Exiting the Underproductive CRT

by Russell A. Willis III, J.D., LL.M.

current events editor
https://www.charitableplannin.co!
When I ave a si!ilar tal" at the national con#erence in $incinnati in %ctober o# &''(, we were )ust
co!in out o# a rather brie# recession that had #ollowed the *irrational e+uberance* o# the ,--'s and the
pea" o# the so.called dot.co! bubble in /&0.
While the e1uities !ar"ets had beun to recover so!e o# the round they had lost, the #ederal #unds rate
had dropped to ,.' pct. #ro! a hih o# 2.3 pct. in May o# &''', and the section 43&' rate, on which
annuity and unitrust interests are valued #or ta+ purposes, had #allen to a then.historic low o# (.' pct. #ro!
a hih o# 5.& pct. in March o# &''', and was only beinnin to cli!b bac", eventually pea"in at 2.& pct.
in Auust o# &''2.
6oday, !ore than #our years a#ter the #inancial collapse o# &''5, while the e1uities !ar"ets, aain, have
recovered al!ost all o# their lost round, the #ederal #unds rate, which had cli!bed bac" to 3.&3 pct. in
June o# &''2, is now e+pressed as a *taret rane* so!ewhere around or even below '.&3 pct., and the
7ederal Reserve has entered at least its third round o# *1uantitative easin,* buyin up loner ter! and
sellin o## shorter ter! 6reasuries to put downward pressure on lon ter! interest rates.
6he section 43&' rate hit yet another historic low at ,.' pct. in Auust o# &',&, and as this paper oes to
press, the announced rate #or 8epte!ber is aain ,.' pct.
9et asset values in charitable re!ainder trusts have also #allen, althouh the available data are
inco!plete. Accordin to IR8 statistics o# inco!e reports, the decline in &''- was about ,.4 pct. in
unitrusts and about 3.2 pct. in annuity trusts. In &',', unitrust net asset values #ell another &.3 pct., #or an
areate loss since &''5 o# :.,5 pct.
9et asset values in annuity trusts actually increased !arinally in &',', but the absolute nu!ber o#
annuity trusts #ell by nearly twelve pct. over those two years, so it is possible these #iures re#lect the #act
that so!e nu!ber o# $RA6s si!ply crashed.
As net asset values #all, o# course, unitrust payouts will su##er correspondin declines. And the da!ae a
#i+ed annuity payout can do to a trust in a #allin !ar"et !ay be irreparable.
Meanwhile, the recession has also ta"en a toll on charities the!selves. A study published earlier this year
by the 9ational Association o# $ollee and ;niversity <usiness %##icers =9A$;<%> showed that
endow!ents within that sector had returned !inus ,5.4 pct., net o# #ees, in #iscal &''-, and while net
returns over the ne+t two #iscal years were ,,.- pct. and ,-.& pct.,
*returns were still below the averae in#lation.ad)usted spendin rates o# educational
institutions, indicatin that the da!ae in#licted by the downturn is still bein #elt.*
Willis pae ,
And althouh &',, saw a sliht rebound #ro! two years o# sharp declines, total contributions were still
down nearly #our pct. #ro! &''4 in current dollars, and !ore than eleven pct. a#ter ad)ustin #or in#lation.
6he Indiana ;niversity $enter on ?hilanthropy predicted it !iht ta"e *!ore than a decade to et bac" to
where we were* be#ore the #inancial collapse.
%ur conversation today about *e+itin the underproductive $R6* ta"es place in this conte+t.
What we are talking about
In &''(, I introduced !y tal" with a little story, to #ra!e the discussion. I tried to "eep it si!ple, even
na!in the characters Richard and Jane.
I had Richard in an eiht pct. 9IM$R;6 #unded with an illi1uid property. ?ost.contribution ains were
de#ined as inco!e, so when the property sold not lon a#ter the trust was set up, the !odest accu!ulated
arrearae, or !a"e.up a!ount, was distributed.
<ut then the proceeds were invested in a balanced port#olio yieldin only about ,.3 pct. currently, the
payout to Richard dropped, and the arrearae bean to accu!ulate in earnest.
7ortunately, when the 6reasury adopted reulations in ,--5 per!ittin a 9IM$R;6 to be *#lipped* to a
straiht $R;6, Richard too" advantae o# the opportunity, and he bean receivin a straiht unitrust
payout o# eiht pct. o# corpus, !ost o# it ta+ed as pre.contribution ain.
*<ut,* the story continued, *with the recent decline in the stoc" !ar"et, the a!ount o# the unitrust payout
has been trendin downward dra!atically.*
And this was where Jane, the planned ivin director in the develop!ent o##ice at the university that was
desinated to receive the trust re!ainder, ca!e in. 6he story portrayed her enae!ent as a !atter o#
stewardship and o# networ"in with advisors.
Jane suested three possibilities, and these are aain the sub)ect o# our conversation today:
one, a co!!utation, in which Richard and the university would each receive the
present value o# their respective interests in the trust, or
two, a surrender o# his unitrust interest, either as an outriht i#t to the university,
or
three, in e+chane #or a i#t annuity.
6ypical scenarios in which this conversation !iht arise include not only those suested in the story, i.e.,
. a relatively hih stated unitrust or annuity payout,
. principal balances trendin down,
but also
. a 9IM$R;6 with no *#lip* provision or with the trierin event unli"ely to
occur,
Willis pae &
. the reduced li#e e+pectancy o# a continent successor inco!e bene#iciary =albeit
not the current bene#iciary, #or reasons we will e+plore shortly>,
and o# course
. the i!!ediate needs o# the charitable re!ainder!an supersedin those o# the
inco!e bene#iciary.
An aside
%ur conversation in &''( was to so!e e+tent #ocused on this latter transaction, i.e., the surrender in
e+chane #or a i#t annuity, which had then been the sub)ect o# a recent letter rulin. We put so!e
nu!bers to it, and we will put so!e nu!bers to it today, but let !e )ust !ention at the outset that a couple
o# thins have chaned.
In the continuin a#ter!ath o# the #inancial !eltdown o# &''5, the A!erican $ouncil on @i#t Annuities
has lowered its reco!!ended i#t annuity rates several ti!es. <ut !uch !ore sini#icantly, in April o#
&',, the A$@A adopted a policy that the present value o# the residuu! at the ti!e the contract is issued
should be not )ust ten pct., as re1uired by the ac1uisition indebtedness rule o# section 3,:=c>=3>, but at
least twenty pct. o# the a!ount trans#erred.
With the section 43&' rate down at, say, ,.: pct., where it has been #or !ost o# the past year, an annuity
paid at the lowered A$@A reco!!ended rates at !ost aes would !eet the ten pct. re1uire!ent, but
would #ail the twenty pct. re1uire!ent #or anyone aed 3- or youner. And with the section 43&' rate
#allin to ,.' pct., where it was when I was writin this paper, an annuity paid at the A$@A reco!!ended
rate o# :.: pct. to an annuitant aed 2, would #ail the twenty pct. re1uire!ent, and an annuity paid at the
reco!!ended rate o# (.- pct. to an annuitant aed 3( would #ail even the ,' pct. re1uire!ent.
Another aside
9ot so very lon ao, it was not unco!!on to see unitrusts with rather hih payout rates. Many o# these
had been *oversold* by aressive invest!ent !anaers, o#ten in con)unction with *replace!ent* li#e
insurance trusts. In a down !ar"et, the settlors or other li#e or ter! bene#iciaries !ay have beco!e
disillusioned with these, particularly i# there is a net inco!e li!itation and not !uch prospect o# ever
recoverin the accu!ulated arrearae.
6o put this in perspective, #ully ,(.3 pct. o# unitrusts #ilin returns #or ta+ year &''- had stated payout
rates o# ,' pct. or hiher. A s!all hand#ul o# #ilers, :.5 pct., were net inco!e trusts without !a"eup,
while )ust over one.si+th, ,4.( pct., were 9IM$R;6s.
More than two.thirds o# all unitrusts, 2-.: pct., reported net assets under A3''", while about (.- pct.
reported net assets o# A( !illion or !ore. And !ore than a 1uarter o# these very lare unitrusts, &2.- pct.,
were 9IM$R;6s.
