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The crux of the clutch CRUT crutch: how to fix an impermissible split-interest trust to obtain an estate tax charitable deduction.

Creating a charitable remainder trust (CRT) at death is a technique that has been used for many years to obtain an estate tax charitable deduction in a decedent's estate. The Internal Revenue Code (1) contains numerous requirements that an otherwise nondeductible split-interest trust must satisfy in order to be accepted as a qualifying CRT. Unfortunately, due to mistake or otherwise, there are instances when one or more of such requirements are not satisfied, in which case the CRT fails to qualify as such and the estate tax charitable deduction is lost. The good news (especially for the lawyer who drafted the CRT) is that the code includes a mechanism that allows such a trust to be reformed so that the "broken" CRT can be cured and the deduction can be taken (the qualified reformation regime). The rules to reform the trust are complex. This article discusses such rules, provides a roadmap to navigate them, and concludes with alternatives for situations in which a reformation will not be allowed.

Charitable Remainder Trust Requirements

Section 2055(e)(2) prohibits the estate tax charitable deduction for transfers of charitable remainder interests in so called "split-interest trusts" unless the trust qualifies as a charitable remainder annuity trust (CRAT) or a charitable remainder unitrust (CRUT). (2) To qualify as a CRAT, a trust must provide 1) at least annually to one or more then-living noncharitable beneficiary(ies) in what must be the sole noncharitable distribution, a fixed-dollar annuity ranging from 5 percent to 50 percent of initial trust asset fair market value (FMV) for the beneficiary's life or for a maximum 20-year term; and 2) at termination, the entire remainder interest with an actuarial value of at least 10 percent of initial trust asset FMV (tested at inception, not termination) must pass to one or more qualified charities. (3) The CRUT requirements are essentially identical, except that the annual noncharitable distribution must be a unitrust amount between 5 percent and 50 percent of annually determined trust asset FMV. (4)

Reformations Required Even After IRS Provides Sample Forms

Section 664 and the Treasury Regulations promulgated thereunder (5) also include technical requirements. (6) In an effort to assist taxpayers and drafters of CRTs (and consequently reduce the administrative burden of technically deficient trusts that were clearly intended to be CRTs), beginning in 1989, the Internal Revenue Service promulgated sample trust language (most recently updated in 2003 and 2005) for CRATs and CRUTs. (7) While the existence of government-issue CRT forms should have substantially reduced the need for a qualified reformation regime, it appears, at least based on private letter rulings (PLRs) issued in this area, that practitioners continue to draft impermissible split-interest trusts. (8)

Qualified Reformation Requirements

* What Interests May Be Reformed?

--Section 2055(e)(3) allows the charitable deduction for split-interest trusts that are subject to a "qualified reformation," defined as a change within a governing instrument (by reformation, amendment, construction, or otherwise) of a "reformable interest" into a "qualified interest." A qualified interest is any interest for which a charitable deduction would normally be allowable if made outright {i.e., under [section]2055(a)). A reformable interest is any interest for which the charitable deduction would be allowed but for the split-interest prohibition.

* How Much Can Interests Vary?

--For a reformation to be "qualified," the difference between the actuarial value of the qualified (post-reformation) interest and reformable (pre-reformation) interest cannot exceed 5 percent of the actuarial value of the reformable (pre-reformation) interest. Stated differently, the value of the charitable remainder interest cannot be less than 95 percent or more than 105 percent of its original actuarial value on the date of the decedent's death. Although this variance requirement technically applies only to the charitable remainder interest, in practice, the adjustment of the life tenancy beyond 5 percent of the charitable remainder interest value in either direction will preclude the charitable deduction because such modification will, in turn, impermissibly alter the value of the charitable remainder interest.

For example, consider an impermissible split-interest trust with a single noncharitable life tenancy interest actuarially valued at $100,000 and a charitable remainder interest actuarially valued at $900,000. Under the qualified reformation regime, the charitable remainder interest after the reformation cannot be actuarially valued at less than $855,000 or more than $945,000. Inversely, the noncharitable life tenancy interest's post-reformation actuarial value must be valued at less than $145,000 (necessitating a charitable remainder interest reduction to $855,000) and more than $65,000 (dictating a charitable remainder interest increase to $945,000).

