The Taxable CRT" Is Back!"

The Taxable CRT" Is Back!"

Article posted in Charitable Remainder Trust on 31 December 2001| comments
audience: National Publication | last updated: 16 September 2012
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Summary

Just when you thought the year-end tax planning season might come to a close without hearing of any shady charitable tax avoidance schemes, it appears one has come back to life-- the "Taxable CRT." In this final edition of Planned Giving Online for 2001, PGDC Editor-in-Chief Marc D. Hoffman describes this plan and why prudent gift planners will want to avoid it.

by Marc D. Hoffman

Note: This article was modified on 1/8/02.

Just when you thought the year-end tax planning season might come to a close without hearing of any shady charitable tax avoidance schemes, it appears one has come back to life. A planner called recently to ask our opinion of a plan he had been asked to review by one of his clients. The client, who was considering the sale of a multi-million-dollar asset had been told by his investment advisor that he could transfer his asset to a charitable remainder trust, sell it tax-free, and immediately start receiving tax-exempt income for the rest of his life. "If this can be done," the client exclaimed, "where do I sign up?"

When the caller went on to explain this could be accomplished by intentionally disqualifying the tax-exempt status of the trust, I knew we were probably dealing with a technique known as the "Taxable CRT."

Background

In the April/May 1996 issue of Estate Planning magazine, respected estate planner, author and lecturer Howard M. Zaritsky, J.D. critiqued a plan that is designed to circumvent the four-tier system of taxation.1

The plan would work as follows:

Suppose that on December 31st, an individual transfers $1,000,000 in stock, having a $100,000 cost basis, to a charitable remainder unitrust bearing a five percent payout rate. Income will be paid to the trustor for life; however, the target of the income and the trust's measuring term is actually immaterial to the plan. The trustee sells the stock the same day and makes a prorated distribution covering the last day of the trust's first tax-year--in the case, $137 ($1,000,000 x 5% x (1/365)). The remaining proceeds are reinvested in tax-exempt bonds.2 The key is that during this first tax year, the trust is tax-exempt; therefore, no tax is paid on the sale of the contributed property.

Under the four-tier system of taxation described in Treas. reg. section 1.664-1(d)(1)(i), the $900,000 long-term capital gain from the sale of the contributed property will drop into tier-two. Therefore, the $137 distribution in year one will be taxable to the income recipient as long-term capital gain. In theory, assuming there are no changes in trust valuation or the yield from the bonds, the process will repeat itself for the next 18 years until the entire $900,000 long-term capital gain from the sale of the contributed stock has been distributed--after which, the distributions would finally be tax-exempt. For this reason, it makes little sense to reinvest the proceeds from the sale of a highly appreciated asset within a CRT in tax-exempt securities.

The Role of Unrelated Business Taxable Income

Here's the twist. To understand how the Taxable CRT works, it is important to understand the concept of unrelated business taxable income and its effect on the trust. If a charitable remainder trust has any unrelated business taxable income in its taxable year, it loses its tax exemption for that year entirely and is subject to taxes on all of its income during the entire year as a complex trust.3 In addition to filing Forms 5227 and 1041-A, CRTs having unrelated business taxable income are required to file Form 1041 - U.S. Fiduciary Income Tax Return.

The loss of tax exemption is not permanent, but is determined for each tax year. In computing unrelated business taxable income, it is important to distinguish unrelated business income from unrelated business taxable income. Only the presence of the latter causes the charitable remainder trust to lose its exemption. In calculating UBTI, a charitable remainder trust is allowed certain modifications including a $1,000 specific exemption.4 Therefore a CRT can have some UBI and still retain its tax-exemption provided its deductions result in it having no net UBTI. The consequences of a CRT having UBTI can range from benign to catastrophic. If, for example, the loss of exemption occurs in the same year that highly appreciated assets are sold, the trust will pay tax on all of the gain. For purposes of the Taxable CRT, it is important the trust retain its tax-exemption in any year in which highly appreciated contributed assets are sold.

Continuing with our scenario, at the beginning of year two, the trustee invests $50,000 in a partnership that produces $1,001 of unrelated business income (e.g., debt-financed income) during the year. In this case, the trust has no deductions against UBI other than the specific deduction of $1,000; therefore, the trust produces $1 in UBTI which results in the loss of its exemption for year two.

The "Taxable CRT" plan relies on the fact that all income of a charitable remainder trust should be taxed if any of it is UBTI. Because a non-exempt trust is taxed as a complex trust, proponents of the plan contend the four-tier system is no longer applicable. Accordingly, the $50,000 distribution to the income recipient in year two should consist of $1,001 of ordinary income (from the partnership) and $48,999 in tax-exempt income (attributable to the bonds). Furthermore, the loss of the trust's tax-exemption is not troublesome because the trust can claim a deduction against its taxable income for amounts it distributes to the income recipient. In this case, since the trust distributes all its income, it pays no tax.

Why the Plan Doesn't Work

Mr. Zaritsky cautioned that many practitioners may be reluctant to recommend this approach, "particularly in light of the IRS's recent willingness to view the use of a charitable remainder trust for the grantor's tax benefit as self-dealing." You may recall that two years earlier in 1994, the IRS had lowered the boom on the so-called "Accelerated CRT," a scheme that also attempted to skirt the four-tier system. For further reading see Notice 94-78. He also cautioned there might be issues of fiduciary liability for trustees that engage in such plans.

Shortly following publication of Mr. Zaritsky's article, Robert Coplan, currently the National Director of Ernst & Young's Center For Family Wealth Planning in Washington, D.C. discussed with him Treas. Reg. 1.664-1(d)(i) which he believes undermines the attempt to have tax-exempt interest flow out before capital gains from a CRT that intentionally blows its exemption in the year following the sale of an asset. The regulation reads in part as follows:

(i) Order of distributions.

Annuity and unitrust amounts shall be treated as having the following characteristics in the hands of the recipients (whether or not the trust is exempt) [emphasis added] without credit for any taxes which are imposed by Subtitle A of the Code on the trust:

As a result of their conversation, Mr. Zaritsky also concluded that the regulation directly impacted the Taxable CRT, so he wrote the following note, which appeared only in the print version of the June 1996 issue of Estate Planning:

"IMPORTANT NOTE: An alert reader notes that a parenthetical phrase in Reg. 1.664-1(d) retains the tier system for taxable charitable remainder trusts, while applying the normal rules of Subchapter J to the trust itself. This makes intentional taxability ineffective as a means of generating tax-exempt income for the trust beneficiary, contrary to the suggestion in the March/April 1996 column, "Joys of a Taxable CRT" (23 EP 144), Readers should still be alert to avoid the other complications discussed in that column regarding a CRT that holds assets that produce unrelated business taxable income."

The bottom line regarding the Taxable CRT is that while it might be an interesting topic for a theoretical tax conversation, it has no place in the playbook of conscientious gift planners. Remember the first commandment of gift planning -- "Make not thy donor/client famous--well at least not with the IRS!"


Endnotes


  1. Howard M. Zaritsky, J.D., "The Joys of a Taxable CRT," Estate Planning, March/April 1996 Vol. 23 No. 3 p. 144.back

  2. A 5% yield on tax-exempts was possible in 1996. Today it is not; therefore, a net income unitrust could be used.back

  3. IRC §511(b)back

  4. IRC §512(a)(12)back

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