A brief overview
<ac" in &''(, there were about a doBen private letter rulins dealin with various #or!s o# this
transaction, #ro! which we drew the #ollowin tentative conclusions:
Willis pae (
=a> assu!in Richard had not created the split interest trust #or the purpose o#
evadin the partial interest rule o# section ,4'=#>=(>=A>, and
=b> assu!in there is no reason to believe RichardCs li#e e+pectancy at the ti!e o#
the transaction is less than would be indicated #or a person o# the sa!e ae under the
tables set #orth at Re. ,.4&.-, then
Din the case o# a surrenderE
=c> i# Richard were to surrender a portion or all o# his unitrust interest to the
re!ainder charity outriht, then
=d> he could clai! a charitable contributions deduction, both #or inco!e ta+
purposes and #or i#t ta+ purposes, in the a!ount o# the present value o# the surrendered
interest, deter!ined usin the *section 43&'* rate in e##ect at the ti!e o# the surrender,
and
=e> he would not reconiBe undistributed ains accu!ulated in prior years, or
Din the case o# a co!!utationE
=#> i# instead Richard too" distribution o# the present value o# his unitrust interest,
deter!ined usin the *section 43&'* rate in e##ect at the ti!e o# the trans#er, or o# a
portion o# that interest, and the re!ainder charity too" distribution o# the present value o#
the re!ainder, or o# a correspondin portion o# the re!ainder,
=> he would reconiBe lon.ter! capital ain in the #ull a!ount he received,
treatin his basis in the unitrust interest as Bero, or
Din the case o# a surrender in e+chane #or a i#t annuityE
=h> i# instead Richard surrendered his unitrust interest to the re!ainder charity in
e+chane #or a i#t annuity,
=i> he would reconiBe lon.ter! capital ain under the *barain sale* rules o#
section ,,',=b> in the a!ount o# the present value o# the i#t annuity, ratably over the
period o# years !easured by the e+pected return !ultiple, #ro! that portion o# the annuity
payout that was treated as a return o# his invest!ent in the contract, i.e., the present value
o# the unitrust interest, deter!ined usin the *section 43&'* rate in e##ect at the ti!e o#
the trans#er.
In addition, althouh the point was not covered in any o# the rulins, we speculated that
=)> i# the interest Richard was surrenderin was in an annuity trust rather than a
unitrust, his deduction probably would be li!ited to the lesser o# the present value o# the
une+pired annuity or the current principal balance o# the trust,
Willis pae :
c#. Re. &3.43&'.(6=b>=&>=v>, e+a!ple 3, illustratin the calculation o# the value o# an annuity where the
payout e+pressed as a percentae o# corpus e+ceeds the then.current section 43&' rate.
Din the case o# a partial surrender or co!!utationE
In the case o# a partial surrender or co!!utation, several rulins cited Re. ,.22:.(=a>=:> as in e##ect
re1uirin that
="> the assets surrendered or distributed be *#airly representative* o# the ad)usted
basis o# all assets in the trust.
6he reulation per!its the trust instru!ent to provide #or current distributions, apart #ro! the unitrust
payout, to an e+e!pt entity, provided that i# the distribution is !ade in "ind, *the ad)usted basis o# the
property distributed is #airly representative o# the ad)usted basis o# the property available #or pay!ent on
the date o# pay!ent.* 6here is a si!ilar provision at Re. ,.22:.&=a>=:> with respect to annuity trusts.
The net income limitation
At the ti!e, there was e+actly one rulin, ?LR &''&'3''5 =,'/&(/',>, suestin that
=l> i# the 9IM$R;6 had not #lipped to a straiht $R;6, RichardCs deduction on a
surrender o# his interest to the re!ainder charity !iht have been li!ited to the lesser o#
the present value o# the speci#ied eiht pct. unitrust payout or o# a straiht inco!e
interest, deter!ined usin the *section 43&'* rate in e##ect at the ti!e o# the surrender or
trans#er.
6here were at least two earlier rulins in which this *lesser o#* li!itation had not been !entioned .. ?LR
-33''&2 ='-/,5/-3>, a partial surrender o# a nine pct. net inco!e trust without !a"eup, and ?LR -4&,',:
='&/,-/-4>, a #ull surrender o# a #ive pct. net inco!e trust with !a"eup .. but then, at the ti!e each o#
these rulins was re1uested, the section 43&' rate was hiher than the stated unitrust payout rate.
8o it was perhaps pre!ature to speculate. And over the ne+t #ew years, there were several rulins
concernin net inco!e trusts that did not e+pressly i!pose such a li!itation .. even in the conte+t o# a
co!!utation, where the 1uestion, as we shall see, beco!es one o# sel#.dealin. 8peci#ically,
e. in ?LR &''&'5'(- =,,/&-/',>, the 8ervice ruled that the proposed )udicial co!!utation o# an
eiht pct. 9I$R;6 =without !a"eup>, with actuarial values calculated *usin the !ethodoloy under
section ,.22:.: o# the reulations,* would not be an act o# sel#.dealin. *6he critical 1uestion,* the rulin
said,
is whether early ter!ination !ay be e+pected to result in a reater allocation o# the trust
assets to the inco!e bene#iciary, to the detri!ent o# the charitable bene#iciary, than a non.
early ter!ination. 6he possibility o# a!es!anship by the inco!e bene#iciary and
whipsawin o# the 8ervice e+ists here.
9onetheless, the rulin concluded that this concern was su##iciently addressed by a##idavits #ro! both the
bene#iciary and his physician that he had no !edical condition that would suest a shorter li#e
e+pectancy than set #orth in the Re. ,.4&.- tables.
Willis pae 3
6o put the re#erences to *a!es!anship* and *whipsawin* in so!e conte+t:
. when the rulin was re1uested in June o# &''', the section 43&' rate was still at
eiht pct., but
. it #ell to 4.2 pct. two !onths later, and it was down to #ive pct. when the letter
was #inally issued in 9ove!ber o# &'',,
. the ta+payer was the last survivor o# several successive inco!e bene#iciaries,
and !ost sini#icantly,
. the trust was invested #or total return and was yieldin less than three pct.
current inco!e.
8i!ilarly,
#. in ?LR &''(':'&3 =,'/&(/'&>, the )oint settlors o# a #ive pct. 9IM$R;6 =with !a"eup> had
partitioned the trust into two trusts, allocatin assets e1ually between the! in a !anner that was
represented to be *#airly representative o# ad)usted basis,* and they proposed to co!!ute their unitrust
interests in one o# these trusts, with actuarial values calculated *usin the !ethodoloy under section
,.22:.: o# the reulations.*
When the rulin was re1uested in January o# &''&, the section 43&' rate was 3.: pct., but by the ti!e the
rulin was issued in %ctober it had #allen to :.& pct. 6he 8ervice ruled the co!!utation would not be an
act o# sel#.dealin. 9othin was said about *a!es!anship* or *whipsawin.*
Fowever, althouh the ta+payers had apparently not as"ed, the 8ervice did also rule that the transaction
would be treated as a sale o# their unitrust interests to the re!ainder!an, that their basis was Bero, and
that they there#ore would reconiBe lon.ter! capital ain in the #ull a!ount that they were to receive in
the transaction.
9o #or!al authority was cited #or these conclusions. 8ee the discussion o# *co!!utation as a capital
transaction,* below.
In the conte+t o# outriht surrenders,
. in ?LR &''3&:',: ='(/,3/'3>, the settlor o# ten pct. 9IM$R;6 =with !a"eup> proposed to
divide the trust into two trusts, allocatin assets proportionately between the! in a !anner that was
represented to be *#airly representative o# the areate ad)usted bases o# Dthe trustCsE assets and their
overall appreciation or depreciation,* and to accelerate the re!ainder o# one o# the trusts to a private
operatin #oundation o# which he was both a !anaer and a substantial contributor.
6he 8ervice ruled:
=,> that the re#or!ation o# the trust instru!ent necessary to acco!plish the
transaction would not dis1uali#y the trust under 22:=d>=&>,
=&> that the ta+payer could clai! charitable contributions deductions #or both
inco!e and i#t ta+ purposes in the a!ount o# the present value o# his unitrust interest,
=(> that the ta+payer would not reconiBe undistributed ains accu!ulated in
prior years, and
Willis pae 2
=:> that the transaction would not be treated as a direct or indirect act o# sel#.
dealin.