An additional wrinkle exists if the pre-reformation trust provides for an annuity or unitrust amount substantially outside the 5 percent to 50 percent CRT "window" set forth in [section]664(d). For instance, an otherwise permissible split-interest trust with a 1 percent unitrust amount must be increased to 5 percent (the statutory floor) to qualify as a CRUT, but if the modification causes the date-of-death actuarial value of the charitable remainder interest to decrease by more than 5 percent, the reformation will not be qualified and a charitable deduction would be denied. As such, it is critical that a practitioner "run the numbers" prior to pursuing a qualified reformation.

* Retroactivity and Tenancy Duration Requirements--The qualified reformation regime also requires that the nonremainder interest(s) terminate at the same time as originally drafted. For example, if the decedent's child has a term certain interest in the split-interest trust, the reformation cannot convert the child's interest to a life tenancy.

The final requirement for a qualified reformation is also straightforward: The change must be retroactive to the decedent's date of death. A review of published PLRs suggests that this burden should not be a problem; indeed, not once in the last decade has the IRS denied a taxpayer's PLR request involving a qualified reformation because a reformation was not retroactive. (9)

* Timing of Judicial Reformations

--A noncharitable life tenancy not expressed in a fixed dollar amount or fixed percentage is not reformable un less a judicial reformation proceeding is commenced within 90 days of the estate tax return (ETR) filing deadline (including extensions) if an ETR filing is required, or the trust's first income tax return filing deadline if no ETR filing is required (the 90-day deadline). Further complicating this particular deadline is that, because the cutoff is prescribed by statute rather than by regulation, [section]9100 relief is not available. While most IRS decisions have the relevant dates redacted, at least one technical advice memorandum rejected a qualified reformation because the proceeding was not commenced until more than one year after the ETR was filed. (10) The Tax Court has addressed the 90-day deadline twice; in both instances, it punished the taxpayer for missing the deadline; the taxpayer appealed; and the applicable federal circuit court upheld the Tax Court's decision. (11)

What if the CRT is created after the termination of a trust that qualified as qualified terminable interest property (QTIP)--assuming that ETR's are required to be filed for each spouse's estate, which ETR filing date applies for purposes of the 90-day deadline--the first spouse to die (the deceased spouse) or the second spouse to die (the surviving spouse)? The answer is unclear. Arguments in favor of the earlier deadline include the fact that the deceased spouse created the instrument whose sub-trust is now at issue and that it was his or her charitable intent that created the bequest for which the deduction is being sought. Arguments supporting use of the later deadline are that the residual sub-trusts at issue only come into existence at the death of the surviving spouse due to the QTIP nature of the trust. It necessarily follows that 1) the residual beneficiaries' interests do not truly become ascertainable until the surviving spouse's death; 2) that the residual trusts would not otherwise be subject to estate tax until the surviving spouse's death; and 3) that if an ETR filing was not required, the trust's first income tax return filing deadline would be used, which would not occur for a postQTIP residual trust until after the surviving spouse's death.

Factors Surprisingly Irrelevant to Qualification of Reformation

*Scrivener's Error Not Strictly Required --A "scrivener's error," while commonly asserted by taxpayers as a reason to modify trust terms in state court, appears to have little bearing on whether the IRS or a court will qualify a reformation for purposes of granting a charitable deduction. Of the numerous PLRs reviewed seeking an IRS ruling on qualified reformation status, only one references a scrivener's error, and a charitable deduction was nevertheless denied for failure to meet the requirements of the qualified reformation regime. (12)

* Court Formalities Not Strictly Required--There is no strict requirement that all interested parties to a reformation have adequate representation for qualification under [section]2055(e). However, a qualified reformation requires "a change of a governing instrument by reformation, amendment, construction, or otherwise...." Thus, to the extent that state law requires independent representation to achieve a reformation, amendment, construction, or other modification of the governing instrument, separate counsel must be retained.

