[This article was originally published as “CRUTs, CRATs and Spousal Elections” in the PBA Real Property, Probate and Trust Law Newsletter, No. 60, p. 10 (Fall 2005).]

Rev. Proc. 2005-24, 2005-16 IRB 1 (3/30/2005), addresses the problem of spousal elective rights that arise when the grantor is married, creates a charitable remainder trust, and retains an annuity or unitrust interest in the trust for his or her lifetime. By statute in Pennsylvania (and many other states), a surviving spouse can elect against the will of a decedent, and the property subject to the elective share can include charitable remainder trusts. The Revenue Procedure therefore provides a “safe harbor” to allow a charitable remainder trust to qualify for a charitable deduction for estate, gift or income tax purposes despite state laws that would otherwise give the surviving spouse an “elective share” in the trust and disqualify the trust for any charitable deduction (or for the special income tax treatment under Internal Revenue Code Section 664). An understanding of the elective share problem and the safe harbor provisions of the Revenue Procedure is important to anyone advising a married client who is about to create a charitable remainder trust or who has created a charitable remainder trust since June 28, 2005.

Charitable Remainder Trusts

A “charitable remainder trust” (or “CRT”) is a trust that qualifies under Internal Revenue Code Section 664 as either a charitable remainder annuity trust (or “CRAT”), which pays a fixed amount each year to one or more noncharitable beneficiaries, or a charitable remainder unitrust (or “CRUT”), which pays a fixed percentage of the trust assets (revalued annually) to one or more noncharitable beneficiaries. At the end of the trust’s term (which may be measured by the life or lives of the noncharitable beneficiaries, by a term of years not exceeding 20 years, or certain combinations of lives and years), the entire balance of the trust assets remaining must go to charity.

There are two advantages to this kind of trust:

• There is an immediate deduction for federal income tax, gift tax and estate tax purposes based on the present value of the future (projected) amounts to be paid to charity. This present value is determined in accordance with the interest rate and mortality table required by Code Section 7520.
• A CRT is exempt from federal income tax, but the noncharitable beneficiaries are required to pay tax on the trust’s undistributed income when (and if) distributions are made. Code Section 664 has a “tier” system of determining the tax consequences of distributions that is sometimes called a “worst-in, first-out” (or “WIFO”) system, because ordinary income is considered to be distributed first, then capital gains, then nontaxable principal. Any undistributed income or gains are carried forward to future years until distributed.

A grantor who wishes to make gifts to charity at death therefore has an incentive to create a CRT during his or her lifetime, retaining a life interest in the trust. The grantor gets an immediate income tax deduction for the present value of the remainder and, if the grantor uses appreciated property to fund the trust, the sale of the property results in taxable gain to the grantor only when (and if) the gain is distributed back to the grantor as part of the regular distributions from the trust. The grantor therefore gets the benefit of both an income tax deduction and an income tax deferral on gains realized by the trust.

However, Code Sections 664(d)(1)(B) (for CRATs) and (d)(2)(B) (for CRUTs) provide that “no amount” other that the unitrust or annuity payments may be paid to any person other than a charitable organization. In Rev. Proc. 2005-24, the IRS concluded that, if a CRT is subject to elective share rights, the mere possibility that a surviving spouse might make an election and the trust might have to make any payment to a surviving spouse is enough to disqualify the entire trust from the moment of creation.

Safe Harbor

Rev. Proc. 2005-24 provides a “safe harbor” that will allow spousal rights of election to be ignored for purposes of determining whether or not a CRT meets the requirements of Code Section 664.

The safe harbor generally requires that the spouse of the grantor of a CRT irrevocably waive elective rights to the extent necessary to insure that no part of the CRT will be used to satisfy the elective share. Because the goal is to protect the CRT, a spousal waiver is not necessary if the spouse would have no right of election under state law, or if under state law the assets of the CRT could not be used to satisfy the right of election.

The irrevocable waiver must be valid under state law, in writing, signed and dated by the spouse, and retained by the trustee. One of the examples in the Rev. Proc. (Example 4, Section 4.04) states that a prenuptial agreement that includes a waiver of elective rights will satisfy the safe harbor “Unless the agreement as a whole (or only the waiver) is subsequently found to be invalid or unenforceable.” This suggests that the Service will not attempt to look past the formalities of a waiver to see if it might later be challenged as “unconscionable.”

For CRTs created on or after June 28, 2005, the required spousal waiver must be signed within the six months following the due date for the CRT’s information return (Form 5227) for the year in which occurs the later of the following:

• The creation of the trust;
• The marriage of the grantor and the spouse;
• The date the grantor becomes domiciled in a state that allows a spousal right of election that could be satisfied from the CRT; or
• The effective date of a state law that gives the grantor’s spouse a right of election that could be satisfied from the CRT.