9othin was said about the ta+payerCs li#e e+pectancy, and nothin was said about the spread between the
stated unitrust payout rate and the section 43&' rate, which was considerably lower than ten pct. Instead,
the rulin concluded si!ply:
we e+press no opinion as to the !ethod o# deter!inin the present value o# the unitrust
interest D E #or purposes o# calculatin the a!ount o# the inco!e and i#t ta+ charitable
deductionsD.E
h. an essentially identical rulin, ?LR &''3&3''5 ='(/,3/'3>, substituted the ender o# the
personal pronouns throuhout.
8i!ilarly,
i. in ?LR &''5'5',5 =,,/'4/'4>, the ta+payer had created a seven pct. #lip$R;6 =with !a"eup>,
apparently #or a ter! o# years, with a continent payout at his death to a *#a!ily trust.* 6he trierin
event had apparently not yet occurred. Aain, the ta+payer proposed to partition the trust and to
accelerate one o# the trusts to the re!ainder!an, in this case a public charity. 6he *#a!ily trust* was to
see" approval o# a state court to renounce its interest.
Aain, the 8ervice ruled the ta+payer would be entitled to clai! inco!e and i#t ta+ deductions in the
a!ount o# the present value o# the unitrust interest, but aain it e+pressly withheld co!!ent on how that
value was to be calculated, concludin nonetheless that the transaction would not constitute an act o# sel#.
dealin.
Selfdealing of the third kind
A series o# three related rulins brouht the 1uestion o# sel#.dealin into sharper relie#.
6he #acts as recited in ?LR &''3&3',: ='(/('/'3> involved a #i#teen pct. 9I$R;6 =without !a"eup>
payable to the settlors #or their )oint lives, with the re!ainder to a private nonoperatin #oundation o#
which they were substantial contributors, sub)ect to a reserved power to redesinate.
6he ta+payers proposed to e##ect a )udicial co!!utation, with the consent o# the state attorney eneral,
*usin the !ethodoloy under DRe.E ,.22:.:* to value the inco!e and re!ainder interests. 6he closely
held stoc" with which the trust had been #unded had been sold, and *the purpose o# Dthe trust,E to provide
!anae!ent over the trust assets, no loner e+istDedE.*
6he ta+payers conceded that the transaction was to be treated as a sale o# their unitrust interests to the
re!ainder charity, and that the entire proceeds would be reconiBed as lon ter! ain, with no o##settin
basis.
9othin was said about the trust not havin been created #or the purpose o# evadin the partial interest
rule. <oth settlors and their physicians sub!itted a##idavits that neither had a !edical condition that
would suest a shorter li#e e+pectancy than set #orth in the Re. ,.4&.- tables.
Willis pae 4
6he 8ervice ruled that the proposed co!!utation would not constitute an act o# sel#.dealin by the
trustee, by either settlor with respect to either the trust or the #oundation, or by any #oundation !anaer,
and that no #oundation ter!ination ta+ would be incurred.
9ine !onths later, the rulin was revo"ed by ?LR &''2,:'(& =',/'-/'2>, with no e+planation iven, and
replaced by ?LR &''2,2'(3 =',/&3/'2>, recitin so!ewhat con#usinly altered #acts .. there was now
only one settlor and a sinle li#e payout, and the reserved power to redesinate the re!ainder bene#iciary
had been e+ercised in #avor o# a nu!ber o# public charities. Apparently it was this latter chane that
allowed #avorable rulins on the sel#.dealin issues.
6his series o# rulins !iht have been understood to i!ply a deter!ination that a dee!ed sale to a private
nonoperatin #oundation with respect to which the re!ainder trust bene#iciary is a dis1uali#ied person is
per se sel#.dealin, #or which purpose it is *i!!aterial whether the transaction results in a bene#it or a
detri!ent to the private #oundation,* per Re. 3(.:-:,=d>.,, despite the e+ception at Re. 3(.:-:4.,=c>=&>
#or a!ounts payable under the ter!s o# a split interest trust to the noncharitable bene#iciary.
<ut in retrospect, at least, a !ore li"ely interpretation is that these rulins were the last straw, #orcin IR8
to rethin" the 1uestion o# how to value the interests in a net inco!e unitrust, at least in the conte+t o# a
co!!utation.
A steep learning curve
6he turnin point see!s to have co!e with ?LR &''4&3':: ='(/&4/'4>.
6he case was #actually very si!ilar to ?LR &''2,2'(3 =',/&3/'2>, above .. a ten pct. 9IM$R;6 =with
!a"eup>, re!ainder to a private nonoperatin #oundation, sub)ect to a reserved power to redesinate. 6he
settlor had proposed a non)udicial co!!utation, aain *usin the !ethodoloy under section ,.22:.: o#
the reulations* to value the inco!e and re!ainder interests.
<ut be#ore the IR8 would issue a #avorable rulin, the ta+payer was called upon not only to e+ercise his
reserved power to redesinate the re!ainder to one or !ore public charities, but also to concede that
contrary to the #or!ula assu!ed in Dthe rulin re1uestE, the payout rate to be used in
calculatin the respective interests Din the unitrustE will be the lesser o# the DsectionE 43&'
rate in e##ect at the ti!e or ter!ination o# the trust and the stated interest rate o# Dten pct.E
In the leal *analysis* section o# the rulin, the author e+plained that in order to brin the distribution to
the noncharitable bene#iciary within the e+ception at Re. 3(.:-:4.,=c>=&>=i> #ro! sel#.dealin, it would
be necessary to use a *reasonable !ethod* o# calculatin the actuarial value o# his interest that *does not
inappropriately in#late* that value *to the detri!ent o# the charitable re!ainder!en.* And *DoEne
reasonable !ethod* would be to use a *special #actor,* !odi#yin the !ethodoloy o# Re. ,.22:.:=a>=(>
to assu!e that the stated payout was
a #i+ed percentae which is e1ual to the lesser o# the trustCs stated payout percentae or
the section 43&' rate #or the !onth o# ter!ination.
At the ti!e, the section 43&' rate was 3.5 pct.
Willis pae 5
6he use o# this *special #actor,* the author suested, was *indicated* by Re. ,.43&'.(=b>=,>=ii>, which
says the standard section 43&' rate !ay not be used to value a *restricted bene#icial interest,* de#ined as
an annuity, inco!e, re!ainder, or reversionary interest that is sub)ect to a continency,
power, or other restriction, whether the restriction is provided #or by the ter!s o# the
trust, will, or other overnin instru!ent or is caused by other circu!stances.
!et another aside
It !iht be observed that the author stopped so!ewhat short o# sayin the net inco!e li!itation was in
#act a *restriction* #or purposes o# Re. ,.43&'.(=b>=,>=ii>, or that a deviation #ro! the standard section
43&' rate was in #act re1uired. What he said was that an advance rulin would not be issued e+cept on
the assu!ption the *special #actor* would be used.
6he e+a!ple iven at Re. ,.43&'.(=b>=:>, e+a!ple &, is the shortened li#e e+pectancy o# an individual
who has been dianosed with a ter!inal illness *and there is at least a 3' percent probability o# the
individual dyin within , year.* 6his #or!ulation re#lects the substantive provision at Re. ,.43&'.(=b>
=(>, which, however, !a"es an e+ception i# the individual in #act survives the trans#er by at least eihteen
!onths.
6hese provisions were added to the reulation in ,--3 by 6D 52(', a#ter the IR8 #ound itsel# on the
wron end o# a valuation dispute.
In Gstate o# McLendon v. $o!!issioner, ,(3 7.(d ,',4 =3th $ir. ,--5>, the decedent had trans#erred his
interest in various partnerships to his son and an irrevocable trust in e+chane #or annuity contracts
valued usin the table rates, which pro)ected a li#e e+pectancy o# #i#teen years, despite the #act he was
dyin o# esophoeal cancer.
