CRAT Attack.

A charitable remainder trust (CRT) may allow a taxpayer to obtain substantial tax benefits. The taxpayer can retain an income stream and receive an income and gift tax charitable deduction for the remainder interest. A CRT can also help to shelter gain on appreciated assets sold after contribution to the CRT. Although gain is realized by the CRT, it is taxable only to the income beneficiary as distributed. If the interest in the trust is retained for life, the assets remaining in the CRT at death are deductible for estate tax purposes.

A CRT must make a minimum annual distribution of at least five percent of the fair market value (FMV) of the trust assets for either the lifetime of an individual(s) or a term of years not to exceed 20. No distributions are permitted to any other individual, but a qualifying charity may in certain circumstances also receive income. Another individual (or individuals) can receive an interest for a term of years or for life following the first interest, but the second beneficiary must agree to pay any estate taxes due on the first beneficiary's death on account of the successor interest. After the term of years or on the death of the measuring individual, the remainder interest (the present value of which must be at least 10% of the initial FMV of assets on funding) must pass to a qualifying charity. The trust must operate according to these rules from inception.

The Tax Court recently disqualified a trust as a charitable remainder annuity trust (CRAT) and denied an estate tax charitable deduction for the value remaining in the CRAT at death. In Estate of Atkinson, 115 TC 26 (2001), the annuity payments required by the trust instrument were not actually paid to the donor. The trustee recognized that the payments were due the decedent, but they were never actually paid to her and no liability was ever accrued on the trust's books for the payments. The amounts due the decedent were, however, included as an asset of her estate.

The trust also violated the rule regarding the payment of estate taxes. Following the decedent's death, several beneficiaries were left an income interest. The trustee informed them of their interests, but told them that they would have to pay their share of the estate taxes. All but one of the successor beneficiaries declined their bequest. The one who accepted produced a document signed by the decedent guaranteeing that she would not be responsible for any estate taxes on the trust interest. The issue was eventually settled by a court order, stating that the estate taxes due on the CRAT would be payable from another trust created by the decedent prior to death. Unfortunately, because there were insufficient funds available in the trust to pay the taxes and the administrative expenses, the CRAT had to be invaded to pay the estate taxes due on the successor's interest.

Even though withholding payment of the annuity may have benefited the charity, the court held that this violation of the trust's terms was unacceptable. It created, in effect, a private foundation without the taxes and limits imposed on such entities.

Caution: Annuity and unitrust payments can be made within a reasonable time after the close of the tax year, provided the amount payable is considered taxable income and not a return of capital. However, any trust that does not make the required annual payments runs the risk of failing to qualify as a CRT, such that the grantor will lose substantial CRT benefits. Moreover, if there are successor interests to the initial CRT interest, the recipient should be sure to have sufficient resources to pay any estate taxes due. No special arrangements should be made that might cause the taxes to be paid from the CRT itself. Otherwise, loss of the charitable deduction will result.

FROM RANDI A. SCHUSTER, J.D., LL.M., NEW YORK, NY