A letter ruling, sometimes referred to as a "private" letter ruling, is a written statement issued to a taxpayer by the IRS National Office that interprets and applies the tax laws to the taxpayer's specific set of facts. Letter rulings are applicable only to the taxpayer to whom they are addressed and, therefore, cannot be relied upon by others as tax precedent.

CHARITABLE REMAINDER UNITRUST THAT INCLUDES GAINS AS INCOME AND DEFICIENCY ACCOUNT AS LIABILITY QUALIFIES

Reference:

Section 664 -- Charitable Remainder Trusts UIL Number(s) 0664.03-03

Full Text:

Date: December 12, 1994

Refer Reply to: CC:DOM:P&SI:3 TR-31-1603-94

LEGEND:

Taxpayer: * * *
Trust: * * *
Foundation: * * *
State: * * *
Company: * * *
Cite 1: * * *
Cite 2: * * *
a: * * *
b: * * *
x: * * *
y: * * *

Dear * * *

This responds to a letter from your authorized representative dated June 8, 1994, as supplemented and amended November 16, 1994, in which he asks us on your behalf to rule on the qualification of Trust as a charitable remainder unitrust under section 664 of the Internal Revenue Code and on the income and gift tax consequences of a transfer to Trust.

According to section 4.01(39) of Rev. Proc. 94-3, 1994-1, I.R.B. 79, the Service ordinarily will not rule on whether a charitable remainder trust that provides for annuity or unitrust payments for one or two measuring lives satisfies the requirements described in section 664 of the Code. In addition, according to sections 4.01(16), (44), and (46) of Rev. Proc. 94-3, the Service ordinarily will not rule on whether a transfer to a charitable remainder trust described in section 664 that provides for annuity or unitrust payments for one or two measuring lives qualifies for charitable deductions under sections 170(f)(2)(A), 2055(e)(2)(A), and 2522(c)(2)(A).

In lieu of seeking the Service's advance approval of a charitable remainder unitrust, taxpayers are directed to follow the sample provisions for charitable remainder unitrusts outlined in Rev. Proc. 90-31, 1990-1 C.B. 539. By following the models contained in Rev. Proc. 90-31, taxpayers can be assured that the Service will recognize a trust as meeting all of the requirements of a charitable remainder unitrust under section 664(d)(2) and (3), provided that the trust operates in a manner consistent with the terms of the trust instrument and provided it is a valid trust under applicable local law. For transfers to a qualifying charitable remainder unitrust, the present value of the remainder interest will be deductible under sections 170(f)(2)(A), 2055(e)(2)(A), and 2522(c)(2)(A) if the charitable beneficiary otherwise meets all of the requirements of these sections.

Pursuant to Rev. Proc. 94-3, the Service will not rule on whether Trust qualifies as a charitable remainder unitrust under section 664 of the Code or whether charitable income tax and gift tax deductions will be allowed to Taxpayer under sections 170 and 2522 for the present value of the remainder interest.

The trust Agreement contains provisions, however, that are not included in, or are different from, the sample provisions outlined in Rev. Proc. 90-31. Paragraph x of the trust agreement directs the trustee to allocate realized capital gains to trust income. Paragraph y of the trust agreement provides for the accrual of the makeup amount as a liability in computing the unitrust amount. Therefore, we will rule on whether these provisions comply with the requirements for a charitable remainder unitrust under section 664 of the Code.

FACTS

Taxpayer will establish Trust, to be governed by the laws of State. Taxpayer will fund Trust in a with approximately $b of Company common stock. Taxpayer will be the initial trustee and the lifetime income beneficiary of Trust.

Foundation will be the charitable remainder beneficiary of Trust. Taxpayer is the trustee of Foundation.

Trust will distribute annually to Taxpayer an amount equal to the lesser of trust income for the tax year or 10 percent of the net fair market value of trust assets (determined as of the first day of each tax year of Trust). If trust income for the tax year is less than 10 percent of the fair market value of trust assets, the income shortfall will accumulate and be distributed in subsequent years when trust income exceeds 10 percent.

Paragraph x of the trust agreement provides that the trustee shall allocate to trust income all gains realized on trust assets after contribution to Trust (whether attributable to appreciation occurring before or after contribution).