At the ti!e, the controllin authority was Rev. Rul. 5'.5', ,-5'., $.<. ,-:, which said you had to use
the tables unless death was *clearly i!!inent,* and death was not *clearly i!!inent* i# there was *a
reasonable possibility o# survival #or !ore than a very brie# period,* and speci#ically death was not
*clearly i!!inent* i# the possibility you !iht survive a year or !ore was *not so re!ote as to be
neliible.*
6his in itsel# was a retreat, in the #ace o# adverse court rulins, #ro! Rev. Rul. 22.('4, ,-22.& $.<. :&-,
which had said you could not use the tables in valuin a li#e estate i# you "new the li#e tenant had a
ter!inal illness and could not survive *#or !ore than a brie# period o# ti!e.*
At the ti!e the decedent in Gstate o# McLendon !ade the trans#er, he was in *co!plete re!ission,* and
his doctors were ivin hi! a ten pct. chance o# survivin at least a year. In #act he died within a #ew
!onths a#ter the trans#er.
6he 6a+ $ourt areed with the $o!!issioner that it was not appropriate to use the tables to value the
annuities. 6he 3th $ircuit reversed, sayin a ten pct. chance o# survival was not *neliible* and the
ta+payer was entitled to rely on the published revenue rulin.
8hortly a#ter the reulations were revised in ,--3, the two earlier revenue rulins were obsoleted by Rev.
Rul. -2.(, ,--2., $.<. (:5, which si!ply re#ers to the revised reulations.
Willis pae -
With one e+ception, discussed below, in each o# the letter rulins we are loo"in at today the ta+payer
represented that there was no reason to believe her li#e e+pectancy at the ti!e o# the transaction was less
than would be indicated #or a person o# the sa!e ae under the tables set #orth at Re. ,.4&.-. <ut on its
#ace, Re. ,.43&'.(=b>=,>=ii> does not re1uire this.
9ote also that while section 43&'=b> re1uires that e+ceptions #ro! the application o# the standard discount
rates be prescribed by reulation, Re. ,.43&'.(=b>=3> purports to allow #or *additional e+ceptions* #ro!
those enu!erated in that reulation. <ut these are to be provided throuh #or!al uidance, which has not
yet been #orthco!in.
Returning to the sub"ect at hand
6he "ey lanuae o# ?LR &''4&3':: ='(/&4/'4>, above, was pasted verbati! into several subse1uent
rulins, includin
p. ?LR &''4((',: =':/&2/'4>, which was conditioned on the ta+payers usin the
*special #actor* !ethodoloy. Althouh the stated unitrust payout rate, the aes o# the
bene#iciaries, and the applicable section 43&' rate were redacted, the te+t disclosed that
even usin the *special #actor* the ta+payers would still receive distribution o# -'.34(
pct. o# the trust corpus.
1. ?LR &''5'-':: =,&/'2/'4>, an eleven pct. 9I$R;6 =without !a"eup> created
by a li!ited partnership, payable #or the shorter o# twenty years or the )oint lives o# the
two partners. 6he ta+payers had conceded the *special #actor* !ethodoloy. 6he
transaction was treated as havin closed in Dece!ber o# &''2, when the section 43&' rate
was 3.5 pct., yieldin a distribution to the ta+payers, aed 44 and 45, o# ::.3,4 pct. o# the
trust corpus =versus rouhly 4&.((2 pct.>.
r. ?LR &''5,2'(& =',/&(/'5>, a ten pct. 9IM$R;6 =with !a"eup> #or the )oint
lives o# the settlors. Aain, the ta+payers had conceded the *special #actor* !ethodoloy.
6he transaction was treated as havin closed in Dece!ber o# &''2, when the section
43&' rate was 3.5 pct., yieldin a distribution to the ta+payers, aed 34 and 4', o# 4(.(5'
pct. o# the trust corpus =versus rouhly 55.3,( pct.>.
s. ?LR &''5,2'(( =',/&&/'5>, a co!panion rulin to ?LR &''5,2'(& =',/&(/'5>.
t. ?LR &''5,4'(- =',/(,/'5>, a ten pct. 9IM$R;6 =with !a"eup> #or the
shorter o# the )oint lives o# the settlors or twenty years. Aain, the ta+payers had
conceded the *special #actor* !ethodoloy. 6he transaction was treated as havin closed
in 7ebruary o# &''5, when the section 43&' rate was :.& pct., yieldin a distribution to
the ta+payers, aed :5 and 3&, o# (2.(:5 pct. o# the trust corpus =versus rouhly 52.2(4
pct.>.
Willis pae ,'
u. ?LR &''5&4''- =':/'(/'5>, which was conditioned on the ta+payers usin the
*special #actor* !ethodoloy. Althouh the stated unitrust payout rate, the aes o# the
bene#iciaries, and the applicable section 43&' rate were redacted, the te+t disclosed that
even usin the *special #actor* the ta+payers would still receive distribution o# 5(.((2
pct. o# the trust corpus.
and
v. ?LR &''5((',& ='3/'-/'5>, which was conditioned on the ta+payers usin the
*special #actor* !ethodoloy. Althouh the stated unitrust payout rate, the aes o# the
bene#iciaries, and the applicable section 43&' rate were redacted, the te+t disclosed that
even usin the *special #actor* the ta+payers would receive distribution o# 25.2(5 pct. o#
the trust corpus.
8o!ewhat ratuitously, in ?LR &''-,&'(2 =,&/&&/'5>, approvin the co!!utation o# a #ive pct.
9IM$R;6, the author !entioned this series o# rulins, but then noted that the *special valuation
!ethodoloy* was not re1uired in the particular case *because the unitrust payout rate is not in e+cess o#
the section 43&' rate #or the !onth o# the transaction.* %ddly, the author then calculated the present
value o# the unitrust interest usin the 3.2 pct. section 43&' rate #or April, &''2 rather than the stated
payout rate o# #ive pct. 6hat rulin is interestin #or other reasons, which we will e+plore under
*continent or de#easible successive interests,* below.
8hortly a#ter the #irst o# these letters were released, the $o!!ittee on Gstate and @i#t 6a+ation o# the 9ew
/or" 8tate <ar wrote to the Associate $hie# $ounsel, ?assthrouhs and 8pecial Industries, and the
Director o# the G+e!pt %raniBations division, pointin out that these represented a departure #ro!
earlier rulins and as"in IR8 to publish #or!al uidance con#ir!in
that the proper !ethod #or valuin the inco!e interest and the re!ainder interest o# a
9IM$R;6 that is bein ter!inated early is the sa!e !ethod that is used to value those
interests when a 9IM$R;6 is createdD.E
6o date, o# course, the aency has not acted on this re1uest.
What about an outright surrender
It !iht be noted that this series o# rulins dealt only with co!!utations, and that the loic o# these
rulins, which centers on the 1uestion o# sel#.dealin, !iht not readily e+tend to outriht surrenders.
<ut then recall that we bean this discussion by !entionin ?LR &''&'3''5 =,'/&(/',>, which did li!it
the deduction on the surrender o# the settlorCs interest in a 9IM$R;6 to the lesser o# the present value o#
the speci#ied unitrust payout or o# a straiht inco!e interest.
6hat rulin cited as authority Re. &'.&'(,.4=d>, which has since been replaced by te!porary Re.
&'.&'(,.46=d>, which in turn e+pired on May ,, &',&. 8ubpararaph =d>=&>=i> o# the te!porary
reulation re#ers to te!porary Re. ,.22:.:6=e>=&>, also e+pired, which deals only with the valuation o# a
straiht unitrust.
Willis pae ,,
6he letter rulin also cited Re. &3.&3&&=c>.(=d>=&>=v>, which says the present value o# a straiht unitrust
payout is to be deter!ined
by subtractin the present value o# all interests in the trans#erred property other than the
unitrust interest Di.e., the re!ainderE #ro! the #air !ar"et value o# the trans#erred
property.
In turn, Re. &3.&3&&=c>.(=d>=&>=ii> says the re!ainder value is to be deter!ined under Re. ,.22:.:,
presu!ably subpararaph =e>=&>, which aain has been replaced by te!porary Re. ,.22:.:6=e>=&>, aain,
e+pired.
9one o# these reulations deal speci#ically with valuin interests in a net inco!e unitrust. In short, the
conclusion drawn in ?LR &''&'3''5 =,'/&(/',> is si!ply an assertion, albeit a super#icially reasonable
assertion.