For CRTs created before June 28, 2005, the Service will ignore a spousal right of election unless the surviving spouse actually exercises the right of election and assets of the CRT are paid to the surviving spouse, in which case the CRT will be considered to have failed to qualify under Section 664 continuously since its creation.

Fortunately, Pennsylvania’s elective share statute specifically provides that a surviving spouse does not have a right of election against “Any conveyance made with the express consent or joinder of the surviving spouse.” 20 Pa.C.S. § 2203(b)(1). In most cases, it should be possible to get the consent or joinder of the spouse at the time the CRT is created, which should solve the problem as long as the grantor remains a Pennsylvania domiciliary and Pennsylvania does not change the elective share statute.

But is it possible for elective share rights to apply to a CRT created before a marriage?

And what happens if there is no consent or joinder, so that the safe harbor of the Rev. Proc. does not apply?

Elective Share Rights in Pennsylvania

The Pennsylvania elective share rules are found in Chapter 22 of the Probate, Estates and Fiduciaries Code (Title 20 of the Pa. Consolidated Statutes). 20 Pa.C.S. §2203(a) says that the surviving spouse has a right to an elective share of one third of six different kinds of property, of which the following may be relevant to a CRT in which the grantor has retained a lifetime interest:

“(2) Income or use for the remaining life of the spouse of property conveyed by the decedent during the marriage to the extent that the decedent at the time of his death had the use of the property or an interest in or power to withdraw the income thereof “(3) Property conveyed by the decedent during his lifetime to the extent that the decedent at the time of his death had a power to revoke the conveyance or to consume, invade or dispose of the principal for his own benefit.”

These two provisions are very different, because under Paragraph (2) the spouse has the right to elect against the income from the property, while under Paragraph (3) the spouse has the right to elect against the property itself. So if Paragraph (2) applies to a CRT, then the spouse is entitled to one third of same annuity or unitrust payments that had been received by the decedent, while if Paragraph (3) applies then the spouse is entitled to one third of the investments held by the CRT. (The right of the spouse to elect against the income and not the principal may be unique to Pennsylvania. Compare, for example, Uniform Probate Code § 2-205(2)(i) (1993 Amendments).)

Another difference between the two provisions is the timing of the conveyance. Paragraph (2) applies only to property conveyed “during the marriage,” but Paragraph (3) applies to property conveyed “during his lifetime” and so would apply to CRTs created before the decedent and spouse were married.

So which paragraph applies is important, but choosing between them is difficult because an annuity from a CRAT and a unitrust payment from a CRUT are neither “income” nor “principal” in the traditional sense, but usually a combination of both. (The annuity or unitrust payment could be entirely income if the payout is relatively low and the income of the CRT is sufficient to make the required distributions. Otherwise, the annuity or unitrust payments will be partially income and partially principal, the exact amounts depending on the income earned by the trust and the annuity or unitrust payments required from the CRT.)

There are several reasons to believe that the annuity or unitrust payments from a CRT should be considered “income” within the meaning of Paragraph (2) and not a power to “consume, invade or dispose of” the principal within the meaning of Paragraph (3).

• Paragraph (3) seems to have been written to deal with revocable trusts and other revocable transfers, as well as discretionary powers to invade trusts, rather than regular required distributions of fixed amounts. (The official comments to the 1980 amendments to Section 2203 refer to this Paragraph as “Revocable transfers.”) So it is by no means clear that Paragraph (3) should apply at all.
• The official comments to the 1978 enactment of § 2203(a) state that “It is intended that the spouse should have a right of election only with respect to assets which the decedent retained the right or power to enjoy during his lifetime.” Treating an annuity or unitrust payout as “income” for purposes of Paragraph (2), rather than as a right to “revoke” or “consume” principal under Paragraph (3), would seem to be more consistent with this legislative intent, because the spouse would be able to receive one third of what the decedent actually retained (i.e., the annuity or unitrust payments).
• The Pennsylvania Legislature has already identified at least two situations in which a unitrust payout may be considered a distribution of “income” from a trust. See 20 Pa.C.S. §§ 8105(d)(3) and 8113(c). The legislature has also given trustees greater latitude in adjusting “income” and “principal” (20 Pa.C.S. § 8104), and so it is not clear that a painstaking distinction between “income” and “principal” should be required by § 2203.
• The Uniform Probate Code specifically defines “right to income” to include an annuity trust or unitrust for purposes of elective share rights. See UPC § 2- 201(9) (1993 Amendments). The official comments to the 1978 enactment of Section 2203 states that Paragraph (2) is based on the Uniform Probate Code, so it is possible that Pennsylvania courts will look to the later amendments to the UPC in interpreting this provision.
• Separating each annuity or unitrust payment between “income” and “principal” in order to determine the “extent” to which the decedent had retained a right to “invade” principal would be difficult and complicated, requiring assumptions about life expectancy and future income yields. Requiring these kinds of valuations would be contrary to the one of the goals of Chapter 22, which was to minimize problems of valuation (as will be discussed in more detail below).
• Applying Paragraph (3) to a CRT would mean that a spouse could elect against a CRT that was created before the marriage, and this would be contrary to the legislative intent expressed in the other paragraphs of § 2203(a) that a spouse should not be able to elect against conveyances that were irrevocable at the time of the marriage.

