Analysis of the 643(b) Proposed Regulations - Part II

Analysis of the 643(b) Proposed Regulations - Part II

Are the IRS and Treasury Abolishing PIFs and NIMCRUTs?
Article posted in Regulations on 4 June 2001| comments
audience: National Publication | last updated: 18 May 2011
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Summary

Part I of this two-part article detailed the historical background, state law changes and the nature of the proposed Regulations under IRC §643(b). Part II details the impact of these new proposed Regulations on charitable gift planning vehicles and answers the question, "Are the IRS and Treasury abolishing pooled income funds and net income unitrusts?"

by: Emanuel J. Kallina, II, Esquire & Jonathan D. Ackerman, Esquire

What impact will the proposed Regulations have on Pooled Income Funds?

Pooled Income Funds ("PIFs") are entitled to a special income tax charitable deduction1 for any amount of net long-term capital gain that is permanently set aside for charitable purposes pursuant to the terms of the governing instrument. The IRS has expressed the following two concerns based upon certain recent changes to the fiduciary accounting statutes of some states:

(1) State statutes that permit a PIF to pay its income beneficiaries a "unitrust amount" in satisfaction of their right to income are problematic. The Service is concerned that realized gains allocated to principal in one year may be used in a future year to make the unitrust payment to the income beneficiaries. Therefore, such capital gains realized by the PIF would no longer be "permanently set aside for charitable purposes."

(2) State statutes that allow a PIF trustee to make equitable adjustments to income distributions with respect to any unrealized appreciation in the value of the trust assets are also a problem because a portion of any subsequently realized capital gain may already have been treated as distributed to the income beneficiaries. This might preclude future realized capital gains from being "permanently set aside for charitable purposes."

To address these concerns, the proposed Regulations provide a conforming amendment to pooled income fund Reg. §1.642(c)-22 by adding the following sentence to its subparagraph (c):

"No amount of net long-term capital gain shall be considered permanently set aside for charitable purposes if it is possible, under the terms of the fund's governing instrument or applicable local law, that the income beneficiaries' right to income may, at any time, be satisfied by the payment of either an amount equal to a fixed percentage of the annual fair market value of the trust property or any amount based on unrealized appreciation in the value of the trust property." [Emphasis Added]

The official Treasury comment on this amendment is as follows:

"Thus, no net long-term capital gain qualifies for the charitable deduction if, under the terms of the governing instrument and applicable state law, income may be a unitrust amount or may include an equitable adjustment with respect to unrealized appreciation in the value of the trust assets." [Emphasis Added]

The language of the proposed regulation is troubling in that it threatens an existing PIF's charitable deduction for realized long-term capital gains the minute the applicable state law is changed to merely make it possible for a unitrust-type distribution to satisfy a donor's income interest. By drafting the proposed regulation with an "or" between what the trust document and state law make possible in the way of permissible distribution methods, existing PIFs would be well-advised to amend their trust documents as a defensive measure to ensure the state law definition of fiduciary income upon which they currently rely will not be changed to render unitrust-type distributions a possibility with a corresponding disallowance of the PIF's IRC §642(c)(3) charitable deductions.3

In light of this wording, states that are now considering permitting a split-interest trust income interest to be satisfied with a unitrust-type distribution may consider either excepting PIF trusts from those to which the new law will apply, or making it clear in the statute that the provision will apply only if it is expressly endorsed in the PIF trust document. This latter approach provides greater flexibility to the charity sponsoring the PIF.

Drafters of new PIF trust agreements will also need to consider state statutes that permit an income interest to be satisfied with a unitrust-type distribution. If such permission is contained within the state's version of the 1997 Uniform Principal and Income Act ("1997 UPIA"), together with the standard provision permitting the trust instrument to expressly override provisions of the state law, the PIF trust drafter should be fairly safe expressly precluding the trustee from satisfying the income interest of a PIF donor with a unitrust-type payout, either pursuant to state law or the trustee's discretion. However, in the unlikely event a state statute mandates that a unitrust amount constitutes fiduciary income, the ability of the drafter to except-out the unitrust-type distribution for a PIF is uncertain, with a significant risk of the PIF losing its charitable income tax deduction.

