8094 / Can a charitable remainder unitrust be reformed in order to qualify for a charitable deduction?

A trust must qualify as a charitable remainder unitrust at its inception in order to generate a charitable deduction. The extent to which the provisions of a CRUT may be changed in any way after its inception has been the subject of a variety of ruling requests.

In a position consistent with the regulations described above, the IRS has prohibited the reformation of a trust to change from a net income with make-up provision to a fixed percentage provision¹ or to remove a net income limitation.²

The Service has ruled that reforming a CRUT by converting the trust from a net income method CRUT (NIMCRUT) to a fixed percentage CRUT would not adversely affect the CRUT’s qualification status.³

The Service has permitted reformation of a trust instrument with respect to certain characteristics that have little or no impact on its payouts. For instance, the reformation of a unitrust to allow a grantor to change or designate other charitable organizations as the remainder beneficiaries did not affect the trust’s qualification as a CRUT.⁴ Moreover, an amendment that merely reallocated the unitrust amount between the beneficiaries during their joint lives to comply with the requirements for a CRUT, effective retroactively to the date of the creation of the trust, was permitted under the qualified reformation provisions of IRC Section 2055(e)(3).⁵ However, the IRS has determined that a trust would be disqualified by an amendment to change the successive order of the noncharitable lifetime beneficiaries, regardless of the consent of all interested parties.⁶

The IRS has also determined that the division of one CRUT into two CRUTs would not cause the original or resultant trusts to fail to qualify under IRC Section 664.⁷ The IRS has treated the division of a charitable remainder trust into separate trusts as a nontaxable event where the separate trusts are funded pro rata and beneficiaries receive interests that are essentially equal to the original interests.⁸

The Service ruled that the assignment of trust principal to three of four named charitable remainder beneficiaries of the CRUT would not disqualify the trust as a CRUT provided that the named charitable remainder beneficiaries were public charities.⁹

The IRS has privately ruled that the donor/unitrust recipient of a CRUT could donate his entire unitrust interest in an existing CRUT to the charitable remainderperson in consideration for a gift annuity that would be payable to him.¹⁰

The termination of a CRUT and the disposition of the donor/noncharitable beneficiary’s interest in the trust resulted in the noncharitable beneficiary having to recognize long-term capital gain on the entire amount realized from the disposition of his unitrust interest in the trust. However, no act of self-dealing resulted from the termination and disposition of the unitrust interest.¹¹

The Service determined that the rescission of a CRUT (because of the charity’s misrepresentations about the income tax consequences of the trust) would be recognized for federal income tax purposes as of the date the trust was created.¹²

If for any reason, the CRUT is not a qualified CRUT under Section 664 and the regulations, there are limited opportunities to reform the CRUT to qualify it for the gift tax or estate tax charitable deduction.

The first requirement is that the reformation be a “qualified reformation,” i.e., not all reformations are qualified. A “qualified reformation” is “a change of a governing instrument by reformation, amendment, construction, or otherwise which changes a reformable interest into a qualified interest.”¹³ Second, the interest must be a “reformable interest,” which is defined to include two possibilities: the first is where the noncharitable interests are expressed as a unitrust percentage, and the second is where the noncharitable interests are not expressed as a unitrust percentage, but a proceeding to reform the trust is timely instituted.¹⁴ In both situations, the trust must be in a form that would have qualified for a charitable deduction prior to the rules in effect prior to the Tax Reform Act of 1969.

In order to qualify as a “qualified reformation,” the reformed interest must be a “qualified interest.”¹⁵ In order to meet this requirement, the trust must comply with the mandatory governing instrument requirements of Section 664 and meet three tests: (1) an actuarial test; (2) an equal duration test; and (3) an effective date test. Under the actuarial test, the actuarial value of the reformed charitable interest cannot vary from the actuarial value of the pre-reformation CRUT by more than 5 percent.¹⁶ The equal duration test requires that the noncharitable interests must terminate at the same time both before and after reformation, although a noncharitable interest that is expressed as a term of years (as opposed to lifetime) may be reformed down to 20 years.¹⁷ Under the effective date test, the reformation must be retroactive to the date of the decedent’s death, or, in the case of a lifetime trust, the date of trust creation.¹⁸