The Service has issued (Revenue Procedure 2016-42) a sample provision that may be included in charitable remainder annuity trust (CRAT) instruments that provide annuity payments for one or more measuring lives followed by the distribution of trust assets to one or more charitable remaindermen. Revenue Procedure 2016-42 is effective August 8, 2016, and applies to CRATs created on or after that date.

Section 664(d)(1) contains the requirements for CRATs. In Revenue Ruling 70-452, the Service applied those rules to a split-interest charitable remainder trust and ruled that "if there is a greater than 5% probability that payment of the annuity will defeat the charity's interest by exhausting the trust assets by the end of the trust term, then the possibility that the charitable transfer will not become effective is not so remote as to be negligible" (i.e., the probability of exhaustion test). Revenue Ruling 77-374 applied the probability of exhaustion test to a CRAT. Under the test, if the probability that the life beneficiaries will survive exhaustion of the CRAT assets is greater than 5%, the CRAT's charitable remainder interest will not qualify for an income, gift, or estate tax charitable deduction and the CRAT will not be exempt from income tax under Section 664(c).

Section 5 of Revenue Procedure 2016-42 contains the sample provision, which includes an alternative to satisfying the probability of exhaustion test. Under the sample provision, the CRAT will terminate early on the date before the date on which an annuity payment would be made, if the annuity payment amount would result in the trust corpus value, when multiplied by a specified discount factor, being less than 10% of the initial trust corpus value. Upon termination, the remaining CRAT assets will be distributed to the charitable remainder beneficiary.

The Service will treat the sample provision as a qualified contingency under Section 664(f). If a CRAT contains a provision that is similar but not identical to the sample provision, the CRAT may not be disqualified, but it will not be assured of qualified contingency treatment.

Section 6 of Revenue Procedure 2016-42 contains an example illustrating the use of the sample provision.

Implications

This Revenue Procedure is in response to an interest rate environment that has not existed in the United States since the Service created the exhaustion test in the 1970s. As a result of historically low interest rates on US government debt, CRATs that failed the 5% probability test became so common that they caused CRATs to be unavailable to a segment of the population that could have used them before the 2008 financial crisis.

Both before and after this Revenue Procedure, CRATs are subject to potential exhaustion because of the negative consequence of even one bad year of performance. Once the qualified contingency language is added, it may result in more CRATs terminating early, which may precede the actual exhaustion of trust assets. Consequently, this new provision results in the charity getting some value at the end of the term. Said differently, the new provision causes the charitable remainder's interest to be more protected, but at the expense of the income beneficiary.

The Revenue Procedure also amplifies the sample CRAT language published in Revenue Procedure 2003-53, Revenue Procedure 2003-55, Revenue Procedure 2003-56, Revenue Procedure 2003-57, Revenue Procedure 2003-59 and Revenue Procedure 2003-60. The Service could have republished the sample documents, but instead chose to supplement them via an amendment in Section 5 of this Revenue Procedure. Therefore, taxpayers and practitioners should be aware that simply taking last year's CRAT document off the shelf to use as next year's CRAT is not advisable.

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