The second threat to a PIF's IRC §642(c)(3) charitable deduction, the possibility of equitable adjustments with respect to "unrealized appreciation" in the value of the trust assets, is also problematic for many of the same reasons noted above concerning unitrust-type distributions.

Is there a better way? The preceding discussion presumes the proposed regulatory changes affecting PIFs are set in stone, which as yet they are not. It is unlikely there will be significant public criticism of the prohibition against making equitable adjustment distributions of "unrealized" appreciation. However, denying a PIF its long-term capital gain deduction merely because the state whose laws govern its operation adopts a statute that permits a unitrust amount definition of fiduciary income is an unfair and draconian solution to the perceived problem.

The nature of the problem itself needs to be considered in more detail before succumbing to a simple outright ban on all "unitrust amount" definitions of fiduciary PIF income. To this end, consider the following: No language appears in IRC §643(c)(3) or Reg. §1.642(c)-2(c) that absolutely requires a PIF to permanently set aside its realized, net long-term capital gains. Such a "set-aside" appears to be merely an elective condition precedent to the right to claim an income tax charitable deduction of the amount of such gains so set aside. In addition, the Code refers to income as the amount that is distributed to a PIF's income beneficiaries, and no limitation can be placed on the payout from a PIF under Treasury Regulations, without changing the Code itself.

Thus, if the charity sponsoring the PIF wishes to allocate, by the terms of the governing instrument, all or any portion of their PIF's realized, net long-term capital gains to income, the charity should be entitled to do so, provided they are willing to give up the PIF's special capital gains charitable income tax deduction to whatever extent such gains are not "permanently set aside" for its ultimate benefit.

In a world where the number and quality of traditional fiduciary income sources have been trimmed significantly, PIFs are struggling to provide competitive returns to their donors. The obvious solution is to permit PIFs to treat some portion of its realized long term capital gains as fiduciary income to remain competitive, but without losing the income tax charitable deduction for the portion of any long term gains that are not (or expressly may not be) distributed. It is hoped that the IRS will consider total return solutions that charities sponsoring PIFs can use to remain competitive in times like these when interest income and dividend rates are low.

What impact will the proposed Regulations have on Charitable Remainder Trusts?

The amount distributed annually ("unitrust amount") to the noncharitable income recipients of a standard charitable remainder unitrust ("S-CRUT") is a fixed percentage (not less than 5% and not more than 50%) of the annual fair market value of the trust assets.4 However, the annual unitrust amount for NIMCRUTs, NIOCRUTS and Flip-CRUTs (collectively, "income exception CRUTs") is defined as the lesser of this fixed percentage amount or trust income,5 where "income" assumes the definition provided in IRC §643(b) and the applicable regulations.6

The proposed Regulations modernizing the 643(b) definition of fiduciary "income" for income exception CRUT purposes address the problem that could arise if state laws permit such income to be defined in terms of a unitrust amount. If you find this confusing, do not feel badly; it is. The interests of the non-charitable income recipients of income exception CRUTs are already defined in unitrust terms (i.e., as a fixed percentage of the trust's assets, revalued annually). The proposed state statutes would do the same (presumably for all types of split-interest trusts); however, the permissible fixed percentage for state-sanctioned, unitrust-type distributions is likely to be less than the 5% minimum required of tax-qualified income exception CRUTs. Since the income exception CRUT definition of fiduciary income is drawn from IRC §643(b), and since that section relies upon the applicable state law defining "principal and income," such trusts (as currently drafted) could automatically import from such state laws a fixed percentage unitrust amount requirement that would be lower than the 5% minimum required by the Code. To prevent this from happening, the IRS is proposing the following modification to Reg. §1.664-3(a)(1)(i)(b)(3):

For purposes of this paragraph (a)(1)(i)(b), trust income generally means income as defined under section 643(b) and the applicable regulations. However, trust income may not be determined by reference to a fixed percentage of the annual fair market value of the trust property. If applicable state law provides that income is a unitrust amount, the trust's governing instrument must contain its own definition of trust income. In addition, capital gain attributable to appreciation in the value of a trust asset after the date it was contributed to the trust or purchased by the trust may be allocated to income pursuant to applicable local law and the terms of the governing instrument but not pursuant to a discretionary power granted the trustee. [Emphasis Added]7

Should remedial action be taken with respect to existing income exception CRUTs that are subject to a new state law that defines fiduciary income as a Aunitrust amount? A careful review of the trust's definition of "income" should be undertaken immediately in this scenario. The proposed regulation states unequivocally that, ". . .trust income may not be determined by reference to a fixed percentage of the annual fair market value of the trust property." This new tax-qualification rule appears to apply both at the inception of an affected trust and during the term of such trust.

