Early Termination of Private Trusts and Charitable Trusts: Valuation of the Interests and the Allocation of Income Tax Basis

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1 Early Termination of Private Trusts and Charitable Trusts: Valuation of the Interests and the Allocation of Income Tax Basis By Jerome M. Hesch, Esq. Miami, Florida Director Notre Dame Tax & Estate Planning Institute South Bend, Indiana September 20 th and 21 st, 2012 Fiduciary Income Tax Committee ACTEC 2012 Annual Meeting Miami Beach, Florida March 8,

2 Table of Contents Introduction... 1 Allocation and Amortization of Basis: In General... 2 Wasting Assets and Non-Wasting Assets Coupon Stripping: Separating the Right to Income from an Income-Producing Debt Obligation... 3 Allocating Basis Between Income and Remainder Beneficiaries in a Private Trust... 5 Basis Allocation to Sales of Term Interests... 6 Basis Allocation Assuming the Trust Continues... 7 Basis Allocation to Sales of Term Interests Before Basis Allocation to Sales of Term Interests After Basis Allocation to Termination of Private Trusts... 8 Basis Allocation Upon Trust Merger... 8 Basis Allocation of Purchased and Resold Term Interest... 9 Ascertaining Whether to Sell a Life Estate... 9 Allocating Basis Between Income and Remainder Beneficiaries in a Charitable Remainder Trust Term Interests Taxation of CRT Distributions to Term Interest Holder Basis Allocation Upon Termination of Charitable Remainder Trusts No-Rule Position Is a Term Interest a Capital Asset? Drafting Considerations Impaired Life Expectancy Valuation Issues Transaction of Interest: Notice CRT Exit Strategy Alternatives Partial Acceleration of Remainder Interest Full Acceleration of Remainder Interest CRT Termination Divide Assets Among Beneficiaries Sell Term Interest to Third Party Simultaneous Sale of Term and Remainder Interest to Third Party Gift Term Interest to New CRT Convert CRT to Charitable Gift Annuity Notice Conclusion Presentation Slides

3 Introduction A charitable remainder trust ( CRT ) is a widely-used charitable planning technique that provides the settlor with significant income tax benefits and a source of future payments, followed by the distribution of trust assets to one or more charities at the end of the trust term. The CRT generates an immediate income tax charitable deduction (equal to the present value of the interest passing to the charitable remainder beneficiary) that can offset ordinary income. 1 And the CRT can be used to eliminate the income tax on the gain realized from the sale of appreciated assets. The CRT creates a financial benefit because the person who transfers assets to the CRT receives (or can gift to one or more others) an annuity or unitrust payment for life or for a fixed term. Sometimes the person entitled to the future annuity or unitrust payments the term interest holder desires to accelerate these payments. Reasons for desiring such an acceleration range from an immediate need for more cash to a concern that income tax rates will increase in the future. In response to this phenomenon, several companies now specialize in purchasing charitable remainder trust annuity streams for cash. 2 In addition, there are individuals who would like to accelerate the charitable distribution instead of delaying it until the end of the CRT term. And there are times when both the term interest holder and the charitable remainder beneficiary decide it is best to terminate the trust. Because of concerns about self-dealing and the income tax treatment of an early termination, several taxpayers have obtained private letter rulings from the Internal Revenue Service regarding early CRT terminations. 3 In these private letter rulings, the facts stated that the holder of the annuity interest first sold the annuity interest to the CRT and that immediately thereafter, as a separate step, the trust distributed its remaining assets to the charitable remainder beneficiary. Since the term interest holder is separately selling the annuity interest, the gain on that sale needs to be determined. Based on prior case law and a published Revenue Ruling, the Service held that the gain is a capital gain. 4 In calculating the amount of the capital gain, the Service disallowed the use of the term interest holder s basis by concluding that the term interest holders were, in substance, selling their interests to the remainder beneficiaries, thereby triggering 1001(e)(1). 5 In effect, the entire amount received from the sale of the term interest must be reported as a capital gain, and the entire basis in the CRT s assets is allocated to the charitable remainder beneficiary, which does not need this extra allocation of basis because the charitable remainder beneficiary is tax-exempt. The focus of this paper is to examine how basis is allocated when there is a sale or other disposition of an income interest in a CRT. Before we examine how basis should be allocated with respect to CRTs, we will first examine how basis is allocated when there is a separation of the income 1 2 The charitable itemized deduction is not a tax preference item under the alternative minimum tax. One such company is Sterling Foundation Management 3 See, e.g., PLR , PLR , PLR , PLR , PLR , PLR , PLR , PLR , and PLR McAllister v. Commissioner, 157 F.2d 235 (2d Cir. 1946), and Rev. Rul , C.B. See PLRs cited at Note 2, supra

