Analysis of Final Four-Tier Regulations

Analysis of Final Four-Tier Regulations

Article posted in Regulations on 29 March 2005| comments
audience: National Publication | last updated: 16 September 2012
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Summary

When we read "Final Four" in the title of Ted Batson's new article, we immediately thought of "March Madness." Although Ted's article has nothing to do with college basketball, it does discuss what many believe to cause another form of madness -- interpreting the four-tier system rules for charitable remainder trusts and the recently issued final regulations.


By Ted R. Batson, Jr., MBA, CPA

Background
On March 15, 2005 the Treasury released final regulations under Internal Revenue Code §664(b) amending the four-tier accounting rules which govern the taxation of distributions from charitable remainder trusts. These regulations were first issued in proposed form on November 20, 2003.

The regulations were issued to:

  • Address changes in the income tax rates under the Taxpayer Relief Act of 1997 (TRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), including the affect of these rate changes on the ordering rules for characterizing distributions;
  • Codify guidance regarding the netting of capital gains and losses previously issued in IRS Notice 98-20 and later amended by IRS Notice 99-17;
  • Provide specific guidance as to the proper placement of qualified dividends, as defined at IRC §1(h)(11), within the ordering scheme of IRC §664(b)(1); and
  • Provide a conceptual framework for addressing future changes in income tax rates and classifications that are added to the Internal Revenue Code, temporarily suspended (as with qualified 5-year gains under the sunset provision of JGTRRA, and/or permanently repealed (as was the case with mid-term capital gains under the Internal Revenue Service Restructuring and Reform Act of 1998).

The final regulations reflect only one substantive change in the capital gain/loss netting rules from the proposed regulations and offer a number of clarifying points as described more fully below.

The Four Basic Tiers Affirmed
The final regulations continue to affirm the four basic tiers, or categories, used to characterize charitable remainder trust distributions in the hands of the income recipients. Income is assigned to these categories in the year in which it is to be taken into account by the trust. This distinction is important as it dictates the class of income (as described below) within a category to which the income is to be assigned.

The four basic categories are:1

  1. Ordinary Income--Gross income, other than gains from the sale or disposition of capital assets.
  2. Capital Gains--Gains and amounts treated as gains from the sale or other disposition of capital assets.
  3. Other Income--Specifically municipal bond income.
  4. Corpus.

Introduction of Tax Rate Classes2
One of the most significant concepts introduced in the regulations (as proposed and finalized) is the use of tax-rate classes as a mechanism for further subdividing a category of income. This concept first surfaced after the TRA as a means of differentiating between mid-term gains, unrecaptured section 1250 gains, and other long-term gains. It was further extended by the subsequent introduction of a 28% rate class for collectibles gains and section 1202 gains, and a preferential 18%/8% rate for qualified 5-year gains.

The final regulations explain that each time a new tax rate treatment is devised by Congress to apply to a category of income, a new class within that category will spring into existence. For example, prior to the enactment of JGTRRA in 2003, dividends were simply part of a homogenous grouping of interest, dividends, rents, royalties, and other forms of ordinary income within the ordinary income tier. With the enactment of JGTRRA and a preferential income tax rate of 15%/5% applicable to "qualified" dividends, those "qualified" dividends are required to be segregated from other forms of ordinary income within the ordinary income category.

Special Rule for Qualified Dividends
To be included in the special tax rate class for qualified dividends, the dividend must be received after December 31, 2002.3

Order of Distributions
The traditional worst-in-first-out rule traditionally associated with charitable remainder trusts is somewhat altered. The order is as follows:

  1. First, from the ordinary income category;
  2. Second, from the capital gains category to the extent that ordinary income is insufficient;
  3. Third, from the other income category to the extent that ordinary income and capital gains are insufficient; and
  4. Fourth, from corpus.

When a category contains more than one tax rate class, the progression within the category moves from the tax rate class subject to the highest tax rate, to the class subject to the next highest class rate, and so on. For example, in 2004 a charitable remainder unitrust receives $10,000 of interest income and $8,500 of qualified dividends. The unitrust amount required to be paid for 2004 is $12,500. The unitrust amount in the hands of the income recipient will be taxed as $10,000 of interest income (which is subject to a higher income tax rate than qualified dividends) and $2,500 of qualified dividends. The remaining $6,000 of undistributed qualified dividends is carried over into the following trust tax year.

