Estates and Trusts

December 1999


By Peter Brizard, CPA

There have been noteworthy recent developments pertaining to charitable remainder trusts (CRT). Among them are changes in actuarial values, more lenient treatment of "flip" unitrusts, and a relaxation of requirements to make distributions by December 31. Moreover, there is a window of opportunity to reform nonqualifying trusts.

Revised Actuarial Values

Effective May 1, 1999, actuarial values to be used based on life expectancy have been revised to comply with the findings in the 1990 census. (IRS Publication 1457 Actuarial Values, Alpha Volume and IRS Publication 1458 Actuarial Values, Beta Volume, which were based on the 1980 census, will be replaced by the soon to be issued IRS Publication 1457 Actuarial Values, Book Aleph and IRS Publication 1458 Actuarial Values, Book Beth.)

Although the new tables became effective May 1, 1999, there are transition rules. For transfers occurring between May 1, 1999, and July 1, 1999, an election may be made to use either the old or the new tables when determining a remainder value. This also applies to the estates of competent individuals created during that period, although the executor must consistently use one set of tables or the other. For the estates of mental incompetents, the transition rules are more flexible. If the decedent became incompetent before May 1, 1999, and remains so, or if the person regains competency after April 30, 1999, but dies within 90 days, the executor may use either set of tables when determining remainder value.

Until the new tables become available, temporary and proposed regulations have been issued that revise Table S, Single Life Remainder Factors, and Table U(1), Unitrust Single Life Remainder Factors (See Internal Revenue Bulletin No. 1999-20, May 17, 1999). Factors for the last to survive of two lives can be obtained by contacting the IRS. Factors not involving life expectancy remain unchanged.

Unsurprisingly, the 1990 census confirmed that life expectancy had increased. Consequently, remainder values are less. This has a negative impact on CRTs, where remainder values equate to allowable charitable deductions. It also increases the possibility that, for a younger grantor with a given annual payout, the remainder value will fall below 10%, a threshold for determining whether a trust will qualify as a CRT.

Flip Charitable Remainder Unitrust

A flip charitable remainder unitrust (CRUT) is a trust that at some point converts permanently, or "flips," from having annual payments determined under an income exception method to a standard CRUT. In practice, typically, the income exception method is accomplished through a net income makeup charitable remainder unitrust (NIMCRUT). Each year, a NIMCRUT pays the lesser of the income it generates or a fixed percentage of its fair market value. Shortfalls in years when income is less than the percentage amount can be made up in later years when income exceeds the percentage amount. A flip trust is often useful when the grantor wishes to receive a relatively steady income stream but has only illiquid assets with which to fund the trust. Deficient distributions at the beginning are made up and become more consistent once the assets have been sold.

The flip trust is a relatively recent concept that the IRS at first did not recognize as qualifying for CRUT status. Gradually, a policy for qualification emerged provided:

* 90% of the trust's pre-flip assets were unmarketable;
* the trust would flip from its net income limitation only when a specific asset or group of assets was sold or when nonmarketable assets fell below 50% of all assets; and
* the switch to the fixed percentage method is irreversible; and the income makeup feature is eliminated when the switch is made.

Final regulations issued December 10, 1998, are noticeably different and essentially more lenient:

* The change in method must be triggered on a specific date or by a single event whose occurrence is not discretionary, or within the control of, the trustee or any other person. An event based upon the sale of unmarketable assets or the marriage, divorce, or birth of a child will not be considered a discretionary trigger.
* The change from the net income to the fixed percentage method must occur at the beginning of the taxable year immediately following the triggering event.
* After the conversion to the fixed percentage method, the trust must pay only the fixed percentage amount, and not any makeup left over from the net income method.

Trusts that use a net income method and wish to change to the flip method or that specify a nonqualifying flip method may be reformed either judicially or nonjudicially under state law. Judicial proceedings must begin by June 30, 2000. Nonjudicial reformations must be completed by June 30, 2000.

The final regulations on flip trusts reduce uncertainty in this area, and the possible choice of other triggering events in addition to the sale of unmarketable assets expands planning opportunities. Regarding other possible triggering events, unitrust interests in an income exception CRUT retained by the donor or a family member might have to be valued at zero when a noncharitable beneficiary of the trust is someone other than the donor or the donor's U.S. citizen spouse.

