The nonqualified testamentary CRAT
This is also a fairly common problem, particularly in the present low interest rate environment. And sometimes, as here, there is no clear answer.
The preparer of an estate tax return asked whether he would be able to defend a claimed deduction under section 2055(e)(2) for the present value of the remainder of a testamentary charitable remainder annuity trust.
The trust was to pay the minimum five pct. quarterly at the end of the quarter to an individual aged fifty-eight. The section 7520 rate for the date of death was three pct.
While the present value of the remainder would be nearly twenty-three pct., well over the required ten pct. minimum, the "probability of exhaustion," that is, the likelihood the annuity payout would exhaust the trust before the annuitant died, was something north of twenty-four pct.
Reg. 20.2055-2(b)(1) disallows a deduction if the remainder interest can be defeated by an event the possibility of the occurence of which was not, at the date of the decedent's death, "so remote as to be negligible." But how remote is "negligible," you might ask.
In Rev. Rul. 70-452, the Service ruled that a charitable deduction would not be allowed for gift tax purposes for the present value of the remainder of an inter vivos CRAT, where the probability that the annuitant would survive the exhaustion of the corpus was greater than five pct.
The five pct. figure was rationalized by analogy to section 2037, which includes in the gross estate a reversionary interest in a transfer that would otherwise take effect as a springing executory interest, and to section 2042, which treats a reversion as an incident of ownership in a life insurance policy, in each case only if the reversion exceeds five pct.
Okay, but could we maybe reform the trust under section 2055(e)(3) to an eight pct. unitrust, which would keep the remainder within the five pct. tolerance required by 2055(e)(3)(B) but get rid of the exhaustion problem.
Unfortunately, in Rev. Rul. 77-374, the Service said no, because this was not a matter of qualifying the trust under section 2055(e)(2)(A), but of meeting the additional requirement of Reg. 20.2055-2(b)(1).
But maybe Rev. Rul. 77-374 was wrong. The logic of the ruling appeared to be that reformation would not be required to qualify the trust for income tax purposes, but only for the transfer tax deduction. But there was some dissonance here, as Reg. 1.170A-1(e) also includes the "so remote as to be negligible" language.
In Estate of Moor, a 1982 Tax Court memorandum decision, Judge Scott found the probability of exhaustion to be negligible in a borderline case where the CRAT was in fact earning slightly more than the 7520 rate, then six pct. Rev. Rul. 77-374 was cited in a footnote, but in a context that suggested the court was simply treating the ruling as the Commissioner's litigating position.
Of course, ours was not a borderline case.
What we finally decided to do was to claim the estate tax deduction, file the reformation petition, maybe make the final order contingent on a favorable private letter ruling, and on a second track also claim an income tax deduction for the distribution from the estate funding the trust, and then sort the whole thing out in examination.
This is also a fairly common problem, particularly in the present low interest rate environment. And sometimes, as here, there is no clear answer.
The preparer of an estate tax return asked whether he would be able to defend a claimed deduction under section 2055(e)(2) for the present value of the remainder of a testamentary charitable remainder annuity trust.
The trust was to pay the minimum five pct. quarterly at the end of the quarter to an individual aged fifty-eight. The section 7520 rate for the date of death was three pct.
While the present value of the remainder would be nearly twenty-three pct., well over the required ten pct. minimum, the "probability of exhaustion," that is, the likelihood the annuity payout would exhaust the trust before the annuitant died, was something north of twenty-four pct.
Reg. 20.2055-2(b)(1) disallows a deduction if the remainder interest can be defeated by an event the possibility of the occurence of which was not, at the date of the decedent's death, "so remote as to be negligible." But how remote is "negligible," you might ask.
In Rev. Rul. 70-452, the Service ruled that a charitable deduction would not be allowed for gift tax purposes for the present value of the remainder of an inter vivos CRAT, where the probability that the annuitant would survive the exhaustion of the corpus was greater than five pct.
The five pct. figure was rationalized by analogy to section 2037, which includes in the gross estate a reversionary interest in a transfer that would otherwise take effect as a springing executory interest, and to section 2042, which treats a reversion as an incident of ownership in a life insurance policy, in each case only if the reversion exceeds five pct.
Okay, but could we maybe reform the trust under section 2055(e)(3) to an eight pct. unitrust, which would keep the remainder within the five pct. tolerance required by 2055(e)(3)(B) but get rid of the exhaustion problem.
Unfortunately, in Rev. Rul. 77-374, the Service said no, because this was not a matter of qualifying the trust under section 2055(e)(2)(A), but of meeting the additional requirement of Reg. 20.2055-2(b)(1).
But maybe Rev. Rul. 77-374 was wrong. The logic of the ruling appeared to be that reformation would not be required to qualify the trust for income tax purposes, but only for the transfer tax deduction. But there was some dissonance here, as Reg. 1.170A-1(e) also includes the "so remote as to be negligible" language.
In Estate of Moor, a 1982 Tax Court memorandum decision, Judge Scott found the probability of exhaustion to be negligible in a borderline case where the CRAT was in fact earning slightly more than the 7520 rate, then six pct. Rev. Rul. 77-374 was cited in a footnote, but in a context that suggested the court was simply treating the ruling as the Commissioner's litigating position.
Of course, ours was not a borderline case.
What we finally decided to do was to claim the estate tax deduction, file the reformation petition, maybe make the final order contingent on a favorable private letter ruling, and on a second track also claim an income tax deduction for the distribution from the estate funding the trust, and then sort the whole thing out in examination.