An Elegant Solution to Rev. Proc. 2005-24 Spousal Election Tax Trap

An Elegant Solution to Rev. Proc. 2005-24 Spousal Election Tax Trap

Article posted in Revenue Procedures on 21 November 2005| 1 comments
audience: National Publication | last updated: 20 May 2014
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Summary

On March 30, 2005, Treasury and IRS published Rev. Proc. 2005-24, which was intended to provide a safe harbor procedure to avoid the disqualification of a charitable remainder trust because of the existence of a spousal right of election under state law. Since that time, however, many charitable gift planners and organizations have written Treasury to express their dismay for a cure that has been imposed for a problem many think is "so remote as to be negligible." In this article, Steve Leimberg shares an "elegant" solution offered by Lawrence Katzenstein that in their opinion can make all parties whole.

Leimberg Information Services
by Stephan R. Leimberg

Previous Leimberg Information Services newsletters warned of a major tax trap triggered by recently announced Revenue Procedure 2005-24.

We predicted in those LISI newsletters that Rev. Proc. 2005-24 could cause unnecessary major problems for advisers, donors and charities for years to come.

The problem has not gone away!

So if you are involved in CRATs and CRUTs or OTHER charitable creatures, (I know the Rev. Proc. appears on its face to cover ONLY CRATs and CRUTs -- but if the potential of a spouse's right of election could be fatal to a CRAT or CRUT, why would a pooled income fund gift or remainder interest in a personal residence and farms or a charitable lead unitrust and lead annuity trusts be treated differently?), KEEP READING!

THE PROBLEM:

Unless the requirements of Rev. Proc. 2005-24 are met for CRTs created on or after June 28, 2005, inter vivos CRUTs and CRATs are DISQUALIFIED--RETROACTIVELY TO THE DATE OF CREATION--if a spousal right of election NOW exists under state law, exists in the FUTURE, or exists if the grantor of a CRUT or CRAT MOVES, MARRIES, or REMARRIES. (A second marriage is a triumph of hope over experience!)

TREASURY'S HEART WAS IN THE RIGHT PLACE

The Treasury's motivation was a reasonable one: Tax Benefits should not be available if a charity's remainder interest in a CRT will be reduced or eliminated by a surviving spouse -- or by anyone else.

TREASURY'S SOLUTION IS NEITHER FAIR NOR REALISTIC:

Unfortunately, as Conrad Teitell pointed out so ably, the revenue procedure doesn't take everyday realities into account:

  • Not all lawyers who prepare CRTs are specialists. Many are likely to be unaware of Rev. Proc. 2005-24. Should the non-specialist's unawareness be visited on generous donors and disqualify charitable trusts - even though it is highly unlikely that a right of election will ever be exercised?
  • If a state does not now have a spousal right of election, but enacts one in the future, as a practical matter, the CRT grantor is not going to know that he or she has to get a waiver.
  • A single individual who later marries or a married individual who divorces and remarries is unlikely to know or remember that he or she has to get a waiver.
  • A couple moves to a new state that has a right of election law that has different requirements for a waiver than the waiver that the spouse executed when the CRT was created. It is unlikely that a new waiver will be obtained.
  • A "protective" waiver signed before one is required may be invalid because it isn't possible to know the requirements for a valid waiver before a statute is enacted or before a grantor and spouse know the state that they might move to in the future.
  • A husband creates a CRT on June 28, 2005 (or thereafter). He gets a waiver of the right of election from his wife. It is timely, irrevocable, and meets all the other requirements of Rev. Proc. 2005-24. It is an effective waiver under the law of the state in which the husband and wife are domiciled. The husband delivers it to the trustee who keeps the waiver with the CRT records.

Five years later, the husband and wife move to a new state. It also gives spouses the right of election against CRUTs and CRATs. But the new state has different requirements for a valid waiver than those of their old state. Although the husband is elderly, he remembers that his wife may have to sign a new waiver. He sees a lawyer.

But unfortunately the years have taken their toll, and his wife is then incompetent and can't sign an effective waiver. The husband dies. Neither the wife nor her court-appointed guardian elect against the trust. Nevertheless, the CRUT is disqualified retroactively - to the date it was created--with loss of all the attendant tax benefits.

