Charitable Planning Upon Divorce: Avoiding Adverse Tax Consequences
By Christopher DeFilippis, Citrin Cooperman –
November 7, 2016
Lawyers set up charitable remainder trusts (CRTs) for high net worth taxpayers, largely because they allow a grantor to engage in charitable giving while taking advantage of income, gift and estate tax benefits. If set up correctly, the CRT is not taxed on income that is accumulated in the trust, the transfer of assets to the CRT is not considered a gift, and the transferred assets are not taxable in the grantor’s gross estate upon his or her death. In most cases, this plays out favorably if there is one grantor. When a CRT is set up by a married couple, however, the outcome can be less certain.
Essentially, a CRT pays a fixed dollar amount to the grantor (Charitable Remainder Annuity Trust, CRAT) or a percentage of the value of trust assets (Charitable Remainder Unitrust, CRUT) to one or more noncharitable beneficiaries for life or a specific term of years, and upon termination, the remainder passes to a charitable beneficiary.
In the case of married taxpayers, it is not uncommon to see one CRT established by both spouses. Typically, each spouse will receive equal annual distributions during their joint lifetimes; distributions often go wholly to the survivor upon the death of the first spouse. With the U.S. divorce rate hovering at 50 percent, it begs the question: What happens to a CRT established by both spouses when the marriage ends in divorce?
This is a critical question because once a CRT forfeits its classification as a charitable trust, it loses the benefit of its aforementioned income, gift and estate tax advantages. In these situations, the CRT must be divided. This can be accomplished without adverse tax consequences, but tax advisers must be aware of the mechanics in doing so.
Successful CRT Divisions
The IRS specifically provides two examples of successful nontaxable CRT divisions (Rev. Ruling 2008-41). In each example, the original CRT is divided on a pro rata basis into two separate and distinct trusts for the divorcing spouses. Each separate trust incorporates the same provisions as the original trust, though the trusts may have different trustees and the trust assets are invested independently.
In private letter rulings (e.g., PLR 200035014), the IRS has stated that the interests of the parties and their “legal entitlements” should not change from the original CRT to the resulting CRTs. This presumes that each beneficiary, after the division of the original trust, will receive a beneficial interest that is identical or at least substantially similar to what he or she would have received before the division.
A Favorable Outcome
The safest course of action is to put each spouse in the same beneficial and legal position after the division of the CRT as before it. For instance, if the original trust provided the spouses an annual distribution of 5 percent of the value of the assets contributed to the CRT, the resulting trusts after the division should provide distributions of 2.5 percent to each spouse.
There is an abundance of private letter rulings pertaining to the division of CRTs upon divorce. Changes to the rights of the parties upon the division of a CRT, such as incongruent resulting CRUT percentages between the spouses, have been deemed acceptable in those rulings. Divorced couples have the added security of Section 1041(a) of the Code which negates the recognition of gain or loss on a transfer incident to divorce.
Avoiding Unfavorable Results
Taxpayers are more likely to see an unfavorable tax result in the course of dividing a CRT when the lifetime beneficial interests of the parties increase as a result of the division, thereby decreasing the value of the charitable remainder. For example, the spouses received a collective total of $10,000 from the trust each year before the division of the CRT, and each spouse receives $20,000 each year post-division. In this scenario, the taxpayers would receive a charitable deduction in excess of the actuarial value of the charitable remainder trust after the division of the CRT. (None of the successful divisions of CRTs in private letter rulings or revenue ruling examples provided for an accelerated lifetime beneficial interest for the spouses.)
The taxability of the division of CRTs is a fairly uncertain and fact-specific area. It is critical for the tax adviser to be aware of the various considerations associated with these divisions to produce the intended tax-neutral result for his or her client.
Christopher J. DeFilippis
Christopher DeFilippis is an attorney and tax manager with Citrin Cooperman where he advises closely held businesses and high net worth individuals in all aspects of estate, gift and tax trust matters.
This article appeared in the November/December 2016 issue of New Jersey CPA magazine. Read the full issue.