The 5% Solution: IRS Revenue Procedure 2016-42 Provides Relief for the Probability of Exhaustion Test

by M. Robinson & Company, P.C.

Charitable Remainder Annuity Trusts (CRATs) can be a very effective charitable planning tool. Choosing to fund a CRAT can remove assets from the estate of the donor, provide a reliable income stream for a family member and result in income and estate tax benefits through the charitable contribution deduction. To obtain these benefits, a CRAT must follow very stringent requirements and meet a number of tests created by the IRS.

Most of these tests are tough to pass in a low interest rate environment, particularly the “Probability of Exhaustion” test. To provide relief for CRATs which would otherwise pass all the requirements, but fail the Probability of Exhaustion test, the IRS has recently released Revenue Procedure 2016-42. This procedure provides contingency language which can be inserted into the terms of the CRAT, eliminating the need to pass the Probability of Exhaustion test.

Brief Overview on CRATS

Categorized as a split-interest trust, a CRAT’s benefits are split between a charitable beneficiary and a non-charitable beneficiary. Often the non-charitable beneficiary is the donor, a family member of the donor, or a combination of both. For a period of time, the non-charitable beneficiary receives an income stream from the CRAT; this is an annuity of either a fixed amount or a certain percentage of the initial value of the CRAT. The income is paid for a certain number of years or the payments are be made over the lives of one or more non-charitable beneficiaries. Once that period of time has ended, the remainder in the CRAT goes to charity.

Basic Benefits of a CRAT

CRATs can be set up by the donor while living or at death. If the CRAT is established inter vivos, while the donor is living, the donor currently receives a charitable income tax deduction for the present value of the future remainder interest that goes to charity. If it is a testamentary CRAT established upon the death of the donor, the donor receives an estate tax deduction. In either case, the value of the charitable deduction is calculated by reducing the fair market value of the CRAT by the present value of the annuity. The following items affect this calculation:

  • the value of the property transferred to the CRAT,
  • the period of time over which the annuity payments will be made, and
  • the current interest rate.

In addition to the charitable deductions, the earnings in the CRAT grow tax-free. There can be other benefits as well, such as avoiding capital gains tax when contributing appreciated securities to a CRAT, making a CRAT a “win-win” proposition for donors, their family members and charitable organizations.

CRAT Requirements

To qualify as a CRAT, the trust must meet a number of requirements and tests as defined in Section 664(d):

  • Minimum Payouts: A CRAT must make minimum payouts to the non-charitable beneficiary of 5 percent of the initial fair market value (FMV) of the trust property, up to a 50 percent maximum payout;
  • Frequency of Payouts: CRAT payouts must be paid out at least annually;
  • Limitation on Duration: The time period for the non-charitable annuity stream cannot exceed either:
    1. A term of 20 years, or
    2. The life or lives of the individual(s) receiving the payout; and
  • 10% to Charity: The amount of the remainder interest going to a charity must be at least 10 percent of the net FMV of the trust property as of the date it was transferred.

Donors should also be aware that, once funded, no additional contributions may be made to the CRAT because the annuity is a fixed amount determined by the initial net FMV of the CRAT.

The 5% Probability Test

Under Rev. Ruling 77-374, a CRAT must meet the “5% Probability Test.” This applies only to CRATs designed to make annuity payments over a duration of one or more individual’s lifespans. The purpose of this test is to ensure the charity receives its remainder interest. Any chance of this not occurring such that the possibility that the trust corpus will be exhausted before the charity receives its interest must be so remote as to be negligible. If there is a greater than a 5 percent probability that the trust assets will run out, the possibility of exhaustion is not negligible. Failing this test will lead to the assumption that the CRAT will fail to make any distribution to the charitable remainder beneficiary. As a result, the donor will not receive a charitable deduction.

In practical terms, this usually means that the prevailing interest rates used to conduct this test must be equal to or in excess of the payout rate (minimum of 5%) on the income stream. If the payout rate is higher than the annualized earning rate under the Section 7520 applicable federal rate (AFR), then the trust corpus may be diminished over time to zero. This is because principal may be invaded to make the annual income payouts.

While the probability of exhaustion isn’t typically an issue in a high interest rate environment, passing the test becomes difficult when rates are low and, since the Great Recession of 2008, interest rates have been at historic lows. Currently, the AFR for October 2016 is 1.6 percent. These low rates make it very difficult to create a CRAT even if it passes all the other requirements. In particular, it makes it impossible to create a CRAT using the lifespan of a younger person since the longer the trust corpus needs to be invaded to make the annual income payments, the more likely it will be CRAT exhausted.

Revenue Procedure 2016-42 and the Qualified Contingency Provision

Recently Rev. Proc. 2016-42 was released to provide relief from the 5% Probability Test. Its guidance will allow CRATs with a time period based on one or more measuring lives to be an option for donors as long as all other requirements are met. The relief is derived from Section 664(f), which permits certain qualified contingencies to basically shorten the duration of the CRAT. If the CRAT terms contain a provision identifying a “the happening of a contingency” and the contingency occurs, then the trust terminates and the remainder goes to the charitable beneficiary. Meanwhile, the donor’s charitable deduction is maintained and the trust’s status as a CRAT is not threatened.

Rev. Proc. 2016-42 effectively allows the 5% Probability Test to be disregarded if language is provided in the CRAT identifying that the trust will terminate if, at a later point in time, it fails the requirement that the charity receive at least 10% of the CRATs initial value as its remainder interest. Sample language for this contingency is provided in Rev. Proc. 2016-42 for an inter vivos CRAT as follows:

“The first day of the annuity period shall be the date the property is transferred to the trust and the last day of the annuity period shall be the date of the Recipient’s death or, if earlier, the date of the contingent termination.  The date of the contingent termination is the date immediately preceding the payment date of any annuity payment if, after making that payment, the value of the trust corpus, when multiplied by the specified discount factor, would be less than 10 percent of the value of the initial trust corpus.  The specified discount factor is equal to [1 / (1 + i)] t, where t is the time from inception of the trust to the date of the annuity payment, expressed in years and fractions of a year, and i is the interest rate determined by the Internal Revenue Service for purposes of section 7520 of the Internal Revenue Code of 1986, as amended (section 7250 rate), that was used to determine the value of the charitable remainder at the inception of the trust.  The section 7520 rate used to determine the value of the charitable remainder at the inception of the trust is the section 7520 rate in effect for [insert the month and year], which is [insert the applicable section 7520 rate].”

Each year afterwards, the trustee of the CRAT will be required to calculate whether the value of the trust corpus, reduced by that year’s impending annuity payment, would be less than 10 percent of the value of the initial trust corpus. If the amount is less than 10 percent, than the CRAT is terminated. However, it has still qualified as a CRAT and the charitable deduction is intact. The risk of losing the deduction and CRAT status is removed. Meanwhile, the charity receives its remainder interest and the donor’s philanthropic intent is fulfilled.

Additional language is provided in Rev. Proc. 2016 for testamentary CRATs and for CRATs using two measuring lives, either running consecutively or concurrently and consecutively. Hopefully, as word spreads of the new contingency relief provided by Rev. Proc. 2016-42, donors will consider using CRATs more frequently as a charitable planning tool. Charitable organizations will benefit, as will the communities and people they serve.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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