an incompetent person. 12 b. And, can be a trust for a financially disabled person Individual income recipient not required; may be payable to a limited partnership. 14 D. Payments no less frequently than annually. 15 E. Payments for life or term of years Trust term may be life or term of years not more than a. Recipient s life must be used as measuring life Treas. Reg (a)(3)(i), (a)(3)(i). 12 Rev. Rul ; Priv. Ltr. Ruls , , , Rev. Rul Priv. Ltr. Rul Code 664(d)(1)(A), (2)(A); Treas. Reg (a)(1)(i), (a)(1)(i), (a)(1)(i)(a). 16 Code 664(d)(1)(A), (2)(A); Treas. Reg (a)(1)(i). 17 Code 664(d)(1)(A), (2)(A); Treas. Reg (a)(5)(i), (a)(5)(i). 18 Treas. Reg (a)(5)(i), (a)(5)(i).

7 b. Trust may provide that payments cease with the regular payment next preceding termination of the period Exception for qualified contingencies that cut term short. 20 a. Includes divorce, remarriage or earlier death of an individual Acceleration and commutation permitted. 22 F. Payment amount is a sum certain not less than 5 percent of the initial fair market value of trust property (CRAT), or 19 Treas. Reg (a)(5)(i), (a)(5)(i). 20 Code 664(f). 21 Rev. Rul ; Priv. Ltr. Ruls , Code 664(d)(1)(A), (2)(A); Treas. Reg (a)(5), 3(a)(5); Priv. Ltr. Ruls (acceleration provision in trust agreement), (commutation by agreement of remainder beneficiaries to purchase life interests). 23 Treas. Reg (a)(1)(i).

8 2. is a fixed percentage not less than 5 percent of the fair market value of the trust assets, valued annually (CRUT) Payment amount cannot exceed 50 percent Payment methods may not be combined Testamentary trust cannot bear administrative expenses or debts Value of unmarketable assets must be determined by an independent trustee or by a current qualified appraisal from a qualified appraiser. 28 a. Consider prohibiting hard-to-value assets Distribution in kind from CRAT or non-income exception CRUT is deemed a sale of property by the recipient Code 664(d)(1)(A), (2)(A). 25 Code 664(d)(1)(A), (2)(A). 26 Treas. Reg (a)(2). 27 Treas. Reg (a)(6), Egs., (3), (4) and (5). 28 Treas. Reg (a)(7)(i). 29 See Priv. Ltr. Rul

9 G. For short taxable years, the trust must provide proration formula. 31 H. For last taxable year, the trust must provide proration formula Trust may provide that payments cease with the regular payment next preceding termination of the period. 33 I. Cannot restrict the trustee s investments Note that although the Regulations do not require the trust to contain a provision that there are no restrictions, the Service s sample trusts contain such a provision. See last paragraph of each sample trust agreement in Rev. Procs , 89-21, 90-30, and J. Can be no power to alter amounts paid to noncharitable recipients if power would result in a grantor trust Treas. Reg (d)(5). 31 Treas. Reg (a)(1)(iv)(a), Reg (a)(1)(v)(a). 32 Treas. Reg (a)(1)(iv)(b), (a)(1)(v)(b). 33 Treas. Reg (a)(5)(i), (a)(5)(i) Treas. Reg (a)(3)(ii), (a)(3)(ii).

10 1. Independent trustee may sprinkle income. 36 K. No amount may be paid to anyone else but a charitable organization Can be no power to invade, alter, amend or revoke for benefit of anyone other than charitable organization Trust should expressly provide to avoid adverse state law Testamentary trust cannot bear administrative expenses or debts. 40 a. If there is a secondary income beneficiary, trust should obligate that person to pay death taxes associated with his or her interest Rev. Rul , C.B Code 664(c)(1)(B), (2)(B); Treas. Reg (a)(4), (a)(4). 38 Treas. Reg (a)(4), (a)(4). 39 Rev. Rul , C.B Treas. Reg (a)(6), Egs., (3), (4) and (5). 41 Rev. Rul , C.B. 71; Priv. Ltr. Ruls ,

11 4. This does not exclude trustee s commissions that are reasonable and ordinarily paid under state law. 42 L. Remainder must go to one or more Code Section 170(c), Section 2055(a) and Section 2522(a) organizations Trust must provide for alternative remainder beneficiaries if intended organization doesn t qualify at time income interest terminates Trust may provide that grantor or income beneficiary may substitute charitable beneficiary To avoid limitations on income tax deduction for gifts to private foundations, trust should also reference organizations described in Section 170(b)(1)(A) Priv. Ltr. Ruls , Code 664(d)(1)(C), (2)(C); Treas. Reg (a)(6)(i), (a)(6)(i). 44 Treas. Reg (a)(6)(iv), (a)(6)(iv). 45 Rev. Ruls. 76-7, 76-8, C.B. 179; Priv. Ltr. Rul See Priv. Ltr. Rul

