One of the most misunderstood rules in the world of charitable remainder trusts (CRTs) is the so-called “10% remainder test.” For lawyers and accountants reading this blog post, the test is found at Internal Revenue Code Sec. 664(d)(1)(D) for charitable remainder annuity trusts (CRATs) and Sec. 664(d)(2)(D) for charitable remainder unitrusts (CRUTs).
A common way that I hear this test misrepresented goes something like this:
“I funded my trust with a $600,000 contribution. How can I ensure that the trust investments perform so that there is at least $60,000 left at the end so that I meet the 10% rule?”
As we will see below, this example illustrates that the point in time at which the 10% remainder test is relevant is commonly misunderstood. So how is the test applied?
The 10% remainder test can be analogized to a train journey: the conductor collects your ticket at the start of your journey, not at the end. So too, the 10% remainder test is your ticket to get on the CRT train, not a ticket to get off. What do I mean by this? To answer the question, let’s examine the text of the rule. The text of the CRUT rule (the CRAT rule is virtually identical) reads:
[A] charitable remainder unitrust is a trust
with respect to each contribution of property to the trust, the value (determined under section 7520 ) of such remainder interest in such property is at least 10 percent of the net fair market value of such property as of the date such property is contributed to the trust.
Unpacking the legalese we find five key elements to the 10% remainder test:
- It is an integral part of the definition of a CRT. If a trust doesn’t meet the test, the trust isn’t a tax qualified CRT.
- The test only applies to contributions. Consequently, it’s an entrance test, not an exit test; it doesn’t apply to value of the remainder at maturity.
- We are told to compute the remainder interest value using the valuation method under Sec. 7520. This is the standard method used to compute the amount of the charitable deduction. So at its core, the 10% remainder test is merely the computation of the charitable deduction.
- We are told to compute the remainder interest value on the date the property is contributed to the trust, which is the date used to compute the charitable deduction. This further reinforces the idea that the charitable deduction amount is the only information needed to determine if a trust passes the test. It also affirms the fact that we aren’t interested in the value of the remainder at some future date.
- We are told that the value of the remainder computed under Sec. 7520, that is, the charitable deduction amount, must be at least 10% of the value of the property contributed.
So, as an example, if we contribute property valued at $750,000 to a CRT, then the charitable deduction allowed for that contribution must be at least $75,000. Once we’ve met this simple test, the 10% remainder test becomes irrelevant until the next contribution is made.
Why did Congress create the 10% remainder test? At the time the test was instituted, planners were creating high-payout CRTs designed to circumvent the four-tier accounting rules and multiple generation CRTs that delayed the payment of the remainder for many decades. Because the two biggest factors that impact the size of the charitable deduction are the payout rate and the length of the trust term, by requiring that the output of this computation be at least 10% of the contribution value, Congress effectively eliminated high-payout lifetime CRTs and multiple generation CRTs whose duration was not limited by a term of years.
In conclusion, for the purpose of the 10% remainder test, the actual value that passes to charity is irrelevant. Instead, our sole concern is that the actuarially determined value of the remainder (i.e., the charitable deduction amount) is at least 10% of the value property transferred.
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