As Henry VIII said to each of his wives: “I shall not keep you long.”1 And that’s why our discussion of charitable remainder trusts (CRTs) spans three issues.
Last month, we told you about some bad actors who tried to make capital gains disappear using recent tax schemes involving charitable remainder annuity trusts (CRATs) to avoid federal income tax on the sale of appreciated assets. Real estate investors and soybean farmers fell victim to the promise of avoiding capital gains tax and receiving tax-free income.2
Let’s turn to the better way to use CRTs, with a deep dive into some of their complexities.
High Speed Overview
CRATs. CRATs pay the income beneficiary (the recipient) a fixed dollar amount (at least annually) as specified in the trust instrument. On the death of the beneficiary or survivor beneficiary (or at the end of trust term if trust measured by a term of years—not to exceed 20 years), the charity gets the remainder. The fixed dollar amount must be at least 5% but not more than 50% of the initial net fair market value (FMV) of the transferred assets, and the remainder interest must be at least 10% of the initial net FMV of all property placed in the trust. Additional contributions after the initial one may not be made to a CRAT.
Caveat: A CRAT must meet the “5% probability test” of Revenue Ruling 77-374 (that is, a CRAT that will make payments for one or more lifetimes must have less than a 5% chance of corpus exhaustion).3
CRATs are generally for older beneficiaries. Reason: Unlike charitable remainder unitrusts (CRUTs), they provide no hedge against inflation. But, they do protect against deflation.
CRUTs. CRUTs are much more common than CRATs. Here are some variations:
Standard CRUT (stan-CRUT). This type of CRUT pays the income beneficiary (recipient) an amount determined by multiplying a fixed percentage of the net FMV of the trust assets, revalued each year. On the death of the beneficiary or survivor beneficiary (or at end of the trust term if the trust is measured by a term of years, not to exceed 20 years), the charity gets the remainder. The fixed percentage can’t be less than 5% nor more than 50%, and the remainder interest must be at least 10% of the initial net FMV of all property placed in the trust. These percentage requirements also apply to the types of CRUTs discussed below.
Net income with makeup CRUT (NIM-CRUT). This CRUT pays only the trust’s income if the actual income is less than the stated percentage multiplied by the trust’s FMV. Deficiencies in distributions (that is, when the unitrust income is less than the stated percentage) are made up in later years if the trust income exceeds the stated percentage.
Net income CRUT (NI-CRUT).This CRUTpays the fixed percentage multiplied by the trust’s FMV or the actual income, whichever is lower. Deficiencies aren’t made up.
Flip-CRUT. A NIM-CRUT or NI-CRUT but, on a qualifying triggering event specified in the trust instrument (for example, the sale of the unmarketable asset used to fund the trust) it switches (flips) to a stan-CRUT. Treasury regulations sometimes refer to this trust as a “combination of methods unitrust.”
Flex flip-CRUT. We made up this name for a trust we use to give flexibility in determining when, if ever, a NIM-CRUT or NI-CRUT will flip to a stan-CRUT. If you want a NIM-CRUT or NI-CRUT to flip on the sale of a parcel of real estate or on a specified date or event, say so in the CRT. But, if you want maximum flexibility, specify that the trust is to flip on the sale of an unimportant unmarketable asset that’s one of the assets used to fund the trust. That way, you have flexibility in determining when, if ever, a NIM-CRUT or NI-CRUT will flip to a stan-CRUT.
Capital gains as trust income CRUT.This isanother name we made up for the situation in which, as provided in the trust instrument (if not provided by state law), the capital gains attributable to appreciation subsequent to the assets’ transfers to the trust (governing state law permitting) can be treated as income for purposes of paying income to the income beneficiary. This provides another way of making up NIM-CRUT deficits in payments from earlier years.
Full monty-CRUT. We gave this name to a flip-CRUT that goes all the way and has flex-CRUT and capital gains CRUT provisions.
