IRS keeping close watch on popular estate planning tool.
Although many investment assets have lost value in the past year, individuals coming to CPAs for estate planning advice often hold highly appreciated assets, and many want to make significant charitable gifts. For that reason, charitable remainder trusts remain a popular method of reducing assets subject to estate tax. They allow donors an income stream from assets that also support a charity. Thus, it's not surprising that the IRS continues to place a high priority on regulating these vehicles.
CPA financial advisers should note three developments affecting charitable remainder trusts (CRTs) that occurred in the latter part of 2008.
First, the IRS and the Treasury Department issued final regulations modifying the Service's stance on the consequences of receipt of unrelated business taxable income (UBTI) by a CRT. Formerly, a CRT that received UBTI in any tax year was subject to tax for that year on its entire net income. However, for tax years beginning after Dec. 31, 2006, if a CRT has UBTI in any year, it retains its tax-exempt status but is liable for a 100% excise tax on its UBTI.
The Service also provided guidance on the tax consequences of a pro rata division of a CRT for the lives of two or more individuals.
In addition, the IRS labeled as a "transaction of interest" certain sales to a third party by grantors and remainder beneficiaries of their interests in a CRT that result in an artificially reduced gain claimed by the grantor from appreciated assets originally donated to the trust.
ADVANTAGES OF A CRT
By setting up a CRT, a donor can avoid currently paying tax on the disposition of appreciated assets and invest the sale proceedsto generate a future income stream. The donor forms a CRT and contributes assets (such as appreciated stock) to it. The donor receives an income tax charitable deduction (as well as a gift or estate charitable deduction) when the CRT is created. The amount of the deduction is measured by the actuarial present value of the charity's right to receive the corpus on termination of the noncharitable (remainder) interest. The CRT sells the stock but does not pay tax on the gain, because the CRT is generally a tax-exempt entity under IRC § 664(c). The CRT then invests the proceeds of the stock sale and pays the donor an income stream for a fixed term of years (or over the course of a life or lives), based either on the value of the assets at the time the trust is created (annuity trust) or a fixed percentage of asset value each year going forward (unitrust). Any gain is taxable to the income beneficiary only when it is distributed. On completion of the term, the CRT distributes the remaining assets to a charity, which can include a private foundation established by the donor. If the donor retains an interest in the trust for life, the assets remaining in the CRT at death are deductible for estate tax purposes.
Another type of charitable trust is the charitable lead trust (CLT), which pays an income stream to the charity on the front end, with a remainder interest payable to noncharitable beneficiaries. CLTs are generally used to minimize gift and estate tax.
CRT REQUIREMENTS
A CRT must make a minimum annual distribution of at least 5% of the fair market value (FMV) of the trust assets for either the lifetime of an individual or individuals or a term not to exceed 20 years. No distributions are permitted to any other individual, but a qualifying charity may in certain circumstances also receive income. Another individual or individuals can receive an interest for a term of years or for life following the first interest. However, state law may require that federal estate or state death taxes due upon the first beneficiary's death be equitably apportioned among the interests in the estate.
In such cases, in the absence of clear direction to the contrary in a decedent's will, the secondary beneficiary will lose the life estate unless the secondary beneficiary pays any estate or death taxes for which the trustee may be liable on the first beneficiary's death (Revenue Ruling 82-128, 1982-2 CB 71). After the term of years or on the death of the measuring individual, the remainder interest (the present value of which must be at least 10% of the initial FMV of assets on funding) must pass to a qualifying charity. The trust must operate according to these rules from its inception.
UBTI AND CRTs
Under IRC § 664(c), a CRT is a tax-exempt entity. For taxable years beginning before Jan. 1, 2007, section 664(c) provided that a CRT would not be tax-exempt for any year in which it had UBTI within the meaning of section 512. The Tax Relief and Health Care Act of 2006 (PL 109-432) ameliorated this result to provide that if a CRT had UBTI in any taxable year, the CRT would remain tax-exempt, but a 100% excise tax would be imposed on its UBTI. The amendment applies to taxable years beginning after Dec. 31, 2006.
The IRS on July 24, 2008, issued final regulations (TD 9403, amending Treas. Reg. § 1.664-1) to reflect this change. The final regulations also clarify that the excise tax imposed on a CRT with UBTI is treated as paid from corpus, and the trust income that is UBTI is income of the trust for purposes of determining the character of the annuity or unitrust payment made to the beneficiary under section 664(b). The effect is that UBTI is taxed twice—once when it is incurred by the CRT and a second time when it is paid to the annuity or unitrust recipient. The final regulations provide further examples illustrating the tax effects of UBTI on a CRT.
