Treasury Issues Ordering Rules for Distributions From Charitable Remainder Trusts

In Reg. § 1.664-1(d) , (March 16, 2005), the Treasury issued new ordering rules for characterizing distributions from charitable remainder trusts. The regulations assign all items of trust income to one of three categories in the year in which it must be taken into account by the trust. These categories are gross income, gains and amounts treated as gains from the sale or other disposition of capital assets, and other income (including tax-exempt income). Distributions are first taxed as gross income, to the extent of current and undistributed gross income, then as capital gains and losses, to the extent of current and undistributed capital gains and losses, and then as other income. Items within each category are assigned to different classes, based on their highest potential income tax rate, and the higher-rate items are taxed first. Separate classes are maintained for income that is temporarily taxed at a more favorable rate, such as when the 28 percent long-term capital gain class is taxed at 15 percent during a temporary period. Generally, these rules apply to tax years ending after November 20, 2003, but certain provisions attributable to Notice 98-20, 1998-1 CB 776 and Notice 99-17, 1999-1 CB 871 (relating to certain types of capital gains and losses, apply to tax years beginning after 1998.

For more on the ordering rules for charitable remainder trust distributions, see

Colliton: Charitable Gifts ¶  6.16[1]

Esperti & Peterson: Irrevocable Trusts ¶  10.07[1]

Henkel: Estate Planning and Wealth Preservation ¶  33.05[1]

Westfall & Mair: Estate Planning Law and Taxation ¶  19.06[3][b]

Zaritsky: Federal Income Tax Estates & Trusts ¶  14.03[6][b][i]

 

 

 

¶ 10.07 Taxation of Payments to the Recipients

Payments of the annuity amount or the unitrust amount may be taxable to the recipients. Normally, the Code determines tax on distributions to beneficiaries from a complex trust under the distributable net income (DNI) rules. 240 However, these rules do not apply to CRTs. Instead, the tax characteristics of distributions from CRTs are determined and taxed under a special four-tiered accounting system that is unique to CRTs. 241

¶ 10.07[1] Four-Tiered Accounting System

Under the four-tiered system, payments of ordinary income, short-term capital gain income, long-term capital gain income, all other types of income earned by the trust, and any returns of trust principal are allocated to the annuity amount or the unitrust amount in the following order of priority:   First Tier.   All amounts distributed to the recipients are characterized and taxed as ordinary income to the extent of trust ordinary income for the year and undistributed ordinary income for past years. 242   Second Tier.   If the payout amount (i.e., the annuity amount or the unitrust amount) exceeds the total amount of ordinary income for the current year or accumulated ordinary income from past years, capital gain income is distributed to the extent of the trust capital gain income for the year and undistributed capital gain income for prior years. 243   Third Tier.   If the payout amount exceeds the total of current and accumulated ordinary income and capital gain income for the year of distribution, then other income is distributed to the extent of the trust's other income for the year and such income that is undistributed for prior years. 244   Fourth Tier.   If any portion of the payout amount in a given year exceeds the sum of current and accumulated income and gains, the balance is treated as a distribution of principal. 245

Distributions that the trustee allocates to the annuity amount or the unitrust amount under the four-tiered system have the same characteristics in the hands of the recipient whether or not the trust is subject to tax because of UBTI and without any credit for taxes imposed on the trust. 246

¶ 10.07[2] Purpose of the Four-Tiered Accounting System

Although complex, the four-tiered system has a straightforward purpose: It forces the recipients to pay the highest possible income tax on their distributions. Each year, the trustee must account for all four distribution categories and completely distribute all of the historical value of one category before distributing the next category. Income subject to the highest potential federal tax rates is deemed to be distributed first; income subject to the second highest potential federal tax rates is deemed to be distributed second; income not subject to the federal income tax but subject to the alternative minimum tax is deemed to be distributed third; and completely nontaxable principal is deemed to be distributed last. This system is sometimes called the “worst in, worst out” method of income tax accounting. The practical impact of these rules is shown in the following example.