Tax Issues
Income tax contribution rules. Itemizers are allowed to deduct the value of the remainder interest computed using Treasury tables. Be mindful of various percentage of adjusted gross income ceilings for the income tax charitable deduction and the 5-year carryover.4
CRUT and CRAT payments. These payments are taxable under the four tier categories of Internal Revenue Code Section 664(b) and Treasury Regulations Section 1.664-1(d)(1) (that is, (1) ordinary income; (2) capital gains; (3) other income (tax-exempt income); and (4) trust corpus). The income paid to the income beneficiary retains the character it had in the trust.
Treatment of payments. Each payment is treated in the following order: (1) as ordinary income to the extent of the trust’s ordinary income for the year (and any undistributed ordinary income from prior years); (2) as capital gains for the year (and any undistributed capital gains from prior years); (3) as tax-exempt income to the extent of the trust’s exempt income for the year (and any undistributed exempt income from prior years); and (4) as a tax-free return of principal.
Under the worst-in, first-out rule, in the first two orders above, the income and gains that are taxable at the highest rates are deemed distributed first.
No capital gains are incurred on the transfer of appreciated assets to the trust.5 Nor is there gain to the donor on a sale by the trust (except as taxable under the four tier category system). Avoidance of gain on a sale by the trust enables a donor to avoid tax on changing from one investment to another. Exception: Gain is taxable to the donor if the trust assets were sold and the proceeds were invested in tax-exempt securities pursuant to an express or implied agreement between the donor and the trustee.6
Unrelated business taxable income (UBTI). CRTs with UBTI in taxable years beginning after Dec. 31, 2006 remain exempt from federal income tax but are subject to a 100% excise tax on the trust’s UBTI.
Tax-exempt CRUTs and CRATs. Caution: The investment or reinvestment in tax-free bonds won’t disqualify the trust as a CRT and won’t “affect the trust’s exemption from income taxation under section 664(c) of the Code as long as there is no express or implied agreement that the trustee must invest or reinvest in those bonds.”7Caveat:Be mindful of diversification issues under state prudent investor laws.
Transferred property. A trust funded with appreciated property that’s to be sold and the proceeds invested in tax-exempt securities results in at least a double whammy. If the trustee is under an express or implied obligation to sell or exchange the transferred property and purchase tax-exempt securities, the donor is deemed to have sold the property and given the trustee the proceeds.8 The gain from the sale is imputed to the donor and includible in the donor’s gross income. Heads the IRS wins, tails the donor loses. If the donor loses the Rev. Rul. 60-370 argument,9 the donor has to pay capital gains tax out of the donor’s own pocket (not out of proceeds of the trust’s sale). If the donor wins the Rev. Rul. 60-370 argument, the taxpayer doesn’t have tax-exempt income until the entire gain is deemed distributed to the taxpayer under the four tier category in satisfaction of the taxpayer’s annual payments.
CRUT Termination
An IRS revenue ruling addressed the situation in which the donor wanted to terminate a CRUT and divide the assets between the beneficiary (the donor) and the charitable remainder organization. The donor was the income beneficiary of a CRUT that was to make unitrust payments to the donor for 20 years with the remainder to charity. The CRUT provided that if the donor died during the 20-year period, the payments would be made for the balance of the term to an individual the donor appointed in the donor’s will or, in default thereof, to the donor’s estate.
The donor wanted to terminate the CRUT without giving the charity the donor’s income interest. Instead, the trustee and the charity agreed to terminate the trust, with the donor getting assets equal to the then-value of the donor’s interest and the charity getting assets equal to the then-value of its remainder interest.
The IRS ruled that the donor realized capital gains equal to the value of the donor’s remaining term-of-years interest. Here’s how it reached that conclusion: The donor was selling the donor’s interest in trust to the charity. Provided that the property received by the donor was distributed to the donor in accordance with the donor’s interest in the trust, the amount that the donor would realize from the sale of the donor’s interest in the trust was the FMV of the property received by the donor. The IRS then reviewed how unitrust amounts distributed to a unitrust beneficiary are taxed under IRC Section 664(b). But after that recital, the IRS said that money or property received by the donor on the trust’s termination doesn’t represent a distribution of an annual unitrust amount. Thus, the taxable four tier categories are inapplicable. Rather, the donor was disposing of the donor’s interest in the trust in exchange for money and property, and the donor’s transaction was governed by IRC Section 1001.
