A recent decision by the Tax Court (Gladys L. Gerhardt et al. v. Commissioner of Internal Revenue, 160 T.C. No. 9 (April 20, 2023)) exposes the hazards in using a charitable remainder annuity trust (CRAT) as a tax-saving vehicle. In these consolidated cases, four members of the same family (collectively, the Gerhardts) executed a number of charitable remainder annuity trusts (CRATs) and contributed low-basis, highly appreciated properties to each. (CRATs are a type of charitable remainder trust most often used when individuals have highly appreciated assets, charitable intent and a need for a source of income for their lifetimes. At the end of the noncharitable beneficiary’s lifetime, or a term of up to 20 years, any remaining assets are distributed to the charitable beneficiary. This remainder passing to charity must be at least 10% of the fair market value of the property transferred to the trust. The grantor doesn’t recognize gain when transferring appreciated property to a CRAT, and a CRAT can sell appreciated property without paying tax on the sale.) Shortly after the contributions, the CRATs sold the properties and used the proceeds to purchase immediate annuities payable to the CRAT’s noncharitable beneficiaries. The Gerhardts believed that this structure would allow them to receive most of the sales proceeds back tax-free over the term of each CRAT. The Tax Court quickly and succinctly ruled that wasn’t the case.
Ordering Rules
First, the Tax Court addressed an issue applicable to all four petitioners: whether the annuity payments were taxable to the Gerhardts. The Tax Court explained that Congress established specific ordering rules that apply to characterizing and reporting annuity amounts distributed from a CRAT to its beneficiaries. (Internal Revenue Code Section 664(b)). Distributions from a CRAT to the income beneficiaries are first characterized as ordinary income to the extent of the CRAT’s current and previously undistributed ordinary income. Capital gains classification is next, to the extent of the CRAT’s current and previously undistributed capital gains, followed by other income, to the extent of the CRAT’s current and previously undistributed other income. Finally, such a distribution is characterized as a nontaxable distribution of trust corpus.
Ordinary Income Earned
The Gerhardts contributed appreciated property to each CRAT. The Gerhardts didn’t recognize gain on the transfers, and the CRATs had the same bases in the properties as the Gerhardts did before the transfers. When the contributed properties were sold, the CRATs realized gains. While the CRAT didn’t have to pay tax on those gains, the income earned was pertinent for establishing the character of the distributions to the noncharitable beneficiaries. Because the properties sold by the CRATs were subject to IRC 1245, the Tax Court determined that the income the CRATs earned was ordinary income. The Tax Court cited to Furrer v. Comm’r, T.C. Memo. 2022-100 (No. 7633-19, which involved nearly identical facts and arguments to the case at hand and in which the Tax Court made the same determinations.
Three Issues Relating to Specific Petitioners
The Tax Court then narrowed its focus to individual questions involving only certain, specific petitioners. The three separate matters at issue were: (1) whether Jack and Shelley Gerhardt should have recognized ordinary income under IRC Section 1245 when they disposed of depreciated property as part of an IRC Section 1031 exchange, (2) whether Jack and Shelley Gerhardt realized long-term capital gains from the sale of depreciated property, and (3) whether Tim and Pamela Gerhardt were liable for an accuracy-related penalty under Section IRC 6662(a).
Like-Kind Exchange
Turning to the first specific question, the property at issue was held by Jack and Shelley Gerhardt as a rental and produced income. It included raw land, hog buildings and equipment. Jack and Shelley met the requirements of a Section 1031 exchange when they substituted the property for another parcel in Cape Coral. Normally, no gain or loss is recognized on a like-kind exchange. However, if Section 1245 property is involved, then the gain from disposing of that property could be recognized as ordinary income. Jack and Shelley were unable to provide any evidence that the hog buildings and equipment were merely incidental to the property as a whole. Therefore, the Tax Court held that they failed to meet their burden. The gain from the original property was subject to the rules of Section 1245 and was treated as ordinary income.
Long-Term Capital Gains
Next, the Tax Court examined how Jack and Shelley reported gains from the sale of yet another property, which consisted of a hog-finishing barn, land and hog equipment. They gifted a partial interest to their CRAT and later sold the rest for $75,000. The Commissioner decided that the gain reported on their Form 4797 should have been zero because the recapture amounts from the property and the land basis amounts were included in the CRAT amounts. Thus, the entirety of the sale proceeds should have been long-term capital gains to Jack and Shelley. Having offered no argument against the Commissioner’s findings, Jack and Shelley forfeited any objections. The Tax Court ruled for the Commissioner.
Accuracy-Related Penalty
Finally, the Tax Court examined whether another couple, Tim and Pamela Gerhardt, were liable for an accuracy-related penalty under Section 6662(a) and (b)(2) for substantially understating income. To be considered substantial, the understatement of income tax must exceed the greater of $5,000 or 10% of the tax that should have been shown on the return. It’s the Commissioner who bears the burden to prove the liability of an individual for any penalty. At the same time, the Commissioner must show that the relevant procedural requirements were met.
If the taxpayer can show that there was reasonable cause for the underpayment, a penalty won’t be imposed. After the Commissioner proves liability for penalty, the taxpayer is then tasked with showing that they’re excused from the penalty for reasonable cause. Such a determination is made on a case-by-case basis with the most important factor being the taxpayer’s effort to calculate the proper tax liability. Here, Tim and Pamela claimed that they had reasonable cause for the underpayment because they relied on their tax advisors, and such reliance was reasonable. The Tax Court applied a three-prong test to determine whether the reliance was reasonable: (1) the advisor was a competent professional with appropriate proficiency to warrant reliance, (2) the taxpayer provided necessary and accurate information to the advisor, and (3) the taxpayer actually relied in good faith on the advisor’s judgment. Because there wasn’t any information in the record about the advisor’s qualifications, the nature of Tim and Pamela’s communications with him or what kind of advice they received, the Tax Court was unable to determine that Tim and Pamela reasonably relied on the advice of their advisor. Thus, the Tax Court allowed the penalty.
Lesson in Preparedness
In addition to acting as a primer on CRAT law and some of the intricacies of Section 1245 property, this case also serves as a lesson in preparedness. Advisors must check out the precedent, understand the law and weigh the risks before implementing even seemingly straightforward tax saving strategies. While CRAT law and the ordering rules may seem clear-cut, as demonstrated in this case, they’re certainly areas fraught with potential hazards.