Treasury and the Internal Revenue Service just issued final regulations that thwart a capital-gain-avoidance plan. The plan purports to avoid capital gain for a life (or term-of-years) beneficiary of a charitable remainder unitrust or annuity trust on a sale to a third party by the life beneficiary and the charitable remainder organization of their respective interests.
The final regulations adopt last year’s proposed regulations and follow up on a 2008 IRS Notice in which the Treasury and the IRS described the plan (scheme*?), required notification to the IRS by participants and imposed costly penalties for non-notification.
IRS Notice 2008-99 said the Donor’s basis would be reduced to zero on a trust termination by a sale of a CRT’s assets to a third party by the life beneficiary and the charitable remainder organization.
The American Council on Gift Annuities submitted comments, that I prepared, to the IRS on Notice 2008-99. ACGA agreed that abuses should be curbed, but suggested a way to protect the fisc without adversely punishing non-abusive CRT terminations.
ACGA suggested to the IRS that on a sale by the life-income beneficiary and the charitable remainder organization of the trust assets to a third party, the life-income beneficiary’s basis be his pro rata share of the charitable remainder unitrust’s or annuity trust’s basis reduced by any undistributed amounts then in the capital gains category of the four-tier taxation rules. Under Notice 2008-99, the life beneficiary would, in effect, have to pay tax on amounts already distributed to him and which were taxable to him.
Happy to report. The IRS in its proposed 2014 regulations and now in its 2015 final regulations adopted ACGA’s suggestion.
Before getting to the final regulations, here is background helpful in understanding them and assuaging concerns about early termination of CRTs in typical “non-abuse” situations.
Stepped-up basis—general rule. For appreciated assets inherited at death, an heir gets a basis equal to the then fair market value (FMV) (rather than taking over the decedent’s lower basis). But a decedent had to give his life to achieve this.
Can the beneficiary of a CRUT or CRAT during his lifetime step up the basis of appreciated assets used to fund the trust (and any other trust assets) and then on an early termination of the trust receive proceeds equal to his interest in the trust free of capital gains tax? That’s what concerned the IRS in Notice 2008-99, and in the recently issued final regulations that are the subject of this article.
Three situations follow.
Situations 1 and 2 don’t concern the IRS and shouldn’t concern you. Situation 3 won’t deliver the hoped-for benefits.
Situation 1—no problem. Every schoolchild knows that a donor can transfer appreciated assets to a charitable remainder unitrust or annuity trust and avoid capital gain on the trust’s funding and not be taxed on the capital gain on a subsequent sale by the trust. The capital gain is, however, taxable to the trust beneficiary but only to the extent that the gain is deemed distributed to him under the four-tier taxation regime in satisfaction of the annual unitrust or annuity trust amount.
Situation 2—no problem. Some beneficiaries terminate their CRTs before the end of the specified term and the trust assets are divided between the beneficiary and the charitable remainder organization according to their respective interests at the CRT’s termination. Letter rulings have sanctioned this. The termination is treated as a sale of a capital asset, not to a third party, of the beneficiary’s term interest (generally measured by his life but sometimes a term-of-years). The beneficiary is deemed to have a zero basis and have capital gain. If the trust was created more than one year before its termination, the gain is taxed favorably. Although capital gains are taxable, this isn’t a penalty situation involving the participants in the transaction. More about this later when the sale is to a third party.
Situation 3—problem. The IRS announced in Notice 2008-99 that it was aware of a transaction (described soon) in which a sale or other disposition of all interests in a charitable remainder trust (subsequent to the contribution of appreciated assets to the trust and their sale and reinvestment by the trust) resulted in the donor or other noncharitable beneficiary getting the value of that person’s trust interest and claiming to recognize little or no taxable gain. “The IRS and Treasury Department believe this transaction has the potential for tax avoidance or evasion**, but lack enough information to determine whether the transaction should be identified specifically as a tax avoidance transaction.” The IRS identified this transaction and substantially similar transactions as transactions of interest for purposes of Treasury Regulations section 1.6011-4(b)(6) and Internal Revenue Code section 6111 and 6112. The IRS also alerted persons involved in these transactions to certain responsibilities that may arise from their involvement. More about transactions of interest, listed transactions and reportable transactions later. To keep this article from becoming a book, I won’t explain all the IRC and regulation sections cited in Notice 2008-99 regarding required notifications to the IRS. Suffice it to say if you’re involved in this type of transaction, you’ll want to study them.