In computing the unitrust amount for each year, the liability to the taxpayer resulting from any income shortfall will be taken into account. Paragraph y of the trust agreement provides that the net fair market value of the trust assets as of the valuation date is to be determined by first subtracting the amount of the shortfall as of that date, provided that the reduction is no more than the amount of the unrealized gain then inherent in the trust Assets.

LAW & ANALYSIS

Section 664(d)(2) of the Code provides that, for purposes of this section, a charitable remainder unitrust is a trust--

(A) from which a fixed percentage (which is not less than 5 percent) of the net fair market value of its assets, valued annually, is to be paid, not less often than annually, to one or more persons (at least one of which is not an organization described in section 170(c) and, in the case of individuals, only to an individual who is living at the time of the creation of the trust) for a term of years (not in excess of 20 years) or for the life or lives of such individual or individuals,

(B) from which no amount other than the payments described in subparagraph (A) may be paid to or for the use of any person other than an organization described in section 170(c), and

(C) following the termination of the payments described in subparagraph (A), the remainder interest in the trust is to be transferred to, or for the use of, an organization described in section 170(c) or is to be retained by the trust for such a use.

Section 664(d)(3) of the Code provides that, notwithstanding the provisions of paragraphs (2)(A) and (B), the trust instrument may provide that the trustee shall pay the income beneficiary for any year --

(A) the amount of the trust income, if such amount is less than the amount required to be distributed under paragraph (2)(A), and

(B) any amount of the trust income which is in excess of the amount required to be distributed under paragraph (2)(A), to the extent that (by reason of subparagraph (A)), the aggregate of the amounts paid in prior years was less than the aggregate of such required amounts.

Section 1.664-3(a)(1)(i)(b)(1) of the Income Tax Regulations provides that the amount of trust income for purposes of section 664(d)(3) of the Code is the amount of trust income as defined in section 643(b) and the regulations thereunder.

Section 643(b) of the Code provides that, for purposes of subparts A through D, part I, subchapter J, chapter 1, the term "income", when not preceded by the words "taxable", "distributable net", "undistributed net", or "gross", means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which a fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument and applicable local law shall not be considered income.

Section 1.643(b)-1 of the regulations provides, however, that trust provisions which depart fundamentally from concepts of local law in the determination of what constitutes income are not recognized. For example, if a trust instrument directs that all the trust income shall be paid to A, but defines ordinary dividends and interest as corpus, the trust will not be considered one which under its governing instrument is required to distribute all its income currently for purposes of section 642(b) (relating to the personal exemption) and section 651 (relating to "simple" trusts).

Under State law, principal includes, but is not limited to, consideration received by the trustee on the sale or other transfer of principal. Cite 1. Thus, capital gains generally are allocated to principal under State law. However, State law allows the terms of the governing instrument to control the allocation of receipts and expenditures.

A trust shall be administered with due regard to the respective interests of the income beneficiaries and remainder beneficiaries. A trust is so administered with respect to the allocation of receipts and expenditures if a receipt is credited or an expenditure is charged to income or principal or partly to each in accordance with the terms of the trust notwithstanding contrary provisions of this chapter.

Cite 2.

In the present situation, Trust's governing instrument provides that all gains realized on Trust's assets are to be allocated to trust income, and such an allocation is permitted under State law. Thus, under the terms of the governing instrument and applicable local law, the amount of trust income for purposes of the computations under section 664(d)(3) includes the appreciation in trust assets once the appreciation is realized by the sale or other disposition of those assets.

The unitrust amount determined under section 664(d)(2)(A) of the Code is a fixed percentage of the fair market value of the trust's assets valued annually. For a trust described in section 664(d)(2), the unitrust amount is paid each year to the noncharitable beneficiary. If the trust's income is insufficient to cover the unitrust amount, the principal must be invaded to make up any shortfall. Under these circumstances, the fair market value of the trust assets will decrease by the unitrust amount that was paid from principal. The unitrust amount for the subsequent years will be decreased accordingly.

The income exception provision of section 664(d)(3) was enacted by Congress to permit greater flexibility for certain charitable remainder gifts, but it was crafted in such a manner as to prevent the manipulation of the trust assets to the detriment of the charitable remainder interest. If the income exception provision is included in a trust's governing instrument, this provision prevents the trust from having to invade corpus when the income for the year is below what was originally contemplated. For purposes of this provision, the determination of what constitutes trust income is to be made under the applicable local law and, thus, is not to include items such as capital gains which must be allocated to the trust principal. S. Rep. No. 552, 91st Cong., 1st Sess. 87-89 (1969); reprinted 1969-3 C.B. 423, 480-481.