The Effect of an Election

The effect of an election under Chapter 22 is very different from the effect of an election under the Uniform Probate Code, because the UPC calculates the value of the right of election and then determines what assets to apply against that value, while Chapter 22 provides that the spouse is entitled to a one-third share of each conveyance subject to the right of election. This is implicit in provisions such as § 2203(a)(2) and is explicit in § 221 1(b)(l), which states:

“Property which otherwise would pass by intestacy shall first be applied toward satisfaction of the spouse’s elective share. The balance of the elective share shall then be charged separately against each conveyance subject to the election, the passing of property by will to be treated as a conveyance for this purpose, but the spouse shall have no right to share in any particular item of property within each conveyance. After the value of the electing spouse’s fractional interest in each conveyance at the time of distribution is determined, items of property within the conveyance may be allocated disproportionately at distribution values between the elective and nonelective shares in order to give maximum effect to the decedent’s intention with respect to the disposition of particular items or kinds of property. Property in the nonelective share shall be distributed among the beneficiaries of each conveyance in accordance with the rules of abatement or by analogy thereto.” (Emphasis added.)

If a spouse’s right of election against a CRT is under § 2203(a)(2) and not § 2203(a)(2), the impact on the CRT (and the grantor’s charitable deduction) might be minimal, because the effect of the election should be to divide the CRT into two shares. In order to “give maximum effect to the decedent’s intention,” the nonelective share of the CRT (i.e., two thirds) will be distributed to charity immediately, just as though there had been no election. The elective share (i.e., one third) would continue in the CRT so that the spouse will receive one third of the annuity or unitrust payments that had been received by the decedent during his or her lifetime, and any remainder would be paid to charity at the death of the spouse.

If this interpretation of Chapter 22 is correct, then a failure to comply with the safe harbor of Rev. Proc. 2005-24 will have relatively mild effects for a Pennsylvania taxpayer.

Because the electing spouse will not be entitled to any of the principal of the CRT and will only be entitled to a continuing annuity or unitrust payout, the requirements of Code Section 664 that were cited in the Rev. Proc. (that “no amount” other that the unitrust or annuity payments may be paid to any person other than a charitable organization) will be satisfied. That means that the trust will qualify as a CRT and will be exempt from income tax.

And the impact on the grantor’s income tax deduction (and gift tax deduction) may be relatively small.

Even if the safe harbor does not apply and the CRT is potentially subject to an election by the surviving spouse, at least two thirds of the CRT will be distributed to charity as originally intended. At most, one third of the trust will continue for the life of the surviving spouse before passing to charity, meaning that one third of the trust will be valued as a joint and survivor interest instead of a one life interest.

To illustrate, assume that a 65- year-old grantor creates a CRUT for $1 million with an eight percent payout at the beginning of each year, and that the grantor’s 55- year-old s p o u s e fails to consent to the transfer. Ignoring the spouse’s right of election, the factor for the charitable remainder following the grantor’s retained unitrust interest would be .30871, resulting in a $308,710 income tax deduction (ignoring other limitations that might apply). If the spouse has a right of election that makes one third of the trust a joint-and-survivor interest, then the remainder following that joint and survivor interest would be valued using a factor of .13157. Taking two thirds of .30871 and one third of .13175 produces a “blended” factor of .24966, meaning that the grantor would be entitled to an income tax deduction of $249,660 instead of $308,710, a reduction of about $59,000. (That $59,000 also represents a taxable gift, because it is the value of the spouse’s interest and does not qualify for the federal gift tax marital deduction.)

Steps To Take

When representing a married client who is creating a CRT, it will obviously be advisable to get the grantor’s spouse to sign a consent or joinder to the conveyance, so that the CRT will not be subject to elective rights in Pennsylvania, and otherwise comply with Rev. Proc. 2005-24. But there are some other circumstances that should also be considered:

1. When advising a client who has moved to Pennsylvania and who created a CRT while domiciled in another state, it would be prudent to determine whether a consent or joinder was signed when the trust was created, or whether other steps should be taken to comply with the Rev. Proc.
2. When advising a client who has previously created a CRT and who is about to marry, it would be prudent to arrange for the new spouse to sign a waiver of any rights in the existing CRT, just in case 20 § 2203(a)(3) might apply to give the new spouse elective rights.

Conclusion

Many practitioners have expressed concerns about complying with the safe harbor provisions of Rev. Proc. 2005-24, but most decisions by married people to create CRTs are joint decisions by both the husband and wife so spousal consents should not be a problem. Furthermore, the peculiar features of the Pennsylvania elective share suggest that failure to comply with the safe harbor would have tax costs, but would not be a tax disaster.