Valuation Consideration: Early Termination of a QTIP or CRT

In the context of estate tax and income tax planning, taxpayers commonly choose to protect their assets by leveraging various types of annuity trusts, unitrusts, or both. These trusts provide income to an income beneficiary for a designated period of time, then leave the assets to one or more remainder beneficiaries. The income stream is structured as a payment for either a set number of years, or for the duration of the income beneficiary’s lifetime. Once the income distribution period ends, the assets in the trust transfer to the designated remainder beneficiary or beneficiaries.

Early Termination of QTIPs and CRTs

Two specific types of trusts that use these structures are Charitable Remainder Trusts (CRTs) and Qualified Terminable Interest Property Trusts (QTIPs). While these structures can provide many benefits, even the best laid plans may need to be altered due to unforeseen circumstances. In cases such as these, the income beneficiary may wish to terminate the trust ahead of its scheduled end date. While there could be numerous reasons to terminate a trust early, two common reasons are:

1. The income beneficiary no longer needs or wants the income and would like the designated remainder beneficiary to receive the assets sooner than planned. In this instance, all assets in the trust would pass to the remainder beneficiary at once, instead of being spread over a period of time (as was originally designated by the CRT or the QTIP).
2. The income beneficiary prefers to receive their portion of the trust’s assets now, rather than wait on a series of payments spread across several years in the future. In this case, the trust assets are divided between amounts attributable to the income beneficiary and those designated for the remainder interests, and the assets are then distributed to each party. 

In either scenario¹, it is necessary to determine the present value of the income interest as well as the value of the trust’s remainder interest. When a QTIP or CRT is terminated early, it’s critical to understand the rules that guide the valuation process to determine the income interest and remainder interest.

Valuation Upon Early Termination

First, it’s important to note that when terminating a QTIP or CRT early, the value of the trust’s underlying assets must reflect fair market value (FMV). Most CRTs and QTIPs exclusively hold marketable securities, however, if a QTIP’s or CRT’s underlying assets are non-marketable, a specialist appraiser may need to assess their FMV. For example, hiring an outside specialist appraiser could be necessary if the trust holds assets such as real estate, art, or machinery and equipment.

Second, the FMV of the trust’s assets must be divided between the value attributable to the income beneficiary and the value attributable to the remainder beneficiary pursuant to present value factors outlined by IRS-prescribed interest rates and actuarial tables. We’ll discuss this process in the next section. 

Present Value Factors

A CRT can be structured to pay the income beneficiary a set dollar annuity each year (i.e., a Charitable Remainder Annuity Trust or CRAT) or pay a fixed percentage of the trust’s assets each year (i.e., a Charitable Remainder Unitrust or CRUT). These different payment structures result in different calculations for the present value. In either case, the present value of an income interest will be determined by the discount rate under IRC §7520 in effect at the time of the termination and the number of years until the trust’s original expiration date. In the event the payments were to be made for the lifetime of the beneficiary, the number of years is determined by IRS actuarial life expectancy tables.²

For CRATs, IRS Publication 1457 provides guidance and useful examples on how to use the IRS actuarial tables, if needed. It also includes the calculations required to arrive at the present value of the income interest. Specific to CRUTs, IRS Publication 1458 provides similar guidance and examples to calculate the present value of the income interest.

For early termination of a QTIP, the present value of the income interest is determined in the same fashion: by the discount rate under IRC §7520 and the life expectancy of the beneficiary, as determined by IRS actuarial tables. IRS Publication 1457 provides useful guidance in determining these values.

Final Thoughts

In addition to acquiring the data necessary to substantiate the qualified FMV of the trust’s underlying assets (e.g., account statements, tax filings, company financials, offering documents, real estate appraisals, etc.), an appraiser must have the beneficiaries’ trust agreement, date of birth, and date of trust termination. This information will enable them to select the appropriate factors within the applicable IRS actuarial tables. 

Accurately determining values for the early termination of a trust can be a complicated and challenging process. If you need help understanding the rules and considerations involved, Intrinsic can help. Our team has specialized experience helping clients at every knowledge level intelligently navigate the valuation complexities of early termination of QTIPs and CRTs.

¹Due to tax considerations that are beyond the scope of this article, even in the instance where all trust principal passes to the remainder, it will still be necessary to determine how much of the trust principal is attributable to the income interest, and how much is attributable to the remainder interest.

² The life expectancy tables can only be relied upon if the income beneficiary has no medical condition that would otherwise shorten their life expectancy.