Thus, the reviewer will have to determine whether the offending definition of income will be imported automatically into existing income exception CRUTs by virtue of a boilerplate definition of fiduciary income based on IRC §643(b). If so, a conforming amendment to a CRUT document will be in order once the state law definition of income becomes final.8 However, an amendment might be avoidable if the CRUT document incorporates by reference a static version of the state's principal and income laws as they existed at the time the trust was established, or if the offending state statute does not apply to income exception CRUTs in particular or any trusts created before the statute's effective date in general.

In any event, the proposed Regulation appears to place the burden of rectifying this problem on the trustees of any existing income exception CRUTs that may be affected by it.

How should a prudent drafter of an income exception CRUT deal with this issue if the offending state law is only in the proposal stages at the time the trust is being established or not yet on the state's legislative agenda? The requirement for a trust-specific definition of income does not appear to arise unless and until the applicable state principal and income law "provides that income is a unitrust amount." If such a state law is not effective before an income exception CRUT subject to it is established and funded, the trust should be tax-qualified initially (assuming all other tax-qualification requirements are then satisfied) without any special language in the trust document concerning offending modifications to the applicable state's principal and income laws that might be made in the future. Nevertheless, it may be prudent to provide in all new income exception CRUT documents that any future promulgation of a state principal and income statute declaring income to be a unitrust amount is ineffective and inconsistent with the definition of income under the CRUT document.

In drafting such a provision, it would be wise not to focus solely on the possibility that any future, state-enacted, fixed-percentage unitrust amount definition of trust income may be less than the required 5% minimum imposed by IRC §664(d)(2). For example, if the trust has a 7% fixed percentage unitrust amount, the applicable state passes a law defining "income" to include a unitrust amount of 6%, and the trustee reduces the payout to the state-specified 6% level, such action would violate the tax-qualification rule of Reg. §1.664-1(a)(1)(i) even though the state-specified fixed percentage exceeds 5%.

However, drafters of new income exception CRUTs who must confront an existing state statute that permits "income" to be defined as a unitrust amount will have to analyze the statute carefully in crafting a trust provision that will override its application. The description in the proposed Regulation regarding the attributes of an offending state statute is unclear. We can only say for sure that if the statute provides that "income" is a unitrust amount, the trust document must expressly override it. It remains unclear what action must be taken if the statute merely gives discretion to a trustee to define income as a unitrust amount. The safest course in light of this uncertainty would be to include a trust provision that renders either a mandatory or discretionary definition of income as a unitrust amount inapplicable to the trust. In addition, if the offending state law is contained in the state's principal and income law and gives trustmakers express authority to override any of its provisions, it may be prudent to cite the specific statutory authority for overriding the offending state statute in crafting the trust instrument.

Why are S-CRUTs and charitable remainder annuity trusts ("CRATs") not affected by this proposed regulatory change? Neither type of trust defines its distributions to the non-charitable recipients in terms of the "income" of the trust. Thus, the addition of an "income = a unitrust amount" provision to the state principal and income laws applicable to a S-CRUT or CRAT would not be imported into the trust by virtue of IRC §643(b) and Reg. §1.664-3(a)(1)(i)(b)(3), neither of which apply to CRATs and S-CRUTs.

Is there a better way? The proposed requirement that income exception CRUT documents must include their own definition of trust income, if the applicable state principal and income law contains a definition of income as a unitrust amount, creates unnecessary uncertainty in the charitable gift planning community and unnecessarily complicates the drafting of income exception CRUTs. The proposed Regulation would require drafters of income exception CRUTs to address all aspects of what is and is not trust income in the governing instrument. This would be a daunting task with all types of inconsistent and potentially faulty results likely. Also, as noted above, a complicated array of new rules would become necessary to determine the fate of existing income exception CRUTs in states where the law changes (i.e., either such trusts would have to be "grandfathered" such that no amendments would be necessary or a time period and procedures would have to be established for potentially costly qualified reformations).

