Long-term capital gains and distributions from traditional individual retirement accounts (IRAs) exist in separate constellations of the tax universe.1 But there is at least one convergence: If a trust is named as a beneficiary of an IRA, after the IRA owner dies, beneficiaries of that trust might be able to realize long-term capital gains by selling an interest in the trust. But the sellers must have held the trust interest for more than one year.
This should be the result even if the trust corpus consists entirely of a beneficial interest in an IRA. When the interest sold is a life estate or other term interest for life, the sale eliminates the risk of an untimely end to the beneficiary's life, and therefore to further rights to trust payments. For the charitably inclined, involvement of a charity — either as a remainder beneficiary, buyer, or both — can combine charitable giving with a high degree of tax efficiency.
The same holds true for any type of income in respect of a decedent (IRD) that produces ordinary income to its recipient, if the IRD is payable to a trust instead of to individuals.2
The basis for this result is Revenue Ruling 72-243,3 which concludes that selling an income interest in a trust results in the sale or exchange of a capital asset. If the income interest is held for the requisite period, long-term capital gain is realized.
In a series of private letter rulings (PLRs),4 commutations of charitable remainder unitrusts (CRUTs) have been treated as sales by the beneficiaries of their trust interests, and, based on Rev. Rul. 72-243, gains from those deemed sales were characterized as capital gains.
Let's first look at a few examples to explore the tax economics of a sale of an interest in a trust; then we can discuss the applicable tax law.5
The tax economics of selling trust interests depends on the details. Let's look at three examples that illustrate this. The examples are oversimplified but useful to gain an understanding of what practitioners face.
Bargain sale to a charity: Don Smith named the Smith Marital Trust as beneficiary of his IRA. Don died on March 15, 2002. When he died, the IRA was worth $500,000. The trust provides income for life to Sheila Smith, Don's surviving spouse, payable at the end of each calendar quarter. Upon Sheila's death, the remainder of the trust will go to the couple's children. Sheila is the oldest beneficiary of the trust. There is no spendthrift clause to prohibit the sale.
Under the terms of the trust, the annual total of distributions from the IRA to the trust will be either required minimum distributions (RMDs) or income, whichever is greater. Income of the trust is defined to include income earned inside the IRA. Sheila will be paid trust income only. The trust will add IRA distributions to the trust principal, to the extent that RMDs exceed income. The terms of the IRA and the regulations regarding RMDs permit distributions to be made over Sheila's life expectancy. The IRA and the trust both qualify for an estate tax marital deduction, if the election is made under the so-called qualified terminable interest property (QTIP) rules of Internal Revenue Code Section 2056(b)(7), in accordance with Rev. Rul. 2000-26.
Don had no income tax basis in his IRA. Therefore, all of the IRA distributions to the trust will be taxed as ordinary income. To the extent the IRA distributions constitute trust accounting income, there will be distributions to Sheila. Therefore, the ordinary taxable income of the trust will be shifted to Sheila, to the extent of the income distributions to her. But any RMDs trapped in the trust because they are distributions of principal will be taxed at trust income tax rates.
Sheila and the couple's children, who are beneficiaries of the trust, cooperate and agree to a bargain sale of all of their beneficial interests to a charity that is exempt from income tax. The charity is interested in the transaction, because of the bargain sale element. The parties agree on a price of $450,000. The basis of each beneficiary's interest in the trust is zero, because that was the basis of the property transferred to the trust.
Sheila's nearest age on the date of sale is 65. Rev. Rul. 2004-102, Table 57 provides that the discount rate for determining the actuarial value of a life estate under IRC Section 7520 for transactions occurring during November 2004 is 4.2 percent. Based on standard actuarial tables prescribed under Section 7520, Sheila will receive and pay a capital gains tax on $213,696, and the children will receive and pay a capital gains tax on $236,304.
