This post was originally published on Forbes Aug 5, 2015
The decision in the case of the Estate of Arthur Schaefer made me realize that I had left something out of Reilly's Laws of Tax Planning. It was a caution about being too aggressive that we used to use at Joseph B Cohan and Associates, back in the day - "Pig's get fed. Hogs get slaughtered." (That brings the count to a nice prime eleven. Maybe I will stop). For some clients our managing partner, Herb Cohan, would say "Don't be a chazzer".
The Estate's problem is that it took a great planning tool - the NIMCRUT - and stretched it just a little too far. The NIMCRUT is so cool that I think it is worth explaining before I get into the decision. The other thing I like about these babies is that I often remark that you learn all the math you need to do most tax work by fourth grade , but this is one area where that masters in applied mathematics I got, because they were going to make the tax laws so simple, really pays off.
The core of that acronym is CRT, which stands for charitable remainder trust. The charitable remainder trust is the closest you will get to a free lunch in tax planning. You give property, often appreciated property, to a trust, which is itself an exempt entity. The trust makes distributions to you which can be taxable. What is left in the trust at the end of the distribution period, which is often the rest of your life, goes to charity. You get an upfront deduction when the trust is created based on the actuarial value of the remainder going to charity. I'll spare you the fancy math.
If you are going to leave a good chunk of your estate to charity anyway you should really look at a CRT. Even if you are not all that charitable, if the numbers break right you might find that the tax savings from a CRT are enough to fund life insurance in an irrevocable trust that will make your heirs whole.
The U stands for "unitrust". A unitrust rather than paying a fixed annuity pays a percentage of its fair market value. So the income beneficiary's payment changes each year based on how well the trust is doing.
NI stands for net income. The payment to the beneficiary is further limited by the trust's net income. If the trust does not have enough net income to cover the payment, the payment is limited, possibly to zero. This will require further discussion because the "net income" is something that a lot of people don't understand.
M is for makeup. Distributions that are limited because of not enough net income can be "made up" in future years
One of the things that a lot of people don't grasp is that the term income has a very different meaning in trust accounting and that is the income that is being referred to in NIMCRUT - not taxable income. If you really want to get into this you would start by looking at Uniform Principal and Income Act. Ahhh - don't get me started. A couple of big differences between what is referred to as "accounting income" on trust tax returns and taxable income are capital gains and income from flow-through entities. Generally capital gains are not part of accounting income and partnerships, for example, generate accounting income when they make distributions, but not otherwise.
What this means is that if the assets of the NIMCRUT are inside partnerships, the general partner can control the accounting income of the NIMCRUT perhaps turning the tap on and off depending on what fits the needs of the beneficiary. There are a number of traps to watch out for, one being unrelated business tax income which can disqualify the trust in a given year.
The Schaefer estate had a more fundamental problem.
Something Should End Up With Charity
The Schaefer case is about a charitable estate tax deduction for two NIMCRUTs. You start out with the value of the assets in the trusts and then you do some fancy math - life contingencies combined with present value - to divide that between the income interest and the remainder interest. The latter is deductible either for estate tax purposes as in this case or as an income tax deduction. If the remainder interest computes to less than 10% of the overall value, no charitable deduction is allowed.
The higher the payout ratio, the lower the value of the remainder. One of the trusts had a payout rate of 10% and the other was 11%. Both the IRS and the executor agreed that with that payout the charity would be getting less than 10% of the value. The executor argued that in doing the valuation the net income limit should be taken in account. Apparently there was some sense that the trust would not hit that target rate. The Tax Court wanted them to also consider using 5%, which is the minimum allowed payout rate.
Each approach is arguably flawed. Although the estate's approach yields a remainder interest value that is possibly closer to what the charitable beneficiary will ultimately receive, there is no basis for this approach in the statute. Respondent's approach potentially undervalues the remainder interest that will pass to the charitable beneficiary because it assumes the maximum distribution by using the fixed percentage, even though that amount can be distributed only if the trust produces sufficient income. And a 5% distribution rate potentially overvalues the remainder interest that will pass to the charitable beneficiary because if the trust produces income leading to distributions higher than 5%, the charitable beneficiary receives less than projected. Nevertheless, our task is not to look to the varying results and choose the best answer. Instead, we interpret the statute to the best of our ability, looking beyond it if necessary.
The Tax Court ended up backing the IRS.
Conclusion Section 664(e) is ambiguous in its description of how to value a remainder interest in a NIMCRUT where actual distributions will be the lesser of a fixed percentage or net income. Where the statute is ambiguous, we can look to legislative history as an aid in the interpretation of the statute. And where a statute is ambiguous, the administrative agency can fill gaps with administrative guidance to which we owe the level of deference appropriate under the circumstances. With regard to the statute before us, the legislative history and the administrative guidance point us to only one conclusion—that the value of the remainder interest of a NIMCRUT must be calculated using the greater of 5% or the fixed percentage stated in the trust instrument. Accordingly, the estate must use an annual distribution amount of 11% or 10% of the net fair market value of the trust assets when valuing the remainder interests of Trust 1 and Trust 2, respectively. Because the parties have previously stipulated that the estate would not be entitled to a charitable contribution deduction if the remainder interests are valued using this method, respondent's determination denying the charitable contribution deduction is sustained.
Don't Let This Discourage You
The NIMCRUT is still a fantastic tool in the right circumstances. Just don't be too aggressive on the payout.
Lew Taishoff did a post on this titled The Five Percent. He finished with
IRS issued Rev.Ruls. and Rev. Procs following that lead, although the regs aren’t clear, and the Code is not much better. So IRS’s guidance gets Skidmore deference.
Clear? Thought not.
Michael Jones did a piece called Crippled CRUTs on wealthmanagment.com. He noted a subtle point, which had passed me by.
A question not expressly raised in Schaefer is whether a CRUT or CRAT established during lifetime must re-qualify as such on death. Yet, this court and, presumably, the litigants, acted as if that is so.
He noted one other important point.
The opinion doesn’t mention collateral income tax consequences of its holdings. Because the CRUTs didn’t qualify as such, the general rules regarding taxation of trusts and trust beneficiaries apply.
I hope there were no big capital gains while this was going on. That would be nasty.
Timothy Todd, who is relatively new to forbes.com also covered this case and goes into a bit more technical depth.
In turns out that Mr. Schaefer was a rather interesting fellow, but I decided the tax stuff was interesting enough. You can read about him here if you are curious.