A far less problematic approach to curbing the Treasury's concerns would be to simply preclude the trustees of income exception CRUTs who wish to maintain their trust's tax-exempt status from exercising such an allocation of income, regardless how granted. It is the exercise and not the grant of the power that is problematic. To this end, the first sentence as proposed by the Treasury, with the modification reflected below, should be sufficient to curb any potential abuses and render the need for "from-scratch" definitions of income in each trust document (and any amendments to existing trust documents) unnecessary:

". . . However, trust income may not be determined by reference to a fixed percentage of the annual fair market value of the trust property, notwithstanding any provision in applicable state law to the contrary."

In any event, the final Regulations should give further assurances that whatever language the drafter crafts to correct this problem will not be interpreted by Treasury as a provision that can or will be disregarded merely because it "departs fundamentally from local law." With respect to enforcing this new requirement, a simple question could be inserted into IRS Form 5227 to determine whether trust income has been impermissibly allocated.

Does this proposed amendment to the CRUT regulations have any other important attributes and ramifications? The new provision also shuts the door on income exception CRUT provisions that grant to their trustees unfettered discretion to decide whether, when and how often to treat realized capital gains as distributable fiduciary income. Under this rule, it would no longer be permissible to make discretionary decisions from year-to-year or from asset-sale-to-asset-sale with respect to whether and when realized, post-contribution or post-purchase gains are distributable fiduciary income.

According to this proposed regulation, if state law permits and the governing instrument of an income exception CRUT so provides, gains can be allocated to income only where such allocations are totally non-discretionary and apply solely to realized, post-contribution or post-purchase capital gains. This new provision is being added to the roster of tax-qualification rules for income exception CRUTs appearing in Reg. §1.664-3(a)(1) and will presumably affect all of them, including pre-existing ones for which no grandfathering rules have been provided.

However, the purpose for this proposed prohibition is unclear and any abuses it attempts to prevent remain undefined. Given that only realized post-gift gains can be allocated to trust income under existing regulations, neither the income tax charitable deduction nor the interest of the charitable remainderman can be abused. Treating realized post-gift gains as distributable income could in no way reduce the actuarial present value of the charitable remainderman's interest in the trust or produce any benefits for the income recipients outside those anticipated under Code '664. Given that it is permissible for all net realized capital gains to be treated as fiduciary income, then the only discretion a trustee could exercise in this regard would be to reduce the amount of net realized gains treated as income all the way down to zero. Such a reduction could only serve to enrich the charitable remainderman.

The "once-you-do-it-your-stuck-with-it-forever" approach of the proposed Regulations dealing with such capital gains allocations are unlikely to be well-received by the settlors, income recipients, and many trustees of affected split-interest trusts. In addition, losing the discretion to treat all or part of the realized capital gains as fiduciary income may make it much more difficult to craft distributions that will satisfy the needs of income and remainder beneficiaries in a constantly changing economic environment.

Reformation City. This unnecessary prohibition is potentially very costly. All existing income exception CRUTs, which do not contain a mandatory provision allocating all realized capital gain to income, will have to be amended to expressly preclude the trustee from exercising the equitable adjustment power under a state's principal and income law (as patterned after UPIA §104(a)).

UPIA §104(a) provides that a trustee may conditionally "adjust between principal and income to the extent the trustee considers necessary" if the trustee invests and manages trust assets as a prudent investor. Although this discretionary "equitable adjustment" provision says nothing specific about "capital gains," it does provide that in deciding whether and to what extent to exercise this power, a trustee is required to consider all factors relevant to the trust and its beneficiaries. These include (among others) the intent of the settlor, whether and to what extent the terms of the trust give the trustee the power to invade principal or accumulate income or prohibit the trustee from invading principal or accumulating income, and the anticipated tax consequences of an adjustment. The section also provides that the terms of a trust that limit the power of a trustee to make an adjustment between principal and income do not affect the application of the equitable adjustment power unless it is clear from the terms of the trust that the settlor intended to deny the trustee the equitable adjustment power.

