What are the Requirements of Charitable Remainder Trusts?

Charitable Trust

We learn to avoid mistakes by experience. Experience comes from making mistakes. The trick is to gain experience from the mistakes of others.

One mistake that is made over and over again is creating trusts for charities that don’t qualify for the estate tax charitable deduction. For example, a trust is set up for the benefit of a spouse or child, with the remainder going to a charity. The estate of the donor is entitled to a charitable deduction if, and only if, the trust is a charitable remainder unitrust or annuity trust.

Both kinds of trusts have very specific, technical requirements. There is little room for creativity in drafting these trusts. The statutory formula must be followed exactly. All too often the drafting attorney, perhaps at the insistence of the client, tries to add bells and whistles and loses the charitable deduction.

Mistakes in drafting these kinds of trusts are so common that the IRS has a special procedure to reform these trusts after the decedent’s death. Even with faulty drafting there is still a chance to fix up the trust through a reformation proceeding in court and compliance with the IRS’s guidelines. Not all faulty trusts will qualify for reformation, but many will. The fact that an IRS approved procedure exists for reformation is very unusual. The IRS does not usually go out of its way to help taxpayers fix mistakes, especially when the fix means less tax revenue. The over-riding public policy in favor of charitable giving is at work here.

An example of a mistake in making one of these trusts comes from the 9th circuit (yes, that's California). A man included a trust in his will that gave an annual amount to his wife for her life, if she survived him and the remainder went to charity. No problem there. Then he decided that she might outlive him long enough for inflation to eat away at the payment value, so he decided to adjust the payment annually for inflation.

Seems harmless enough, doesn’t it? But inflation adjustments are not permitted in charitable remainder trusts.

A trust can be written with inflation-adjusted payouts, but don't look for a charitable deduction for the charitable remainder. In this case, Sansone vs. U.S., the executor filed a tax return taking the charitable deduction. The entire trust is shared by the surviving spouse and the charity. There are unlimited deductions for property passing to surviving spouse and to charities, but in each case, only if the property interest qualifies for the deduction.

The charitable deduction was denied because the amount of future payments to the spouse was undeterminable due to the inflation adjustment. It did not meet the requirements of a charitable remainder trust. The estate, having lost the charitable deduction, reasoned then, that there would be no tax because the property would pass to the surviving spouse, also a fully deductible disposition. 

Wrong again. The marital deduction was available only for the stated annuity amount. The inflation adjustment is undeterminable and thus, does not qualify for the marital deduction.

The taxpayer appealed to the Ninth Circuit Court of Appeals and the IRS prevailed again.

The court said the regulations covering the marital deduction were fair, and that the remainder interest in the trust did not qualify for a charitable deduction because it was neither a charitable remainder annuity trust nor a charitable remainder unitrust.

What a weird result! Here is a trust going wholly to a surviving spouse and charity (both usually non-taxable dispositions) that is subject to estate tax. (Can you say malpractice?)

A charitable remainder trust requires that the payment to the non-charity be stated as a fixed annual amount (a CRAT) or a fixed percentage of the trust value as determined annually (a CRUT).  These are the only ways a charitable remainder trust can qualify as a charitable deduction. The only variance is that the payments may be limited to current income, either with or without a provision for shortfalls to be made up in following years when income becomes larger than the annual payment.

While it is permitted to include inflation adjustment for trust payments, such a provision cancels any charitable deduction, and the extra amounts paid in successive years do not qualify for the marital deduction.

The IRS has issued revised regulations on the applicable portions of the law. One of the changes is that model CRAT and CRUT clauses are included. When a regulation is published saying, "look, you can save taxes this way, and here's how to do it," mistakes seem to drop dramatically.