Distributions After December 31

Earlier proposed regulations had required that distributions to noncharitable beneficiaries from a charitable remainder annuity trust (CRAT) or a CRUT other than a NIMCRUT be made before the end of the year. These were burdensome for trusts with valuation dates on the last day of the year.

Prior to the proposed regulations, distributions could be made within a reasonable period of time after the end of the year to which they applied. Notice 97-68 provided some relief for the year 1997, but the final regulations are both more lenient and more complicated. For CRTs other than income exception CRUTs, distributions may be made to a noncharitable beneficiary within a reasonable period of time after the end of the year for which they are due, provided that--

* the character of the receipt is ordinary, capital gain, or tax exempt income, but not corpus;
* the distribution is of property other than cash, and any income generated by the distribution is treated by the trustee as occurring on the last day of the year for which the distribution was due; or
* the trust was created before December 10, 1998, and the figure used to compute the annuity or unitrust amount is 15% or less.

Consecutive Noncharitable Beneficiaries

The general rule for valuing unitrust interests when there is a succession of nonspousal family member beneficiaries is to first value the charitable remainder interest, then the interest of the grantor, and allocate what is left to the family member or members. Because there is an inherent potential for gift tax abuse with income-exception-method CRUTs, Reg. section 25.2702 was amended. For transfers made after May 18, 1997, the grantor's interest in such trusts is to be valued at zero. An exception to the restrictive amendment occurs when there are only two consecutive noncharitable interests and the second is the grantor's.

Valuing Unmarketable Assets

For trusts created on or after December 10, 1998, unmarketable assets may be valued by an independent trustee, an independent cotrustee, or a qualified appraiser. They may not be valued by the grantor, the spouse, a noncharitable beneficiary, or someone related or subordinated to any of them.

Capital Gains as Income

In the case of many NIMCRUTs and NICRUTs (NIMCRUTs without the makeup feature), it was clear to planners that if income were limited to conventional or statutory definitions, it would never be sufficient to equal the fixed percentage amount and that capital gains should be included. Private letter rulings from the IRS permitted capital gains to be included as income for determining distributions from net income trusts, but only to the extent of appreciation after an asset was transferred to the trust. Capital gains on appreciation prior to transfer could not be included in the definition of income in determining allowable distributions and had to be allocated to principal. For sales and exchanges occurring after April 18, 1997, final regulations firmly establish what had been policy, provided state law permits gains to be treated as income. Even though private letter rulings had indicated that NIMCRUT makeup amounts being carried over were to be treated as liabilities and subtracted from the annual valuation of a trust, the final regulations were expected to eliminate this policy. However, they failed to address the matter.

Tax Rate on Capital Gains

In general, for tax purposes, distributions from a charitable remainder trust are to be made from those current and accumulated amounts that may be taxed at the highest rate; more specifically, first from ordinary income, second from capital gains, third from other income (such as tax exempt income), and last from corpus. Within capital gains various rates may apply, depending upon the type of asset and when it was sold. The Tax Reform Act of 1997 created confusion regarding capital gains taxes, and the area of CRTs suffers from this confusion. The IRS has subsequently attempted to clarify and appropriately modify its policy. Most recently, on April 5, 1999, the IRS released its second notice regarding the tax on distributions of accumulated long-term capital gains for assets sold before January 1, 1998.

Pre-1997 Long-term Capital Gain (LTCG):

* 20% rate applies

LTCGs realized from January 1, 1997 through May 6, 1997:

* 20% if property held longer than 12 months

LTCGs realized from May 7, 1997 through December 31, 1997:

* 28% on collectible gains
* 25% if property held longer than 12 months and LTCG is unrecaptured section 1250 gain
* 20% for all other property held longer than 12 months
Limited Window

As a side note, the final regulations may have created a limited window of opportunity to reform nonqualifying unitrusts [See notice 99-31 and Reg. section 1.664-3(a)(1)(i)(f)(3)]. Advisors should address the possibility as soon as possible. *

Lawrence M. Lipoff, CPA
Rogoff & Company, P.C.
Alan D. Kahn, CPA
The AJK Financial Group

Contributing Editors:
Barry C. Picker, CPA
Richard H. Sonet, JD, CPA
Marks Shron & Company LLP
Peter Brizard, CPA
Ellen G. Gordon, CPA
Margolin, Winer & Evens LLP

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