Aain, the 1uestion !ay co!e down to whether the net inco!e li!itation is a *restriction* #or purposes o#
Re. ,.43&'.(=b>=,>=ii>. <ut as noted above, the 8ervice has been reluctant to pic" up this thread in
connection with outriht surrenders.
Commutation as a capital transaction
7or at least ten years, the IR8 has consistently ruled that the co!!utation o# an annuity or unitrust
interest in a re!ainder trust is to be treated as a sale or e+chane o# a capital asset, with the re!ainder!an
in e##ect purchasin the inco!e interest, and that under section ,'',=e>=,> the bene#iciary has a Bero
basis, so that the entire a!ount received in the co!!utation is ta+able as capital ain.
%ne o# the earliest such rulins, i# not the earliest, is ?LR &'',&4'&( =':/':/',>, which involved a
twenty.year unitrust, payable in the event the settlor predeceased the ter! to who!ever he !iht appoint
under a reserved testa!entary power, or in de#ault o# the e+ercise o# that power to his estate.
6he #our tier !echanis! o# section 22:=b> #or characteriBin distributions #ro! a re!ainder trust did not
apply to a co!!utation, the rulin said. Instead, the ta+payer was *disposin o# DhisE interest in Dthe
trustE in e+chane #or !oney and property in a transaction that is overned by DsectionE ,'',.* 6he rulin
cited Rev. Rul. 4&.&:(, ,-4&., $.<. &((, #or this proposition.
A si!ilar result was reached in ?LR &''(,:'&, =,&/&:/'&>, aain citin Rev. Rul. 4&.&:(. 6he trust had
been re#or!ed, a#ter the closely held stoc" with which it was #unded was sold, to a straiht twelve pct.
unitrust. 6he settlor had retained a power to redesinate the re!ainder!en, which he e+ercised in #avor
o# a private nonoperatin #oundation with respect to which he and his spouse were dis1uali#ied persons.
6he ta+payer proposed to see" a )udicial co!!utation o# the trust, with notice to the state attorney
eneral. At the ti!e o# the rulin re1uest, the trust still held patents it had received as part o# the proceeds
o# the sale o# the closely held stoc". 6he rulin does not !ention how the settlor proposed to handle the
distribution o# these patents.
8ee also
. ?LR &''(':'&3 =,'/&(/'&>, noted above under *net inco!e li!itation,
Willis pae ,&
. ?LR &''(&:'(3 ='(/':/'(>, a )udicial co!!utation o# a straiht $R;6 #or the
li#e o# the settlor, since deceased, plus twenty years or the earlier death o# two successor
bene#iciaries,
. ?LR &'':'('3, ='-/('/'(>, a )udicial co!!utation o# a straiht seven pct.
$R;6 #or the )oint lives o# the settlors, husband and wi#e,
. ?LR &''::,'&: ='2/,'/':>, a )udicial co!!utation o# a straiht ten pct. $R;6
#or a twenty year ter!,
. ?LR &''4&4',( =':/'3/'4>, a non)udicial co!!utation o# two straiht $R;6s
#or the )oint lives o# the settlors, husband and wi#e, and
. ?LR &''4(-'': ='2/&,/'4>, a )udicial co!!utation o# a straiht $R;6 #or
several bene#iciaries in separate shares, each share ter!inatin at the death o# the
bene#iciary, re!ainder to a donor advised #und.
%# so!e interest here also is ?LR &''5:2'(4 ='5/&'/'5>, a non)udicial co!!utation o# a si+ pct.
9IM$R;6 #or the )oint lives o# the settlors, husband and wi#e, which had been converted to a straiht
$R;6.
Althouh the te+t o# the letter characteriBed the transaction as a sale, citin Rev. Rul. 2-.:52, ,-2-.& $.<.
,3-, the rulin itsel# was li!ited to the 1uestion o# sel#.dealin. And in that connection, the rulin was
!ade e+pressly sub)ect to the continued 1uali#ication o# the re!ainder!an as a supportin oraniBation.
A criti1ue o# these rulins re1uires an e+a!ination o# the two revenue rulins cited, and o# the leislative
history o# section ,'',=e>.
Rev# Rul# $%%&'( )*$%) C#+# %''
It is certainly the case that Rev. Rul. 4&.&:( recites that a li#e tenantCs sale o# her entire interest in a
testa!entary trust to the re!ainder!an is the sale o# a capital asset. 6he rulin is in e##ect a belated
ac1uiescence in <eulah Gaton McAllister v. $o!!issioner, ,34 7.&d &(3 =&d $ir. ,-:2>, cert. den., (('
;.8. 5&2 =,-:2>, to that e##ect.
6he appeals court rulin was a de#eat #or the $o!!issioner, who had arued that the transaction was an
anticipatory assin!ent o# inco!e, and that the proceeds should be ta+ed as ordinary inco!e. 6he
8econd $ircuit re)ected this aru!ent, citin <lair v. $o!!issioner, ('' ;.8. 3, 34 8.$t. ((', 5, L.Gd.
:23 =,-(4>, in which the 8upre!e $ourt had ruled that i#ts by a trust bene#iciary to his children o#
speci#ied a!ounts o# the net inco!e o# the trust in #uture years were e##ective to shi#t to the! the liability
#or ta+ on that inco!e.
6he loic o# the <lair decision was that the ta+payer had in e##ect trans#erred to his children a portion o#
his li#e inco!e interest in the trust, substitutin the! as direct bene#iciaries. 6he !a)ority in McAllister
reasoned that the trans#er was there#ore o# a capital asset.
Willis pae ,(
6he situation in McAllister was so!ewhat co!plicated by the #act that the ta+ code did not then include a
!echanis! #or ad)ustin the li#e tenantCs basis, so that when she sold her interest to the re!ainder!an she
reported a capital loss. Fad she sold her interest to a third party, the purchaser would have been able to
a!ortiBe the purchase price aainst inco!e.
6he enact!ent o# section ,'',=e> as part o# the 6a+ Re#or! Act o# ,-2- was intended to address these
ano!alies.
Section ),,)-e.
What the statute literally says is
In deter!inin ain or loss #ro! the sale or other disposition o# a ter! interest in
property, that portion o# the ad)usted basis o# such interest which is deter!ined pursuant
to section ,',:, ,',3, or ,':, =to the e+tent that such ad)usted basis is a portion o# the
entire ad)usted basis o# the property> shall be disrearded.
Disrearded, entirely.
6he leislative history indicates that this provision was speci#ically intended to address a situation in
which *a li#e estate or si!ilar interest DwasE ac1uired by i#t, be1uest, or inheritance DandE the li#e tenant
sold his interest.* As stated in the *eneral e+planation* o# the ,-2- act prepared by the Joint $o!!ittee
on 6a+ation, J8$.,2.4', under then.e+istin law,
DtEhe li#e tenant was not ta+ed on the inco!e to the e+tent o# the basis which he was
treated as havin in the li#e estate when he sold it D, andE the purchaser o# the li#e estate
was not ta+ed on !ost o# the inco!e because he was allowed to reduce that inco!e by
a!ortiBin his basis =the purchase price> in the li#e estate. In so!e cases D#or e+a!ple,
McAllisterE the sellerCs basis even e+ceeded the a!ount he received upon its sale, and, as
a result, he was per!itted to ta"e a deductible loss.
6here is an e+ception at section ,'',=e>=(> #or a disposition that includes both the inco!e and re!ainder
interests, but we will postpone that discussion #or a !o!ent.
6he cross re#erences are to sections deter!inin the basis o# property ac1uired #ro! a decedent =section
,',:>, by i#t =section ,',3>, and in a trans#er incident to a divorce =section ,':,>. 6he loic o# the letter
rulins centers on section ,',3, titled *basis o# property ac1uired by i#ts and trans#ers in trust.*
8everal o# the rulins bein by !entionin section ,',3=b>, which so!ewhat inconruously provides that
i# property was ac1uired by a trans#er in trust *other than by a trans#er in trust by a i#t, be1uest, or
devise,* basis is to be *increased in the a!ount o# ain or decreased in the a!ount o# loss reconiBed to
the rantor on such trans#er.*
6he aru!ent would appear to be that the settlor *ac1uired* her annuity or unitrust interest *other than by
i#t* and that her basis in that interest is deter!ined *pursuant to* section ,',3=b>.