Example  10-14

On January 1, 1997, Todd creates a CRAT paying $5,000 to him each year.   Tax Character of Distributions for 1997.   Assume that the CRAT income for 1997 consists of $2,000 in dividends, $1,000 in interest from tax-free municipal bonds, and long-term capital gain of $1,000 on the sale of some stock. Todd's income is characterized as $2,000 ordinary income, $1,000 long-term capital gain, $1,000 tax-free income, and $1,000 return of principal.   Tax Character of Distributions for 1998.   Assume that the CRAT income for 1998 consists of $6,000 in dividends, $500 in tax-exempt interest, and $1,000 in long-term capital gain on another sale of stock. Todd's income for 1998 is all ordinary income.   Tax Character of Distributions for 1999.   Assume that the CRAT income for 1999 consists of $2,000 in dividends and $500 interest from tax-free municipal bonds. Todd's income is characterized as $3,000 ordinary income ($2,000 in dividends from 1999 plus $1,000 in undistributed dividends from 1998); $1,000 long-term capital gain (undistributed in 1998), and $1,000 tax-free interest ($500 received by the trust in 1999 plus $500 undistributed in 1998).

The one exception to this “worst in, worst out” method of income accounting relates to qualifying dividends. Under Section 1(h), the 15 percent maximum long-term capital gain rate applies to qualifying dividends but the Code does not treat such dividend income as a capital gain. As a result, qualifying dividend income would fall under the ordinary income category and thus come out before short-term capital gains, which are taxed at a higher rate than qualifying dividend income.

¶ 10.07[3] Pro-Rata Distributions

If there is more than one current recipient, each recipient is deemed to receive a pro-rata share of each category of income and principal distributed under the four-tiered order of distribution. 247 This concept is illustrated in the following example.

Example  10-15

Gary Fester creates a CRAT that pays an annuity amount of $50,000 each year to him and his sister, Paula. The trust allocates 75 percent of each annuity amount payment to Gary and 25 percent to Paula. In the current year, the annuity amount consists of $35,000 in ordinary income, $10,000 in long-term capital gain income, and $5,000 in tax-exempt income. For 1997, Gary must report $26,250 as ordinary income (75 percent of $35,000), $7,500 as long-term capital gain income (75 percent of $10,000), and $3,750 as tax-exempt income (75 percent of $5,000). For 1997, Paula will report $9,750 as ordinary income, $2,500 as long-term capital gain income, and $1,250 as tax-exempt income.

¶ 10.07[4] Year of Inclusion

Income attributable to annuity amounts or unitrust amounts is deemed to be distributed on the last day of the tax year in which the trust was required to make the distribution, although the trustee may actually make the distribution after the close of the year. 248 The following example shows how this distribution is made.

Example  10-16

In 1997, Georgette is the sole recipient of a CRAT that pays an annuity amount of $10,000 per year, payable in quarterly installments of $2,500 at the end of each quarter. The payments are actually distributed by the trustee on April 3, 1997, July 5, 1997, October 4. 1997, and January 4, 1998. Georgette must include all these payments on her 1997 tax return because all the payments are deemed to be made in 1997.

An exception applies for the year in which the recipient dies. For that year, a cash basis recipient's gross income for his or her last taxable year includes only amounts actually distributed to the recipient before his or her death. 249 Amounts that are required to be distributed to the recipient before his or her death but that are distributed to the recipient's estate are includable in the estate's gross income as “income in respect of a decedent.” 250

¶ 10.07[5] Distributions in Kind

A distribution in kind rather than a cash payment may be used to satisfy the annuity amount or the unitrust amount. Where an in-kind distribution is made, the FMV of the property distributed is treated as an amount received by the trust from a sale of the property. 251 Any gains or losses the trust is deemed to recognize are taken into account in computing the character of the income received by the recipient under the four-tiered tax accounting system. The recipient's basis in the received property is the FMV of the property on the date the distribution was paid, credited, or required to be distributed. 252 A distribution in kind used to satisfy a unitrust amount rather than a cash payment is illustrated in the example that follows.

Example  10-17

A CRUT is required to distribute a unitrust amount equal to $60,000 to Ken in 1997. The trust has no undistributed gains or income from prior years under the four-tiered system. In satisfaction of the unitrust amount, the trustee distributes to Ken $10,000 in cash and stock with a FMV of $50,000 and a cost basis of $10,000. The trust is deemed to recognize a gain of $40,000 for the stock. Ken is deemed to receive $10,000 ordinary income, $40,000 in capital gain income, and $10,000 in principal.

¶ 10.07[6] Abusive Use of the Four-Tiered System

The Service will challenge CRTs that use the four-tiered system in an abusive manner. In Notice 94-78, 253 the Service stated:

In these transactions, appreciated assets are transferred to a short-term charitable remainder trust that has a high percentage unitrust amount. For example, assume that capital assets with a value of $1 million and a zero basis are contributed to the trust on January 1. Assume further that the assets pay no income and that the term of the trust is 2 years. The unitrust amount is set at 80% of the fair market value of the trust assets valued annually.