12 M. Value of remainder must be at least 10 percent of the initial fair market value of the trust property (CRAT) or trust assets, valued at time of contribution (CRUT). 47 N. Testamentary trust may defer payment to end of year of full funding Local law or trust must permit Must provide formula for retroactively determining payments to beneficiary. 50 O. Certain private foundation rules apply under Sections 4947(a)(2) and 4947(b)(3)(B) Code Section 4941, self-dealing. 2. Code Section 4943, excess business holdings. 3. Code Section 4944, jeopardy investments. 47 Code 664(d)(1)(D), (2)(D). 48 Treas. Reg (a)(5)(i). 49 Treas. Reg (a)(1)(i). 50 Treas. Reg (a)(1)(i), (ii); Rev. Rul , C.B. 117, modified by Rev. Rul , C.B. 127 and Rev. Rul 92-57, C.B Treas. Reg (b).

13 4. Code Section 4945, taxable expenditures. P. Trust must provide for correction of valuation where payments are tied to value of assets Trust must pay underpayment and recipient must restore overpayment. 53 Q. For the gift tax and estate tax charitable deduction, the possibility that the charitable transfer will not become effective must be so remote as to be negligible (test: possibility that income beneficiary will survive exhaustion of the trust s assets must be not more than 5 percent) Applies to all CRATs. 2. Does not apply to net income only CRUT. 52 Treas. Reg (a)(1)(iii), (a)(1)(iii). 53 Treas. Reg (a)(1)(iii), (a)(1)(iii). 54 Treas. Reg (b)(i), (c)-3(b)(1); Moor Est. v. Comm r, T.C. Memo ; Rev. Rul , C.B. 329.

14 3. Applies to other CRUTs where payout rate is high and either initial asset value is small or the income recipient is young. 55 R. A CRT with too many donors will be an association, not qualifying as a CRT. 56 Charitable Remainder Annuity Trusts. A. Sum certain is a stated dollar amount that is the same each year during the trust term Can be reduced on death of a recipient or expiration of term of years if there is a distribution to Section 170(c) organization May be expressed as a fraction or percentage of initial fair market value as finally determined GCM (Nov. 30, 1978). 56 Priv. Ltr. Rul (grandparents and grandchildren contributed property). See also Priv. Ltr. Rul (S Corporation and sole stockholder grantors). 57 Treas. Reg (a)(1)(ii). 58 Treas. Reg (a)(1)(ii). 59 Treas. Reg (a)(1)(iii).

15 B. Minimum annuity amount is 5 percent of initial fair market value Can be reduced on death of a recipient or expiration of term of years if there is a distribution to Section 170(c) organization. 61 C. Maximum annuity amount is 50 percent of initial fair market value. 62 D. Trust must prohibit additional contributions. 63 Charitable Remainder Unitrusts. A. Trust must provide for a fixed percentage paid not less often than annually Trust may limit payment to amount of income for taxable year ( income-only CRUT ). 65 For example, if the net 60 Treas. Reg (a)(2)(i). 61 Treas. Reg (a)(2)(ii). 62 Code 664(c)(1)(A). 63 Treas. Reg (b). 64 Treas. Reg (a)(1)(i)(a). 65 Code 664(d)(3)(A); Treas. Reg (a)(1)(i)(b)(1).

16 value of the trust s assets on the valuation date are one million dollars and the unitrust percentage is 5 percent, the unitrust amount will be $50, If income is only $30,000.00, a straight CRUT will have to distribute $20, of principal. A NICRUT will only distribute the $30, income. a. Trust may also provide for make up provision to extent income exceeds unitrust amount ( NIMCRUT ). 66 Going back to the previous example, assume the same unitrust payment in year two, but trust income is $60, The NICRUT will distribute only $50,000.00; the NIMCRUT will distribute $60, b. Beneficiaries of an income-only CRUT or a NIMCRUT are limited to the donor, the donor s 66 Code 664(d)(3)(B); Treas. Reg (a)(1)(i)(b)(2).

17 U.S. citizen spouse, or both the donor and the donor s U.S. citizen spouse. 67 c. Post-contribution appreciation may be allocated to income only if permitted by local law and the trust instrument. 68 d. NIMCRUT must prohibit allocation of precontribution gain to income on sale of contributed asset. 69 e. Can switch or flip from an income exception method or a straight unitrust payment during the term. 70 (1) Trigger must be a specific date or an event not in control of the trustee or any other person (for example, the sale of nonmarketable assets or the marriage, divorce, 67 Treas. Reg (c)(3)(i) Treas. Reg (a)(1)(i)(c).

18 death or birth of a child with respect to any individual). 71 (2) Flip must occur at beginning of taxable year following triggering date or event. 72 (3) Unmade up income from prior NIMCRUT years forfeited on flip Percentage is fixed if it is the same throughout the term. a. May reduce percentage on distribution to Section 170(c) organization following death of an income recipient. 74 b. The trust must provide for correction of valuations Income in excess of Unitrust amount may be paid to a charitable organization Treas. Reg (a)(1)(i)(c)(1), (a)(1)(i)(d). 72 Treas. Reg (a)(1)(i)(c)(2). 73 Treas. Reg (a)(1)(i)(c)(3). 74 Treas. Reg (a)(1)(ii). 75 Treas. Reg (a)(1)(iii).

