Order of Beneficiaries

As a reminder, when calculating the decedent’s estate tax liability, an unlimited deduction may be taken for the value of property included in the decedent’s gross estate this is transferred in a qualifying manner to a charity. If the settlor leaves interests in the same property to both charitable and noncharitable beneficiaries, special rules apply to still get a charitable deduction. Two such methods to carry out the settlor’s dual purpose are charitable lead and remainder trusts (collectively known as “split interest” trusts).

Charitable Lead Trusts (CLTs)

In a charitable lead trust (CLT) property is devoted exclusively to charitable purposes for a specific term. When that period expires, the CLT is devoted exclusively to private purposes.

EXAMPLE: Royce’s will establishes a trust “to pay $25,000 annually to Duquesne University for 20 years, principal then to Maria or her issue.”

To qualify for estate or gift tax charitable deductions, the CLT must be in the form of:

• A charitable lead annuity trust (CLAT) or
• A charitable lead unitrust (CLUT).

See IRC § 2522(c)(2)(B). A CLAT is a CLT that pays a percentage of the value of its trust assets, determined annually, to a named charity for the charitable term. A CLUT is a CLT that pays a fixed percentage of the initial value of the trust assets to the charity for the charitable term.

To qualify for a charitable deduction for gift or estate tax purposes, the CLT, whether in the form of a CLAT or CLUT, must have the following elements:

1. An irrevocable trust valid under state law;
2. Property or money must be transferred to the trust;
3. A qualifying income interest in the form of a guaranteed annuity or charitable unitrust;
4. The governing trust instrument must prohibit certain activities (e.g., self-dealing between the trust and the grantor) and restrict the use of the income exclusively for charitable purposes.

The CLT saves wealth transfer taxes because only the “present value” (calculated by using the prevailing applicable federal rate) of the private beneficiary’s remainder interest, rather than the entire value of the assets transferred to the trust, is considered a taxable gift. In addition, any appreciation of the assets that takes place during the term of the trust is not subject to additional gift or estate taxes.

The method for valuing an annuity interest in a CLT is set forth in Treasury Regulations § 25.7250-2(b). The present value of the annuity is calculated by multiplying:

1. The amount of the annuity by
2. The appropriate annuity factor found in Table B (for term of years) or Table S (for the life of an individual) contained in IRS Publication 1457, which contains actuarial values.

The annuity factor depends on the applicable IRC § 7520 interest rate and term of the annuity. The applicable federal rate for September 2003 is 4.2%. See Rev. Rul. 2003-101, Table 5.

Charitable Remainder Trusts (CRTs)

In a charitable remainder trust (CRT) property is devoted exclusively to a private purpose for a period of time. When that time ends, the CRT is devoted exclusively to charitable purposes.

EXAMPLE: Miles bequeaths to David in trust “to pay $25,000 per year to my wife, Anna, for life, and on her death to Duquesne University.”

Contributions to CRTs are eligible for an income, gift and estate tax charitable deductions equal to the fair market value of the charity’s remainder interest. The deduction is based on the age of each private beneficiary and the percentage of the trust assets that will be paid to him or her annually.

EXAMPLE: Miles bequeaths to David in trust “to pay $25,000 per year to my wife, Anna, for life, and on her death to Duquesne University.” In the year the trust is created, Miles receives a charitable deduction equal to the fair market value of the university’s remainder interest. The deduction amount will be based on Anna’s age and the percentage of the trust assets that will be paid to her annually.

Two types of CRTs are available: a charitable remainder annuity trust (CRAT) and a charitable remainder unitrust (CRUT). A CRAT is a trust that must pay, at least annually, a specific dollar amount equal to at least 5 percent of the initial value of the trust assets to a private beneficiary for the life of an individual or for a term of years (not to exceed 20 years) with the remainder passing to a named charity. A CRUT is similar except that the amount of the annual payments is a fixed percentage of the trust assets, valued annually. See IRC § 664(d).

To qualify for a charitable deduction for gift or estate tax purposes, the CRT, whether in the form of a CRAT or CRUT, must have the following elements:

1. An irrevocable trust valid under state law;
2. Property or money must be transferred to the trust;
3. An income interest in the form of a guaranteed annuity or charitable unitrust;
4. The governing trust instrument must create an interest that is payable to one or more private beneficiaries followed by an irrevocable disposition of the remainder interest to a charitable organization, effective from the time when the trust is funded;
5. The governing trust instrument cannot restrict the trustee’s ability to invest trust assets in income-producing property; must bar anyone from changing the trust in a manner that would jeopardize the charity’s right to the remainder interest; and prohibit certain activities (e.g., self-dealing);
6. The settlor can retain a power to: accelerate the charitable remainder interest and change the specific charity to whom the remainder is paid;
7. Lifetime payments must be paid to and measured by the recipient’s life and no one else’s; and
8. At the time of death of the last private beneficiary or at the end of 20 years, the remainder interest must be paid or held for the benefit of the qualified charitable organization. See IRC §§ 664(d)(1), 664(d)(2).