The Internal Revenue Service recently issued Proposed Regulations (proposed regs) Section 1.6011-15, which aims to limit the abuse of certain charitable remainder annuity trusts. In particular, the proposed regs target CRATs funded with appreciated assets that are then sold, and the sale proceeds are used to buy a single premium immediate annuity (SPIA). The proposed regs seek to identify these transactions as “listed transactions.”
To thwart arrangements that are “abusive” of the U.S. tax system, the Internal Revenue Code allows the IRS to find them to be “reportable transactions.” As the name implies, taxpayers must report these transactions to the IRS or be subject to severe penalties. Advisors or promoters who recommend these transactions may also be subject to special reporting requirements and penalties. The “reported transactions” category includes arrangements the IRS identifies as “listed transactions.”
How CRATs Are Taxed
The IRC gives special tax treatment to charitable remainder trusts (CRTs), which include CRATs. Among other attributes, CRTs are entirely exempt from income tax (although they face a 100% excise tax on any unrelated business income they receive or is imputed to them). However, IRC Section 664(b) treats distributions from a CRT (other than to charity) as first consisting of ordinary income experienced by the trust, then capital gains, then tax-exempt income and lastly of the trust’s corpus. These trusts are commonly used to postpone the imposition of income tax for individuals, not to avoid the tax entirely. It’s perceived that the postponement of income taxation provides individuals with an enhanced wealth base to derive future income. When the trust ends, which can’t be later than 20 years or the death of individual beneficiaries identified in the trust when it begins, the trust assets (that is, the remainder) must pass to charity.
How CRAT Distributions Are Taxed
IRC Section 72 also provides a special regime for taxing distributions from a CRAT. In general, distributions are deemed to consist of the investment in the CRAT (which may not be subject to income tax) plus capital gains (if any, in the property used to acquire the annuity contract) and profit from the arrangement (taxed as ordinary income). The ability to have distributions that consist of those elements means the income taxation may be postponed rather than treated as currently included in the annuitant’s gross income.
Transaction Identified as Listed Transaction
Under Prop. Reg. 1.6011-15, a transaction will be identified as a listed transaction if:
- The grantor creates a trust purporting to qualify as a CRAT under IRC Section 664;
- The grantor funds the trust with property having a fair market value in excess of its basis (contributed property);
- The trustee sells the contributed property;
- The trustee uses some or all of the proceeds from the sale of the contributed property to purchase a SPIA; and
- On a federal income tax return, the trust’s beneficiary treats the amount payable from the trust as if it were, in whole or in part, an annuity payment subject to Section 72 instead of as carrying out to the beneficiary amounts of ordinary income and capital gains of the trust in accordance with Section 664(b).
The preamble to the proposed regs states that those involved in the above transaction (including, in some cases, the charitable remainder beneficiary) face penalties and special reporting requirements (which, if not met, may result in additional significant penalties). They must also maintain special records.
Steer away from this or similar transactions, and advise any client to do so too.