19 a. Basis of distributed property must be fairly reflective of all property available for distribution. 77 B. If trust doesn t pick valuation date(s), trustee may elect on first Form If the valuation date is a date other than the first day of the year, the trust must provide that where no valuation date occurs in a short taxable year, the trust assets will be valued as of the last day of such short taxable year or as of the day on which such noncharitable interests terminate. 79 C. Minimum unitrust amount is 5 percent of fair market value Can be reduced on death of a recipient or expiration of term of years if there is a distribution to Section 170(c) organization Treas. Reg (a)(4). 77 Treas. Reg (a)(4). 78 Treas. Reg (a)(1)(iv). 79 Treas. Reg (a)(1)(v)(a)(3), (b)(1). 80 Treas. Reg (a)(2)(i).

20 D. Maximum unitrust amount is 50 percent of fair market value. 82 E. Trust must prohibit additional contributions Exception if trust requires revaluation on date of additional contribution and payment of prorated increased unitrust amount Contribution must not cause CRUT to fail 10 percent charitable remainder interest rule. The Internal Revenue Service Sample CRT Forms The Internal Revenue Service has issued sample charitable remainder trust forms. Appendix B contains a table organizing the Service s forms by type of trust. It must be emphasized that the sample forms do not represent best or current practices and should not be used without substantial modification. Most recently, the Internal Revenue Service issued replacement Charitable Remainder Annuity Trust forms in Internal Revenue Bulletin While these 81 Treas. Reg (a)(2)(ii). 82 Code 664(d)(2)(A). 83 Treas. Reg (b). 84 Treas. Reg (b).

21 sample forms are a substantial improvement over prior forms, they remain incomplete. Among other issues: The final payment at the income beneficiary s death may be prorated to the date of death. Alternately, the payments may cease with the last payment preceding the income beneficiary s death. Most practitioners use the second alternative, but the forms provide for the prorated stub period annuity payment. The default language does not limit the charitable remainder beneficiary to public charities described in Section 170(b)(1)(A) of the Code. In the case of a testamentary CRAT, the Code Section 7520 rate at the date of death will not be known at the time of drafting. Therefore, a testamentary CRAT should always contain language reducing the amount of the annuity to the extent necessary to avoid failing the 10 percent minimum remainder requirement of Section 664 of the Code or the 5 percent exhaustion test of Revenue Ruling The sample testamentary forms do not contain such language.

22 Calculating value of remainder Unless trust provides otherwise, payouts are assumed to be made at beginning of period. 85 The remainder is valued using tables provided by the Internal Revenue Service with the interest rate equal to the current rate under Section 7520 of the Code. Most practitioners use commercially available software for this purpose; the author uses Number Cruncher, published by Leimberg & LeClaire. Charitable Contribution Acknowledgments Code Section 170(f)(8) does not apply to charitable remainder trusts Tax Benefits Charitable Contribution Deduction A properly structured charitable remainder trust will allow the donor to take an income, gift or estate tax charitable deduction for the present value of the remainder interest. The general income tax rule is that a donor does not receive a charitable income tax deduction for a gift of a remainder interest. 87 However, a donor will receive a 85 Treas. Reg (a)(3). 86 Treas. Reg A-13(f)(13). 87 Code 170(f)(2)(A).

23 charitable income tax deduction for a remainder interest in trust where the trust is charitable remainder trust described in Section 665 of the Code. 88 The same rules apply to the gift and estate taxes. The general rule is that there is no deduction for a charitable remainder interest, 89 with an except for a charitable remainder trust described in Section 664 of the Code. 90 Tax-Exempt Trust A charitable remainder trust is exempt from income tax, except for any year in which it has unrelated business taxable income or debt-financed income. 91 If a charitable remainder trust has either or both unrelated business taxable income or debtfinanced income, tax exemption is lost for the entire year on all income of the trust. 92 Thus, a donor may create a charitable remainder and contribute highly appreciated assets to the trust. The donor will not be taxed on the gain resulting from the trustee s sale of the contributed assets. 88 Id. 89 Code 2522(c)(2); 2055(e)(2). 90 Code 2522(c)(2)(A); 2055(e)(2)(A). 91 Code 664(c); Treas. Reg (a)(1)(i). 92 Treas. Reg (c). The regulation was held valid in Leila G. Newhall Unitrust v. Com r., 104 T.C. 236 (1995, aff d, 105 F.3d 482 (9th Cir. 1997).

