Inter vivos charitable remainder trusts (CRTs) are often advantageous alternatives to bequests to charity. Unlike charitable gifts by will, CRTs can generate life income and income tax charitable deductions. Most estates aren’t subject to tax; for those that are, estate taxes are also saved by lifetime CRTs.
Inter vivos CRTs provide life income to the donor and/or others, favorable taxation of life income payments and reduce or eliminate capital gains taxation on changing appreciated investments.
But there’s an ugly side to CRTs involving off-the-wall and unethical schemes using charitable remainder annuity trusts (CRATs). The Internal Revenue Service is cracking down on these abusive tax schemes using CRATs to ostensibly avoid federal income tax on the sale of appreciated assets.1
Farmer’s Tax Scheme
If there were an Internal Revenue Code Section E-I-E-I-O, the farmers in this case would have been forewarned not to fall for a colossal tax scheme that provided not tax benefits, but tax losses and penalties. Donald and Rita Furrer were actively engaged in the farming business from 2015 to 2017. They grew and sold corn and soybeans. In
July 2015, after reading an advertisement in a farming magazine, they formed the Donald & Rita Furrer Charitable Remainder Annuity Trust of 2015 (CRAT I), naming their son as trustee. The Furrers are the life beneficiaries, and three IRC Section 501(c)(3) charities are the remainder organizations. They funded CRAT I with 100,000 bushels of corn and 10,000 of soybeans grown on their farm.
CRAT I sold the crops for $469,003 and then distributed $47,000 of the sales proceeds to one of the charitable remainder organizations. The balance was used to purchase a single premium immediate annuity (SPIA), which, in turn, paid out $84,368 annual annuity payments to the Furrers from 2015 to 2017. Each year, the annuity company issued a Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. The forms listed the annuity payments as “gross deductions” and showed a small amount of interest as the “taxable amount.” In 2016, the Furrers created a second CRAT (CRAT II) using the same technique (scam).
In 2015 and 2016, the Furrers claimed charitable contribution deductions for cash gifts, but didn’t claim deductions for their in-kind crop transfers to the CRATs. On each return, they reported interest income from the SPIA as shown on the Form 1099-R issued to the trustee. But they didn’t report the balance of the annuity distributions, maintaining those payments constituted a nontaxable return of corpus under IRC Section 664(b)(4).
While the Furrers filed Form 709, United States Gift (and Generation-Skipping Transfer) tax return, Form 5227 and Form 4797 for each CRAT, the IRS audited their 2015 to 2017 returns and increased their farm income for each of the three years. The IRS also sent the Furrers a timely notice of deficiency determining deficiencies for each of the three years.
The Tax Court considered whether the Furrers were entitled to noncash charitable contribution deductions for 2015 and 2016 and whether the CRAT annuity distributions were taxable to the Furrers as ordinary income from 2015 to 2017. The IRS carried its burden, and the Tax Court disallowed the Furrers’ deductions. The court also provided an excellent primer on the taxability of CRAT distributions.
CRAT I and CRAT II sold the corn and soybeans transferred to them for $469,003 and $691,827, respectively. Because each CRAT had a basis of zero in the crops, they realized profits of $469,003 and $691,827, respectively. Under the statutory ordering rules, annuity amounts distributed by a CRAT to its life beneficiaries are treated first as ordinary income, to the extent of the CRAT’s ordinary income. CRAT I and CRAT II thus realized ordinary income of $469,003 and $691,827, respectively on sale of the crops, just as the Furrers would have done had they sold the crops themselves. Even if the corn and soybeans were considered capital assets in the CRATs’ hands, the CRATs sold the crops a few months after receiving them. The gains realized by the CRATs would thus be short-term capital gains taxable at ordinary income rates.2
The Furrers tried to claim the CRATs acquired a stepped-up basis, rather than a zero basis, in the corn and soybeans. They contended that they sold the crops to the CRATs, so the CRATs acquired a “cost basis” under IRC Section 1012. In response, the Judge noted that the Furrers’ argument didn’t even “pass the straight-face test.”3 As evidenced by the filing of gift tax returns, the Furrers contributed the crops to the CRATs. There was no evidence of any consideration that could give rise to a sale or exchange.