Here’s the transaction of interest to the IRS. Step 1. Donor creates a CRUT or CRAT and contributes appreciated assets to the trust. Donor retains an annuity or unitrust interest (the term interest) and designates a charity as the remainder organization. The charity may, but need not, be controlled by the donor; he may, but need not, reserve the right to change the charity designated as the remainder beneficiary.
Step 2. The CRT sells or liquidates the appreciated assets and reinvests the net proceeds in other assets (new assets) such as money market funds and marketable securities often to acquire a diversified portfolio. Because a charitable remainder trust is tax-exempt under IRC section 664, the trust’s sale of the appreciated assets is exempt from income tax, and the trust’s basis in the new assets is the price the trust pays for those new assets. Some portion of the trust’s ordinary income and capital gains may become taxable to the term recipient as the periodic annuity or unitrust payments are made by the trust (under the rules of IRC section 664 and its regulations).
Step 3. The donor and the charity, in a transaction they claim is described in IRC section 1001(e)(3), sell or otherwise dispose of their respective interests in the trust to Unrelated Third Party, for approximately the FMV of the trust’s assets including the new assets.
Step 4. The trust then terminates, and the trust’s assets, including the new assets, are distributed to Unrelated Third Party.
Donor takes these positions regarding the tax consequences of this transaction:
- Donor claims an income tax charitable deduction for the portion of the FMV of the appreciated assets attributable to the remainder interest as of the date of their contribution to the trust.
- Donor claims to recognize no gain from the trust’s sale or liquidation of the appreciated assets. When the donor and the charity sell their respective interests in the trust to Unrelated Third Party, the donor and the charity take the position that they have sold the entire interest in the trust within the meaning of IRC section 1001(e)(3). Because the entire interest in the trust is sold, the donor claims that IRC section 1001(e)(1), which disregards basis in the case of a sale of just the term interest, doesn’t apply. The donor also takes the position that, under IRC section 1001(a) and related provisions, the gain on the sale of the donor’s term interest is computed by taking into account the portion of uniform basis allocable to the donor’s term interest under Reg. section 1.1014-5 and 1.1015-1(b), and that this uniform basis is derived from the basis of the new assets rather than the basis of the appreciated assets. (If this works, the donor has achieved Tax Nirvana—a stepped-up basis without giving his life.)
Variations on a scheme:
- A net-income-with-make-up charitable remainder unitrust (NIM-CRUT) is used.
- Trust may have been in existence for some time prior to the sale of trust interests.
- The appreciated assets may already be in the trust before the commencement of the transaction.
- The beneficiary and the seller of the term interest may be the donor and/or another person.
- The donor may contribute the appreciated assets to a partnership or other pass-through entity and then contribute the interest in the entity to the trust.
Claimed tax treatment of the transaction. The gain on the sale of the appreciated assets is never taxed, even though the donor receives his share of the appreciated FMV of those assets.
Ordinary folks needn’t worry. The IRS and the Treasury aren’t concerned about the mere creation and funding of a charitable remainder trust with appreciated assets and/or the trust’s reinvestment of the contributed appreciated assets. Those events alone don’t constitute the transaction subject to Notice 2008-99. And the final regulations echo this.
