Tax Notes recently reported that according to Robert Malone, director of exempt organizations and government entities in the Internal Revenue Service’s Tax-Exempt and Government Entities Division, the IRS will start cracking down on charitable remainder annuity trust (CRAT) abuse.
Certain promoters are marketing CRATs as a way to eliminate capital gains on the sale of highly appreciated property, but a 2020 Chief Counsel memorandum found that the proposed structure doesn’t meet the requirements of Internal Revenue Code Sections 72 or 664.
Alexandra P. Brovey, senior director of gift planning at Northwell Health Foundation in New Hyde Park, N.Y., explains that the abuse occurs when appreciated assets donated to a CRAT are treated as principal. When the trustee sells the appreciated assets and purchases an annuity, the promoters wrongly conclude that there’s no gain in the trust to be taxed. The trustees are ignoring the four-tier ordering rule that directs how trust distributions are taxed, by ignoring the accumulated capital gains from the sale of the appreciated assets.
The distributions will be taxed to the extent there’s ordinary income for the current year (from the annuity) and any accumulated ordinary income from prior years, then to the extent there’s current capital gains and any accumulated capital gains. Only when income from those two categories is exhausted would the income not be taxable as principal.