4 interest from the principal for debt obligations 6 and then examine the treatment where the same issues occur among private trusts. Because we conclude that the Service is taking a position that is inconsistent with the basis allocation treatment in analogous situations, we question whether the Service correctly applied 1001(e)(1) to situations in which a CRT was terminated by all beneficiaries. We believe that the complete termination of a CRT provides a ratable share of basis to the holder of the income interest. We believe this is true for two reasons. First, we believe that basic principles that apply to private trust terminations should apply to CRT terminations allocating basis ratably among income and remainder beneficiaries. Second, we believe a CRT termination triggers the exception to 1001(e)(1) found in 1001(e)(3). To support our position, we have analyzed how basis is allocated among debt obligations, private trusts, and the legislative history of 1001(e). The reader should note that this is a discussion of tax principles, not tax policy. The Service wins the policy argument inasmuch as, taken to the extreme, our theories would allow the income beneficiary of a CRT to accelerate the beneficiary s income interest at no tax cost. This would allow those using a CRT to defer tax to instead use a CRT to eliminate tax. The Service clearly understands this risk, as evidenced by the text of its many rulings on the matter and a recent notice identifying a related structure as a transaction of interest. But in its effort to enforce sound tax policy, the Service has taken an unprincipled approach. The intent of this paper is not to identify new, too-good-to-be-true, tax planning opportunities but, instead, to insist that the Service acknowledge its unprincipled approach and request the assistance of Congress in addressing the underlying policy issues. Allocation and Amortization of Basis: In General Wasting Assets and Non-Wasting Assets. Basis is a fundamental income tax concept that measures a taxpayer s investment in an asset and is typically the asset s initial cost. 7 A taxpayer can adjust the property s basis under certain circumstances, as set forth in the Code. 8 It is the adjusted basis that is ultimately used to determine the taxpayer s gain or loss upon a sale or exchange of the property. 9 Basis allocation can significantly affect the amount of gain or loss a taxpayer realizes upon a subsequent taxable disposition of the property. We will start by examining the recovery of basis between wasting assets and non-wasting assets. Consider annuities and bonds. Since annuities are wasting assets, their basis can be amortized over their useful life. As a result, a portion the exclusion ratio of each annuity payment received is a non-taxable return of basis. 10 The amount of each annuity payment in excess of the return of basis is taxable annuity income. 6 tree This is so-called coupon stripping, which is, fundamentally, the separation of the fruit from the IRC IRC IRC 1001(a) and IRC

5 Example 1: Taxpayer (T) purchases a 20-year fixed annuity (yielding an investment rate of return of 6%) for $1,000,000. The annual annuity payment over the 20-year term is $87, Using the exclusion ratio, $50,000 of each annuity payment is a non-taxable return of basis and $37,185 is taxable as ordinary income. 12 By the time all 20 annual annuity payments are received, T will have treated the entire $1,000,000 paid for the annuity as a return of basis. Bonds, on the other hand, are not wasting assets. Therefore, the cost of a bond cannot be amortized. Instead, the cost basis is allocated to the payment of the principal upon the maturity of the bond. A taxpayer who purchases a bond is actually purchasing two interests: (i) the right to the annual coupons, 13 which is the right to annual annuity payments for the term of the bond, and (ii) the right to the payment of the of principal at the end of the term. Since bonds cannot be amortized, no portion of the basis can be allocated to the annual interest payments. Instead, the entire basis is allocated to the principal that is returned at the end of the bond s term. Example 2: Taxpayer (T) purchases a 20-year bond paying 6% annual interest, $60,000 a year, for $1,000,000. Using a 6% discount rate, the present value of the annual coupons is $688,195.27, and the present value of the $1,000,000 payment in twenty years is $311, Taken together, the value of both the right to receive the annual interest payments and the right to receive the future principal payment is $1,000,000. Since no portion of T s basis is allocable to the annual coupons, T must report the entire coupon payment as ordinary income upon receipt. Since all of T s basis is allocable to the $1,000,000 that T will receive at the end of the bond term, the entire principal payment received at maturity is a non-taxable return of basis. If the bond is placed in a trust, where the income is to be distributed to A for 20 years and the remainder to B upon maturity of the bond, the Code prohibits holders of the income interest from taking any depreciation deductions attributable to the lapse of time. 14 Coupon Stripping: Separating the Right to Income from an Income-Producing Debt Obligation As you can see, with wasting assets, such as annuities, a taxpayer is allowed to allocate a portion of basis to the amount received each year; whereas with non-wasting assets, such as bonds, all of the basis must be allocated to the principal. This principle, in modified form, has been extended by legislation when the right to the annual interest income is separated from the underlying debt obligation producing that income. This legislation prohibits the allocation of the entire basis in a debt obligation to the incomeproducing principal, such as a bond, whenever a taxpayer who owns both the right to the income and the 11 Using the 2000 CM (2000) tables found in Publication 1457, the annuity factor is ($1,000,000 divided by = $87,184.72) Based on an exclusion ratio of %. The right to the annual interest payment is commonly referred to as the coupon payment. IRC

6 right to the principal separates these rights among different taxpayers. In 1982, Congress added Section 1286 to the Internal Revenue Code, which provides that stripped coupons be allocated a portion of the basis initially allocated all to the principal, using the original issue discount rules to make this allocation. 15 Allocation of basis to the coupons allows separated income interests to be amortized. And the holder of only the right to the future principal payment must report income on an annual basis, even though no payment was received. 16 By reporting annual income under the OID rules, at the end of the term the holder of the right to the principal payment has an adjusted basis equal to the total amount of the principal received at maturity. Example 3: Taxpayer (T) owns a $1,000,000 bond, paying 6% annual interest, $60,000 a year for 20 years, with a remaining maturity of 20 years. Using a 6% discount rate, the value of the right to the future $60,000 annual coupon is $688,195.27, and the right to receive the $1,000,000 principal payment at the end of 20 years is $311, If T continues to retain both the coupons and the principal, T has no basis in the income interest and a $1,000,000 basis in the remainder interest. If the coupons are separated from the principal, 1286(b)(3) requires that the basis in the bond be allocated among the coupons and the principal using the value of each as the way to measure the allocation of basis. Example 3(a). T sells the principal to X for its $311, value. Since T is treated as having a $311, basis in the principal, T does not realize any gain or loss on the sale. And as T continues to collect the $60,000 annual interest payments, T can amortize his remaining $688, basis over the 20 annual coupon payments and report only the excess as income. X will be treated as having acquired an OID debt obligation and must report the imputed income amount each year as it accrues. Example 3(b). T sells the right to the annual coupons to Y for their $688, value. T will not report any gain or loss as $688, of basis is allocated to the coupons that T sold. Y will take a $688, cost basis in the coupons (a wasting asset) purchased, and Y can amortize that cost over 20 years as Y collects the $60,000 annual interest payments. T will treat the right to receive the $1,000,000 of principal as an OID debt obligation and will have to report the imputed interest income under the OID rules as it accrues. To further complicate matters, the coupon stripping rules under 1286 apply to all transfers where the coupons are separated from the principal, including gifts and bequests. If the owner of a bond separates the coupons from the principal by gift or by bequest, the uniform basis rules state that each 15 See, e.g., General Explanation of the Revenue Provision of the Tax Equity and Fiscal Responsibility Act of 1982, p (a), (b)