The charity will succeed to all future taxable distributions from the IRA. But because the charity is exempt from income taxes, it will be able to use the full $500,000 for its charitable purposes. In most cases, the purchasing charity should be able to empty out the IRA without paying any income taxes, thus recouping its investment of $450,000 and realizing a $50,000 net contribution.
Simplistically viewing the economic analysis of the family, here's how they fare, assuming an ordinary income tax rate of 35 percent and a capital gains tax rate of 15 percent. State and local income taxes have been ignored:
The Surviving Spouse — By selling her interest to charity in a bargain sale, Sheila realizes $181,642, net of capital gains taxes. Also, Sheila may claim a charitable income tax deduction of the $50,000 bargain element times the actuarial factor associated with her life estate. That results in a charitable income tax deduction of $23,744 and tax savings of $8,310, assuming the alternative minimum tax does not reduce or eliminate that benefit. Adding the tax savings to the after-tax sale proceeds, Sheila has received a total value of $189,952.
Without the sale, the present value of Sheila's life estate in the IRA, net of income taxes, is $154,336. By selling her income interest to charity in a bargain sale, Sheila is better off by $35,616. Sheila also receives her value now, rather than over whatever time period she happens to survive.
The sale by Sheila of her income interest in the trust will be treated as a taxable transfer by gift of the value of the remainder interest, under IRC Section 2519. If a gift tax is payable, the net value received by Sheila and the children will be reduced.
The Children — Similarly the children are better off by $39,384, and they receive the value of their interest now, rather than after their mother dies.
Altogether — The family as a whole is better off by $75,000, not taking into account potential estate or gift tax effects. In reality, taking IRA distributions slowly over Sheila's life expectancy would have extended income tax deferral on IRA investments over Sheila's lifetime. That in turn would have increased the present value of IRA distributions. However, that increased value depends on investment performance within the IRA and after-tax investment performance outside the IRA. Sophisticated financial models can provide a more refined portrayal of how a sale of trust interests compares with stretching out IRA distributions.
Still, the benefits of income tax deferral need not be entirely lost. To imitate the effect of income tax deferral lost by selling all interests in the trust, other forms of sales could be considered, such as an installment sale, or a charitable gift annuity.
Selling a CRUT: Let's use the same fact pattern, but have Don Smith name the Donald and Sheila Smith Charitable Remainder Unitrust as beneficiary. The unitrust provides annual unitrust payments to Sheila for life.
The unitrust will pay the greatest fixed percentage, but not less than 5 percent nor more than 50 percent, of the net fair market value of its assets, valued annually, to Sheila for life, that will qualify under IRC Section 664(d)(1)(A), which requires that the actuarial value of the remainder interest be at least 10 percent. Thus, the payout percentage will be 20.5 percent, the present value of the remainder interest will be 10.027 percent of the value of the IRA, or $50,135, and the present value of Sheila's unitrust interest will be $449,865.
The unitrust bequest will qualify for the estate tax marital deduction, under IRC Section 2056(b)(8).
The trustee of the unitrust may withdraw the entire IRA and invest the proceeds without paying income taxes. Instead, unitrust distributions will be taxed to Sheila at ordinary income rates under the unitrust distribution rules of IRC Section 644(b).
It is a mathematical feature of unitrusts that the present value of both the noncharitable term interest and the remainder interest are largely insensitive to the discount rate under Section 7520. The discount rate affects the value based only on how frequently distributions are made within each year and when distributions are made relative to the annual valuation date. Because the unitrust distribution is determined each year based on a fixed percentage applied to values that change from year to year, the life and remainder beneficiaries share proportionately in the investment returns, for better or for worse. With a unitrust that pays once annually at or near the valuation date of each year, varying the Section 7520 rate will have no effect on actuarial values. Therefore, if the actuarial tables are to be believed, Sheila's present value is predictable, independent of future investment returns. It is very close to $449,865. Assuming an individual ordinary income tax rate of 35 percent, Sheila's present value net of income taxes should be $292,412.