Willis pae ,:
Re. ,.,',3.,=b> allocates basis in property trans#erred by i#t to a trust between the inco!e and
re!ainder interests. 6he *uni#or!* basis o# the entire trust corpus re!ains #i+ed, sub)ect to the usual
ad)ust!ents, but
the value o# the proportionate parts o# the uni#or! basis represented, #or instance, by the
respective interests o# the li#e tenant and re!ainder!an are ad)ustable to re#lect the
chane in the relative values o# such interest on account o# the lapse o# ti!e.
6here is a cross re#erence to Re. ,.,',:.3=a>, which says the *uni#or!* basis is to be allocated between
the inco!e and re!ainder interests usin the actuarial #actors prescribed by Re. &'.&'(,.4. 8o #ar, so
ood.
Re. ,.,',3.,=b> then oes on to say that in deter!inin ain or loss #ro! the sale or other disposition o#
a ter! interest, includin a li#e estate, ter! or years, or inco!e interest, *the ad)usted basis o# which is
deter!ined pursuant, or by re#erence, to section ,',3,*
that part o# the ad)usted uni#or! basis assinable under the rules o# DRe.E ,.,',:. 3=a> to
the interest sold or otherwise disposed o# shall be disrearded to the e+tent and in the
!anner provided by section ,'',=e> and DRe.E ,.,'',.,=#>.
6hese are the re#erences that are 1uoted repeatedly in the letter rulins.
8o what this all co!es down to is whether the settlorCs annuity or unitrust interest in a charitable
re!ainder trust was *ac1uired by i#t* #or purposes o# section ,',3=a>, or whether her basis in that
interest is to be deter!ined *pursuant to* section ,'3,=b>.
It does see! reasonably clear that a successive annuity or unitrust interest would be *ac1uired by i#t,*
and that an annuity or unitrust interest in a testa!entary re!ainder trust would be *ac1uired #ro! a
decedent.* <ut it is not at all clear that the settlorCs retained annuity or unitrust interest in an inter vivos
re!ainder trust is within the letter or the intention o# the statute.
Rev# Rul# /*&0/( )*/*% C#+# )1*
6he literal holdin o# Rev. Rul. 2-.:52 is that a non.pro rata distribution o# trust property by a trustee
who does not have authority to !a"e such a distribution, but does so as a result o# an aree!ent a!on
the bene#iciaries, is to be treated as a pro rata distribution, #ollowed by an e+chane a!on the
distributees.
In the particular case conte!plated by the revenue rulin, one o# the distributees was an individual and
the other was an e+e!pt entity, and the stratey the rulin was intended to de#eat was the distribution o#
hiher basis assets to the individual and lower basis assets to the e+e!pt entity, in whose hands realiBed
ains would not be ta+ed.
6he rulin was cited in ?LR &''4&4',( =':/'3/'4>, in ?LR &''4(-'': ='2/&,/'4> and, as noted above, in
?LR &''5:2'(4 ='5/&'/'5>, as supportin the conclusion that the co!!utation was to be treated as a sale
to the re!ainder!en, thouh clearly it does not apply, unless the distributions were to be non.pro rata,
which was not stated..
Willis pae ,3
Rev# 2roc# %,,0'( %,,0) 3#R#+# )),
In Rev. ?roc. &''5.(, the IR8 announced that e##ective i!!ediately, that is, January 4, &''5, it would no
loner *ordinarily* ive advance rulins on whether the ter!ination o# a $R6 in which each o# the parties
received its actuarial share o# the value o# the trust assets is to be treated as a sale or other disposition #or
purposes o# section ,'',=a>, or as a sale or e+chane o# a capital asset under section ,&&,=a>.
*9ot ordinarily* !eans in the absence o# *uni1ue and co!pellin reasons* to )usti#y the issuance o# a
rulin. 6here are no clear criteria #or what !iht be *uni1ue and co!pellin reasons.*
In that sa!e revenue procedure, the 1uestion whether the transaction would cause the trust no loner to
1uali#y under section 22:=d> was identi#ied as an *area under study,* in which rulins would not be issued
until the issue was resolved throuh the publication o# #or!al uidance.
6hese three ite!s have been carried #orward in succeedin annual revenue procedure updates, and
startin with Rev. ?roc. &','.(, &''-., $.<. ,'4 the 1uestion whether the transaction would dis1uali#y
the trust under section 22:=d> was !oved to the *not ordinarily* cateory, suestin that #or!al uidance
!ay not be i!!ediately #orthco!in, a#ter all.
And in #act there have been no letter rulins on co!!utations o# re!ainder trusts since &''5. 6he
hand#ul that were issued that year were in response to re1uests that had been !ade several years earlier.
4otice %,,0**( %,,0&$ 3#R#+# ))*&
Fowever, at least one other shoe did drop in %ctober o# &''5, when the IR8 issued 9otice &''5.--,
identi#yin as a *transaction o# interest* the *coordinated* sale o# the inco!e and re!ainder interests in a
charitable re!ainder trust to an unrelated third party, where appreciated assets contributed to the trust had
been sold and the proceeds reinvested.
As noted above, under section ,'',=e>=,>, the holder o# a ter! interest in a trust is treated as havin a
Bero basis #or purposes o# calculatin ain or loss on disposition o# the interest. <ut there is an e+ception
at section ,'',=e>=(> where the disposition is *a part o# a transaction in which the entire interest in
property is trans#erred,* that is, in which both the inco!e and re!ainder interests are sold to a third party.
In that case, the holder o# the ter! interest deter!ines her basis with re#erence to Re. ,.,',:.3=a> and
Re. ,.,',3.,=b>, and would thus report !odest i# any ain.
<y identi#yin this as a *transaction o# interest* under Re. ,.2',,.:=b>=2>, the 9otice i!poses a
reportin re1uire!ent both on the ter! holder and on the charitable re!ainder!an, but not the third party
purchaser. Any *!aterial advisor* who was paid !ore than A3,''' #or providin assistance or advice
with respect to the transaction !ust also report, a substantial reduction #ro! the threshold a!ount
otherwise applicable under Re. (',.2,,,.(=b>=(>=i>=<>.
6he 9otice applies to transactions entered into on or a#ter 9ove!ber &, &''2, e+cept that a charitable
re!ainder!an is not re1uired to report a transaction in which it sold or otherwise disposed o# its interest
in a trust on or be#ore %ctober (,, &''5, the date o# publication o# the 9otice.
Willis pae ,2
In describin the transaction, the 9otice #irst presents the scenario in which the holder o# the ter! interest
is the trust settlor. 6he re!ainder charity *!ay, but need not* be controlled by the settlor, who *!ay, but
need not* have reserved a power to redesinate.
<ut then the 9otice oes on to !ention other variations that e+pand the scope o# the *transaction o#
interest* rather considerably:
. the trust *!ay have been in e+istence #or so!e ti!e prior to the sale,*
. the appreciated assets !iht already be in the trust *prior to the co!!ence!ent
o# the transaction,*
. the settlor !iht have contributed the appreciated assets to a passthrouh entity
and then contributed an interest in that entity to the re!ainder trust, and
. the holder o# the ter! interest !iht be so!eone other than the settlor.
6he 9otice does not !a"e clear what criteria the 8ervice would apply in deter!inin that the transaction
is a *coordinated* sale or disposition.
6he publication o# 9otice &''5.-- drew at least three public co!!ents.
$onrad 6eitell, writin on behal# o# the A!erican $ouncil on @i#t Annuities, suested that in the event
o# either a co!!utation or a sale to a third party the inco!e bene#iciaryCs basis should be calculated with
re#erence to the *uni#or!* basis rules, ad)usted by undistributed ains under Re. 8ec. ,.22:.,.
A si!ilar aru!ent was advanced by Dan 6. Fastins, a lawyer #ro! West %rane, 9ew Jersey,
e+pandin on an article he had written so!e years previously #or ;.8. 6rustCs *?ractical Dra#tin*
co!!entaries.