A sale of an income interest in a trust is a sale of a capital asset within the meaning of IRC Sections 1221 and 1222.10 The holding period for determining whether gain or loss from the disposition of an income interest is long term or short term commences on the date the donor first held the interest. Apparently, the CRUT was created over a year before the CRUT was terminated because the IRS ruled that the donor would have had long-term capital gains. The IRS said the donor had no basis in the donor’s interest in the trust, it’s zero, zip, nada:
Pursuant to section 1001(e)(1), the portion of the adjusted uniform basis assigned to A’s interest in Trust is disregarded. The exception contained in section 1001(e)(3) is not applicable, because the entire interest in Trust’s assets is not being sold, or otherwise disposed of, to a third party.11
The IRS concluded that the donor was “selling the donor’s interest in Trust to the [charitable remainder-organization].” (Emphasis added).
Apparently, the donor is the first party. Is the charity the second party? It seems as if the IRS doesn’t consider it to be a third party. Had the donor sold the donor’s remaining term-of-years interest and the charity sold its remainder interest to the donor’s neighbor (instead of the donor and the charity whacking up the assets), would the donor then have sold to a third party and had a basis greater than zero for determining capital gains?
Self-dealing issue.The donor, as the trust’s grantor, is a disqualified person. But Treas. Regs. Section 53.4947-1(c)(2)(i) exempts the donor from self-dealing. The actuarial amount paid to the donor representing the donor’s term-of-years interest in the trust is derived solely from the donor’s right to annual unitrust payments. Just as the unitrust amounts paid over time are excluded from self-dealing, so too is the payment of the donor’s term-of-years interest in the trust. Reason:That payment is derived from the donor’s legal right to the unitrust amounts under the trust agreement. So, there’s no self-dealing when terminating the trust and distributing the assets to the donor and the charitable remainder organization. Caution: If the remainder is to go to a private foundation (rather than a public charity), there would be a prohibited act of self-dealing.12
Conditions placed by IRS.The trust’s termination must not be prohibited by state law and must be made under a court order resulting from a proceeding to which the state attorney general is a party. And, the amounts distributed to the donor must be determined under IRC Section 7520’s valuation rules. Any distribution of assets in-kind must be made pro rata.13 For determining income, gift and estate tax charitable deductions for split-interest trusts, a donor may use the IRC Section 7520 rate for the month of the transfer or the rate for either of the two proceeding months. However, a charitable deduction isn’t available in the donor’s case. So, the Section 7520 rate to use (although the IRS didn’t discuss this) is, in our opinion, the rate for the month the trust is terminated.
Traps to Avoid
Various actions can derail a CRT. Here are some examples:
Multiple grantor CRTs. In a private letter ruling,theIRS found that a CRUT with more than one donor isn’t a qualified trust.14Responding to requests that the PLR be withdrawn and that the IRS affirmatively announce that multiple grantor CRTs are acceptable, the author of that PLR said the IRS holds to its position, except the PLR wouldn’t apply when spouses are the grantors.15 Also, the IRS in its safe harbor CRUT and CRAT revenue procedures states that multiple grantors are allowed if they’re spouses.16
Funding CRTs with undivided property interests. Spouses wanted to fund CRUTs with an undivided interest in a shopping center, keeping an undivided interest for themselves.17But, the IRS warned the spouses that common ownership of the center with the trusts would be deemed self-dealing. So, the couple transferred their interests to a limited partnership and funded the CRUTs with part of the partnership interest. The partnership arrangement apparently “cleansed” the relationship to IRS’ satisfaction, and IRS ruled that the CRUTs qualified.
