Not all trusts that are created for charities qualify for the estate tax charitable deduction. The estate of a donor is entitled to a charitable deduction if—and only if—the trust is a charitable remainder unitrust or a charitable remainder annuity trust.
Both kinds of trusts have very specific, technical requirements.
What Is a Charitable Remainder Trust?
This type of trust is designed to take ownership of certain assets, then provide an income stream from those assets to its beneficiaries. The creator and funder of the trust can be a beneficiary. Any assets that remain after the deaths of all beneficiaries are sold and the proceeds then go to a designated charity.
The trust isn't liable for any capital gains tax when this happens, and the trustmaker can claim a present-day partial tax deduction for the portion of the trust that passes to a charity or charities. But the trust must be irrevocable. It can't be undone after it's formed and funded.
A unitrust distributes a fixed percentage of the value of the trust's assets each year. Values are reassessed annually. An annuity trust distributes fixed annuities annually, as the name implies.
Rules for Charitable Remainder Trusts
A charitable remainder trust requires that any payments to a 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 for a charitable deduction.
The only variance is that the payments can 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. Payments cannot exceed 20 years as of 2020.
The trust can include inflation adjustments for trust payments, but such provisions cancel any charitable deduction. The extra amounts paid in successive years won't qualify for the marital deduction, either, if a surviving spouse be the other beneficiary of the trust.
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.
Mistakes in drafting these kinds of trusts are so common that the IRS has a special procedure in place to reform them after a decedent’s death. There's still a chance to fix the trust through a reformation proceeding in court and future compliance with IRS guidelines, even after faulty drafting of the trust's formation documents.
The IRS doesn't usually go out of its way to help taxpayers fix mistakes, especially when the fix means less tax revenue. The overriding public policy in favor of charitable giving is at work here.
Not all faulty trusts will qualify for reformation, but many will.
An example of a mistake in making one of these trusts comes from Sansone vs. U.S., heard by the Ninth Circuit Court of Appeals in California.
A man included a trust in his will that gave an annual amount to his wife for her life if she survived him. The remainder went to charity. 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.
It might seem harmless enough, but inflation adjustments are not permitted in charitable remainder trusts. The executor of the estate filed a tax return taking the charitable deduction. The entire trust was shared by the surviving spouse and the charity. There are unlimited deductions for property passing to surviving spouse and 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 didn't meet the requirements of a charitable remainder trust.
A Further Complication
Having lost the charitable deduction, the estate then reasoned that there would be no tax due because the property would pass to the surviving spouse. This would also be a fully deductible disposition according to the terms of the unlimited marital deduction offered by the tax code.
But the marital deduction was available only for the stated annuity amount. The inflation adjustment was undeterminable, and it therefore didn't qualify for the marital deduction.
The taxpayer appealed to the Ninth Circuit Court of Appeals and the IRS prevailed. 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.