Revenue Procedure 2016-42 Helps Charitable Remainder Annuity Trusts Qualify in a Low Interest Rate Environment

One of the many consequences of the government’s manipulation of interest rates is the impact on the qualification of charitable remainder annuity trusts (CRATs).  A CRAT is a split-interest trust where the person transferring property to the trust typically retains a fixed annuity payment for life (or a term of years not exceeding 20) with the balance (called the remainder) of the trust passing to a designated charity at the end of the annuity payment term.  Because the CRAT is tax-exempt, it is typically used in tax planning for the sale of appreciated property. 

There are several rules that a CRAT must meet, one of which is the 5% exhaustion test of Revenue Ruling 77-374.  This ruling requires that the probability of the annuity payment depleting the assets of the CRAT, so that nothing remains for the charity, cannot be greater than 5%.  The probability of exhaustion is computed by considering the annuity as a percentage of the initial value of the property transferred to the trust (the amount of the annuity must be at least 5% of the initial value), the IRS valuation interest rate under IRC §7520 (use the highest of the current month (1.40% for August 2016) or of the two preceding months (1.80% each for June and July)) which is used to discount the annuity stream to present value, and the life expectancy of the annuitant over which the annuity will be paid.  In August 2016, it is clear that the CRAT minimum annuity payout percentage of 5% is greater than the IRS valuation rate of 1.80%; therefore, if the time period over which the annuity is paid is too long, the 5% depletion test will be failed.  For a single life annuitant at the 1.80% IRS valuation rate, only a 72-year-old or older person can establish a CRAT.  For a joint life expectancy of a husband and wife, the spouse of a 72-year-old must be at least age 77!  Contrast this to August 2008 when the §7520 rate was 4.20%.  Then a 52-year-old could establish a CRAT without failing the exhaustion test. 

Because the low interest rate environment has rendered CRATs unusable except for the oldest of taxpayers, the IRS published Revenue Procedure 2016-42.  It provides a provision which, if adopted, enables the CRAT to disregard the exhaustion test upon creation.  The provision requires the CRAT to terminate early if the future value of the CRAT, when discounted back to the CRAT formation, drops below 10% of the initial CRAT value.  The formula could cause an early termination and end of the annuity payment if the CRAT were to suffer a decline in value, even if temporary due to market fluctuations.  The provision will require annual monitoring before each year’s annuity payment is made.  If the 10% test is failed, then no annuity is paid for that year and the CRAT pays all of its assets over to the charity and terminates.  While this revenue procedure opens the door for CRATs to be used by younger taxpayers, younger taxpayers may find that a charitable remainder unitrust (CRUT) or charitable gift annuity may be preferable to the CRAT which bears the risk of early termination.  However, in the right situation, this new provision can enable the CRAT to be used.