Funding CRTs with mortgaged property. TheIRS disqualified a CRUT because it was funded with mortgaged property, and the donor remained personally liable on the mortgage. The IRS reasoned that a CRT must function exclusively as one from its creation. But a trust isn’t deemed “created,” said the IRS, as long as the donor is treated as an owner of the trust under the grantor trust rules.18 Another donor funded a CRUT with mortgaged property but wasn’t personally liable on the mortgage. The IRS ignored the issue of whether the nonrecourse mortgaged property disqualified the trust and didn’t rule on whether the trust qualified. Before 1990, many donors funded CRTs with mortgaged property without a peep from the IRS.
FundingCRTswithtangiblepersonalproperty. In a PLR, the IRS found that no incometax charitable deduction was allowable when a CRT was funded with a violin (tangible personal property) because the donor retained an income interest in the property. But when the trust sells the asset, a deduction would be available, although limited to the remainder value element of the basis because of the “unrelated” use wrinkle.19Will there be a gift tax charitable deduction for the value of the charitable remainder when the property is transferred to the trust? The donor didn’t ask, so the IRS didn’t rule.
CRAT“5%probabilitytest.”A CRAT doesn’t qualify for a charitable deduction (and by implication isn’t a qualified trust) unless the possibility that the charitable transfer won’t become effective is so remote as to be negligible. If there’s more than a 5% probability that the noncharitable income beneficiary will survive the exhaustion of the trust assets, that probability isn’t negligible.20 The Tax Court upheld the “5% probability test” in Moor v. Commissioner.21 However, the court also held that the test is satisfied as long as the trust’s annual earnings can be reasonably anticipated to exceed the required annual payout to the beneficiary. Don’t rely on this Tax Court memorandum decision: Pass the test, or don’t create the trust.
Hope we haven’t kept you too long. We’ll finish up next month.
Endnotes
1. Henry VIII divorced two of his wives; he beheaded two of his wives; one wife died shortly after child birth; and his last wife outlived him. His wives in order were: Catherine of Aragon (m. 1509-1533); Anne Boleyn (m. 1533-1536); Jane Seymour (m. 1536-1537); Anne of Cleves (m. 1540-1540); Catherine Howard (m. 1540-1541) and Catherine Parr (m. 1543-1547).
2. Conrad Teitell, Heather J. Rhoades and Brianna L. Marquis, “The Ugly Side of Charitable Remainder Trusts,” Trusts & Estates (October 2023).
3. Revenue Ruling 77-374. But see Estate of Moor v. Commissioner, 43 T.C.M. 1530 (1982).
4. For unitrusts, see Internal Revenue Code Section 170(f)(2); Treasury Regulations Section 1.664-3(c) and Treas. Regs. Section 1.664-4; IRC Pub. 1458. For annuity trusts, see IRC Section 170(f)(2); Treas. Regs. Section 1.664-2(c) and Treas. Regs. Section 20.2031-7, IRS Pub. 1457.
5. Rev. Rul. 55-275; Rev. Rul. 60-370.
6. Rev. Rul. 60-370.
7. Private Letter Ruling 7803041 (Oct. 20, 1977).
8. Supra note 6.
9. The argument being that there was an express or implied obligation. Ibid.
10. Rev. Rul. 72-243.
11. PLR 200324035 (June 13, 2003). Emphasis added.
12. PLR 200525014 (April 7, 2006), revoked by PLR 200614032 (April 7, 2006); PLR 200616035 (Jan. 25, 2006).
13. PLR 200127023 (July 6, 2001).
14. PLR 9547004 (Nov. 24, 1995).
15. See also PLR 200203034 (Jan. 18, 2002).
16. See Revenue Procedure 2003-53 through Rev. Proc. 2003-60 and Rev. Proc. 2005-52 through Rev. Proc. 2005-59.
17. PLR 9114025 (April 5, 1991).
18. PLR 9015049 (April 13, 1990).
19. PLR 9452026 (Dec. 30, 1994).
20. Rev. Rul. 77-374.
21. Moor, supra note 3.