Due to the broad definition of "reformation" under the qualified reformation regime (quoted directly above), it is possible that, if allowed by state law, the disqualifying aspects of an impermissible split-interest trust could be fixed by nonjudicial settlement agreement. That said, virtually every PLR seeking ratification of a reformation involves either a prior state court ruling made contingent on a favorable PLR or a representation that a state court action will be carried out in conformance with the prospective transaction set forth in the PLR request.

Timing Considerations

PLRs, while not strictly required for a qualified reformation, are often obtained for peace of mind or in "close call" situations. If a PLR is going to be requested, the taxpayer should consider the timing of the state court proceedings. When making a PLR request, the taxpayer is required to provide copies of all documents pertinent to the transaction. (13) If state court proceedings have concluded before the PLR request is made, the IRS could request any submissions made therein. If, however, the PLR is made contingent on a favorable state court ruling in the manner presented within the ruling request, said state court submissions will not be available for the IRS to review because none will have then been filed.

In some circumstances, it will be advisable or imperative to initiate state court proceedings before the PLR request. For instance, if the reformation involves a noncharitable life tenancy that is not already expressed as a fixed dollar amount or percentage of corpus, the 90-day deadline requires timely commencement of state court proceedings. A taxpayer "running up against that clock" should not wait for the IRS to rule because, in some instances, the IRS may not issue a ruling for up to nine months from the filing date of the PLR request.

IRS Determination of Qualified Reformations in Wake of NoRuling Policy on CRTs

In 1990, shortly after providing sample forms for both inter-vivos and testamentary CRTs involving one or two lives, the IRS announced-14 that it will no longer issue rulings on the qualification of CRTs. (15) Thus, multiple PLRs have been issued that condition a qualified reformation on the reformed trust being a CRT that qualifies as such. Despite the age of this no-ruling policy, the IRS has, on occasion, broken its own rule and rendered a determination that a reformed trust is a valid CRT. (16) Practitioners should assume that the IRS will not bless their reformed trusts as CRTs and should determine themselves that all the conditions of a CRT are otherwise met. In PLR 9151022, the IRS suggested that if a taxpayer wanted to be certain that a trust will qualify as a CRT, the applicable state court should be asked to approve a revised trust instrument that is substantially similar to the IRS samples.

When a Reformation Cannot be Qualified

When it is impossible to fix a non-qualifying CRT using the qualified reformation regime, an estate tax charitable deduction may still be salvageable through a judicial modification that eliminates or segregates a problematic interest. At the outset, it is worth noting that it is possible that the following techniques may have adverse consequences to a beneficiary and, thus, should be made contingent on receipt of a favorable PLR whenever possible.

* Disclaimers--Taxpayers have been successful in navigating the qualified reformation regime by disclaiming, in whole or in part, interests that fail to qualify as a reformable interest. (17) For example, in PLR 200840030, a decedent's daughter was given a fixed amount income interest during the life of the surviving spouse; after the surviving spouse's death, the daughter was to receive the surviving spouse's income interest, and upon the daughter's death, a charity was to receive the balance of the trust. If trust income was insufficient, principal distributions could be made to daughter subject to an ascertainable standard. The daughter subsequently disclaimed her right to receive the discretionary principal. (18) The IRS ruled that the reformation was qualified and a charitable deduction was allowed.

This outcome is supported by the Regulations, which provide that a charitable deduction is allowed for a bequest to charity that occurs by virtue of a qualified disclaimer under [section]2518. (19) Alternatively, disclaimers can be used to entirely eliminate all existing noncharitable interests, thereby removing any impermissible split-interest and allowing for an estate tax charitable deduction under [section]2055(a).

Under [section]2518, a qualified disclaimer must 1) be in writing; 2) be received by the correct party (20) within nine months of the later of the day on which the transfer creating the interest in such person is made or the disclaimant's 21st birthday; 3) occur before the disclaimant has accepted the interest or its benefits; and 4) cause the interest to pass without any direction by the disclaimant to the decedent's spouse or a third party.