Mr. 6eitell ured the aency to !ove 1uic"ly to resolve the di##iculties that had led it to suspend the
issuance o# advance rulins on early ter!inations, and to issue #or!al uidance that would !a"e letter
rulins necessary *only in unusual cases.*
9otin the line o# letter rulins valuin a net inco!e interest with re#erence to the *lesser o#* the stated
payout rate or the then.current section 43&' rate, Mr. 6eitell suested that #or!al uidance !iht allow a
ta+payer the opportunity to establish a #air !ar"et value #or a net inco!e interest, usin a 1uali#ied
appraiser.
Ja!es W. Lintott, the chair!an o# 8terlin 7oundation Manae!ent, LL$, which describes itsel# as *a
provider o# bac"o##ice ad!inistration #or private #oundations,* and which is actively enaed in
#acilitatin section ,'',=e>=(> transactions, ured the 8ervice to #ra!e any #or!al uidance *in as narrow
a !anner as possible* to address the *clearly abusive* transaction described in the 9otice, while
*preservin li1uidity* in what he called *the !ar"et #or lead interests.*
8o!ewhat une+pectedly, Mr. Lintott suested that si!ply
prohibitin the use o# basis would have very little to no e##ect on the salability o# $R6
interests, because #ew i# any transactions would be a##ected.
Willis pae ,4
Contingent or defeasible successive interests
An early rulin, ?LR 55'3'&: =,,/'3/54>, allowed a deduction #or the partial surrender o# the settlorCs
interest in a straiht #ive pct. unitrust, but disallowed a deduction #or the partial surrender o# the spouseCs
successive interest, because it was de#easible by the settlorCs e+ercise o# a reserved testa!entary power to
revo"e.
6his !eant not only that the surrender o# the spouseCs de#easible interest did not enerate an inco!e ta+
deduction, but also that the present value o# that interest was reportable as a ta+able i#t.
Where the holder o# the successive interest is so!eone other than a spouse, o# course, the idea behind
reservin the testa!entary power to revo"e is to !a"e the trans#er inco!plete #or i#t ta+ purposes. 6his
approach was e+plicitly validated by Rev. Rul. 4-.&:(, ,-4-.& $.<. (:(.
<ut where the holder o# the successive interest is a spouse, it is not necessary to reserve a testa!entary
power to revo"e, because section &3&(=>, enacted in ,-5, as part o# the Gcono!ic Recovery 6a+ Act,
?ub. L. -4.(:, renders the trans#er eliible #or a i#t ta+ !arital deduction, despite the #act that the
spouseCs interest is continent, and despite the #act that others !ay possess or en)oy a part o# her interest i#
the continency #ails.
In each o# two later rulins, ?LR -33''&2 ='-/,5/-3> a nine pct. 9I$R;6 =without !a"eup>, and ?LR
-4&,',: ='&/,-/-4>, a #ive pct. 9IM$R;6 =with !a"eup>, the ta+payers atte!pted to address the
proble! by havin the holder o# the de#easible successive interest disclai!. 6hose two rulins were
silent on the 1uestion whether this stratey was e##ective.
In ?LR &''5'&'&: ='-/,:/'4>, the settlor proposed to release his reserved testa!entary power to revo"e
the spouseCs successive interest in each o# two straiht #ive pct. $R;6s, as part o# a co!plete surrender,
and instead o# disclai!in, the spouse then participated in the surrender. 6he rulin e+plicitly
ac"nowleded that the release co!pleted a i#t to the spouse that 1uali#ied #or a !arital deduction under
section &3&(=>.
In this connection, note Rev. Rul. 4-.&-3, ,-4-.& $.<. (:-, to the e##ect that where a trust re!ainder!an
trans#erred an undivided one.hal# interest in the re!ainder =which apparently had not yet vested in
possession> to a charity, a charitable deduction would be allowable under section &3&&=c>=&>, because
=a> the trans#er was not !ade in #urther trust and
=b> the trans#eror had no other interest in the property at or be#ore the ti!e o# the
trans#er.
6he rulin was sub)ect to the proviso that the trust had not been created #or the purpose o# evadin the
partial interest rule o# section ,4'=#>=(>=A>.
8o!e rather aw"ward !aneuverin was in evidence in ?LR &''-,&'(2 =,&/&&/'5>, which as noted above
approved the co!!utation o# a #ive pct. 9IM$R;6 =with !a"eup> without re1uirin the use o# the
*special valuation #actor* because the section 43&' rate was then hiher than the stated unitrust payout
rate.
Willis pae ,5
6he trust had been established by a husband and wi#e, payable to the! )ointly, and a#ter the death o# the
survivor in e1ual shares to their two sons. 9either settlor had reserved a testa!entary power to revo"e the
successive interests to the sons, so presu!ably those were co!pleted, ta+able i#ts.
At the ti!e o# the rulin re1uest, the husband had a shortened li#e e+pectancy, albeit not a ter!inal illness.
<oth he and the two sons had assined their interests to the wi#e, who then proposed to sell the co!bined
interests to the re!ainder charity. 6he letter e+pressly reserved rulin on the possible inco!e or i#t ta+
conse1uences o# these trans#ers, or on whether these trans#ers !iht have dis1uali#ied the trust under
section 22:=d>.
6he only rulins actually re1uested were that this trans#er would not constitute an act o# sel#.dealin and
that it would not trier a #oundation ter!ination ta+. A #avorable rulin on these points depended on
whether the a!ount the wi#e would receive in the co!!utation was li!ited to the present value o# the
inco!e interest, per Re. 3(.:-:4.,=c>=&>.
6he letter recites that the ta+payer =i.e., the wi#e> had re1uested that the calculation *not re#lect survival*
#or the husband. 6hus, in !a"in the calculation, the 8ervice disrearded the husbandCs li#e, notin that
DtEhe #actor #or the re!ainder interest #ollowin the re!ainin three !easurin lives is the
sa!e as the #actor #or the re!ainder interest #ollowin all #our lives assu!in the #ourth is
ter!inally illD,E
thouh aain, the husbandCs illness was not ter!inal. In this connection it bears notin, as stated in Rev.
Rul. 5'.5', that the actuarial tables under Re. &'.&'(,.4 and Re. &'.&'(,.46 are not
DtEhe actuarial tables are not based on data that e+clusively involve persons o# CoodC or
Cnor!alC health. 6hey re#lect the incidence o# death by disease and illness as well as by
accident. 6he actuarial tables are properly applicable to the vast !a)ority o# individual
li#e interests, even thouh the health o# a particular individual is obviously better or
worse than that o# the CaveraeC person o# the sa!e ae and se+.
%nly occasionally, the revenue rulin went on to say, are the actual #acts o# an individualCs condition *so
e+ceptional as to )usti#y departure #ro! the actuarial tables.* Althouh Rev. Rul. 5'.5' was obsoleted by
Rev. Rul. -2.(, the #act re!ains that the tables include everyone e+cept the ter!inally ill.
6houh these #our rulins do not directly illustrate the point, we should note that where circu!stances
have e!ered to shorten the li#e e+pectancy o# the spouse or a child o# the settlor whose successive
interest in the annuity or unitrust is continent and/or de#easible, it !ay be desirable #or the settlor to
accelerate all or part o# the re!ainder i#t and clai! an additional inco!e ta+ charitable contributions
deduction.
Surrender in exchange for a gift annuit5
6o date, there has been e+actly one rulin, ?LR &'',3&',5 ='-/&2/',>, dealin with a surrender in
e+chane #or a i#t annuity. 6here, the 8ervice ruled:
Willis pae ,-
=a> the ta+payer would be entitled to clai! a charitable contributions deduction
#or both inco!e and i#t ta+ purposes in the a!ount by which the present value o# the
unitrust interest he would be surrenderin e+ceeded the present value o# the i#t annuity
he would be receivin in e+chane,
=b> because a sale o# the unitrust interest would have resulted in lon.ter! capital
ain, there would be no reduction in the a!ount allowable as a charitable contributions
deduction per section ,4'=e>=,>, and the a!ount o# the deduction that he could ta"e in a
iven year would be sub)ect to a li!itation o# thirty pct. o# his ad)usted ross inco!e,
=c> the ta+payer would not reconiBe undistributed capital ains accu!ulated in
prior years as a conse1uence o# the trans#er, per Re. ,.22:.(, and
=d> the transaction would be treated as a barain sale under section ,',,=b>, i.e.,
the ta+payer would reconiBe lon.ter! capital ain in the a!ount o# the present value o#
the i#t annuity ratably over the period o# years !easured by the e+pected return !ultiple
under the annuity contract, but only #ro! that portion o# the annuity payout that was
treated as a return o# his invest!ent in the contract.