If, after holding her unitrust interest for more than one year, Sheila sells it to the charitable remainder beneficiary based on a valuation of $500,000 of unitrust corpus, she will pay capital gains taxes at the rate of 15 percent, producing a realized value net of income taxes of $382,385. The sale represents an improvement of $89,973.
Sheila's sale of her lifetime interest in the unitrust will not be treated as a taxable gift of the value of the remainder interest, under IRC Section 2519, which applies only to QTIPs. Therefore, no gift tax will be payable.
As with our first example, our analysis is an oversimplification. Tax deferral on future unitrust payments might be worth something. Also, the present value factor of Sheila's life interest one year after formation will be slightly less than 90 percent, because she will age a bit. At that time, one or more distributions will have been taken. Consequently, in real life, it would be prudent to produce a more sophisticated model. On the other hand, Sheila will have realized the actuarial value without having to worry about how long she lives.
Sheila does not have to take all the sales proceeds at once. She can achieve income tax deferral on her capital gains taxes by taking from the buyer an installment sale or a charitable gift annuity.
Commutation of the interests will produce the same results as a sale by Sheila to the charitable remainder beneficiary.
Sale Between Family Members: Let's use the fact pattern in our first example again, except that on Nov. 15, 2004, Sheila sells her income interest to the remainder beneficiaries for the actuarial value of her life estate in the trust. At the time of the sale, the IRA is still worth $500,000. Using standard actuarial tables prescribed in Section 7520, the actuarial value of Sheila's interest in the trust is 0.47488 of the value of trust corpus. Accordingly, the selling price is $237,440 ($500,000 times 0.47488). Sheila's income tax basis in her life estate is zero, under IRC Section 1001(e). Sheila has a long-term capital gain of $237,440.
Next, the trust distributes the right to receive future distributions from the IRA to the remainder beneficiaries, who have no income tax basis in the property they receive from the trust. The remainder beneficiaries must withdraw RMDs over Sheila's lifetime and pay ordinary income tax on each distribution. However, it is possible that the beneficiaries of the remainder may amortize the purchase price of the income interest. The deduction is claimed ratably over Sheila's remaining life expectancy. The match from year to year between the amortization deduction and IRA distributions is bound to be imperfect, because the amortization deduction is a constant amount each year. RMDs, however, vary, and the variations can be dramatic.
The result is that Sheila will pay a capital gains tax on $237,440. The children will pay ordinary income tax on $500,000, less amortization deductions, if allowable. If the amortization deduction is not available, the family as a whole is worse off for having engaged in the transaction.
Also, Sheila's sale of her income interest in the trust will be treated as a taxable gift of the value of the remainder interest, under IRC Section 2519.
CAPITAL GAINS TREATMENT
The only statutory exception to the application of the capital gains tax rates to a sale of an interest in trust is found in IRC Section 1(h)(5), which provides that the 25 percent capital gains rate applies to the extent the trust holds collectibles. This provision is an acknowledgement in the statute that a sale of a trust interest may be subject to capital gains treatment.
The sale of a life estate by the life tenant in a testamentary trust was found to be a sale of a capital asset giving rise to recognition of a capital gain in Estate of Beulah Eaton McAllister v. Commissioner.8 The Internal Revenue Service acquiesced in Rev. Rul. 72-243, adopting the general rule that selling an income interest results in the sale or exchange of a capital asset. Central to these holdings is recognition that an interest in trust is a property right.
McAllister involved a life estate in a trust to which Beulah Eaton succeeded after her husband's death. The trust contained a spendthrift provision. The estate of Beulah's late husband was illiquid. To end family litigation and provide liquidity for the estate, Beulah petitioned for, and was granted, termination of the trust by order of the New Jersey Court of Chancery. Under the order, the remainder beneficiary made a payment to Beulah and her interests in the trust were extinguished.
In holding that a sale of a capital asset occurred, the U.S. Court of Appeals for the Second Circuit relied on Blair v. Comm'r,9 holding that an interest in a trust is a property right. The appeals court distinguished Hort v. Comm'r,10 which held that ordinary income resulted from the receipt of a lump sum payment in cancellation of a lease for a term of years, because the consideration was found to be a substitute payment for the rent as it fell due.