The amount of UBTI is determined pursuant to section 512, with various modifications set forth in section 512(b), including a $1,000 de minimis deduction (section 512(b)(12)).
PRO RATA DIVISION OF A CRT
Occasionally, two or more income recipients of a CRT will want to divide their interests into separate trusts, such as when a couple divorces. Questions that often arise include whether the division could constitute a transfer of remainder interest that would cause the trust or separate trusts to fail to qualify as CRTs. The IRS addressed this and other issues in Revenue Ruling 2008-41, 2008-30 IRB 170, released in July 2008. In it, the IRS set forth two scenarios providing for the pro rata division of a CRT and addressed five questions associated with the division. The revenue ruling essentially consolidated issues that have been the subject of many previous private letter rulings.
In the first scenario, the CRT ("original CRT") provides for the payment of an annuity or unitrust amount ("payment") for the lives of two or more individuals. When one individual dies, the remaining individuals are entitled to the entire payment. Upon the death of the last survivor of the payment recipients, the original CRT is to distribute its remaining assets to its charitable remainder beneficiary. The state court having jurisdiction over the original CRT has approved a pro rata distribution of the original CRT's assets into separate CRTs ("new CRTs"), one for each payment recipient. For purposes of the character of distributions from the new CRTs to the payment recipients, each new CRT will have an equal share of the original CRT's income in each tier described in section 664(b).
The trust instruments of the new CRTs will generally have the same provisions of the original CRT with some changes, the most significant of which is that upon the death of a payment recipient, the new CRT of such recipient is to be divided equally among the remaining living recipients until the last recipient has died. At that time, the new CRT will terminate and distribute its assets to the charitable remainder beneficiary.
The second scenario is similar to the first scenario, except that the pro rata distribution is pursuant to a divorce and, upon the death of a payment recipient, the new CRT for such recipient is distributed to the remainder beneficiary (not the surviving payment recipient).
First, the IRS addressed whether the pro rata division causes the new CRTs to fail to qualify as CRTs under section 664(d). The IRS reasoned that the new CRTs generally operate in the same manner as the original CRT, with slight modifications to mirror the result in the original CRT. It noted that after the original CRT's pro rata division, the new CRTs continue to meet the definition of a CRT in section 664(d). Therefore, the new CRTs do not fail to qualify as CRTs under section 664(d).
Next, the IRS addressed the basis and holding period of the assets of the new CRTs. The IRS noted that the pro rata division of the CRT is not a sale or exchange. Therefore, under section 1015(b), the bases of the assets in the original CRT are "carried over" to the bases of the assets in the new CRTs, and under section 1223(2), the holding period of the assets in the original CRT "tack" to the holding period of the assets in the new CRTs.
Another common concern is whether the pro rata division of the original CRT terminates the CRT, subjecting it to the termination tax of section 507. The IRS noted that the new CRTs generally have the same governing provisions and beneficiaries of the original CRT, and the termination tax of section 507 does not apply.
The IRS also addressed whether the pro rata division of the original CRT results in self-dealing under section 4941(d) by the payment recipients. The IRS noted that because the payment beneficiaries receive a payment from the new CRTs equivalent to what they would have received under the original CRT, the pro rata division of the original CRT is not an act of self-dealing under section 4941(d).
Finally, the IRS addressed whether the pro rata division of the original CRT is a taxable expenditure under section 4945(d) and subject to the excise tax of section 4945(a). The IRS ruled that because the costs of the pro rata division of the CRT will be borne by the payment recipients, there is not a taxable expenditure to the original CRT that would be subject to the tax of section 4945(a).
A CRT "TRANSACTION OF INTEREST"
Certain transactions involving a CRT that the IRS considers as manipulating the uniform basis rules may be deemed to have a potential for abuse and avoidance of tax on gain from the sale of appreciated assets. In Notice 2008-99, 2008-47 IRB 1194, the IRS described such a transaction involving the creation of a CRT and the subsequent sale of the interests in the CRT to a third party. Because of the potential for tax avoidance, the IRS has labeled it and substantially similar transactions "transactions of interest" for purposes of Treas. Reg. § 1.6011-4(b)(6).
In the first part of the transaction, a taxpayer creates a CRT pursuant to section 664 by transferring highly appreciated, low-basis assets to the CRT and taking back an annuity or unitrust interest. The taxpayer gives the remainder interest to a charity. The taxpayer will usually receive an income tax charitable deduction under section 170 for the present value of the remainder interest transferred to charity, as with any CRT. Next, the CRT will sell the appreciated assets and invest the proceeds in a diversified portfolio. Because the CRT is a tax-exempt entity, it will not recognize gain on the sale of the appreciated assets. The taxpayer will recognize the gain as he or she receives annuity or unitrust payments.