7 transferee receives a uniform basis. 17 But if the bond is placed in trust with income to A and principal to B, the coupon stripping rules should not apply. Allocating Basis Between Income and Remainder Beneficiaries in a Private Trust Example 4: G1 owns a $1,000,000 bond paying 6% annual interest with a remaining maturity of 20 years. G1 transfers the bond in trust, providing that all income be paid to G2 and that upon the redemption of the bond at maturity the entire principal be distributed to G3. Section 2702 does not apply because T did not retain any interest in the trust. Therefore, the entire value of the transfer in trust is a gift. Immediately after the gift, using a 6% discount rate, the value of G2 s income interest is $688, and the value of G3 s remainder interest is $311, These values are adjusted each year as G2 receives the income distributions and the number of years to the receipt of the principal declines. If G2 sold the right to the bond s annual coupons before the enactment of 1001(e), G2 could deduct the income interest s share of basis to reduce the gain realized on the sale. 18 The purchaser would take a basis in the income interest equal to the purchase price. And G3 s basis would remain at $1,000,000 at the end of 20 years. Thus, an extra $688, of basis was created, referred to as doubling of basis. In 1969, Congress added Section 1001(e) to prevent the doubling of basis. Section 1001(e) now provides that upon the sale or disposition of a term interest, the term interest holder s adjusted basis, if determined pursuant to sections 1014, 1015, or 1041 (meaning the term interest was created by a lifetime gift or testamentary bequest), will be disregarded. 19 The Code further provides, however, for an exception to 1001(e)(1) when the entire interest (both the term interest and the remainder interest) are disposed of in the same transaction. 20 According to the Committee Report, the exception is appropriate because the purchaser acquires a single entire interest in the property and, therefore, he is not allowed to amortize the separate life interest. 21 Now, under 1001(e)(1), G2 cannot use any basis allocated to the term interest to reduce the gain on the sale, thereby eliminating the doubling of basis problem. It is important to note that although G2 is no longer allowed to use the basis attributable to the income interest, the gain is still characterized as capital gain Treas. Reg (a). 18 See, e.g. McAllister v. Commissioner, 157 F.2d 235 (2d Cir. 1946). For an excellent analysis of the characterization of the gain, see, Douglas A. Kahn, Gain From the Sale of an Income Interest in a Trust, 30 Va. Tax Rev. 445 (2010) IRC 1001(e)(1). IRC 1001(e)(3). 21 See, General Explanation of the Tax Reform Act of 1969, H.R , 91 st Congress, Public Law , Prepared by the Staff of the Joint Committee on Internal Revenue Taxation. 22 Rev. Rul , C.B See, Douglas A. Kahn, Gain From the Sale of an Income Interest in a Trust, 30 Va. Tax Rev. 445 (2010) (excellent analysis of the characterization of the gain)

8 What is the result if G3 sells the remainder interest for its value? Since there is no sale of a term interest, 1001(e)(1) does not apply. Can G3 can use the trust s entire basis to offset the sale price and thus report a loss on the sale? If G2 and G3 sell their rights as part of the same transaction, the exception contained in 1001(e)(3) applies and both parties can use their respective uniform basis to determine the gain or the loss realized on their sales. Basis Allocation to Sales of Term Interests A term interest includes a life interest in property (i.e., life estate), an interest in property for a term of years (i.e., a tenancy for years), or any income interest in a trust. 23 In this paper, we are primarily concerned with term interests in trusts. A term interest in a trust includes a traditional income interest, a unitrust interest, or an annuity interest and may be a combination of two or more of such interests. A term interest may be for one or more lives, a term of years, or a combination of a term of years preceding or following one or more lives. When analyzing the sale of a term interest, we must first determine the appropriate value to allocate to the term interest. This is determined by the life estate and remainder factors set forth in the Estate Tax Regulations. 24 Once we have determined the life estate factor and the remainder factor, we are able to determine the basis to be allocated to the term interest and the remainder interest. 25 The life estate and remainder interest factors are determined by reference to the 2000CM (2000) life expectancy tables. But fair market value of an annuity stream is determined by reference to the 1.401(a)(9) (2002) life expectancy tables. Because this latter table is based on actual purchases of annuities, which tend to be favored by those who are healthier and therefore tend to have longer life expectancies, there may be some degree of mismatch between basis allocation, which is based on estate tax valuation principles, and the market price expected to be paid for a term interest. An individual age 70 has a life expectancy of years based on the 2000CM (2000) (estate tax) tables and a life expectancy of 17 years based on the 1.401(a)(9) (2002) (annuity sales) tables. Assuming the March rate of 3.0%, the same individual has a life estate factor of and a remainder factor of We have rounded these factors to 33% and 67%, respectively, in our examples below. Let us assume that Sam Settlor (G1) created a private trust for the benefit of Tina Termholder (G2) and Ralph Remainderman (G3). Tina Termholder, age 70, received a life estate. The remainder goes to Ralph Remainderman upon Tina Termholder s death. The trust holds a $1.2 Million asset with a $900,000 basis. The trust therefore has unrealized gain of $300,000. Tina Termholder s term interest is actuarially determined to be 33% of the value of the underlying asset, and Ralph Remainderman s remainder interest is actuarially determined to be 67% of the underlying asset. This is based upon Tina Termholder s life expectancy of years and a March rate of 3.0%. The assumptions are set forth in the table below: IRC 1001(e)(2). Treas. Reg Id