In PLR 200027001, a surviving spouse sold her income interest in a trust to the remainder beneficiaries, pursuant to a litigation settlement agreement. A local court approved that sale, setting aside a spendthrift provision to do so. The IRS concluded that the gain was a capital gain, citing Rev. Rul. 72-243. Because the spouse had held the trust income interest for at least 12 months from the deceased spouse's date of death, the gain was a long-term capital gain.
If an income interest is a property right, the sale of which creates a capital gain, the same should be true of an annuity interest or a unitrust interest in a trust, including a charitable remainder trust (CRT).
In PLR 200314021, the life beneficiary and the remainder beneficiary of a CRUT under IRC Section 664 petitioned for and obtained a court order that terminated and divided the trust along actuarial lines. The life beneficiary was also the grantor of and donor to the trust. The IRS concluded that the life beneficiary should be entitled to capital gains treatment, citing Rev. Rul. 72-243. Also, under IRC Section 1001(e)(1), the portion of the adjusted uniform basis assigned to the individual's interest in the trust was disregarded.
See also PLRs 200127023, 200324035, and 200403051, each of which involves divisions of a CRUT. No life beneficiary was ever treated as having received a unitrust distribution by reason of the sale. Neither was any beneficiary treated as having received a distribution-in-kind of trust assets, which would have avoided treatment as a taxable sale or exchange. Instead, the life beneficiaries were treated as having, in substance, sold their life interests in a sale or exchange subject to income taxation. Further, the composition of the assets held in trust was not a factor in determining the character of the gain.
The rulings also concluded that, because a sale of the trust interest occurred, IRC Section 664(b), regarding the character of distributions to beneficiaries, did not operate to carry out to the noncharitable beneficiary any ordinary taxable income or capital gains previously realized inside the trust but previously not distributed. The PLRs further concluded that the entire amount received by the life beneficiary was the amount realized in the sale of a capital asset.
The upshot of these letter rulings is that the result of a taxable sale, exchange, or commutation of a unitrust or annuity trust interest is the immediate imposition of income tax at capital gains rates, just as in the case of a life estate in a trust.
ASSIGNMENT OF INCOME
The assignment of income doctrine is rooted in tax cases decided by the courts. Under the doctrine, a taxpayer cannot shift certain types of taxable income to another taxpayer. Generally, a taxpayer who possesses the right to income that has been realized from property cannot somehow shift to another person the burden of income tax on that income. Also, personal service income is taxable to the person who renders the services and cannot be shifted elsewhere.11
In each of our examples, a trust holds the right to receive IRA distributions. A sale of an interest in a trust is not an assignment of IRA distributions that the trustee has a right to receive. However, an ineffective assignment or sale of an interest in a trust will leave the beneficiary seeking to make the assignment or sale in the same tax position as though the assignment or sale had not occurred. Therefore, trusts having spendthrift clauses should be approached with particular caution.
One situation in which the assignment of income doctrine might apply — although this is by no means certain — is in an IRA conduit trust, which is required by its terms to make trust distributions to the trust beneficiary of all IRA distributions immediately on receipt by the trustee. Because some IRA conduit trusts serve no purpose that differs materially from the purpose of an ordinary IRA beneficiary designation form, the trust beneficiary could be viewed as being in the same position as any IRA beneficiary entitled to all IRA distributions, rather than as a trust beneficiary. In that situation, the IRS might seek to treat a sale of the trust beneficiary's interest in the trust in the same manner as a sale by an IRA beneficiary: Ordinary income would result from the sale. On the other hand, it might be that the existence of a trust that is valid under state law cannot be ignored. Moreover, if the trust is not a grantor trust, the beneficiary of the trust cannot be treated as the owner of the IRA.