Under current law, the categories and their related tax rate classes, in the order they are to be relieved, are as follows:

  • Ordinary Income
    • Other ordinary income
    • Qualified dividends (expires 12/31/2008)
  • Capital Gains
    • Short-Term Capital Gains
    • Long-Term Capital Gains
      • 28% rate gains from collectibles and Sec. 1202 stock
      • 25% rate gains from unrecaptured Sec. 1250 gains
      • 15%/5% other long-term capital gains (returns to 20% effective 1/1/2009)
      • 18%/8% qualified 5-year gains (temporarily suspended through 12/31/2008)
  • Other Income
  • Corpus

Phase-out of Temporary Tax Rate Classes4
A tax rate class may spring into existence on the basis of enabling legislation that is set to expire at a future date. This is the case with qualified dividends that will expire with the sunset of JGTRRA on December 31, 2008. When a temporary tax rate class expires, any remaining dollars in that tax rate class are added back to the class within the category from which it was carved out. For example, assume that on December 31, 2008, after the final characterization of 2008 distributions, there remains $200 of undistributed qualified dividends. On January 1, 2009, those undistributed qualified dividends are merged with any undistributed non-qualified dividends to form a dividend income class that is no longer eligible for preferential tax rate treatment.

Temporary Suspension of a Permanent Tax Rate Class5
An alternative scenario addressed by the regulations is the temporary suspension of a permanent tax rate class. The regulations specify that in this case, any undistributed income in the temporarily suspended tax rate class must remain in the class and retain its position in the tax rate class hierarchy. The position in the tax rate class hierarchy is based on the position it will occupy relative to the other tax rate classes after the suspension is lifted.

If, during the suspended period, it is necessary to use dollars from a suspended tax rate class to characterize a distribution, then the character assigned to those dollars is the character that would be assigned had the temporarily suspended tax rate class been suspended permanently.6

For example, JGTRRA temporarily repealed the preferential 18%/8% tax rate applicable to qualified 5-year gains. However, with the sunset of JGTRRA on December 31, 2008, this preferential rate will spring back into existence effective January 1, 2009.

Assume that a charitable remainder annuity trust with a 2005 annuity amount of $25,000 has the following 2005 activity:

            Interest income                               $1,000

            Other long-term capital gains                $20,000

In addition, the trust has $17,000 of undistributed qualified 5-year gains from prior to January 1, 2004.

The trust's 2005 annuity distribution will be characterized as follows:

            Interest income                               $1,000

            Other long-term capital gains                $24,000

The carryforward amount of undistributed qualified 5-year gains is reduced to $13,000.

Timing for Making Character Determinations
The character of distributions to income recipients, no matter when distributed during the year, is to be made at the end of the taxable year.7

Ordinary Losses

Ordinary losses reduce ordinary income according to the following ordering rule:8

  1. First, reduce current year ordinary income assigned to the same tax rate class;
  2. Second, reduce prior year undistributed ordinary income assigned to the same tax rate class;
  3. Third, reduce the cumulative ordinary income (i.e., current and undistributed income) assigned to the highest ordinary income tax rate class; and
  4. Fourth, reduce the cumulative ordinary income (i.e., current and undistributed income) assigned to the next highest ordinary income tax rate class continuing until the loss is exhausted or no ordinary income remains.

If a net loss remains after applying this ordinary loss ordering rule, then the net loss retains its class assignment and is carried forward to future years to reduce future ordinary income.9

Netting of Capital Gains and Losses
As noted above, the capital gains category currently consists of some five tax rate classes. The classes are maintained on a cumulative net basis. In other words, each year's current year activity within a tax rate class is combined with prior year undistributed income within the category to arrive at a net gain or loss position within the tax rate class. Where one or more of these tax rate classes ends the year in a cumulative net loss position, the net loss is applied to any net gains according to the following ordering rule:10

  1. First, net losses in the long-term tax rate classes are netted against the net gains in the long-term tax rate classes. The highest tax rate class with a net loss is first netted against each tax rate class with a net gain, beginning with the highest tax rate class and proceeding in descending tax rate class order. Then the next highest tax rate class with a net loss is first netted against each tax rate class with a net gain, beginning with the highest tax rate class and proceeding in descending tax rate class order, and so on.
  2. Second, either
    • a net remaining loss from all the long-term tax rate classes is applied in descending tax rate class order to any net short-term capital gain; or
    • a net short-term capital loss is applied (in descending tax rate class order) to any net long-term capital gains.

Note: This is the area with the most substantive change from the proposed regulations. Under the proposed regulations, the order of netting would have applied a net short-term capital loss to a long-term tax rate class with a net gain before net losses in the long-term tax rate classes was applied to the net gain in the long-term tax rate class. This would have produced a potentially abusive result and is inconsistent with the netting rules for individual taxpayers.

If, after apply the netting rules, any capital gains tax rate class remains in a net loss position, then the loss is carried forward in the same tax rate class to the next year when the process is repeated.11

Effective Date
Because the final regulations reflect both prior and current guidance, the effective date is dependent on the specific regulation in question.