9 Tina Termholder (G2) Age 70 Value of Asset in Trust $1,200,000 Basis of Asset in Trust $900,000 March Rate 3.0% 2000CM (2000) Life Expectancy Years Estate Tax Life Estate Factor Estate Tax Remainder Interest Factor Value Life Estate 33% (rounded), or $396, Value Remainder Interest 67% (rounded), or $804,000 Basis Allocated to Life Estate 33%, or $300,000 Basis Allocated to Remainder Interest 67%, or $600,000 Trust Term Life Estate in Tina (G2), Remainder to Ralph (G3) Basis Allocation Assuming the Trust Continues We have assumed that Tina Termholder will report $40,000 annually in gross income as ordinary income. This assumes that adequate trust income was generated from interest, dividends, operating income from a REIT, a partnership, an S corporation, royalties, or rents and passed through as DNI. Of course, qualified dividends distributed as part of DNI would be taxed at capital gain rates. Under 273, Tina Termholder will be unable to depreciate any basis. At Tina Termholder s (G2) death, the remainder will pass to Ralph Remainderman (G3), along with the entire $900,000 basis. Basis Allocation to Sales of Term Interests Before 1969 Let us assume that Tina Termholder chooses to sell her life estate before 1969, the year in which 1001(e) was enacted. Tina Termholder will therefore have some basis in her life estate. Let us further assume that Tina Termholder sells her life estate for a fair market value of $396,000. Tina Termholder s basis is $300,000 (33% of $900,000), and her gain, taxed as capital gain, is $96,000. This result is summarized below: Amount Realized $396,000 Less Basis $300,000 (33% x $900,000) Gain on Sale $96,000 Character of Gain Capital Gain In the example above of Tina Termholder s sale of her life estate, the purchaser receives a basis in Tina Termholder s life estate of $396,000. Upon the death of Tina Termholder (G2), Ralph Remainderman (G3) will still have a basis in his remainder interest of $900,000. Therefore, the sale of the life estate created artificial extra basis. Tina Termholder avoided taxation on $300,000 of the sale, only paying tax on $96,000 of the sale proceeds, the purchaser of Tina Termholder s life estate will depreciate the $396,000 term interest ratably over years under IRC 167 as the purchaser collects

10 annual income, and Ralph Remainderman will have a $900,000 basis in the asset. The net result is that basis was doubled to the tune of $300,000, the exact amount of Tina Termholder s basis. Basis Allocation to Sales of Term Interests After 1969 Congress introduced IRC 1001(e) in 1969 to prevent doubling of basis allocated to the term interest holder. Under IRC 1001(e)(1), if basis in a term interest is determined pursuant to IRC 1014, 1015, or 1041, meaning the term interest was created by a lifetime gift or testamentary bequest, that basis is disregarded upon sale of the term interest. Because Tina Termholder s interest was received as a gift from Sam Settlor, the only basis in her term interest would be determined under IRC Because that basis is disregarded, and because she has no basis in her life estate from any other source, her sale of her life estate interest would be treated as a capital asset sold with zero basis. So after 1969, the transaction would have looked like the following: Amount Realized $396,000 Less Basis Zero Gain on Sale $396,000 Character of Gain Capital Gain After the addition of 1001(e), Tina Termholder would have recognized gain of $396,000, the purchaser of Tina Termholder s life estate would have a basis of $396,000 depreciable over years, and Ralph Remainderman would have received the asset with a $900,000 basis. So the collective reduction in basis/depreciation deductions among the three parties is $300,000 the elimination of Tina Termholder s basis in her life estate. Basis Allocation to Termination of Private Trusts Let us assume the trust holds 1,000 shares of X Corporation. Upon termination of the trust, Tina Termholder will receive 333 shares of X Corporation valued at $396,000 with a basis of $300,000, and Ralph Remainderman will receive 667 shares of X Corporation with a value of $804,000 and a basis of $600, Basis Allocation Upon Trust Merger Let us assume the same facts above, but in this instance, both Tina Termholder and Ralph Remainderman sell their respective interests to the same third party, Paul Purchaser. This action triggers 1001(e)(3), also known as the Uniform Basis Rule. When both the term interest holder and the remainder interest holder sell their interests to a common third party, there is no risk of a doubling of basis. Therefore, there is an exception to the general rule of 1001(e)(1), so the term interest holder is allocated basis. Based on the facts from our example, and assuming the term interest and remainder interest are both sold at fair market value, Tina Termholder has sold 333 shares of X Corporation for $396,000 with a basis of $300,000, and Ralph Remainderman has sold 667 shares for $804,000 with a basis of $600,000. So Tina Termholder recognizes $96,000 of capital gain income, and Ralph Remainderman recognizes $204,000 of capital gain income. This transaction is detailed below: 26 IRC

11 Tina Termholder Amount Realized $396,000 Less Basis $300,000 Gain on Sale $96,000 Character of Gain Capital Gain Ralph Remainderman Amount Realized $804,000 Less Basis $600,000 Gain on Sale $204,000 Character of Gain Capital Gain Combined Sale Results Amount Realized $1.2 Million ($396,000 + $804,000) Less Basis $900,000 ($300,000 + $600,000) Gain on Sale $300,000 ($96,000 + $204,000) Character of Gain Capital Gain Basis Allocation of Purchased and Resold Term Interest Let us assume that Tina Termholder sells her life estate to Bill Buyer for $396,000. Bill Buyer now owns the asset with a $396,000 basis. Assuming Bill Buyer is an unrelated party (within the meaning of 267(b) and (e)), he is entitled to a deduction equal to 1/14.27 of the $396,000 purchase price every year (or $396,000/14.27). 27 This is an annual deduction of $27,751. If Bill Buyer then resells the life estate in Tina Termholder s life, exactly two years later, to Samantha Secondary for $500,000, Bill Buyer will pay tax on that sale, but he will also be able to use his basis (no part of his basis is determined pursuant to IRC 1014, 1015, or 1041, but instead pursuant to IRC 1012). His basis started at $396,000. He depreciated away $55,502 of his basis (2 x $27,751), so his remaining basis is $340,498. $55,502 of his gain is IRC 1245 recapture, so he will pay ordinary income tax on that amount. But the remaining $104,000 of gain will be taxed as capital gain income. Purchase and Resale of Life Estate Purchase Price $396,000 Depreciation $55,502 Resale Price $500,000 IRC 1245 Recapture $55,502 Capital Gain $104,000 Ascertaining Whether to Sell a Life Estate If a term interest holder sells their life estate, the proceeds will be taxed at a combined income tax rate that is 20% lower than the combined ordinary income rate. Therefore, it may be advantageous to sell a life estate to convert ordinary income to capital gain. 27 IRC 167(e)

