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]
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
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
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.
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.
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.
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,
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.
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
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.
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.
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:
In 1995, the Service instructed its staff to examine “accelerated”
CRUTs having the following elements:
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.
See ¶ 4.02[1].
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.
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)
.
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 .
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.
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.
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.
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.
See generally N.
Lane & H. Zaritsky, Federal Income Taxation of
Estates and Trusts, ch. 15 (Warren, Gorham &
Lamont, 3d ed. 2000).
1994-2 CB 55.
Citing Gregory
v. Helvering, 293 US 465 (1935) .
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) .
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.
IRC
§§ 664(d)(1)(A), 664(d)(1)(D),
664(d)(2)(A),
664(d)(2)(D)
; TRA '97, § 1089.
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).
TD 8926, 66 Fed. Reg.
1,034–1,038 (Jan. 5, 2001).
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