Who should be concerned? The IRS and the Treasury “are concerned about the manipulation of the uniform basis rules to avoid tax on gain from the sale or other disposition of appreciated assets. Accordingly, the type of transaction described in Notice 2008-99 includes a coordinated sale or other coordinated disposition of the respective interests of the [donor] or other noncharitable [beneficiary] and the charity in a charitable remainder trust in a transaction claimed to be described in §1001(e)(3), subsequent to the contribution of appreciated assets and the trust’s reinvestment of those assets. In particular, the IRS and Treasury Department are concerned about [donor’s] claim to an increased basis in the term interest coupled with the termination of the trust in a single coordinated transaction under §1001(e) to avoid tax on gain from the sale or other disposition of the Appreciated Assets.”
Notice 2008-99's teeth—transactions of interest. Transactions that are the same as, or substantially similar to, those described in Notice 2008-99 “are identified as transactions of interest for purposes of §1.6011-4(b)(6) and §§6111 and 6112 effective October 31, 2008, the date this notice was released to the public. Persons entering into these transactions on or after November 2, 2006, must disclose the transaction as described in §1.6011-4. Material advisers who make a tax statement on or after November 2, 2006, with respect to transactions entered into on or after November 2, 2006, have disclosure and list maintenance obligations under §§6111 and 6112. See §1.6011-4(h) and §§301.6111-3(i) and 301.6112-1(g) of the Procedure and Administration Regulations.” The final regulations say that these teeth continue to bite.
The IRS’s warning—participants who entered into these transactions at any time may already be in hot water:
Independent of their classification as transactions of interest, transactions that are the same as, or substantially similar to, the transaction described in this notice already may be subject to the requirements of §§6011, 6111, or 6112, or the regulations thereunder. When the IRS and Treasury Department have gathered enough information to make an informed decision as to whether this transaction is a tax avoidance type of transaction, the IRS and Treasury Department may take one or more actions, including removing the transaction from the transactions of interest category in published guidance, designating the transaction as a listed transaction, or providing a new category of reportable transaction.
Who are participants?
Under §1.6011-4(c)(3)(I)(E), each recipient of the term interest and Trust are participants in this transaction for each year in which their respective tax returns reflect tax consequences or a tax strategy described in this notice. Charity is not a participant if it sold or otherwise disposed of its interest in Trust on or prior to October 31, 2008. For interests sold or otherwise disposed of after October 31, 2008, under §1.6011-4(c)(3)(I)(E), Charity is a participant for the first year for which Charity’s tax return reflects or is required to reflect the sale or other disposition of Charity’s interest in Trust. In general, Charity is required to report the sale or other disposition of its interest in Trust on its return for the year of the sale or other disposition. See §6033 and §1.6033-2(a)(ii). Therefore, in general, Charity will be a participant for the year in which charity sells or otherwise disposes of its interest in Trust.
Time for Disclosure. See Reg. section 1.6011-4(e) and 301.6111-3(e).
Material Advisor Threshold Amount. The threshold amounts in Reg. section 301.6111-3(b)(3)(I)(B) are reduced to $5,000.
Penalties—the book will be thrown at those who are required to disclose but don’t. “Persons required to disclose these transactions under §1.6011-4 who fail to do so may be subject to the penalty under §6707A. Persons required to disclose these transactions under §6111 who fail to do so may be subject to the penalty under §6707(a). Persons required to maintain lists of advisees under §6112 who fail to do so (or who fail to provide such lists when requested by the IRS) may be subject to the penalty under §6708(a). In addition, the IRS may impose other penalties on parties involved in these transactions or substantially similar transactions, including the accuracy-related penalty under §6662 or §6662A.”
The IRS in the proposed regulation discussed Notice 2008-99 detailed at the outset of this article. It then explains the proposed regulations. That explanation applies to the final regulation that adopted the proposed regulation without change.