12 In the example above, Tina Termholder s life estate is worth $396,000. Assuming that Tina Termholder will pay an average combined income tax rate of 40% on her annual income from the trust, the present value of her life estate, after taxes, is $237,600 (60% of $396,000). Therefore, if Tina Termholder can sell her life estate, net of taxes, for $237,600 or more, she should do so. This is especially true in an environment in which income tax rates are expected to increase in the future. Countervailing considerations include excellent health, a family history of above-average longevity, and the possibility of a consumption tax partially replacing a portion of the income tax in the future. But assuming tax rates will remain static or increase, and assuming that Tina Termholder has an average life expectancy, she should sell her life estate as long as the sale price exceeds $297,000. Recall that Tina has no basis in her life estate per 1001(e)(1). So assuming a combined capital gain tax rate of 20%, Tina Termholder would net $237,600 from a sale of her life estate for $297,000 (80% of $297,000). So assuming that Tina Termholder can sell her life estate for at least $297,000 (which should be possible given that the actuarial value of the anticipated income stream is $396,000), she will net more. This is further illustrated below: After-Tax Value of Life Estate Present Value of Payments $396,000 Combined Income Tax Rate 40% Tax Due $158,400 Present Value of Net Proceeds $237,600 After-Tax Value of Selling Life Estate Amount Realized $297,000 Less Basis Zero Gain on Sale $297,000 Combined Capital Gain Rate 20% Tax Due $59,400 Net Proceeds $237,600 This example assumes, of course, that all distributions made to Tina Termholder during her life will be taxed as ordinary income. It is therefore critical to have a firm grasp on the taxpayer s current and anticipated average income tax rate and the current and anticipated character of trust distributions when making a hold versus sale comparison. Allocating Basis Between Income and Remainder Beneficiaries in a Charitable Remainder Trust As noted in the introduction, charitable remainder trusts have become a widely-used tax deferral technique in recent decades. During economic downturns, however, taxpayers may need to accelerate some or all of their term interest to help them through a rough patch. Additionally, in more recent years, looming tax increases have incentivized term interest holders to take their money early to avoid the risks of an uncertain future tax environment. In response to these phenomena, not only are more term interest holders seeking to terminate charitable remainder trusts early, but there are now companies that specialize in purchasing charitable remainder trust term interests for cash. Further reflecting increased interest in CRT terminations, the Service has issued 23 private letter rulings, mostly in the last decade, addressing the income tax treatment to the term interest holder upon

13 CRT termination (the CRT Termination Rulings). 28 Upon termination of a private trust, the term interest holder receives trust assets at carryover basis. 29 The Service asserts that CRTs do not enjoy the same tax treatment. Instead, in the CRT Termination Rulings, the Service imputes a deemed sale of the term interest to the charitable remainder beneficiaries, triggering IRC 1001(e)(1). The incongruous result of this Service-imposed factual assumption is that the CRT term interest holder is treated as having sold a capital asset with zero basis, recognizing gain on the entire sale proceeds. It is important to note that the Service has imposed this legal fiction on those seeking positive letter rulings. By so manipulating the facts, the Service has thus far avoided addressing head-on the fact that the income beneficiary s interest may indeed hold at least some basis, if not a basis equal to the full fair market value of the income interest. This is a stunning, although clearly not Congressionallyintended, result. A CRT term interest holder could receive the entire present value of its term interest and pay no tax upon CRT termination effectively eliminating the tax that would otherwise have been due upon sale of the appreciated asset initially contributed to the CRT. The Service is understandably concerned about this issue, but its approach in the CRT Termination Rulings has ignored fundamental principles of tax law. Effectively, the Service has taken an unprincipled approach to enforcing its vision of broader Congressional policy. Term Interests We discussed general principles of term interests in private trusts above. Of course, in the context of a charitable remainder trust, the term interest is limited to an annuity or unitrust interest. 30 There is flexibility in this characterization since, in the case of a charitable remainder unitrust, the trust may also adopt a lesser-of approach using either a net income charitable remainder unitrust or a net income with makeup provision charitable remainder unitrust. 31 For purposes of this paper, we will assume that the charitable remainder trust being terminated is a charitable remainder annuity trust ( CRAT ) with a $40,000 annual payout. Taxation of CRT Distributions to Term Interest Holder CRT distributions are taxed under a four-tier system set forth in IRC 664(b). This is often called the worst-in first-out method since income taxed at higher rates is generally deemed paid out before income taxed at lower rates. Each distribution is deemed to first exhaust any previously undistributed Tier 1 income, which includes ordinary income and dividends (including qualified dividends), then any 28 PLR , 07/09/2001; , 02/22/2002; PLR , 12/26/2002; PLR , 01/24/2003; PLR , 04/04/2003; PLR , 06/13/2003; PLR , 01/16/2004; PLR , 02/20/2004; PLR , 06/08/2004; PLR , 06/24/2005; PLR , 10/28/2005; PLR , 12/02/2005; PLR , 12/30/2005; PLR , 04/07/2006; PLR , 04/21/2006; PLR , 03/27/2007; PLR , 07/06/2007; PLR , 08/17/2007; PLR , 09/28/2007; PLR , 04/25/2008; PLR , 07/04/2008; PLR , 08/08/2008; PLR , 08/15/ IRC Unless, of course, the distribution of appreciated assets was in satisfaction of a required pecuniary distribution IRC 170(f)(2)(A). IRC 664(d)(3)