24 The tax-free growth of assets in a charitable remainder trust is not without cost, however. A charitable remainder trust reduces the amount assets that ultimately pass to the donor s family. Coupling a charitable remainder trust with an irrevocable life insurance trust can solve this problem, if the amount of the life insurance at least equals the amount that will pass to charity. Taxation of Distributions The taxation of the annuity or unitrust amount received by the income beneficiary does not turn on the actual income received by the trust during the year. Instead, the payments are deemed to be made initially from ordinary income, second from capital gains, third from other income (typically, tax-exempt income) and finally from principal. Each tier is determined on a cumulative basis. The character of amounts distributed during the year is made as of the end of the trust s taxable year Variations The variations in charitable remainder trusts are as follows: Annuity Trust pays a fixed dollar amount each year ( CRAT ). Standard Unitrust Pays an amount equal to a fixed percentage of the net fair market value of the trust s assets, recalculated annually ( CRUT ). 93 Treas. Reg (b)-3(c).

25 Net Income Unitrust Pays an amount equal to the lower of the actual income or the unitrust amount ( NICRUT ). Net Income With Makeup Unitrust Same as the net income unitrust, except that deficiencies in earlier years are made in later years if actual income is greater than the unitrust amount (NIMCRUT ). Flip Unitrust Starts as a net income unitrust, but converts to a standard unitrust on the occurrence of a specified triggering event ( FLIP CRUT ). 6. Examples Donor owns one million dollars of low basis stock of a single issuer. The stock pays a dividend of 2 percent, or $20, per year. Donor wants to diversify the portfolio, if for no other reason that to reduce the risk inherent in a non-diversified portfolio. If Donor sells the stock and federal and stated combined capital gain taxes are 20 percent, Donor will be able to reinvest $800, If the dividend rate of the diversified portfolio remains 2 percents, Donor s annual income from this portfolio will drop to $16, per year. Instead, Donor could transfer the stock to a charitable remainder trust. After the charitable remainder sells the stock, the annual income from the portfolio will remain

26 $20,000.00, because the charitable remainder trust will be able to reinvest the entire one million dollars. Charitable remainder trusts have been paired with irrevocable life insurance trusts, sometimes referred to as wealth replacement plans. Appreciated assets are contributed to the charitable remainder trust and the trustee sells the assets and invests the proceeds. The income payment to the beneficiary each year is to cover at least the insurance premium costs. The plan will work if attention is paid to several issues: The donor must have sufficient assets outside of the charitable remainder trust to provide support or the charitable remainder trust must provide large enough distributions to cover the donor s anticipated expenses. The donor s estate plan may need to provide for a gift to charity at death to avoid estate tax. The policy must be adequate to actually replace the donor s wealth. The policy must be structured so that it will not lapse. Returning to the prior example, assume that Donor at age 65 creates and fund a charitable remainder unitrust in October 2000.

27 Charitable Remainder Unitrust Trust Type: Life Transfer Date: 10/2000 IRC Section 7520 Rate: 7.60% FMV of Trust: $1,000,000 Growth of Trust: 6.00% Percentage Payout: 7.000% Payment Period: Annual Months Valuation Precedes Payout: 0 Lives: 1 Ages: 65 Payout Sequence Factor: Adjusted Payout Rate: 7.000% Remainder Factor: Present Value of Remainder Interest = $1,000, x : $349, Donor's Deduction: $349, Donor's Deduction as Percentage of Amount Transferred: % Beginning 6.00% Year Principal Growth Payment Remainder 1 1,000, , , , , , , , , , , , , , , , , , , , , , , , , , , ,735.58

28 8 904, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , Summary: 1,000, , ,226, , Shortly after funding the charitable remainder unitrust, stock market rates of return drop dramatically. If growth drops to from 6 percent to 2 percent, the annual payments become as follows: Beginning 2.00% Year Principal Growth Payment Remainder 1 1,000, , , , , , , , , , , , , , , , , , , , , , , , , , , ,337.30

29 8 698, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , Summary: 1,000, , ,226, , Will the donor be able to afford the life insurance premiums? Perhaps our donor is willing to give up the upside potential of the charitable remainder unitrust and decides to go with the charitable remainder annuity trust to avoid the risk of reduced annual payments. Charitable Remainder Annuity Trust Trust Type: Life Transfer Date: 10/2000 IRC Section 7520 Rate: 7.60% FMV of Trust: $1,000, Growth of Trust: 6.00% Percentage Payout: 7.000%

30 Payment Period: Annual Payment Timing: End Lives: 1 Ages: 65 Exhaustion Method: IRS Amount of Annuity: $70, One Life Annuity Factor Payout Frequency Factor: Present Value of Annuity = Annuity Payout times Factors: $601, Charitable Remainder = FMV of Trust less PV of Annuity: $398, Charitable Deduction for Remainder Interest: $398, Donor's Deduction as Percentage of Amount Transferred: % Year Beginning Principal 6.00%. Growth Payment Remainder 1 1,000, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,849.33

31 Year Beginning Principal 6.00%. Growth Payment Remainder , , , , , , , , , , , , , , , , , , , , , , , , Summary: 1,000, ,032, ,400, , And, after the stock market corrects : Year Beginning Principal 2.00% Growth Payment Remainder 1 1,000, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

