September 19, 2016
Authored by: Charles Lin and Stephanie Moll
One of the many requirements that a trust must meet in order for it to qualify as a Charitable Remainder Annuity Trust (“CRAT”) is the “Probability of Exhaustion Test”. This test applies to CRATs whose annuity term is based on one or more lifetimes, and requires the likelihood that the charitable remainder beneficiary will not receive its interest in the trust be 5% or less. If a trust fails the test, then the charitable remainder interest does not qualify for income, gift, or estate tax charitable deductions, and the trust is not exempt from income tax.
This test poses problems in a low interest rate environment (such as in recent years) because it is calculated by (1) applying Internal Revenue Code (“IRC”) § 7520 assumed rate of return on CRAT assets against the amount of annuity payments to determine when the CRAT assets will be exhausted and (2) using a mortality table to determine the probability that the income beneficiary or beneficiaries will survive CRAT exhaustion.
Good news: the IRS recently provided a sample provision that, if included in the trust, provides for the termination of the trust and distribution of the balance to the charitable beneficiary if the next annuity payment to be made would cause the value of the trust assets, multiplied by a discount factor, to fall below 10% of the initial value of the trust assets. The language in Revenue Procedure 2016-42 is a “qualified contingency” under IRC § 664(f) that would not disqualify the CRAT even though the annuity term is prematurely terminated. It ensures that the charitable beneficiary will receive an interest in the trust corpus.
The Revenue Procedure is effective for trusts created beginning August 8, 2016.