14 previously undistributed Tier 2 income, which includes both short- and long-term capital gain income, then any previously undistributed Tier 3 income, which is tax-free income, and then, finally, Tier 1 income, which is return of basis. The Service notes, in PLR , one of the CRT Termination Rulings, that IRC 664(b) provides rules to determine the character of annual annuity payments to a charitable remainder annuity trust beneficiary. The Service noted that money and property received by the term interest holder upon termination of a CRUT does not represent the distribution of an annual unitrust amount under IRC 664(b) and that, therefore, IRC 664(b) does not apply. This conclusion appears reasonable. IRC 664(b) does indeed apply to annual CRT distributions. The statute does not reference taxation upon CRT termination. Presumably, if IRC 664(b) did apply to a CRT termination, the term interest holder would recognize any previously unrecognized Tier 1, 2, and 3 income and would also benefit from Tier 4 return of basis in the asset(s) contributed to the CRT. Basis Allocation Upon Termination of Charitable Remainder Trusts As we discussed above, the tax principles that apply to basis allocation upon termination of a private trust are very clear. But the Service has abandoned these principles in addressing charitable remainder trust terminations. The Service has instead taken the position, in the CRT Termination Rulings, that a termination of a charitable remainder trust is, in fact, a deemed sale of the term interest to the charitable remainderman. If this factual assumption is correct, then the term interest holder is properly treated as having sold an asset with zero basis under IRC 1001(e)(1). In PLR , one of the CRT Termination Rulings, the Service stated that: [a]lthough the proposed transaction takes the form of a distribution of the present values of the respective interests of A, B, and the charities, in substance it is a sale of A and B's interest to the charities. The amount received by A and B as a result of the termination of Trust is an amount received from the sale or exchange of a capital asset. It appears instead that in substance the transaction precisely matches its form a trust termination. The recast substance of the transaction could just as legitimately have been the sale of the remainder interest from the charity to the term interest holder or as a deemed simultaneous sale of both term and remainder interests (triggering the uniform basis rule of IRC 1001(e)(3), which is an exception to the 1001(e)(1) zero basis rule). It appears likely that the Service, instead of focusing on the true substance of the transaction, assumed substance most convenient to its desire to avoid tax results incongruous with public policy. It is worth noting that in PLR , another of the CRT Termination Rulings, the Service acknowledged the taxpayer s withdrawal of a ruling request under IRC Instead, the taxpayer limited the ruling requests to IRC 507 termination tax issues and IRC 4941 self-dealing issues. It appears likely that the taxpayer took issue with the Service s specious approach of forcing a deemed sale but was unsuccessful in persuading the Service. Of additional interest is the fact that the examples in the regulations never address trust termination as a sale of a term interest. 32 Instead, the examples exclusively address the scenario in which 32 See Treas. Reg (c)

15 the sale of the term interest is made by the term interest holder to a previously uninvolved third party. The applicable regulations were initially written in 1957 but later amended in 1971 and in Both amendments occurred after 1969, the year in which IRC 664 was enacted, creating charitable remainder trusts in their present form (although the CRT regulations were not enacted until 1972). IRC 1001(e)(1), enacted in 1969, was implemented to address trust terminations in general, most certainly including CRT terminations. A public policy analysis bolsters this conclusion. IRC 1001(e)(1) was intended to address the situation in which the owner of a term interest sells it to a third party. Congress was concerned about a doubling-up of basis. But for IRC 1001(e)(1), the term interest holder could reduce its gain by an allocated portion of carryover basis while the trust would continue to hold its assets at the prior basis. Meanwhile, the purchaser of the term interest would receive an asset amortizable over the remaining term. 33 Instead of reducing the trust s basis in the retained asset, accruing additional gain to be recognized upon future sale, Congress simplified the matter by eliminating the term interest holder s ability to use any part of the basis. The double basis/amortization issue does not arise in the context of the simultaneous sale of both the term and remainder interest, which is why there is an exception set forth in IRC 1001(e)(3). Similarly, a trust termination bears no risk of double basis/amortization, and the Service s efforts to apply IRC 1001(e)(1) to CRT terminations are truly strained. It is worth noting that the term sale or other disposition is used in IRC 1001(e)(1). The Service might assert that a CRT termination is an other disposition. But because the policy intent of IRC 1001(e)(1) is not defeated by a trust termination, there is no merit in classifying the CRT termination as an other disposition. Because doubling up of basis is not at issue in the case of a trust termination, it is wholly outside the scope of IRC 1001(e)(1). It is entirely the Service s baseless legal fiction that triggers taxation to the term interest holder upon termination. This theory has never been advanced regarding a private trust termination and is not supportable in the charitable remainder trust context. The plain and simple fact is that trust terminations are not income recognition events. No-Rule Position The Service, apparently aware of the controversial nature of the CRT Termination Rulings, adopted a no-rule position in Rev. Proc that has continued through the most recent no-rule revenue procedure, Rev. Proc The Service will not rule on the amount of gain or loss upon termination of a charitable remainder trust. Additionally, the Service will not rule on whether, upon the termination of a charitable remainder trust, the deemed sale of a term interest is the sale of a capital asset defined under IRC Finally, the Service will no longer rule on whether the termination of a CRT before the end of the trust term will cause CRT to fail to qualify as a charitable remainder trust under IRC 664. Is a Term Interest a Capital Asset? In several of the CRT Termination Rulings, the Service determined that a term interest in a charitable remainder trust is a capital asset. IRC 1221(a) defines a capital asset as property held by a 33 IRC 167(e)