[The] . . . regulations provide a special rule for determining the basis in certain CRT term interests in transactions to which section 1001(e)(3) applies. In these cases, the . . . regulations provide that the basis of a term interest of a taxable beneficiary is the portion of the adjusted uniform basis assignable to that interest reduced by the portion of the sum of the following amounts assignable to that interest: (1) the amount of undistributed net ordinary income described in section 664(b)(1); and (2) the amount of undistributed net capital gain described in section 664(b)(2). These . . . regulations do not affect the CRT’s basis in its assets, but rather are for the purpose of determining a taxable beneficiary’s gain arising from a transaction described in section 1001(e)(3). However, the IRS and the Treasury Department may consider whether there should be any change in the treatment of the charitable remainderman participating in such a transaction.
Issuance of the final regulations doesn’t affect the disclosure obligation stated in Notice 2008-99.
Some examples from the final regulations:
If these examples spin your head (mine is still spinning), see my simplified examples following the IRS’ examples.
Example 7. (a) Grantor creates a charitable remainder unitrust (CRUT) on Date 1 in which Grantor retains a unitrust interest and irrevocably transfers the remainder interest to Charity. Grantor is an individual taxpayer subject to income tax. CRUT meets the requirements of section 664 and is exempt from income tax.
(b) Grantor’s basis in the shares of X stock used to fund CRUT is $10x. On Date 2, CRUT sells the X stock for $100x. The $90x of gain is exempt from income tax under section 664(c)(1). On Date 3, CRUT uses the $100x proceeds from its sale of the X stock to purchase Y stock. On Date 4, CRUT sells the Y stock for $110x. The $10x of gain on the sale of the Y stock is exempt from income tax under section 664(c)(1). On Date 5, CRUT uses the $110x proceeds from its sale of Y stock to buy Z stock. On Date 5, CRUT’s basis in its assets is $110x and CRUT’s total undistributed net capital gains are $100x.
(c) Later, when the fair market value of CRUT’s assets is $150x and CRUT has no undistributed net ordinary income, Grantor and Charity sell all of their interests in CRUT to a third person. Grantor receives $100x for the retained unitrust interest, and Charity receives $50x for its interest. Because the entire interest in CRUT is transferred to the third person, section 1001(e)(3) prevents section 1001(e)(1) from applying to the transaction. Therefore, Grantor’s gain on the sale of the retained unitrust interest in CRUT is determined under section 1001(a), which provides that Grantor’s gain on the sale of that interest is the excess of the amount realized, $100x, over Grantor’s adjusted basis in the interest.
(d) Grantor’s adjusted basis in the unitrust interest in CRUT is that portion of CRUT’s adjusted uniform basis that is assignable to Grantor’s interest under §1.1014-5, which is Grantor’s actuarial share of the adjusted uniform basis. In this case, CRUT’s adjusted uniform basis in its sole asset, the Z stock, is $110x. However, paragraph (c) of this section applies to the transaction. Therefore, Grantor’s actuarial share of CRUT’s adjusted uniform basis (determined by applying the factors set forth in the tables contained in §20.2031-7 of this chapter) is reduced by an amount determined by applying the same factors to the sum of CRUT’s $0 of undistributed net ordinary income and its $100x of undistributed net capital gains.
(e) In determining Charity’s share of the adjusted uniform basis, Charity applies the factors set forth in the tables contained in §20.2031-7 of this chapter to the full $110x of basis.
Example 8. (a) Grantor creates a charitable remainder annuity trust (CRAT) on Date 1 in which Grantor retains an annuity interest and irrevocably transfers the remainder interest to Charity. Grantor is an individual taxpayer subject to income tax. CRAT meets the requirements of section 664 and is exempt from income tax.
(b) Grantor funds CRAT with shares of X stock having a basis of $50x. On Date 2, CRAT sells the X stock for $150x. The $100x of gain is exempt from income tax under section 664(c)(1). On Date 3, CRAT distributes $10x to Grantor, and uses the remaining $140x of net proceeds from its sale of the X stock to purchase Y stock. Grantor treats the $10x distribution as capital gain, so that CRAT’s remaining undistributed net capital gains amount described in section 664(b)(2) and §1.664-1(d) is $90x.
