In the late 1970s, the IRS announced it would apply a new test to charitable remainder annuity trusts (CRATs)—the 5% probability test (5% Test).
If there was more than a 5% probability that a CRAT would be exhausted during the payout recipient’s life, no federal income tax charitable deduction would be allowed with respect to the CRAT. Some years later, the IRS made it crystal clear if a trust set up as a CRAT flunked the 5% Test, it wouldn’t qualify as a CRAT.
The 5% Test only applies to a CRAT for one or more lives.
It doesn’t apply to a CRAT for a fixed term of years, a CRUT or a gift annuity. The IRS hasn’t said whether it applies to a charitable lead annuity trust (CLAT) set up to run for an individual’s life.
Now, in our low-interest-rate environment, which some economic experts predict will last for a couple more years, it’s basically impossible to set up a CRAT for life that won’t flunk the 5% Test. Why? Because the IRS discount rate (0.6% as of this writing) is the assumed earnings rate of a CRAT. Low earnings mean early exhaustion.
But the IRS said in recent years there’s a provision that can be put in a CRAT instrument that will make the 5% Test inapplicable to the CRAT.
What provision? A provision that basically says if a required CRAT payout would drop the value of CRAT assets below 10% of the CRAT’s initial asset value, the CRAT trustee shall not make the payout, and the CRAT shall thereupon terminate and distribute all of its assets to charity.
Historically, in times of low inflation and low interest rates, fixed payment plans (CRATs and gift annuities) have been in demand. Given the damage to the U.S. economy in 2020, perhaps low inflation and low interest rates will prevail for some years and thus make CRATs and gift annuities attractive to donors.
By Jon Tidd
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