The unitrust amount required to be paid for the first year is $800,000, but during the first year no actual distributions are made from the trust to the donor as the recipient of the unitrust amount. At the beginning of the second year, all the assets are sold for $1 million, and the $800,000 unitrust amount for the first year is distributed to the donor between January 1 and April 15 of the second year. The unitrust amount for the second year is $160,000 (80% times the $200,000 net fair market value of the trust assets). At the end of the second year, the trust terminates, and $40,000 is paid to a charitable organization. Proponents of this transaction contend that the tax treatment of this example would be as follows. Because no assets are actually sold or distributed to the donor during the first year, the entire $800,000 unitrust amount is characterized as a distribution of trust corpus under section 664(b)(4) of the Internal Revenue Code. The $160,000 unitrust amount for the second year is characterized as capital gain, on which the donor pays tax of $44,800 ($160,000 times the 28% tax rate for capital gains). The donor is left with net cash of $915,000 ($800,000 from the first year and $115,200 net from the second year). If the donor had sold the assets directly, the donor would have paid tax of $280,0000 on the $1 million capital gain, and would have net cash of only $720,000.

The Service announced that it will attack this type of transaction, because “[a] mechanical and literal application of [the regulations] would yield a result inconsistent with the purposes of the charitable remainder trust.” 254 Three theories under which the Service will deny qualification of the trust as a CRT trust were identified in Notice 94-78:

  • The form of the transaction will not be recognized as a sale by a tax-exempt trust; 255
  • The gain on the sale will be treated as income to the donor under the theory that the income of one person cannot be assigned to another for tax purposes; 256 and
  • The transaction may involve a violation of the self-dealing rules because postponement of the sale of trust assets beyond the first year might be using the trust assets for the benefit of the donor.

In 1995, the Service instructed its staff to examine “accelerated” CRUTs having the following elements:

  • The CRUT has a short period of legal life, usually two or three years;
  • A very high fixed percentage, usually around 80 percent, is used to determine the payment to the noncharitable beneficiary/donor;
  • The assets transferred to the CRUT are comprised of appreciated assets (e.g., stocks, land);
  • The assets usually produce little or no ordinary income;
  • Payment to the beneficiary for the first year is not made during that first year of the CRUT's legal life;
  • The assets are sold for cash at the beginning of the second year of the CRUT's legal life; and
  • Payment to the beneficiary for the first year is made in the second year but before the April 15 deadline for filing Form 5227. 257

For trusts created after June 28, 1997, Congress has eliminated the accelerated CRUT as a planning technique. The annuity or unitrust payout rate cannot be more than 50 percent, and the present value of the remainder interest must be at least 10 percent of the value of all property transferred to the trust. 258 Under the new statutory scheme, the CRUT described in Notice 94-78 would have failed both standards. 259

The Service has uncovered another abuse of the Section 664 accounting system that is similar to the accelerated CRT scenario described above. In this transaction, the maker establishes a short-term CRT with a fairly high payout rate and funds it with highly appreciated assets. The trustee then makes a forward sale of the trust assets, borrows against the assets, or enters into a similar transaction that is not treated as a sale or exchange of the trust assets but brings in a substantial amount of cash. The trustee uses the cash to make annuity or unitrust payments. Because the trust does not recognize taxable gain upon entering into the forward sale or loan transaction, assuming the trust has no other income for the year, the payment to the maker is treated as a tax-free return of corpus. The trustee closes the forward sale or sells the assets to repay the loan in the trust's final year or distributes the assets to the charitable remainderman subject to the loan or forward sale agreement. The result of these events is that the maker is effectively able to convert the highly-appreciated assets into cash without paying capital gains tax.

Needless to say, the Service is most unhappy about this abuse of Section 664 and to stop it issued a regulation in January 2001. 259.1 The regulation provides that a CRT will be treated as having sold a pro rata amount of trust assets during the year to the extent that an annuity or unitrust distribution (1) is not treated as income in the hands of the recipient under Section 664(b) (without the application of this new rule), and (2) such distribution was made from an amount that is neither a return of basis in a sold asset nor attributable to a cash contribution to the trust that qualifies for a charitable tax deduction. For purposes of this new rule, “trust assets” does not include cash or property purchased with the proceeds of a loan, forward sales contract, or similar transaction. The regulation applies to all CRT distributions made after October 18, 1999.


240

  See ¶ 4.02[1].