In the second part of the transaction, the taxpayer and the charity sell their interests in the CRT to a third party for an amount that approximates the fair market value of the assets held by the CRT. Under section 1001(e), if a taxpayer disposes of an income interest (for example, an annuity or unitrust interest) in a trust, any adjusted basis the taxpayer may have in such interest is disregarded in determining the gain or loss from the disposition of the interest.
An exception applies when the disposition of the income interest is part of a transaction in which the entire interest in the property is transferred to a third party. In such case, Treas. Reg. § 1.1001-1(f)(3) provides that the uniform basis rules under Treas. Reg. §§ 1.1014-5 and 1.1015-1(b) apply. Under these rules, the bases of the assets in the CRT are apportioned between the income and remainder interests. Thus, when the taxpayer sells his or her annuity or unitrust interest in the CRT, gain will be determined by the difference between the proceeds received from the sale and the basis the taxpayer derives from the assets in the CRT. The taxpayer claims this provision and calculates any gain on the basis of the new assets rather than the original ones.
In effect, the sale eliminates much of the gain from the sale of the highly appreciated, low-basis assets the taxpayer would have otherwise recognized upon receiving an annuity or unitrust payment from the CRT. CPAs who act as material advisers with respect to these and substantially similar transactions could be subject to penalties if they fail to maintain lists of persons they so advise and to provide such lists to the IRS upon request.
A RESERVOIR OF WEALTH AND PHILANTHROPY
While the number of CRTs was relatively static at 115,754 in 2007—down slightly from the year before—the value of assets within them was considerable at nearly $96 billion in 2007, an increase of nearly 8% over 2006 ("Split-Interest Trusts, Filing Year 2007," IRS Statistics of Income Bulletin, tinyurl.com/ck9s8d). These figures attest to the value of CRTs in providing clients with an income stream while assuring long-term resources for philanthropic concerns. At the individual level, CRTs remain an attractive vehicle for clients. Clients are likely to appreciate advisers' efforts to keep them informed about provisions that could affect their income interests as well as their charitable goals.
EXECUTIVE SUMMARY
Charitable remainder trusts (CRTs) are a favored way for donors to receive a charitable deduction of the present value of a future donation while retaining an annuity or unitrust income.
CPA tax advisers should be aware of recent guidance on CRTs concerning unrelated business taxable income (UBTI), pro rata division of CRTs and a type of transaction involving a CRT that the Service has designated a "transaction of interest."
The IRS issued final regulations modifying the regime for UBTI received by CRTs. For tax years beginning after Dec. 31, 2006, a CRT that receives UBTI in a tax year is liable for a 100% excise tax on UBTI but retains its tax-exempt status.
In a revenue ruling, the IRS addressed pro rata division of a CRT with two or more income recipients into new trusts. Generally, CRTs may be divided without termination or other penalties and the bases of assets carried over to the new trusts.
In the "transaction of interest," a CRT with highly appreciated, low-basis assets sells them and replaces them with new assets. The income and charitable beneficiaries then sell their interests in the CRT to a third party. The income beneficiary recognizes little or no gain on the transaction by claiming an exception to the no-basis rule of IRC § 1001(e).
Justin P. Ransome (justin.ransome@gt.com) is a partner in Private Wealth Services in Grant Thornton LLP's National Tax Office in Washington. Vinu Satchit (vinny.satchit@gt.com) is a senior manager in Private Wealth Services, Grant Thornton LLP, in Charlotte, N.C. A longer version of this article, "Significant Recent Developments in Estate Planning," appeared in the September 2009 issue of The Tax Adviser.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.
AICPA RESOURCES
CPE
Advanced Estate Planning: Practical Strategies for Your Clients, a CPE self-study course (#737120)
The Tax Adviser and Tax Section
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PFP Center and PFS Credential
Membership in the Personal Financial Planning (PFP) Section provides access to specialized resources in the area of personal financial planning, including complimentary access to Forefield Advisor. Visit the PFP Center at aicpa.org/PFP. Members with a specialization in personal financial planning may be interested in applying for the Personal Financial Specialist (PFS) credential. Information about the PFS credential is also available at aicpa.org/PFP.
OTHER RESOURCES
IRS Guidance
- Notice 2008-99, 2008-47 IRB 1194
- Revenue Ruling 2008-41, 2008-30 IRB 170
- Revenue Ruling 82-128, 1982-2 CB 71
- Treasury Decision 9403
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