32 Year Beginning Principal 2.00% Growth Payment Remainder Uh-oh! Summary: 1,000, , ,189, When a taxpayer is contributed the maximum to his or her retirement plans, consider a net income charitable remainder unitrust to which contributions are made each year. The trust will invest in tax free securities, resulting in no income to distribute. At retirement, the investment strategy can change to provide income distributions to the donor. B. Charitable Lead Trusts 1. Overview and Definition Charitable lead trusts are the mirror image of charitable remainder trusts. In a charitable lead trust, the income interest goes to charity and the remainder interest passes to a non-charitable beneficiary. Generally, a charitable income interest in trust is not eligible for the income, gift or estate tax purposes unless the interest is a guaranteed

33 annuity or unitrust interest. 94 It is the guaranteed annuity or unitrust interest that makes a charitable lead trust qualified. 2. Types Charitable lead trusts follow into three main types, the Qualified Non-Grantor Charitable Lead Trust, the Qualified Grantor Charitable Lead Trust (or just Grantor Charitable Lead Trust) and the Non-Qualified, Non-Grantor Charitable Lead Trust. Qualified Non-Grantor Charitable Lead Trust A. Guaranteed annuity or unitrust interest B. Inter vivos 1. No income tax charitable deduction (but no income tax, which equates to a 100 percent deduction of the income on which the grantor would otherwise be taxed) 2. Gift tax charitable deduction 3. Remove appreciating assets from grantor s estate 4. Avoid percentage limitations on charitable contribution deductions 94 Code 170(f)(2) (A) (income tax), 2055(e)(2),(estate tax), 2522(c)(2) (gift tax).

34 C. Testamentary 1. Estate tax charitable contribution deduction 2. Estate inclusion results in basis step up Qualified Grantor Charitable Lead Trust A. Guaranteed annuity or unitrust interest B. Inter vivos grantor trust 1. Grantor taxed on trust income 2. Immediate income tax charitable contribution deduction 3. Estate inclusion Non-Qualified, Non-Grantor Charitable Lead Trust A. Not a guaranteed annuity or unitrust interest B. Inter vivos 1. No initial gift tax charitable contribution deduction 2. Annual trust income tax deduction equal to income 3. Avoid AMT 4. Avoid private foundation restrictions

35 3. Qualification and Requirements General. A. Trust must be valid under local law. B. Trust must be irrevocable. Qualified CLTs A Qualified CLT is a trust meeting the several statutory definitions that qualify the income interest for one or more tax deductions under Section 170(f)(2), 2055(e)(2)(B), and 2522(c)(2)(B). These definitions are substantially identical. To be qualified, the income interest must be paid in the form of a fixed annuity or unitrust amount. 95 The charitable lead may provide that the trustees will select the charitable beneficiary, rather than designating a specific charity. 96 Alternatively, the trustee may be granted the power to allocate the payment among beneficiaries. 97 To avoid an incomplete gift, the grantor should not serve as the trustee if the trustee will have to power to alter the beneficial enjoyment of a charitable beneficiary (or the trust instrument should appoint a special trustee for this purpose). 95 Code 170(f)(2); 2055(e)(2)(B); 2522(c)(2)(B); Treas. Reg A-6(c)(2)(i) and (ii); (e)(2)(vi) and (vii); (c)-3(c)(2)(vi) and (vii). 96 Ltr. Ruls , , , Ltr. Rul

36 As is the case for charitable remainder trusts, the trust instrument should name alternate charitable beneficiaries in case one or the name beneficiaries loses its tax exemption. Again, the donor should not retain this power. The charitable lead annuity trust is an irrevocable trust under which a sum certain is to be distributed periodically, but not less than annually, to one or more charitable beneficiaries. The annuity interest may be paid for a term of years or during the life or lives of one or more individuals who are living when the trust is created. There is no maximum limitation on the number of years for a term of years lead interest. The annuity amount must be determinable when the trust is established. This does not limit the trust to stating a fixed dollar amount. Instead, the trust may use a formula to determine the annuity payment. For example, the trust could provide that the annuity amount equals a stated percentage of the fair market value of the trust corpus as of the funding date. There is no minimum or maximum annuity amount. It is possible to adjust the annuity amount by the use of term interests. For example, the trust could provide for an annual payment of X dollars for the life of an individual and an annual payment of Y dollars for a term of years following expiration

37 of the life time. As another example, the trust may stack terms of years, with a different annuity amount during each term. The trust document must prohibit certain conduct under the private foundation rules under Code Section 4941 (self-dealing), Code Section 4943 (excess business holdings), Code Section 4944 (jeopardy investments) and Code Section 4945 (taxable expenditures). However, where the present value of all of the income interests is 60 percent or less on the valuation date, the trust does not have to prohibit excess business holdings or jeopardy investments. The charitable lead unitrust is an irrevocable trust under which a fixed percentage of the fair market value of the trust s assets, valued annually, is distributed periodically, but not less than annually, to one or more charitable beneficiaries. The unitrust amount may be paid for a term of years or during the life or lives of one or more individuals who are living when the trust is created. Again, there is no limit on the length of a term of years. The unitrust amount may not be limited to trust income. 98 The unitrust percentage must be the same for the entire trust term. 99 Although there is no prohibition on additional contributions in the regulations on additional contributions to charitable lead annuity trusts, there is no method for 98 Rev. Rul , C.B. 352; Ltr. Rul Treas. Reg A-6(c)(2)(ii)(A), (e)(2)(vii)(a), (c)-3(c)(2)(vii)(a).