For a trust described in sections 664(d)(2) and (d)(3), the unitrust amount determined under section 664(d)(2)(A) is used as the ceiling for the amount payable to the noncharitable beneficiary each year and for the amount of any deficiency that may be made up in future years. Provided the trust income does not exceed the current year's unitrust amount and any deficiency from prior years, the trust income is paid out to the noncharitable beneficiary each year. As envisioned by Congress, the trust income used to pay the unitrust amount would never include amounts that in prior years had been included in the fair market value of the trust assets on which the fixed unitrust amount had been based.

The allocation of capital gains to trust income creates the potential to manipulate the trust assets to the detriment of the charitable remainder interest. Year after year, the trustee naturally includes any unrealized appreciation in determining the fair market value of the trust's assets on which the unitrust amount is based. Then when the trustee chooses to realize the appreciation by selling the assets, the realized appreciation is taken out of the base. The realized appreciation becomes trust income that will be paid to the noncharitable beneficiary to the extent of the current year's unitrust amount and any deficiency in the unitrust amounts from prior years. The trustee has, thus, inflated the unitrust amount each year by amounts that will be payable to the noncharitable beneficiary upon the sale of assets. Under these circumstances, the amount that will be paid to the charitable organization at the termination of the trust may well be less than the amount that would be paid to the charitable organization if the fixed unitrust were paid each year pursuant to section 664(d)(2)(A) of the Code.

The income exception of section 664(d)(3) of the Code may not be used in a manner that would allow the value of assets actually passing to the charitable organization to be less than it would have been under section 664(d)(2)(A). If under the terms of the governing instrument and applicable local law the trust's capital gains are allocated to trust income, then the trust's obligation to pay the prior years' deficiency to the noncharitable beneficiary must be accounted for to the extent that the trustee would trigger that obligation if he sold the assets on the valuation date.

Thus, in determining the fair market value of the assets on the annual valuation date, the governing instrument must require the trustee to treat as a liability the amount of any deficiency for prior years computed under section 664(d)(3)(B). The amount treated as a liability need not exceed the trust's unrealized appreciation that would be trust income under the terms of the governing instrument and applicable local law if the trustee sold all the assets in the trust on the valuation date. This trust provision will ensure that the timing of the realization of the gain by the trustee cannot be manipulated to the detriment of the charitable remainder interest.

In the present situation, all gains realized on the sale or other disposition of Trust's assets are allocated to trust income under the terms of the governing instrument and applicable local law. The governing instrument provides that for purposes of determining the unitrust amount each year, the fair market value of the assets shall be reduced by the amount of any deficiency in unitrust payments from prior years but such reduction shall not exceed the amount of the unrealized gain in Trust's assets as of the valuation date. Thus, because the trust provision allocating capital gains to trust income is coupled with a trust provision treating a specific amount of any unitrust deficiency as a liability in valuing the trust's assets, these provisions comply with the requirements for a charitable remainder unitrust described in section 664(d)(2) and (d)(3) of the Code and the regulations thereunder.

RULING

Based solely on the facts as presented in this ruling request, and viewed in light of the applicable law and regulations, we rule that Paragraphs x and y of the trust agreement comply with the requirements for a charitable remainder unitrust under section 664 of the Code.

No opinion is expressed or implied as to any other provisions of the trust agreement or as to the federal tax consequences of the formation and operation of Trust under any other provisions of the Code. Specifically, no opinion is expressed as to whether Trust otherwise qualifies as a charitable remainder trust under section 664.

A copy of this letter should be attached to Taxpayer's federal income tax return for the tax year in which Trust is formed. A copy of this letter is enclosed for that purpose.

In accordance with the power of attorney on file with this office, we are sending copies of this letter to your authorized representatives.

This ruling is directed only to the taxpayer who requested it. According to section 6110(j)(3) of the Code, this ruling may not be cited or used as precedent.

Sincerely,

FRANCES D. SCHAFER
Senior Technician Reviewer, Branch 3
Office of Assistant Chief Counsel
(Passthroughs and Special Industries)
enclosures (2):

copy of this letter
copy for section 6110 purposes