When structuring a sale of an income interest, one detail to address is the fiduciary accounting income that has been realized by the trustee but has not yet been distributed to the income beneficiary (stub income). As a matter of right and good housekeeping, the trustee and parties to a sale should formally agree that the trustee will distribute to the income beneficiary all trust income that the income beneficiary has a right to, determined through the date of the sale. Payouts from unitrusts or annuity trusts would likely be prorated.
INCOME TAX DEDUCTION
Parties to a sale also should consider any deduction for estate taxes available to offset the IRD. IRC Section 691(c) generally provides that a taxpayer who must include IRD in taxable income, which IRD had been subject to the estate tax, may claim an income tax deduction for the portion of the estate tax related to the IRD.
The deduction for an estate or trust must be computed by excluding from the gross income of the estate or trust the portion (if any) of the items of the IRD that was properly paid, credited, or distributed to the beneficiaries during the taxable year.
The statute thus provides a remedy to the problem that both estate and income taxes may apply to IRD. This lowers the effective income tax rate on the IRD, which may dramatically change the economics of any proposed sale of an interest in a trust that is entitled to realize the IRD. A detailed analysis of each case is advisable.
If a charity realizes the IRD after purchasing all interests in a trust, the Section 691(c) deduction belongs to the charity, and thus is wasted.
IRC Section 167 permits a deduction for wasting assets, whether tangible or intangible. The terms “depreciation” and “amortization,” being similar in concept, may be used interchangeably. Typically, amortization is associated with intangible assets.
Treasury Regulations Section 1.167(a)-(3) provides that an amortization deduction may be claimed only if the period of income production of the intangible asset acquired is ascertainable. Reg. Section 1.014-5(c), Examples 1, 3, and 4, recognize the availability of that deduction when a life estate is purchased.
No deduction will be allowed if the property acquired has no ascertainable period of amortization. Accordingly, the deduction may be denied if interests other than the income interest are acquired. That apparently would happen when the value of the income interest is not acquired in a way that isolates it from other acquired interests.12
An amortization deduction may be claimed even if the income and remainder interests merge after the purchaser acquires the income interest, resulting in the transfer of all interests in the property to the purchaser. The IRS so ruled in Rev. Rul. 62-132,13 in which the Service announced that it will permit the deduction to be claimed, following the decisions in Comm'r v. William N. Fry, and Laird Bell v. Harrison.14 In those cases, the IRS unsuccessfully argued that, because the income and remainder interests had merged, the cost basis could be recouped only when the property was later sold by the acquirer.
Section 167(e) bars an amortization deduction for a term interest when the taxpayer is related to the holder of the remainder interest. That would, for example, defeat the amortization deduction when one sibling buys a life estate from another sibling, who owned a fee simple interest in the property. The definition of a term interest found in IRC Section 1001(e) is incorporated by reference. The related person definitions of IRC Sections 267(b) and (e) also are incorporated by reference. That includes families, a lengthy list of entities (corporations, trusts, partnerships and so forth), and pass-through rules. The family of an individual includes only brothers and sisters (whole or half blood), spouse, ancestors and lineal descendants. Note, for example, that aunts, uncles, cousins, nieces and nephews are not included. To the extent that an amortization deduction is disallowed, the taxpayer must reduce basis; the holder of the remainder interest is permitted a corresponding increase in basis.15
In our example of a sale between family members, the children hold the remainder interest and purchase their mother Sheila's income interest. Does Section 167(e) bar an amortization deduction? The income interest is not being acquired from the holder of the remainder interest. But to be barred, the acquirer only need be related to the holder of the remainder interest. The list of related persons does not include oneself, so perhaps the deduction is not barred.
There appears to be no clear guidance on whether the income tax deduction may be claimed in arriving at adjusted gross income or, in the alternative, must be claimed as an itemized deduction. That determination may rest on the nature of the income produced by the underlying property interest acquired.
