IRS has issued
final regs on the ordering rules of Code
Sec. 664(b) for
characterizing distributions from charitable remainder trusts (CRTs). The regs, which adopt proposed regs
issued in 2003 with some revisions, reflect the favorable rates for capital
gains and qualified dividend income carried in the 2003 Jobs and Growth Act. ( T.D.
9190, 03/15/2005 ; Reg.
§ 1.664-1 )
Background. A CRT makes
distributions to one or more noncharitable
beneficiaries for a predetermined period, and then pays the remainder to a
charity. Amounts paid to an income beneficiary of such a trust retain the
character they had in the hands of the trust, with this qualification: each
payment is treated as consisting of:
(1) ordinary income,
to the extent of the trust's ordinary income for that year and undistributed
ordinary income for earlier years;
(2) capital gain, to
the extent of capital gain for that year and undistributed capital gain
(determined on a cumulative net basis) for earlier years;
(3) other income
(e.g., tax-exempt interest), to the extent of that income for that year and
undistributed amounts for earlier years; and
(4) trust corpus. (
Code Sec. 664(b) )
The
guiding principle of Code
Sec. 664(b) is that
income subject to the highest tax rate is deemed distributed before income
subject to a lower (or zero) tax rate. The pre-existing final regs followed this principle by providing that short-term
capital gain was deemed distributed before any long-term capital gain.
After the
enactment of the '97 TRA, different types of long-term capital gains became
subject to different tax rates. In Notice
98-20, 1998-1 CB 776 (see Estate
Planners Alert ¶ 1 4/7/1998 ) and Notice
99-17, 1999-1 CB 871 (see Estate
Planners Alert ¶ 2 4/6/1999 ), IRS
explained how capital gains should be treated under the ordering rules for CRTs
in light of the changes made by the '97 TRA, and technical corrections made by
the Internal Revenue Service Restructuring and Reform Act of 1998.
For tax years
beginning after 2002, the 2003 Jobs and Growth Act taxes qualified dividend
income at the same rates that apply to long-term capital gains. Because
dividends represent one type of ordinary income, different types of ordinary
income thus are subject to different federal income tax rates.
Final
regs reflect different income tax rates that apply to
items of income assigned to same category. The final regs take into account differences in the income tax rates
that apply to items of income assigned to the same category under the Code
Sec. 664(b) ordering rules. The trust's
income is assigned, in the year it is required to be taken into account by the
trust, to one of three categories: the ordinary income category, the capital
gains category, or the “other income” category. (
Reg. § 1.664-1(d)(1)(i)(a) )
Within the
ordinary income and capital gains categories, items also are assigned to
different classes based on the income tax rate applicable to each type of
income in the category in the year the items are required to be taken into
account by the trust. For example, for a trust with a tax year ending December
31, 2004, the ordinary income category may include a class of qualified
dividend income as defined in Code
Sec. 1(h)(11) , and a class of all other
ordinary income. The capital gains category may include separate classes for
short-term and long-term capital gains and losses, such as a short-term capital
gain class, a 28% long-term capital gain class (gains and losses from
collectibles and Code
Sec. 1202 gains), and an unrecaptured Code
Sec. 1250 long-term capital gain class. (
Reg. § 1.664-1(d)(1)(i)(b) )
The regs treat a CRT distribution as being made from the
categories in the following order: ordinary income, capital gain, other income,
and trust corpus. Within the ordinary income and capital gains categories,
income is treated as distributed from the classes of income in that category
beginning with the class subject to the highest income tax rate and ending with
the class subject to the lowest income tax rate. (
Reg. § 1.664-1(d)(1)(ii) ) The determination of the character of amounts
distributed or deemed distributed at any time during the tax year of the trust
is made as of the end of that tax year. (
Reg. § 1.664-1(d)(1)(ii)(a) )
The tax rates
to be used in computing the recipient's tax on the distribution are those that
apply, in the year in which the distribution is required to be made, to the
classes of income deemed to make up that distribution, and not the tax rates
that apply to those classes of income in the year the income is received by the
trust. (
Reg. § 1.664-1(d)(1)(ii)(a) )
The regs provide rules for netting different classes of capital
gains and losses. Under these rules, for each tax year, current and
undistributed gains and losses within each class are netted to determine the
net gain or loss for that class, and the classes of capital gains and losses
are then netted against each other in an order specified in the regs. (
Reg. § 1.664-1(d)(1)(iv) )
An example
has been added to the final regs to address (1) the
end result of a short-term capital loss and a combination of long-term capital
gains and losses that net to a long-term capital loss and (2) the end result
when a class of income has a net-loss amount that is carried forward without
affecting the tax character of distributions. (
Reg. § 1.664-1(d)(1)(viii) , Example 4)
Effective dates. Most provisions in the
regs were adapted from earlier guidance and apply for
tax years ending on or after December 31, 1998. However, some provisions apply
for tax years ending after November 20, 2003. (
Reg. § 1.664-1(d)(1)(ix) )