(c) On Date 4, when the fair market value of CRAT’s assets, which consist entirely of the Y stock, is still $140x, Grantor and Charity sell all of their interests in CRAT to a third person. Grantor receives $126x for the retained annuity interest, and Charity receives $14x for its remainder interest. Because the entire interest in CRAT is transferred to the third person, section 1001(e)(3) prevents section 1001(e)(1) from applying to the transaction. Therefore, Grantor’s gain on the sale of the retained annuity interest in CRAT is determined under section 1001(a), which provides that Grantor’s gain on the sale of that interest is the excess of the amount realized, $126x, over Grantor’s adjusted basis in that interest.
(d) Grantor’s adjusted basis in the annuity interest in CRAT is that portion of CRAT’s adjusted uniform basis that is assignable to Grantor’s interest under §1.1014-5, which is Grantor’s actuarial share of the adjusted uniform basis. In this case, CRAT’s adjusted uniform basis in its sole asset, the Y stock, is $140x. However, paragraph (c) of this section applies to the transaction. Therefore, Grantor’s actuarial share of CRAT’s adjusted uniform basis (determined by applying the factors set forth in the tables contained in §20.2031-7 of this chapter) is reduced by an amount determined by applying the same factors to the sum of CRAT’s $0 of undistributed net ordinary income and its $90x of undistributed net capital gains.
(e) In determining Charity’s share of the adjusted uniform basis, Charity applies the factors set forth in the tables contained in §20.2031-7 of this chapter to determine its actuarial share of the full $140x of basis.
Here are my simplified examples that I hope explain it all:
- Donor creates a CRT on Jan. 2, Year 1, with securities having a zero basis and a FMV of $100,000. The trust sells the appreciated securities on Jan. 2, Year 2, and buys listed stock for $100,000. The trust’s basis in the contributed stock was zero; its basis in the new stock is $100,000. The trust is a Net-Income-With-No-Make-Up CRT (NI-CRUT). Tier 2 of the four-tier distribution rules had $100,000 of capital gain in Year 2. Donor received no income or capital gain in Year 1 or Year 2. Donor and charity sell their respective interests to third party on Dec. 31 of Year 2 for $100,000. Based on the value of Donor’s life interest, he received $80,000 on the sale. He’s deemed to have a zero basis in his share of the assets and has an $80,000 capital gain.
- Suppose the trust had been a STAN-CRUT. It earned no income but he received $10,000 in capital gain from the trust in satisfaction of his unitrust payments for Year 1 and Year 2. He has to report $10,000 of capital gain on his income tax returns. On the sale by the donor and the charity of their respective interests to a third party, his capital gain would be $70,000 and not $80,000.
The rule of the regulations in one sentence. On a sale of the trust assets to a third party by the life beneficiary and the charity of their respective interests, the life beneficiary must reduce the basis allocated to his life interest by any capital gain (and ordinary income) not distributed to him (still sitting in Tier 1 and Tier 2).
Effective dates: The final regulations are effective Aug. 12, 2015, but they apply to sales and other dispositions of interests in CRTs occurring on or after Jan.16, 2014, except for sales or dispositions occurring under a binding commitment entered into before Jan. 16, 2014.
However, the fact that a sale or disposition occurred, or a binding commitment to complete a sale or disposition was entered into, before January 16, 2014, does not preclude the IRS from applying legal arguments available to the IRS before issuance of these final regulations in order to contest the claimed tax treatment of such a transaction.
80 Fed. Reg. 48249 (Aug. 12, 2015)
*In England, a scheme is not a pejorative; but the Brits don’t pronounce the “c”—so what do they know.
**Evasion is more serious than avoidance. Avoidance can be achieved by taking advantage of tax-saving methods specified in the IRC. Sometimes it is achieved by a loophole (something that Congress didn’t think of—but kosher until the loophole is closed by legislation, regulation or revenue ruling). Tax evasion, on the other hand, can end you up in a federal gated community.
© Conrad Teitell 2015. This is not intended as legal, tax, financial or other advice. So, check with your adviser on how the rules apply to you.