POTENTIAL GIFT TAX
An estate or gift tax marital deduction may be elected and claimed for a bequest or a gift of certain QTIP. One requirement to meet the definition of a QTIP is that the spouse or surviving spouse must be granted the right to all income for life. If the marital deduction was elected for that property, IRC Section 2519 treats any disposition by the spouse or surviving spouse of any part of the income interest as a transfer for all purposes of Chapter 11 (estate tax) and Chapter 12 (gift tax) of all interests in the property, other than the qualifying income interest.
Neither IRC Section 2519 nor the regulations identify the transferee. If the transferee is a qualifying charity, a gift tax charitable deduction would be available. In our example of a bargain sale to a charity, the transferees before the sale are the children, who are the remainder beneficiaries of the trust. But the sale of all interests in the trust to a charity occurs at the same time in consequence of the same transaction. At the instant that Sheila disposes of her interest in the trust, the entire trust passes to charity. It is unclear whether the transferee for purposes of Section 2519 is the charity. Because the children receive a portion of the economic value of the trust by participating in the sale, the IRS might argue that some or all of the transfer under Section 2519 is to the children. However, if the children sell their interests in an unrelated transaction before Sheila's sale occurs, then, at the time of Sheila's sale, the remainder interest clearly belongs to the charity and a gift tax charitable deduction should be available. So the fact that the children sell should not by itself determine whether a gift tax charitable deduction is available.
IRC Section 2207A(b) provides a right to recover the gift tax imposed under Section 2519. As a result, it will be the children, not Sheila, who bear the economic burden of the gift tax. Sheila can voluntarily waive that right of recovery.
Detailed legal and financial analyses are key when considering the sale of an interest in trust. At the very least, though, ask such questions as:
Are the IRD assets likely to interest a buyer?
Could a trust holding IRD assets in addition to non-IRD assets be bifurcated before seeking a sale, exchange or commutation? Bifurcation would permit non-IRD assets to remain in one trust for the present beneficiaries and IRD assets to become part of another trust that the beneficiaries sell.
Is there a spendthrift clause? If so, is there a basis for persuading a court having jurisdiction to it set aside?
Whether a spendthrift clause is included in a trust is a drafting decision that should take into account whether beneficiaries might seek a sale of their interests someday. When IRD is involved, making a sale possible might just eliminate some of the tax sting.
- A version of this article was originally published in 107 Tax Notes 211 (Apr. 11, 2005).
- For purposes of this article, a traditional IRA having an income tax basis of zero is used as a proxy for the more general case of IRD.
- Revenue Ruling 72-243, 1972-1 C.B. 233.
- Private letter rulings (PLRs) may not be cited as precedent, but often shed light on the Internal Revenue Service's position on an issue.
- All references are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder.
- Rev. Rul. 2000-2, 2000-3 IRB 305, Doc. 2000-793, 2000 TNT 3-6.
- Rev. Rul. 2004-102, 2004-45 IRB 784, 2004 TNT 202-1.
- Estate of Beulah Eaton McAllister v. Commissioner, 157 F.2d 235 (1946), cert. denied, 330 U.S. 826 (1946).
- Blair v. Comm'r, 300 U.S. 5, 57 S.Ct. 330 (1937), 94 TNT 241-9.
- Hort v. Comm'r, 313 U.S. 28, 61 S.Ct. 757 (1941), 94 TNT 241-70.
- See, for example, Blair v. Comm'r, and Lucas v. Earl, 281 U.S. 111 (1930). (An exhaustive discussion of the assignment of income doctrine is beyond the scope of this article.)
- See Henry W. Sohosky v. Comm'r, 57 T.C. 403 (1971), aff'd 473 F.2d 810 (8th Cir. 1973).
- Rev. Rul. 62-132, 1962-2 C.B. 73.
- Comm'r v. William N. Fry, Jr. et al., 283 F.2d 869 (6th Cir. 1960), and Laird Bell v. Harrison et al., 212 F.2d 253 (7th Cir. 1954).
- Additional provisions of IRC Section 167(e) not related to this article are not discussed.