David T. Leibell and Daniel L. Daniels, partners in the Stamford, Conn. office of Cummings & Lockwood LLC, report that a recently released Technical Advice Memorandum (TAM) provides a lovely roadmap on how not to administer a charitable remainder trust (CRT). Here's what Leibell and Daniels have to say:

In TAM 200628026, released on July 14, the Internal Revenue Service ruled that a trust was not a qualified CRT for federal income tax purposes. That's because the grantor/trustee remained personally liable on the mortgage for the real property transferred to the trust. Also, the trust was used as if it were the grantor/trustee's personal bank account, which means it was not administered in accordance with Internal Revenue Code Section 664's rules governing CRTs.

In the ruling, the IRS first set forth the requirements necessary to have a qualified charitable remainder unitrust (CRUT):

  • The unitrust beneficiary is entitled to receive a fixed percentage (which cannot be less than 5 percent or more than 50 percent) of the net fair market value (FMV) of the trust assets each year.

  • IRC Section 664(d)(2)(B) provides that no amount other than the unitrust amount may be paid to the unitrust beneficiary; or to, or for, the use of any person other than a charitable organization described in IRC Section 170(c), unless the amount is transferred for full and adequate consideration.

  • Treasury Regulations Section 1.664-3(a)(4) provides that for a trust to be a CRT, it must meet the definition of, and function exclusively as, a CRT from the date the trust was created. A CRT is deemed to be created at the earliest time at which neither the grantor nor any other person is treated as the owner of the entire trust (that is to say, a grantor trust). IRC Section 677(a) provides that the grantor is treated as the owner of any portion of a trust if the trust income, at the discretion of the grantor or a nonadverse party, or both, may be distributed to the grantor or, in accordance with Treas. Regs. Section 1.677(a)-1(d), is applied to discharge any of the grantor's legal obligations.

According to the facts of the ruling in TAM 200628026: on Date 1, “A” deeded real property encumbered with a mortgage to the trust. The trust paid the mortgage liability with the proceeds from the sale of the property. Because “A” remained personally liable on the mortgage on the property at the time the trust paid the mortgage liability, the trust was not a qualified CRT. This is because the trust's income was used to discharge a legal obligation of the grantor within the meaning of Treas. Regs. Section 1.677(a)-1(d); therefore, the trust was a grantor trust for income tax purposes. As long as the grantor is treated as the owner of the entire trust under IRC Section 677, the trust is not deemed to be created for IRC Section 664 purposes. As a result, the trust was not a qualified CRUT.

Not only did the grantor's remaining personally liable on the mortgage debt create grant trust status, but the trust also was disqualified because it was not properly administered. “A,” as trustee, wrote checks from the trust's checking account, in addition to the unitrust amount, to himself, his wife, and third parties on a random, ongoing basis, as if the trust was a personal bank account. For example, the trust paid monthly installments for two years on “A”'s pickup truck. The trust also allowed “A” to use real estate owned by the trust rent free. And the trust paid “A”'s rent for 10 years in a building owned by a third party. Each of these payments were in addition to the permitted unitrust amount. As a result, the IRS ruled that the trust does not qualify as a CRUT.

There are two lessons to be learned from this case's egregious facts. First, never fund a CRT with real estate subject to a mortgage. If the grantor remains personally liable on the mortgage after the transfer to the CRT, the trust is treated as a grantor trust for income tax purposes and cannot be a qualified CRT. This means that the grantor loses both the income and gift tax charitable deductions; plus, the trust loses its tax-exempt status. Moreover, the grantor is liable for any capital gains taxes generated when any appreciated trust property is sold.

The second lesson is that anyone establishing a CRT must administer it according to the rules set forth in IRC Section 664. You can't administer such trusts as if they were a personal slush fund. If you do, the trust is disqualified from its inception.

The seminal case on the administration of CRTs is Atkinson v. Commissioner, 115 T.C. 26 (July 26, 2000) aff'd, 309 F.3d 1290 (11th Cir. 2002), cert. denied, 320 U.S. 756 (2003). The Atkinson case, referenced in this TAM, disqualified a CRT that was improperly administered but was not abusive. In Atkinson, a charitable remainder annuity trust (CRAT) was held to be disqualified from inception merely because seven quarterly payments were not made to the donor/beneficiary.