Aain, #or purposes o# calculatin ain, the ta+payerCs basis in his unitrust interest was to be treated as
Bero, ostensibly pursuant to section ,'',=e>.
Let us ta"e a loo" at what this transaction !iht loo" li"e today, with the section 43&' rates at record
lows, and with the A$@A reco!!ended i#t annuity rates havin been reduced several ti!es.
7irst, usin a section 43&' rate o# ,.: pct., rouhly the averae rate over the last twelve !onths, an
annuity at the reco!!ended rate, paid 1uarterly at the end o# the 1uarter, would not !eet the additional
re1uire!ent A$@A has recently i!posed, that the present value o# the residuu! o# the i#t annuity be at
least twenty pct., #or an annuitant youner than 2'. 6he reco!!ended rate #or an annuitant aed 2' is :.:
pct.
With the section 43&' rate all the way down to ,.' pct., the younest ae that would !eet the twenty pct.
residuu! re1uire!ent is ae 2&, with an annuity rate o# :.3 pct. 8o #or convenience, letCs say Richard is
now 2& years old.
And this ti!e we will put Richard in a #ive pct. straiht unitrust, rather than eiht. Aain, payable
1uarterly at the end o# the 1uarter. I# the section 43&' rate is ,.: pct., the present value o# his unitrust
interest is 3-.:'& pct. I# the section 43&' rate is ,.' pct., the present value o# his unitrust interest is
3-.:5( pct. 6his is as ood a place as any to note that depressed section 43&' rates have not all that !uch
e##ect on the valuation o# interests in a unitrust.
I# the unitrust is holdin A, !illion, Richard is receivin a payout o# A3'", and the present value o# his
unitrust interest is so!ewhere north o# A3-:". I# he were to surrender his unitrust interest in e+chane #or
a i#t annuity payin :.3 pct., we are loo"in at a payout o# so!ethin less than A&4" per year, o# which
not 1uite A&'" would be ta+ed as lon.ter! ain and a little over A2" would be ta+ed as ordinary inco!e
#or the ne+t twenty.three years, a#ter which the entire payout would be ta+ed as ordinary inco!e.
Willis pae &'
I# Richard has reserved a power to redesinate the re!ainder!an, he !iht be able to persuade the
issuin charity to treat the entire A, !illion, or at least so!e larer portion o# it, as #undin the annuity, or
otherwise to deviate #ro! the A$@A reco!!ended rate.
0eepin in !ind, o# course, that i# the issuance o# annuity contracts constituted a *substantial part* o# the
activities o# an otherwise e+e!pt oraniBation, this would be treated as an unrelated trade or business,
were is not #or the e+ception at section 3',=!>=3> #or i#t annuities. 6hat e+ception applies only i# the
annuity contacts con#or! to the re1uire!ents o# section 3,:=c>=3> reardin *unrelated debt.#inanced
inco!e* in the #or! o# *ac1uisition indebtedness.*
7or this purpose, the present value o# the annuity cannot be !ore than -' pct. o# the value o# the property
received by the charity in the e+chane. Re. ,.3,:=c>., de#ines this li!itation in ter!s o# *the value o#
the prior ownerCs e1uity* in the property received =an e!bellish!ent o# the statute, which does not use the
word *e1uity*>. And #or inco!e ta+ purposes, Richard not only has no basis in the re!ainder, he has no
property interest in it at all =unless so!e value were to be ascribed to his reserved power to redesinate
the re!ainder charity>.
<ut a#ter all, Richard is acceleratin the re!ainder, reducin by nearly hal# the a!ount o# his current
payout, and acceptin al!ost a 1uarter o# that as ordinary inco!e rather than lon.ter! ain, so !aybe
so!e acco!!odation could be !ade
A si!ilar, possibly !ore attractive result !iht be achieved by havin Richard surrender his une+pired
unitrust interest in e+chane #or a unitrust interest in a #reshly created trust with a so!ewhat lower payout
rate. 6he 1uestion o# deviatin #ro! A$@A rates would not co!e into play. While this transaction has
not yet been the sub)ect o# any letter rulins, the sa!e principles would see! to apply.
6his techni1ue !iht be particularly attractive in a situation in which the settlor is loc"ed into a net
inco!e trust that has accu!ulated a considerable de#iciency and which continues to !a"e payouts below
the stated percentae.
Concluding remarks
0eepin in !ind that letter rulins !ay not be relied on as precedent, what these rulins actually teach us
is how we !iht need to structure the transaction i# we wanted a #avorable advance rulin. 6hey do not
necessarily tell us how we !iht survive a challene i# we structured the transaction di##erently or i# we
reported the ta+ conse1uences di##erently.
<ut #or the !o!ent, at least, IR8 is not issuin advance rulins on the 1uestion o# reconiBin ain on a
co!!utation, or on whether a co!!utation will dis1uali#y the trust under section 22:=d>.
6he leal !echanics o# how this transaction is to be closed are very state law speci#ic. In eneral, whether
the transaction is to be acco!plished by private aree!ent or throuh a *#riendly* )udicial proceedin to
!odi#y or ter!inate the trust, all interested parties, includin the holders o# continent interests =albeit
perhaps not the holders o# interests de#easible throuh the e+ercise o# a power reserved by the settlor>
!ust be represented.
Willis pae &,
Where the identities or shares o# the charitable re!ainder!en are inde#inite, either because the settlor has
reserved a power to desinate the re!ainder!en or because a si!ilar power has been ranted to the
trustee or to one or !ore individual bene#iciaries, it will al!ost certainly be necessary to )oin the state
attorney eneral in a )udicial !odi#ication or ter!ination proceedin.
Russell A. Willis III, J.D., LL.M.
(''( 9G 0nott 8treet, ;nit <, ?ortland, %R -4&,&
(,:.322.((52, rawillis(H)uno.co!
$haritable ?lanned @i#t Desin 8ervices
https://www.charitableplannin.co!
Willis pae &&
2ostscript
6he se!inal rulin underlyin everythin we have tal"ed about here is Rev. Rul. 52.2', ,-52., $.<. ('&.
6he rulin considered two related situations.
In the #irst =*situation ,*>, the ta+payer had created the trust, reservin a li#eti!e annuity #or hersel#, with
the re!ainder over to a desinated charity, and then #our years later she assined the une+pired annuity to
the re!ainder!an. It was assu!ed that the ta+payer had not initially created the trust =thereby dividin
her interest in the trust corpus> #or the purpose o# evadin the partial interest rule o# section ,4'=#>=(>=A>
I. and this was "ey to the rulin, in that the ta+payer was treated as havin trans#erred her entire interest
in the trust to the charity, without reard to the #act that she had earlier owned other interests in the
property co!prisin the trust corpus. 6here#ore, the 8ervice ruled, the trans#er 1uali#ied #or a charitable
contributions deduction #or both inco!e and i#t ta+ purposes. 6he !ethod o# calculatin the a!ount o#
the deduction was not discussed.
In the second situation =*situation &*>, the annuity was to have continued #or the li#e o# the ta+payerCs
spouse, i# he survived her. <oth the ta+payer and her spouse trans#erred their respective interests in the
trust to the re!ainder!an. Aain, the #act that the ta+payer had not =it was assu!ed> initially created the
trust #or the purpose o# evadin the partial interest rule was "ey, because in this circu!stance the trans#er
o# the ta+payerCs annuity interest, standin alone, would not otherwise have 1uali#ied #or the charitable
contributions deduction, in that she had also !ade a trans#er #or private =i.e., noncharitable> purposes: the
annuity to her spouse, i# he survived her.
6he rulin also concluded that the trans#er by the spouse o# his annuity interest to the re!ainder!an
1uali#ied, thouh it was not in the #or! o# a charitable lead annuity trust, because it was the only interest
in the property he had ever had.
Willis pae &(