16 taxpayer with certain exceptions that do not include a term interest. Revenue Ruling provides that the proceeds received by the life tenant of a trust, in consideration for the transfer of the life tenant's entire interest in the trust to the holder of the remainder interest, are treated as an amount realized from the sale or exchange of a capital asset under IRC 1222 (a reference to IRC 1221 might have been more appropriate as 1221 defines capital gain income and IRC 1222 defines the type of capital gain income). The right to income from a trust estate is a right in the estate itself and therefore is a capital asset itself. 35 Drafting Considerations To preserve maximum flexibility for potential CRT terminations, the drafting attorney should be mindful of at least two critical issues. First, a broad spendthrift clause may be read by the Service and/or local Probate Court, assuming judicial permission is necessary for the termination, to preclude termination altogether. Our advice is that the drafting attorney specifically carve out early terminations (including partial terminations) from the spendthrift clause. Similar carve-outs are routinely used to allow the term interest holder to partially or completely accelerate the charitable remainder interest by gifting directly to the charitable remainder beneficiaries out of the CRT. Second, it is advisable to include an express provision in the trust agreement authorizing the trustee to terminate the trust and distribute the actuarial value of each beneficiary s interest in the trust directly to that beneficiary. Such a clause could potentially add weight to an argument that the termination of the trust is not properly classified a deemed sale of the income interest to the remainder beneficiary, triggering the zero-basis rule of IRC 1001(e)(1). Of course, the cautious practitioner will be mindful of the public policy against such a favorable result for the taxpayer. But perhaps an argument can be made that at least basis equal to the pre-contribution basis of the asset contributed to the CRT should be allocated to the term interest. Impaired Life Expectancy It is also important, in the context of a term interest measured by the life of the term interest holder or by another life, to consider the life expectancy of the measuring life. If the term interest holder is terminally ill or has an impaired life expectancy, then a termination in which the term interest holder receives the full value of the life estate may constitute private benefit, subjecting both the term interest holder, the charity, and its board members to intermediate sanctions excise taxes under IRC The Service has required an affirmative statement in each of the CRT Termination Rulings that the term interest holder did not have an impaired life expectancy C.B. 233 McAllister v. Commissioner, 157 F.2d 235 (2d Cir. 1946)

17 Valuation Issues Although we discussed valuation concepts in the private trust context above, the Service has taken a different approach to calculating the fair market value of a term interest in a CRT. They have been inconsistent in their valuation approach in the CRT Termination Rulings. 36 Two rulings, PLR and PLR , are of particular interest. In those two rulings, the Service identified one reasonable approach to term interest valuation as the lesser of the stated percentage rate of distribution for the NIMCRUT or the 7520 rate in effect for the month of the NIMCRUT termination. PLR identifies regulations under 7520 that appear inapplicable as authority for this position. PLR identifies no authority for this position. This valuation method directly contradicts the valuation method imposed upon taxpayers when calculating the value of their income tax deduction attributable to the gifted CRT remainder interest. The income tax deduction methodology values the term interest based upon the CRT s stated distribution rate. Most of the early CRT Termination Rulings used the income tax deduction methodology. Proper valuation is critical because an excessive payment to the term interest holder could trigger a private benefit excise tax under IRC If, instead of terminating the CRT, the term interest holder sells its interest to an unrelated third party, the valuation issue becomes less problematic. This is because the third party can pay a true market price for the income interest. Sterling Foundation Management, noted above, routinely arranges for term interest purchases that exceed the present value as determined by the IRC 7520 rate in effect for the month of the sale of the term interest. Transaction of Interest: Notice The Service has added certain CRT terminations to the transactions of interest list. The fact pattern identified in Notice is one in which the term interest and remainder interest are simultaneously sold to a third party. As noted above, this triggers the uniform basis rule set forth in IRC 1001(e)(3), allowing the term interest holder to exit at no tax cost if the CRT assets have a basis equal to fair market value. It is important to note that the Service did not limit its area of concern to situations in which the CRT was established as part of a prearranged transaction in which the term and remainder interests would be simultaneously sold to a third party. The Service identified simultaneous term and remainder interest sales initiated after a CRT has been funded with appreciated assets as an area of concern as well. Although it appears that a CRT termination other than a joint sale of the term and remainder interest to a third party is outside the scope of Notice , the notice does contain reporting and list maintenance requirements. Additionally, the Service is backed by strong public policy against the manipulation of the uniform basis rule for use with tax exempt vehicles to eliminate income tax liability. Recall that one of our theories on why the Service is wrong in the CRT Termination Rulings is that, under a step transaction analysis, a CRT termination may be best recast as a deemed simultaneous sale of both 36 For additional detail on the inconsistent valuation approaches and recommended solutions, see the April 4, 2008 letter to the Service from the Estate & Gift Taxation Committee of the Association of the Bar of the City of New York. A copy of the letter is posted at IRB

18 the term and remainder interest in the CRT. If our analysis is correct, then a simple CRT termination could well be recast into a transaction requiring special disclosure to the Service. CRT Exit Strategy Alternatives Partial Acceleration of Remainder Interest Many CRTs are drafted to permit acceleration of the remainder interest. The term interest holder is given the right to transfer funds directly from the CRT to one or more charitable remainder beneficiaries. This provides the term interest holder with a charitable contribution income tax deduction for the gift of a capital asset measured by the present value of the term interest foregone by the term interest holder. Full Acceleration of Remainder Interest As with a partial acceleration of a charitable remainder interest, a CRT term interest holder may gift its entire term interest to one or more charitable remainder beneficiaries and receive an income tax deduction equal to the value of the relinquished term interest. There has been some concern about the fact that a full acceleration eliminates noncharitable beneficiaries from the class of CRT income beneficiaries. The lack of any noncharitable beneficiaries would cause the trust to fail as a qualified CRT. But because the CRT also lapses upon a gift of the term interest to the remainder beneficiary, this does not appear to be a major issue. CRT Termination Divide Assets Among Beneficiaries The primary focus of this paper, this approach allows both the charitable remainder beneficiary and the term interest holder to receive their actuarially-determined values currently, terminating the CRT. The term interest holder will pay tax on all of the proceeds if operating in compliance with the CRT Termination Rulings. Of course, this paper posits that the Service is wrong in principle, though not in policy, so there is obvious tax risk. Proper valuation is also a mystery as two approaches may apply: (i) the IRC 664 regulations methodology used to calculate the income tax deduction upon contribution, which bases the discounting on the stated CRT payout rate or (ii) discounting to present value using the IRC 7520 rate for the month of termination. Sell Term Interest to Third Party Those taxpayers desiring to sell their term interest for the maximum possible price may want to sell to a third party. Third party purchasers have the most latitude in the price they pay for the term interest. They are not restricted by the Service s inconsistent valuation methodologies. The selling taxpayer will pay capital gain tax on the entire sale proceeds as the sale of the term interest fits squarely within IRC 1001(e)(1) and will therefore be sold with zero basis. Simultaneous Sale of Term and Remainder Interest to Third Party This is the transaction noted in Notice This transaction ostensibly allows the taxpayer to sell its term interest at no income tax cost given the IRC 1001(e)(3) exception to IRC 1001(e)(1) (the uniform basis rule), but it is extraordinarily aggressive and comes with disclosure requirements