The Regulations indicate that when the disclaimant is 21 years old, the nine-month window with respect to testamentary transfers begins on the decedent's death, regardless of whether an estate tax is imposed on the transfer. (21) If the disclaimed interest is a remainder in a QTIP trust, the Regulations specifically require that the remaindermen disclaim within nine months of the deceased spouse's death, and not when the property is later taxed under [section][section]2044 or 2519, (22) Unfortunately, because no estate tax is incurred at the deceased spouse's death, there is little incentive to investigate the propriety of the residual split-interest trust(s) and, as such, this deadline often passes quietly and unbeknownst to the would-be disclaimants (i.e., the CRT beneficiaries).

* Settlement Payments to Charity Deductible--When outright payments are made to charity in settlement of a bona fide dispute, courts have allowed a deduction under [section]2055(a) for amounts actually paid to charity. (23) The commissioner initially took the position that no deduction would be allowed for payments under a settlement of a will contest that accelerated a nonqualifying charitable remainder where no deduction would have been allowed under any outcome of actual litigation. (24) The IRS ultimately changed its position in Rev. Rul. 89-31, (25) thereafter allowing a deduction for a settlement payment if 1) the payment is made in accordance with a negotiated settlement of a bona fide dispute; 2) the settlement is within the range of reasonable outcomes under the governing instrument and applicable state law; and 3) the payments to charity do not exceed what they would have been entitled to if their rights had been pursued in litigation. Notwithstanding the IRS's position, the courts are generally concerned only with whether the settlement payment arose from a bona fide dispute. (26)

* Severances--In some cases, deductions have been allowed for at least a fraction of an otherwise non-qualifying charitable interest when property passing directly to charity was ascertainable and actually severed from a split-interest trust before the ETR was filed. The law is not perfectly uniform among all jurisdictions, but appears to be mostly consistent in the Third, Fifth, Eighth, and Ninth circuits.

In Oetting v. U.S., 712 F.2d 358 (8th Cir. 1983), the trust at issue was required to provide a negligible fixed amount of trust income monthly to three elderly individuals for their joint lives, with excess income divided among four charities and one other person; upon the death of the last life tenant, the five excess income beneficiaries were to share the corpus equally. Given the enormity of the assets in the subject trust, the trustees became concerned that they would breach their fiduciary duties to the remaindermen by maintaining the trust for the sole purpose of generating a tiny annuity for the three elderly life tenants. Thus, the trustees successfully petitioned their state court to use trust assets to purchase annuities for the three life tenants, with 4/5 of the remaining trust assets to be distributed immediately to the remainder charities and the remaining fifth continuing in trust for the duration of the joint life tenancy. The IRS disallowed a charitable deduction, prevailed at the trial level, and the case was ultimately appealed to the Eighth Circuit Court of Appeals.

On appeal, the IRS argued, unsuccessfully, that the severance was instigated for the sole purpose of avoiding estate taxes. The Eighth Circuit disagreed, finding that there was a legitimate nontax reason for the trustees to seek judicial modification of the trust, namely, fear of breach of fiduciary obligations. (27) However, taxpayer motivation was not the critical inquiry in this case. The day before oral argument, the taxpayer's counsel produced a Revenue Ruling, issued after appellate briefs were submitted, where a charitable deduction was allowed despite a post-death state court decree granting an ascertainable widow's support allowance out of a testamentary residuary bequest to charity (arguably creating an impermissible split-interest). (28) The Revenue Ruling's rationale for allowing the deduction was that because the maximum amount to be received by the widow could be measured and severed from the charitable bequest, [section]2055(e) would not be implicated and [section]2055(a) would allow a deduction. (29) The Eighth Circuit found the underlying facts analogous to those before it and the taxpayer prevailed.

In Galloway v. U.S., 492 F.3d 219 (3d Cir. 2007), the Third Circuit Court of Appeals denied an estate tax charitable deduction where the charitable remainder in a nonqualifying CRT was severable but not severed at the time the ETR filed. In this case, the decedent's attorney was able to obtain a ruling from the Pennsylvania Department of Revenue regarding the actuarial value of the charitable remainder, but was unsuccessful in arguing that the valuation brought the subject trust within the scope of Oetting and outside the grasp of the qualified reformation regime. (30)