38 adjusting the annuity amount for the additional contribution. Most practitioners conclude that additional contributions must be prohibited. 100 All assets and liabilities are taken into account with computing the fair market value of the charitable lead unitrust s assets. The same valuation date and methodology should be used each year. In the absence of direction in the trust instrument, the trustee selects the date and method on the first trust income tax return. 101 Unlike the charitable remainder trust, neither the charitable lead annuity trust nor the charitable lead unitrust may use contingencies to terminate the income interest and accelerate the vesting of the remainder. Both the charitable lead annuity trust and the charitable lead unitrust may provide for concurrent non-charitable income interests. However, a separate trust for the non-charitable beneficiary may be preferable. deduct them. The trust agreement should allocate trustee s fees to income so that the trust may 100 Edward Jay Beckwith, Charitable Lead Trusts Re-Examined: The Dawning of a Golden Age?, 2003 INST. ON EST. PLAN Treas. Reg A-6(c)(2)(ii), (e)(2)(vii), (c)-3(c)(2)(vii).

39 Non-Qualified CLTs Non-qualified charitable lead trusts will provide that all of the trust s taxable income will paid to charitable beneficiaries, rather than a guaranteed annuity or unitrust interest. Unlike a qualified charitable lead trust, the non-qualified lead trust is structured to avoid a completed gift on formation. This may be done by giving the grantor the power to determine the charitable beneficiary. The gift will then be complete only as the income is paid to the charitable beneficiary. This gift will qualify for the gift tax charitable contribution deduction. 4. Tax Benefits above. Please see the review of the tax benefits of charitable lead trusts under 2, Types, 5. Examples Qualified Grantor CLTs have been used to obtain income tax charitable contribution deductions in high income years and recapturing the income in lower income years. Consider a Qualified Grantor CLT in light of declining personal income tax rates. The taxpayer will obtain an up-front charitable contribution deduction when rates are high. The taxpayer will have income from the trust in later years, when rates

40 are lower. An additional strategy is to use tax-exempt securities to avoid the income in later years. Consider a Qualifed Non-Grantor CLT to pass assets on to the next generation. Assume Parents own a commercial rental property worth $2,000,000 and generating $100, (5 percent) in income each year. The property is free of debt and is expected to appreciate at the rate of at least 2 percent each year. Parents have sufficient other sources of income that they do not need the income generated by the property. If Parents make a gift of the property to their children, they will use up their entire gift tax lifetime exclusions. Using a 15 year term charitable lead annuity trust substantially reduces the value of the gift, removes the income from Parents estates and removes the appreciation from their estates. Charitable Lead Annuity Trust 10/26/2003 Trust Type: Term Transfer Date: 10/2003 Code Section 7520 Rate (August 2003 Best Rate): 3.20% FMV of Trust: $2,000, Growth of Trust: 2.00% Percentage Payout: 7.500% Payment Period: Annual Payment Timing: End Term: 15 Exhaustion Method: IRS

41 Annual Payout: $150, Annual Payment: $150, Term Certain Annuity Factor: Payout Frequency Factor: Present Value of Annuity: $1,765, Remainder Interest = FMV of Trust less PV of Annuity: $234, Charitable Deduction for Income Interest: $1,765, Donor's Deduction as Percentage of Amount Transferred: % The gift equal to the value of the remainder interest, $234,935, will leave Parents with over $1,750,000 of their combined gift tax lifetime exclusions remaining. Beginning 2.00% Year Principal Growth Remainder Income Payment 1 $2,000, $40, $2,040, $100, $100, ,040, , ,080, , , ,080, , ,122, , , ,122, , ,164, , , ,164, , ,208, , , ,208, , ,252, , , ,252, , ,297, , , ,297, , ,343, , , ,343, , ,390, , , ,390, , ,437, , , ,437, , ,486, , , ,486, , ,536, , , ,536, , ,587, , , ,587, , ,638, , , ,638, , ,691, , , Summary: $2,000, $691, $2,691, $1,500, $1,500,000.00