19 Gift Term Interest to New CRT A taxpayer desiring to restructure their cash flow and/or increase their ultimate gift to charity may want to consider gifting their term interest to a new CRT. The transfer would be a gift of a capital asset. It is unlikely that IRC 1001(e)(1) would eliminate the term interest holder s basis in the term interest since the transaction is a gift, not a sale. But note that IRC 1001(e)(1) refers sales and other dispositions. It could be that a gift to a new CRT is an other disposition. But this will not be terribly relevant in most situations because basis is trapped at Tier 4 under the IRC 664 CRT accounting rules and is rarely recovered over the course of CRT distributions to a term interest holder. Note the significant distinction, described below, when transferring a CRT term interest to a charitable gift annuity, which is treated as a charitable bargain sale, versus a transfer to a second CRT. Convert CRT to Charitable Gift Annuity Some taxpayers may wish to gift their CRT term interest to a charitable gift annuity to restructure their cash flow and/or increase their ultimate gift to charity. PLR concluded that such a gift: (i) (ii) (iii) (iv) provides the taxpayer with an income tax deduction equal to the difference, if any, between the present value of the income interest surrendered and the annuity interest received; provides the taxpayer with a gift tax deduction equal to the difference, if any, between the present value of the income interest surrendered and the annuity interest received; does not accelerate CRT capital gains income not previously recognized by the taxpayer upon prior payments to the taxpayer (preserving income tax deferral); and the taxpayer will not be able to use any portion of its basis in the CRT term interest to provide a return-of-basis component as part of the annuity exclusion ratio. The exclusion ratio conclusion of PLR is of particular interest in the context of this paper. This is because a gift in exchange for a charitable gift annuity is considered a charitable bargain sale under IRC 1011(b). Because the taxpayer is treated as having sold its term interest in the CRT, IRC 1001(e)(1) prevents the use of any basis determined under IRC 1014, 1015, or Because the transfer to the CRT was a gift, the basis in the term interest is determined pursuant to IRC 1015(b). Therefore, the taxpayer may not use any of its basis in the term interest when calculating the exclusion ratio for the gift annuity. That gift annuity payments will consist entirely of capital gain income and ordinary income. Notice In this notice the IRS announced that the use of a charitable remainder trust to create income tax basis without having to report the taxable income that gave rise to that basis is now a Transaction of Interest. The IRS explained its concern as follows: The IRS has become aware of transactions where, after creating a charitable remainder trust and contributing appreciated assets to it, the grantor retains a term interest with a designated charity as the remainder beneficiary, followed by the trust s sale of acquired assets, with trust s sale being exempt from tax and acquiring basis in new assets. Next,

20 both grantor and charity sell respective interests in the trust to an unrelated third party. Grantor claims a charitable deduction for part of the value of the assets contributed to trust that is attributable to remainder interest and no gain from trust s sale of appreciated assets, because both trust and grantor have sold entire interest in trust within meaning of Sec. 1001(e)(3). Finally, grantor takes position that gain on sale of grantor s term interest is computed from portion of uniform basis, derived from basis of new assets rather than basis of appreciated assets first contributed. IRS is concerned about manipulation of uniform basis rules to avoid tax on disposition of appreciated assets. Transactions same or substantially similar to those described are also identified as of interest for purposes of Reg (b)(6) and Sec. 6111; and Sec. 6112; effective 10/31/2008. Persons entering same, and material advisors making tax statement with respect thereto, on or after 11/2/2006, are subject to disclosure and list maintenance requirements. Rather than deny basis under the approach described above, the IRS can reach the exact same result by applying the tier ordering rules in 664(a). Under 664(a)(4) the distribution of principal contains both basis and realized gain. Thus, the uniform basis rule would only allocate to the sale of the term interest a portion of the basis in the assets contributed to the trust. Conclusion Early CRT terminations is an area into which we, as practitioners, can expand the scope of our practices to more effectively serve our clients. We must be mindful of the Service s approach to the treatment of the sale of CRT term interests and treating the term interest holder as has having sold the term interest at zero basis. The Service, in the CRT Termination Rulings, has adopted an unprincipled approach. They have forced a factual assumption that allocates all CRT basis to an exempt charitable remainder beneficiary. In a typical termination scenario, the principled approach dictates that the termination either be treated (i) the same as a termination of a private trust, in which each beneficiary receives trust assets at carryover basis pro rata with their actuarial interest or (ii) as a step transaction in which the component steps are collapsed to treat the transaction as a simultaneous sale of both the remainder interest and term interest to a third party, triggering IRC 1001(e)(3) and allowing the term interest holder to avail itself of CRT basis. Concerns over the contraindicated policy implications of taking a principled approach are best addressed by Congress through legislative changes, not through the imposition of a legal fiction by the Service

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