A taxpayer, admittedly operating under bad advice from a financial planner and an attorney, nonetheless paid a steep price for failing to administer a charitable remainder unitrust (CRUT) properly.

Grantor established a trust. He intended for the trust to qualify as a CRUT. He named himself as a co-trustee and initial beneficiary. The remainder beneficiary upon termination of the trust was, of course, a charity.

The term of the CRUT was 20 years. During the term of years, the CRUT was required to pay Grantor, if living, otherwise a successor beneficiary “B”, a fixed percentage (presumably 5%) of the trust assets or the net income of the trust, whichever was lesser. If the net income in later years exceeded the fixed percentage, the excess net income could be used to makeup shortfalls in the fixed percentage from previous years. In other words, the trust was a net income makeup CRUT, or NIMCRUT.

The CRUT was funded with low-basis capital assets. By having the trust sell these assets, the Grantor would be able to avoid capital gains. That, at least, was the plan.

After the assets were sold, Grantor, upon the advice of Financial Planner, invested trust assets in annuities and insurance products. Financial Planner assured Grantor that these investments would yield a return equal to the fixed percentage annual payout under the CRUT. The CRUT, however, was never able to generate enough income to equal the fixed percentage. As a result, the trustees, contrary to law and in an effort to bring the net income up to the fixed percentage, augmented the net income by including capital gains in the calculation. This augmented amount was paid out to Grantor each year that he was alive.

After the Grantor’s death, the successor beneficiary, B, apparently realized that the CRUT was flawed. B twice petitioned state court unsuccessfully to have the trust reformed. On B’s third try, it asked the court to reform or terminate the trust. This time the court determined that the CRUT was void from the outset and ordered that the trust be terminated and distributed to B.

The court’s ruling was contingent on a ruling by the IRS that the termination of the trust would not result in additional federal income tax consequences. The IRS could not issue such a ruling. Instead, it determined that:

  • By distributing capital gains along with net income, the trust failed to operate exclusively as a CRUT from its creation;
  • As a result of this failure, the trust was not tax exempt under I.R.C. § 664;
  • Instead, the trust qualified as a split interest trust under I.R.C. § 4947(a)(2);
  • Section 4947(a)(2) trusts are subject to certain private foundation rules, including excise taxes on self-dealing, taxable expenditures, and voluntary termination; and
  • Termination of the trust and distribution of its assets to the non-charitable income beneficiary will trigger these excise taxes.

In addition, because the trust was void from the outset, it was never a charitable trust. Thus, the IRS ruled that the trust must file income tax returns and pay any tax due on the income generated by the trust from the date of inception. This would presumably include tax on the gain from the sale of the low-basis assets that were originally transferred to the trust.

Source: PLR 201714002 (pdf)

Posted by Joel D. Roettger, JD, LLM, EPLS