In Private Letter Ruling 201332011, the grantor created a net income makeup charitable remainder unitrust (NIMCRUT) prior to the issuance of final Treasury regulations governing these trusts and funded the trust with his common shares in a company. The terms of the trust provided that the trustee shall annually pay a unitrust amount to the grantor during his life, equal to a fixed percentage of the net fair market value (FMV) of the trust assets as of the first day of each taxable year. However, if the trust didn’t have sufficient income to pay this amount, the trustee was required to only pay the income earned that year to the grantor. The trust agreement also included a makeup provision, which provided that if the annual unitrust amount wasn’t paid in full to the grantor due to a shortage of trust income, the shortage must be made up in the future when the trust had sufficient income. At the grantor’s death, the trust income and principal was to be paid to a charitable organization that qualified as a public charity under Internal Revenue Code Section 509(a). The trust was irrevocable, although the trustee had the power to amend the trust to ensure that it continued to qualify as a charitable remainder unitrust. No charitable deductions were claimed with respect to the grantor’s income interest in the trust.
After the trust was created, the Internal Revenue Service issued final regulations governing NIMCRUTs under Treasury Regulations Section 1.664-3, effective Dec. 10, 1998. Two significant changes were made that affected the trust at issue. First, under the final regulations, proceeds from the sale or exchange of assets contributed to the trust must be allocated to trust principal rather than income. Further, the preamble to the final regulations provided that taxpayers needn’t treat the makeup amount as a liability when calculating the net FMV of a NIMCRUT’s assets.
The NIMCRUT at issue here didn’t comply with the final Treasury regulations in several respects. First, the trust terms required that all realized capital gains (except for gain realized on shares of common stock which the grantor contributed to the trust) shall be allocated to trust income and distributed to the grantor. Similarly, the trustee was prohibited from accepting additional trust principal and thus effectively couldn’t allocate any realized capital gains to trust principal. In addition, the terms of the trust provided that the makeup amount was to be treated as a liability.
As a result, the trustee petitioned the state court to permit reformation of the trust, claiming that reformation was necessary to effectuate the grantor’s intent that the trust qualify as a NIMCRUT. The court agreed that the trust should be reformed. In particular, the court deleted the makeup liability provision and the provision that allocated realized capital gains to trust income. Further, the court added a new provision to the trust, which required that the proceeds from the sale or exchange of trust assets contributed by the grantor must be allocated to trust principal rather than income.
Reformed Trust Qualifies as a NIMCRUT
The IRS ruled that the judicial reformation of the trust enabled it to continue to qualify as a NIMCRUT. First, the trust terms provided for the payment of a unitrust amount to the grantor at least annually, in accordance with IRC Section 664(d)(2)(A). In addition, pursuant to IRC Section 664(d)(2)(B), no amounts other than the unitrust amount may be paid to any persons other than charitable organizations described in IRC Section 170(c). Further, the trust income and principal remaining at the grantor’s death was to be paid to a charitable organization described in Section 170(c), in accordance with IRC Section 664(d)(2)(C).
In addition, the trust complied with the requirements of IRC Section 664(d)(3) following reformation. Specifically, its terms provided that if there was insufficient income to pay the unitrust amount in any given year, the trustee must instead pay the total annual trust income to the grantor. Further, the trust terms included a net income makeup provision, as required by IRC Section 664(d)(3)(B).
As a result, the IRS held that the judicial reformation enabled the trust to continue to qualify as a NIMCRUT under IRC Section 664.
The more interesting discussion in this PLR was whether the judicial reformation of the trust constituted an act of self-dealing. As noted above, the reformation eliminated the trust provision requiring the makeup amount to be treated as a liability when calculating the net FMV of the trust assets. However, this increased the net FMV of these assets, which also increased the unitrust amount to be paid to the grantor both in the year of reformation and in prior years. However, increasing the unitrust amount payable in prior years would cause the grantor to receive a larger amount than he was entitled to prior to the judicial reformation, and the trustee was concerned that this constituted self-dealing.
Under IRC Section 4941(a), an excise tax is imposed on each act of self-dealing between a disqualified person and a private foundation (PF). “Self dealing” is any direct or indirect transfer to or for the use of, or for the benefit of, a disqualified person of the income or assets of a PF.1 A “disqualified person” includes a substantial contributor to a PF and the sole beneficiary of a trust.2 Further, under IRC Section 4947(a)(2), NIMCRUTs are treated as PFs for purposes of the self-dealing rules. Importantly, no self-dealing arises with respect to income payments from a NIMCRUT to an income beneficiary, so long as no charitable deduction is claimed under IRC Sections 170(f)(2)(B), 2055(E)(2)(B) or 5222(c)(2)(B) with respect to the beneficiary’s income interest.3 The trust at issue in this PLR was treated as a PF for purposes of the self-dealing rules, as it was a NIMCRUT. Further, the grantor was a disqualified person as he was the sole income beneficiary of the trust and a substantial contributor to the trust.
The IRS first analyzed whether the self-dealing rules applied to the grantor in his position as the sole beneficiary of the trust. While the elimination of the makeup liability provision constituted a transfer of the trust’s income to or for the benefit of a disqualified person, no charitable deduction was claimed with respect to the grantor’s income interest. Therefore, under IRC Section 4947(a)(2)(A), there was no act of self-dealing in connection with the grantor’s position as the sole beneficiary of the trust.
In addition, the IRS addressed whether there was any act of self-dealing in connection with the grantor’s position as a substantial contributor to the trust. The IRS noted that the judicial reformation was done to effectuate the grantor’s intent that the trust qualifies as a NIMCRUT. As a result, the IRS held that the judicial reformation of the trust didn’t constitute any act of self-dealing, even though the elimination of the makeup liability provision increased the unitrust amount payable to the grantor.
1. Internal Revenue Code Section 4941(d)(1)(E).
2. IRC Section 4946(a).
3. IRC Section 4947(a)(2)(A); Treasury Regulations Section 53.4947-1(c)(2)(ii).