Under prevailing drafting practices, the intention of a settlor to exclude realized capital gains from the definition of fiduciary income is evidenced by omitting from the trust document any mention of allocating realized gains as income. Thus, the equitable adjustment power is available to the trustee of an income exception CRUT to distribute realized capital gains to an income recipient, and the mere possibility that a trustee could exercise this power will force the reformation of many existing income exception CRUTs.

That leaves for consideration the ramifications of the proposed new rule on income exception CRUTs that contain: (1) express, discretionary "capital gain = income" provisions; and (2) mandatory "capital gain = income" provisions. In the first case, it will be necessary to reform the trust document to comply with the new rule, should it become final. In the second case, these trusts may also have to be reformed because the equitable adjustment power of UPIA §104(a) could conceivably give the trustee the discretion to distribute something less than all of the trust's net realized capital gains in exercising an equitable adjustment power that will be deemed to exist unless the trust document expressly precludes its exercise.

Is there a better way? The IRS should completely eliminate this requirement from the final Regulations. It prevents no abuses, will lead only to unnecessary confusion, and may be very costly as thousands of income exception CRUTs (both testamentary and inter vivos) will have to be amended or judicially reformed.

Conclusions

These proposed regulations further complicate the already complicated business of split-interest trust administration; however, neither Congress nor the Treasury can be blamed for their necessity.

Notwithstanding this effort, the proposed Regulations go well beyond making needed and authorized modifications to the Code definition of fiduciary income, by placing significant new limitations on the discretionary powers of income exception CRUT trustees to allocate realized capital gains to fiduciary income, by adding new governing instrument language which will significantly complicate the drafting of CRUTs, by forcing unnecessary reformations of existing income exception CRUTs and by eliminating any possible use of a PIF under a total return philosophy of investing.

Hopefully, the IRS will consider comments it is receiving prior to its June 8th hearing and will revise the Regulations to accommodate charitable giving, as well as address its specific concerns.


Footnotes


  1. IRC §642(c)(3).back

  2. Reg. §1.642(c)-2(c) [as it existed prior to the proposed amendment]: Pooled Income Funds. Any part of the gross income of a pooled income fund to which section 1.642(c)-5 applies for the taxable year that is attributable to net long-term capital gain (as defined in section 1222(7)) which, pursuant to the terms of the governing instrument, is permanently set aside during the taxable year for a purpose specified in section 170(c) shall be allowed as a deduction to the fund in lieu of the limited charitable contributions deduction authorized by section 170(a). No deduction shall be allowed under this paragraph for any portion of the gross income of such fund which is (1) attributable to income other than net long-term capital gain (2) earned with respect to amounts transferred to such fund before August 1, 1969. However, see paragraph (b) of this section for a deduction (subject to the limitations of such paragraph) for amounts permanently set aside by a pooled income fund which meets the requirements of that paragraph. The principles of paragraph (b) or (2) of this section with respect to investment, reinvestment, and separate accounting shall apply under this paragraph in the case of amounts transferred to the fund after July 31, 1969.back

  3. Note that the Treasury's comment to this proposed amendment indicates a belief that both the trust document and state law must grant authority to a PIF trustee to make either unitrust-type distributions to its income recipients or equitable adjustments with respect to unrealized appreciation in the value of the trust assets before the PIF's section 642(c)(3) charitable deduction would be lost. If this interpretation is adopted in the final Regulations, PIF agreement drafters intent upon protecting the charitable deduction for long term capital gains permanently set aside for charity could rest easier by expressly overriding the possibility of any distributions of unrealized appreciation or in a unitrust form in the PIF trust document.back

  4. IRC §664(d)(2).back

  5. IRC §664(d)(3).back

  6. See Reg. §1.664-3(a)(1)(i)(b).back

  7. Prop. Reg. §1.664-3(a)(1)(i)(b)(3).back

  8. The IRS acknowledged with the publication of its sample CRT document forms that it is permissible to grant the trustee of a CRT a limited power to amend the trust to bring its terms into compliance with Code section 664 requirements. See Rev. Procs. 90-30 through 90-32, I.R.B. 1990-25. Caveat: Before amending an existing CRT document to comply with any new final regulations that affect CRT tax-qualification rules, the trust document should be reviewed to determine whether the trustee has been given the express power to make conforming amendments. If not, it would be prudent to petition the appropriate local court for the right to do so before proceeding.back

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