42 If Parents did not create the Charitable Lead Trust, the after tax income would accumulate and grow in their estates: Beginning 2.00% Year Principal Growth Income Tax (40%) Net Remainder 1 $2,000, $40, $100, $40, $60, $2,100, ,100, , , , , ,205, ,205, , , , , ,315, ,315, , , , , ,431, ,431, , , , , ,552, ,552, , , , , ,680, ,680, , , , , ,814, ,814, , , , , ,954, ,954, , , , , ,102, ,102, , , , , ,257, ,257, , , , , ,420, ,420, , , , , ,591, ,591, , , , , ,771, ,771, , , , , ,959, ,959, , , , , ,157, Summary: $2,000, $863, $4,157, strategies: The following table compares the accumulation and charitable lead trust Accumulation CLT Gross Amount to Children $4,157, $2,691, Less Estate Tax (50%) Less Gift Tax Adjustment 117, Net to Children $2,078, $2,574, Difference 495,341.00

43 Appendix A Table Comparing Charitable Remainder and Charitable Lead Trusts CRT [Qualified] Grantor CLT Qualified Non-Grantor CLT Non-Qualified, Non-Grantor CLT Inter Vivos Yes Yes Yes Yes Testamentary Yes No Yes No Income Tax Charitable Deduction Yes When Formed No No Gift Tax Charitable Deduction Yes Yes Yes Only to Income Actually Paid Estate Tax Charitable Deduction Yes No Yes No Tax-Exempt Trust Yes Yes; Grantor Taxed No; 642(c) Deduction No; 642(c) Deduction Income Only Payment Guaranteed Annuity or Unitrust Payout Less Than 5 Percent Term More Than 20 Years Subject to Private Foundation Rules Measuring Life Must Be Beneficiary Term May Be For More Than 1 Life If Unitrust No No Yes Yes Yes Yes No No Yes Yes Yes No Yes Yes Yes Yes Yes Yes No Yes No No No Yes Yes Yes Yes

44

45 Appendix B The Internal Revenue Service s Sample Charitable Remainder Trust Forms Type Term Interests Procedure Section CB CRUT Inter vivos Single Life CB 841 Two Lives Consecutive CB 534 Consecutive and concurrent CB 534 Testamentary Single Life CB 534 Two Lives Consecutive CB 534 Consecutive and concurrent CB 534 NIMCRUT Inter vivos Single Life CB 539 Two Lives Consecutive CB 539 Consecutive and concurrent CB 539 Testamentary Single Life CB 539 Two Lives Consecutive CB 539 Consecutive and concurrent CB 539 CRAT Inter vivos Single Life IRB 230 Two Lives Consecutive IRB 242 Consecutive and concurrent IRB 249 Years IRB 236 Testamentary Single Life IRB 257 Two Lives Consecutive IRB 268 Consecutive and concurrent IRB 274 Years IRB 262

46 Rev. Proc , C.B. 841 SECTION 1. PURPOSE This revenue procedure makes available a sample form of declaration of trust that meets the requirements for a charitable remainder unitrust as described in section 664(d)(2) of the Internal Revenue Code. SEC. 2. BACKGROUND The Internal Revenue Service receives and responds to requests for rulings dealing with the qualification of trusts as charitable remainder trusts and the availability of deductions for contributions made to such trusts. In many of these requests, the trust instruments and charitable objectives are very similar. Consequently, in order to provide a service to taxpayers and to save the time and expense involved in requesting and processing a ruling on a proposed charitable remainder unitrust, taxpayers who make transfers to a trust that substantially follows the sample trust instrument contained herein can be assured that the Service will recognize the trust as meeting all of the requirements of a charitable remainder unitrust, provided the trust operates in a manner consistent with the terms of the trust instrument and provided it is a valid trust under applicable local law. SEC. 3. SCOPE AND OBJECTIVE The sample declaration of trust made available by section 4 of this revenue procedure meets all of the applicable requirements under section 664(d)(2) of the Code for an inter vivos charitable remainder unitrust providing for unitrust payments during one life, followed by distribution of the trust assets to the charitable remainder beneficiary, if the trust document also creates a valid trust under local law. If the trust instrument makes reference to this revenue procedure and adopts a document substantially similar to the sample, the Service will recognize the trust as satisfying all of the applicable requirements of section 664(d)(2) of the Code and the corresponding regulations. Moreover, for transfers to a qualifying charitable remainder unitrust, the remainder interest will be deductible under sections 170(f)(2)(A) and 2522(c)(2)(A) for income and gift tax purposes, respectively. Therefore, it will not be necessary for a taxpayer to request a ruling as to the qualification of a substantially similar trust, and the Service generally will not issue such a ruling. See Rev. Proc , page 59, this Bulletin. The Service, however, will continue to issue rulings to taxpayers who create trusts that are not substantially similar to the sample trusts. SEC. 4. SAMPLE CHARITABLE REMAINDER UNITRUST On this day of, 19, I,, (hereinafter referred to as "the Donor") desiring to establish a charitable remainder unitrust, within the meaning of Rev. Proc and section 664(d)(2) of the Internal Revenue Code (hereinafter referred to as "the Code") hereby create the Charitable Remainder Unitrust and designate as the initial Trustee. 1. Funding of Trust. The Donor transfers to the Trustee the property described in Schedule A, and the Trustee accepts such property and agrees to hold, manage and distribute such property of the Trust under the terms set forth in this Trust instrument. 2. Payment of Unitrust Amount. The Trustee shall pay to [a living individual] (hereinafter referred to as "the Recipient") in each taxable year of the Trust during the Recipient's life a unitrust amount equal to [at least five] percent of the net fair market value of the assets of the Trust valued as of the first day of each taxable year of the Trust (the "valuation date"). The unitrust amount shall be paid in equal quarterly