In Estate of Johnson v. U.S., 941 F.2d 1318 (5th Cir. 1991), the Fifth Circuit Court of Appeals upheld the IRS's denial of a charitable deduction for an impermissible split-interest trust where, subsequent to the denial, a state court interpreted the decedent's will as instead establishing three separate trusts, for which taxpayer argued eliminated the split-interest issue pursuant to Oetting. The Fifth Circuit differentiated Oetting as a case in which the noncharitable beneficiary's interest was capable of measurement; the fact that a firm amount was placed irrevocably into the severed charitable trust did not in and of itself entitle the estate to a charitable deduction. (31)

Parenthetically, the Johnson court refused to adopt the IRS's position that a "motive test" should be applied to reject the deduction where the sole purpose of the trust modification was to reduce estate taxes. Conversely, the Ninth Circuit Court of Appeals adopted the motive test in Burdick v. C.I.R., 979 F.2d 1369 (9th Cir. 1992). In that case, the taxpayer contacted a charitable remainderman and, with its consent, orchestrated the termination of a nondeductible split-interest trust one year after the charitable deduction was denied. The taxpayer argued that it had additional reasons other than tax avoidance, but the Ninth Circuit was unconvinced, holding that the only charitable deduction relief available was via the qualified reformation regime.


Despite the existence of government-blessed forms, practitioners will continue to encounter split-interest trusts that fail to qualify as CRTs. In such circumstances, careful application of the qualified reformation regime to the problem trust as drafted and intended is necessary. This analysis will determine whether any reformation will be respected for estate tax charitable deduction purposes and, if so, the limits on the restructuring. If the split-interest trust at issue is created from the remainder of a QTIP trust, said inquiry should not be delayed until the death of the surviving spouse. If a reformation is pursued, consideration should also be given as to the order of proceedings to provide the estate with the highest chances of success.

If a qualified reformation is not possible, the trust may be able to be removed from [section]2055(e) by way of disclaimer, settlement, or severance, thereby allowing a charitable deduction under [section]2055(a). Courts are often sympathetic to taxpayers in this setting because there is no question that the decedent intended to make a charitable bequest that is practically certain to occur, and will strain to find a charitable deduction. That said, the rubric for these techniques is not universal across all local authorities; practitioners should prudently investigate the precedent in their jurisdiction before initiating proceedings.

(1) Unless otherwise stated, all section references shall be to the Internal Revenue Code of 1986, as amended.

(2) A pooled income fund would also qualify but are less common and not discussed herein.

(3) I.R.C. [section]664(d)(l).

(4) I.R.C. [section]664(d)(2).

(5) All references to the "Regulations" shall be to the Treasury Regulations.

(6) See Nathan R. Brown, A Primer on Charitable Remainder Trusts, Tax Mgmt. Est. Gifts & Tr. J. (BNA) (Nov. 13, 2014) (for a detailed discussion of these requirements).

(7) Rev. Proc. 2003-53 through 2003-60; Rev. Proc. 2005-52 through 2005-59.

(8) See PLRs 201450003, 201333006, 201125007, 201115003, 200927013, 200840030, 200832003, 200818003, 200746010, 200726005, 200632013. 200622005, 200605001, 200541038, and 200535006.

(9) See note 7. That said, this statistic might be due to the fact that taxpayers requesting such qualified reformation rulings have already determined their reformation will be eligible for retroactivity under state law. Numerous state courts and the Tax Court have investigated whether a reformation qualifies for retroactivity under state law. See, for example, In re Cohen, 203 P.3d 734 (Kan. 2009): Harbison v. U.S., 87 A.F.T.R.2d 1523 (N.D.Ga. 2001); Pellegrini v. Breitenbach, 456 Mass. 876, 926 N.E.2d 544 (2010).

(10) TAM 8950001.

(11) See Estate of Hall v. C.I.R., 93 T.C. 745 (1989); Estate of Tamulis v. C.I.R, 92 T.C.M. 189 (2006).

(12) PLR 200350012.

(13) See Rev. Proc. 2015-1, [section]7.01(2)(a).

(14) See Rev. Proc. 90-3, [section]4.01(28).

(15) See, for the most recent iteration of the no-ruling policy, Rev. Proc. 2015-3, [section][section]4.01(35), (36).

(16) See PLR 9202033, for example.