Gain Disappearing Act
In a different case,4 the Gerhardts learned about a tax CRAT scheme from John Eickhoff, an advisor with Hoffman Associates, LLC and a licensed insurance agent. Like the Furrers, they contributed substantially appreciated assets—real estate this time instead of crops—to a CRAT. The CRAT later sold the assets and used the sale proceeds to purchase a SPIA. The annuity payments, in turn, were then paid to the Gerhardts. The CRAT reported no taxable gain, the Gerhardts claiming that the sale of the appreciated property and the annuity payments were entirely free from federal income tax. The Tax Court quickly dismissed the Gerhardts’ position, reasoning that while a CRAT is statutorily exempt from income tax, the annuity payments made to the noncharitable beneficiaries carry out income taxable at the beneficiary level. Thus, the annuity payments carried out taxable income, which should have been recognized by the CRAT when the real property was sold. The court described the “gain disappearing act the Gerhardts attribute to the CRATs” as “worthy of a Penn and Teller magic show” but without any “support in the Code, regulations, or caselaw.”5 Accordingly, the Gerhardts should have paid income tax on that taxable income.6
In February 2022, the Justice Department filed a complaint against Eickhoff, Hoffman Associates LLC and others for promoting abusive tax schemes. According to the Justice Department, Eickhoff and his co-schemers caused about $40 million of taxable income to go unreported and a total loss of about $8 million in potential tax revenue for the Treasury.7 This May, the U.S. District Court for the Western District of Missouri permanently enjoined Hoffman Associates from operating. It had to pay a $1.1 million judgment, and Eickhoff personally had to pay $400,000 and was permanently barred from marketing CRTs.8
Eickhoff was ordered to be a whistleblower and required to identify all of his customers who took part in the abusive scheme.
An IRS News Release followed up with a clear warning to others considering the CRAT scheme: Don’t do it. The IRS also reminded taxpayers not to rely on their tax advisors when taking risky positions. They’re ultimately responsible for what’s on their returns.9
Law-Abiding Professionals
“The evil that men do lives after them; The good is oft interred with the bones.”10The two cases we’ve discussed and the IRS’ widely disseminated publicity about the abusive schemes to avoid capital gains taxes, generate large charitable deductions and sell annuities by promoters of the scheme can put a damper on the 99.9% of CRATs and charitable remainder unitrusts (CRUTs) that have since 1970 been a mainstay of planned-giving programs of our nation’s charities.
In the next two issues of Trusts & Estates, we’ll detail the income, capital gains, gift and estate tax rules governing CRUTs and CRATs so that law-abiding professionals can follow the myriad rules, and donors can do good for the people served by our nation’s charities—and do so tax-wisely.
Always proceed with caution. The rules are complicated, and the smallest mistake can result in losing all tax benefits.
Endnotes
1. IR-2023-65 (May 31, 2023).
2. Furrer v. Commissioner, T.C. Memo. 2022-100 (Sept. 25, 2022).
3. Ibid., at p. 11
4. Gerhardt v. Comm’r, 160 T.C. No. 9 (April 20, 2023).
5. Ibid., at p. 26.
6. See supra note 4.
7. United States v. Eickhoff, Jr., No. 2:22-cv-04027 (W.D. Mo. Feb. 23, 2022) ECF No. 1.
8. “Court Permanently Bars Five Defendants From Promoting Charitable Remainder Annuity Trust Tax Scheme,” Office of Public Affairs, U.S. Department of Justice Press Release (May 31, 2023).
9. Supra note 1.
10. William Shakespeare, Julius Caesar, Act 3, Scene 2.