47 amounts from income and, to the extent that income is not sufficient, from principal. Any income of the Trust for a taxable year in excess of the unitrust amount shall be added to principal. If the net fair market value of the Trust assets is incorrectly determined, then within a reasonable period after the value is finally determined for Federal tax purposes, the Trustee shall pay to the Recipient (in the case of an undervaluation) or receive from the Recipient (in the case of an overvaluation) an amount equal to the difference between the unitrust amount properly payable and the unitrust amount actually paid. 3. Proration of the Unitrust Amount. In determining the unitrust amount, the Trustee shall prorate the same on a daily basis for a short taxable year and for the taxable year of the Recipient's death. 4. Distribution to Charity. Upon the death of the Recipient, the Trustee shall distribute all of the then principal and income of the Trust (other than any amount due Recipient or Recipient's estate, under paragraphs 2 and 3, above) to (hereinafter referred to as the Charitable Organization). If the Charitable Organization is not an organization described in sections 170(c), 2055(a), and 2522(a) of the Code at the time when any principal or income of the Trust is to be distributed to it, then the Trustee shall distribute such principal or income to such one or more organizations described in sections 170(c), 2055(a), and 2522(a) as the Trustee shall select in its sole discretion. 5. Additional Contributions. If any additional contributions are made to the Trust after the initial contribution, the unitrust amount for the year in which the additional contribution is made shall be [the same percentage as in paragraph 1] percent of the sum of (a) the net fair market value of the Trust assets as of the first day of the taxable year (excluding the assets so added and any income from, or appreciation on, such assets) and (b) that proportion of the value of the assets so added that was excluded under (a) that the number of days in the period that begins with the date of contribution and ends with the earlier of the last day of the taxable year or the Recipient's death bears to the number of days in the period that begins on the first day of such taxable year and ends with the earlier of the last day in such taxable year or the Recipient's death. In the case where there is no valuation date after the time of contribution, the assets so added shall be valued at the time of contribution. 6. Prohibited Transactions. The income of the Trust for each taxable year shall be distributed at such time and in such manner as not to subject the Trust to tax under section 4942 of the Code. Except for the payment of the unitrust amount to the Recipient, the Trustee shall not engage in any act of self-dealing, as defined in section 4941(d), and shall not make any taxable expenditures, as defined in section 4945(d). The Trustee shall not make any investments that jeopardize the charitable purpose of the Trust, within the meaning of section 4944, or retain any excess business holdings, within the meaning of section Successor Trustee. The Donor reserves the right to dismiss the Trustee and to appoint a successor Trustee. 8. Taxable Year. The taxable year of the Trust shall be the calendar year. 9. Governing Law. The operation of the Trust shall be governed by the laws of the State of. However, the Trustee is prohibited from exercising any power or discretion granted under said laws that would be inconsistent with the qualification of the Trust under section 664(d)(2) of the Code and the corresponding regulations. 10. Limited Power of Amendment. The Trust is irrevocable. However, the Trustee shall have the power, acting alone, to amend the Trust in any manner required for the sole purpose of ensuring that the Trust

48 qualifies and continues to qualify as a charitable remainder unitrust within the meaning of section 664(d)(2) of the Code. 11. Investment of Trust Assets. Nothing in this Trust instrument shall be construed to restrict the Trustee from investing the Trust assets in a manner that could result in the annual realization of a reasonable amount of income or gain from the sale or disposition of Trust assets. IN WITNESS WHEREOF and [TRUSTEE] by its duly authorized officer have signed this agreement the day and year first above written. [DONOR] [TRUSTEE] By [Acknowledgements, Witnesses, etc.] SEC. 5 APPLICATION The Service will recognize a trust as meeting all of the requirements of a qualified charitable remainder unitrust under section 664(d)(2) of the Code if the trust instrument makes reference to this document and is substantially similar to the sample provided in section 4, provided the trust operates in a manner consistent with the terms of the trust instrument and provided it is a valid trust under applicable local law. A trust that contains substantive provisions in addition to those provided by section 4 (other than provisions necessary to establish a valid trust under applicable local law) or that omits any of these provisions will not necessarily be disqualified, but neither will it be assured of qualification under the provisions of this revenue procedure. SEC. 6. EFFECTIVE DATE This revenue procedure is effective for ruling requests received in the National Office after February 27, 1989, the date of publication of this revenue procedure in the Internal Revenue Bulletin. DRAFTING INFORMATION The principal author of this revenue procedure is John McQuillan of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue procedure, contact John McQuillan on (202) (not a toll-free call).