(17) See generally PLRs 200840030, 200535006, 200428013, 200330028, 200330029, 200010019, 9852034, 9823037, 9610005, 9853014, 200232015, and 9827010.

(18) Specifically, I.R.C. [section]664(d)(2)(B) requires that other than the unitrust amount, no amount may be distributed to noncharitable beneficiaries. The parallel citation for CRATs is I.R.C. [section]664(d)(l)(B).

(19) Treas. Reg. [section]20.2055-2(c)(1).

(20) The transferor of the disclaimed interest, their legal representative, or the holder of legal title to the property disclaimed.

(21) Treas. Reg. [section]25.2518-2(c)(3)(i).

(22) Id.

(23) See Flanagan v. U.S., 810 F.2d 930 (10th Cir. 1987): Estate of Strock v. U.S., 655 F. Supp. 1334 (WD Pa. 1987); Northern Trust Co. v. U.S., 78-1 USTC 1113, 229 (ND 111. 1977); Estate of Williams v. C.I.R., 97 T.C.M. 1019 (2009); Estate of Palumbo v. U.S., 2011-1 USTC 1160, 616 (ED Pa. 2011).

(24) See Rev. Rul. 77-491 (subsequently revoked by Rev. Reel. 89-31).

(25) 1989-1 C.B. 277, 1989-9 I.R.B. 32.

(26) See, for example, Estate of Simpson v. C.I.R., 67 T.C.M. 3062 (1994), disregarding a judgment entered by a Florida court in a nonadversarial proceeding and disal lowing charitable deductions for amounts paid to charity in lieu of non-qualifying remainder interests. See also Terre Haute First Nat'l Bank <Estate of Burns, Sr.) v. U.S., 91-1 USTC 1160,070 (SD Ind. 1990), limiting the deduction to the actuarial value of the charity's interest under a will rather than allowing a deduction for the larger amount paid to the charity pursuant to the settlement of a will contest,

(27) While the Oetting decision does not appear to turn on the fact that there was a significant nontax reason for instigating the judicial severance, the language of the holding suggests that it was a factor in the court's rejection of the IR S' position.

(28) Rev. Rul. 83-20.

(29) Counsel for the IRS produced a subsequent Rev. Rul. 83-45 that it argued distinguished Rev. Retl. 83-20. The Oetting court was not swayed, holding that the Rev. Rul. 83-20 was neither distinguished, nor overruled, nor even cited by Rev. Retl. 83-45.

(30) The court distinguished Oetting, stating "In Oetting, and every case to allow the deduction using its reasoning, the charitable beneficiary had already received its interest in the trust. Therefore, the noncharitable beneficiary no longer had any interest in that property. At that point, the charitable and noncharitable beneficiaries no longer had an interest in the same property. In the case before us, at the time the deduction was claimed in 2000, the charitable and noncharitable beneficiaries retained an interest in the same property. Their interests did not diverge until the first distribution...."

(31) The court held that "[i]n spite of the chancery court-approved severance of trusts, accurate measurement of the liability for supporting [the noncharitable beneficiary] remains impossible, and there is no justification for bending the admittedly stiff rules of [section]2055(e)."

David Pratt is the chair of the personal planning department of Proskauer Rose LLP, and the managing partner of the firm's Boca Raton office. He is Florida board certified in taxation and wills, trusts and estates, and has served on The Florida Bar's Real Property, Probate and Trust Law Section's Wills, Trusts and Estates Certification Committee. He is also a past chair of The Florida Bar's Tax Section and an adjunct professor at The University of Florida Levin College of Law and the University of Miami Law School.

Michael Rosenblum is an associate in the personal planning department of Proskauer Rose LLP's Boca Raton office. He received his B.A. in English from the George Washington University, his J.D. from the Emory University School of Law, and his LL.M. in estate planning from the University Miami School of Law. He is licensed to practice law in New York, Florida, and Colorado.

This column is submitted on behalf of the Tax Law Section, James Herbert Barrett, chair, and Michael D. Miller and Benjamin Jablow, editors.
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Title Annotation:charitable remainder unitrust
Author:Pratt, David; Rosenblum, Michael
Publication:Florida Bar Journal
Date:Nov 1, 2015
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