  • A waiver wasn't required when the grantor created his CRUT because his state had no right of election law. But when he moved to a new state that had such a law, he got a waiver from his spouse.But he didn't send it to the trustee. The waiver is found with his will in his safe deposit box. Is his CRUT disqualified? Rev. Proc. 2005-24 requires: "Trustee To Retain Copy." A copy of the signed waiver must be provided to the trustee of the CRAT or CRUT. The trustee must retain the copy in the official records of the trust so long as the contents thereof may become material in the administration of any internal revenue law. See 1.6001-1(e) of the Income Tax Regulations."
  • Should the grantor and spouse have different lawyers because their interests are potentially adverse? Is it right to, in essence, require additional legal fees for making a significant charitable gift?

THE "SPECIAL K" SOLUTION:

Lawrence P. Katzenstein of Thompson Coburn LLP in St. Louis and creator of the popular Tiger Tables Software (www.tigertables.com)has suggested to Treasury that the section 664 regulations be amended to remove the Rev. Proc. 2005-24 problem and in its place provide that any distribution from a charitable remainder trust to a spouse exercising a right of election should carry out income under the tier system applicable to charitable remainder trusts.

Larry pointed out to the Treasury that:

Inter vivos charitable remainder trusts provide two primary tax benefits:

  1. an initial income tax deduction, and
  2. a tax-free buildup in the charitable remainder trust.

Larry suggested that "rough justice could be accomplished simply by amending the regulations under section 664 to provide that any distribution from a charitable remainder trust to a spouse exercising a right of election will carry out income under the tier system applicable to charitable remainder trusts."

This, change, which Treasury could make unilaterally, would indirectly solve any abuse problem.

How? Code Section 664 contemplates that distributions to individual beneficiaries will carry out income from the tiers. Of course, it does not deal with spousal elections because, when section 664 was enacted in 1969, augmented share elections were either unknown or extremely rare. But the theory of section 664 is that distributions to individual beneficiaries carry out income under the tiers. A spouse given rights by state law in a charitable remainder trust is, in effect, a beneficiary of the trust.

With regard to the initial income tax deduction, Larry suggested that that initial benefit simply be ignored. He posited that this makes sense for several reasons:

"First, even under the Treasury's solution of declaring the trust void ab initio, in many if not most cases, the statute of limitations on the initial charitable gift will have expired anyway. That will undoubtedly be the case in many of the situations described in the Revenue Procedure: later adoption by the taxpayer's state of an augmented share spousal election, subsequent remarriage, relocation to a state which has adopted an augmented spousal election rule and so forth. In all of these situations, the Treasury solution already contemplates allowance of the initial charitable deduction because in many cases the statute of limitations on the initial contribution deduction will have expired anyway.

Further, the charitable deduction should be allowed in these cases because it meets the test of the chance of diversion to a non-charitable beneficiary being so remote as to be negligible. The number of cases in which an augmented spousal share election is made against a charitable remainder trust must be vanishingly small."

Larry points out that "Most of us -- even those of us who have advised planned giving programs on a national basis for many years -- have never seen or heard of such a case."

AN ELEGANT SOLUTION:

Larry's solution accomplishes the Treasury's goal, it's much simpler than that proposed in the Revenue Procedure, and avoids disqualification of trusts through inadvertence.

Bravo Larry!

Now let's hope that someone high up in Treasury has the sense to take this simple solution and run with it. Until then, Rev. Proc. 2005-24 remains a tax land mine for the unwary!

HOPE THIS HELPS YOU HELP OTHERS!

Steve Leimberg

CITE AS:

Steve Leimberg's Charitable Planning Newsletter # 85 (November 14, 2005) at www.leimbergservices.com Copyright 2005 Leimberg Information Services, Inc. Republished by Planned Giving Design Center by permission. (LISI) Reproduction in Any Form or Forwarding to Any Person Prohibited -- Without Express Permission.

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Comments

Taxation of Spouse

I really like the gist of Larry's solution, but I suspect it will need a little tweaking to be acceptable to IRS. Assume a CRT is funded with cash and has no undistributed income when spouse takes assets. Under proposed solution, spouse will have no income, but charitable deduction will still have been allowed. Or the opposite extreme, CRT is funded with zero basis property. Spouse will have 100% gain. However, had property initially been sold instead of doing CRT, there would also have been 100% gain, BUT NO charitable deduction. Again, taxpayer comes out a bit ahead. When taxing the spouse, I would suggest using the four-tier system only up to the current value of the income interest, and then taxing any further amount entirely as ordinary income. It's not a perfect solution, but I think is one that the IRS would be happier with, and as an advisor, it is not something I would have any problem with since, as Larry says, when have we ever seen this happen anyway?

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