241

  IRC § 664(b). In Private Letter Ruling 200314021, the Service held that an early termination of a CRUT did not fall under the provisions of the four-tiered accounting system. The taxpayer wanted to terminate his CRUT, allowing the charity to receive its share and the taxpayer to receive the present value of his income interest. The Service held that the transaction was really a sale of his interest in the trust to the charitable remainderman. Thus, Section 1001(c) rather than Section 664(b) applied; the taxpayer would be taxed on the proceeds as a long-term capital gain, but would have a zero basis in his interest. The Service also held that the transaction would not be an act of self-dealing within the meaning of Section 4941. See also Priv. Ltr. Rul. 200310024, dealing with the partial termination of a CRUT with net income make-up provisions.


242

  IRC § 664(b)(1); Reg. § 1.664-1(d)(1)(ii)(1) . An ordinary loss for the current year is used to reduce undistributed ordinary income for prior years, and the excess is carried forward indefinitely to reduce ordinary income in future years. Income for any current or prior year is calculated without regard for any deduction for net operating losses under Sections 172 and 642(d) .


243

  IRC § 664(b)(2); Reg. § 1.664-1(d)(1)(ii)(2) . These capital gains are generated by the sale or exchange of capital assets by the trust. If a trust has both undistributed long- and short-term capital gain, the short-term capital gain is deemed to be distributed before any long-term capital gain. Gains and losses are determined annually. Excess losses are carried forward and retain their character as do excess gains, the latter to the extent they are not deemed to be distributed. See Notice 98-20, 1998-13 IRB 25; Notice 99-17, 1999-14 IRB 6 .


244

  IRC § 664(b)(3); Reg. § 1.664-1(d)(1)(ii)(3) . “Other income” generally means tax-exempt income determined under Sections 101 through 123.


245

  IRC § 664(b)(3); Reg. § 1.664-1(d)(1)(ii)(4) . Principal (corpus) is the net FMV of the trust assets, less any undistributed trust income, without adjustment for capital losses.


246

  Reg. § 1.664-1(d)(1)(ii) . The determination of the tax character of the distributions is determined at the end of the tax year. Reg. § 1.664-1(d)(1)(ii). A CRT is allowed most of the deductions permitted other types of trusts, except for the personal exemption, the deduction for amounts paid to charity, the deduction for distributions, and the deduction for capital gains. Allowable deductions generated by the trust directly attributable to a category of income or principal within the tiers is allocated to that category. Reg. § 1.664-1(d)(2). For example, deductions directly attributable to short-term capital gain income are allocated to short-term capital gains. If an allowable deduction is not directly attributable to any particular category of income or principal, the deduction is allocated among all the classes of items within the categories (except classes with net losses) on the basis of the gross income of each category for the year. This amount is reduced by the deductions that were directly attributable to items within a category. The deductions cannot exceed the income of the class for the taxable year. Private foundation excise taxes and taxes on UBTI are allocated to principal.


247

  Reg. § 1.664-1(d)(3).


248

  Reg. § 1.664-1(d)(4)(i). See supra ¶¶ 10.03[5] and 10.04[5] regarding payment of annuity and unitrust amounts after the close of the taxable year.


249

  Reg. § 1.664-1(d)(4)(iii)


250

  See generally N. Lane & H. Zaritsky, Federal Income Taxation of Estates and Trusts, ch. 15 (Warren, Gorham & Lamont, 3d ed. 2000).


251

  Reg. § 1.664-1(d)(5).


252

  Reg. § 1.664-1(d)(5).


253

  1994-2 CB 55 .


254

  1994-2 CB 55.


255

  Citing Gregory v. Helvering, 293 US 465 (1935) .


256

  Citing Comm'r v. Court Holding Co., 324 US 331 (1945) ; Malkan v. Comm'r, 54 TC 1305 (1970), acq., 1971-2 CB 3 ; Applestein Estate v. Comm'r, 80 TC 331 (1983) .


257

  Topic G, “Self-Dealing and Other Tax Issues Involving Charitable Remainder Unitrusts,” 1995 (for FY 1996) Exempt Organizations CPE Technical Instruction Program Textbook at 173–174.


258

  IRC §§ 664(d)(1)(A), 664(d)(1)(D), 664(d)(2)(A), 664(d)(2)(D) ; TRA '97, § 1089.


259

  The Treasury also joined the effort against accelerated unitrusts by issuing proposed regulations designed to eliminate the tax benefits of such plans. The proposed regulations require that CRATs and CRUTs make all distributions of the annuity amount or the unitrust amount prior to the close of the tax year in which the payment is due. Prop. Reg. §§ 1.664-2(a)(1)(i) , 1.664-3(e).


259.1

  TD 8926, 66 Fed. Reg. 1,034–1,038 (Jan. 5, 2001).

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