Capital Gains Distribution Order
The rules specifying that 28% rate gains are to be distributed before unrecaptured Sec. 1250 gain, which must be distributed before other long-term capital gains are applicable for taxable years ending on or after December 31, 1998.

Capital Gains Netting Rules
The rules specifying the order in which capital gains and losses are to be netted are applicable for taxable years ending on or after December 31, 1998.

Transition Rule Governing Pre-1997 Realized Long-Term Capital Gains
The rule permitting the inclusion of pre-1997 long-term capital gains (that would have been subject to a 28% rate in the year they were realized) in the class of "other long-term capital gains," is applicable for taxable years ending on or after December 31, 1998.

Transition Rule Governing Long-Term Capital Gains Realized Between January 1, 1997 and May 6, 1997
The rule permitting the inclusion of long-term capital gains realized between January 1, 1997 and May 6, 1997 and not distributed in 1997 (that would have been subject to a 28% rate in the year they were realized) in the class of "other long-term capital gains," is applicable for taxable years ending on or after December 31, 1998.

All Other Provisions
All other provisions included in these regulations, including the treatment of qualified dividends, are effective November 20, 2003.

Comprehensive Example
Activity for the year ended December 31, 2004 consists of the following:

The annual unitrust amount is $57,300.

The trust has the following income receipts:

  Interest income..... $7,500
  Municipal bond interest..... $4,500
  Net rental loss*..... ($11,000)
  Non-qualified dividends..... $2,500
  Qualified dividends..... $22,500
  Net short-term capital losses..... ($6,750)
  Net 28% rate loss..... ($4,500)
  Unrecaptured section 1250 gains..... $3,500
  Net other long-term capital gains..... $25,000

Carryforward balances from 2003 are as indicated below, including qualified 5-year gains realized before May 5, 2003 in the amount of $16,000.

 

Carry-forward
from 2003

 

2004
Class Additions

 

Allocation of Losses*

 

K-1 Reporting

 

Carry-forward
to 2005

Ordinary Income Tier

 

 

 

 

  Other Ordinary Income:

 

 

 

 

    Interest

 

7,500

 

(7,500)a

 

        

 

 

    Non-Qualified Dividends

 

2,500

 

(2,500)b

 

 

0

    Net Rental Income

 

(11,000)

 

11,000

 

 

0

    Royalties

 

0

 

 

 

0

      Subtotal

 

(1,000)

 

1,000

 

0

 

0

 

 

 

 

  Qualified Dividends Class

 

22,500

 

(1,000)c

 

21,500

 

0

 

 

 

 

 

Total Ordinary Income Tier

 

21,500

 

0

 

21,500

 

0

 

 

 

 

Capital Gain Tier

 

 

 

 

  Short-Term Capital
  Gains/Losses

 

 

(6,750)

 

6,750e

 

 

 

0

 

 

 

 

  Long-Term Capital
  Gains/Losses

 

 

 

 

    28% Rate Gains

 

(4,500)

 

4,500d

 

 

0

    Unrecaptured §1250 Gains

 

3,500

 

(3,500)

 

 

0

    Other Long-Term Gains

10,000

 

25,000

 

(7,750)

 

27,250

 

0

    Qualified 5-Year Gains

16,000

 

 

 

8,550f

 

 7,450

      Subtotal

26,000

 

24,000

 

(6,750)

 

35,800

 

7,450

 

 

 

 

Total Capital Gains Tier

26,000

 

17,250

 

0

 

35,800

 

7,450

 

 

 

 

Other Income (Tax Exempt) Tier

3,750

 

4,500

 

 

0

 

8,250

 

 

 

 

Principal Tier

65,000

 

 

 

0

 

65,000

 

 

 

 

Total Unitrust Distribution

 

 

 

57,300

 

a This amount represents 7,500/10,000ths of the $11,000 net rental loss.

b This amount represents 2,500/10,000ths of the $11,000 net rental loss.

c Because the total of the interest income and nonqualified dividend income is less than the rental loss, the excess is used to reduce the qualified dividends.

d The net 28% rate loss is allocated first to the unrecaptured Section 1250 tax rate class to the extent of the class.

e The short-term capital loss is first allocated to the other long-term capital gain class to the extent of the short-term capital loss.  Note that this allocation takes place after the net 28% rate loss is allocated to the unrecaptured Section 1250 tax rate class and other long-term capital gain class.

f The because the other long-term capital gain class is fully exhausted, the remainder of the distribution comes from the undistributed qualified 5-year gains.  Note that this amount will be included on the 2004 Schedule K-1 as other long term capital gains.

* For purposes of this illustration the potential passive character of this loss is ignored.


  1. Treas. Reg. §1.664-1(d)(i)(a).back

  2. Treas. Reg. §1.664-1(d)(i)(b).back

  3. Treas. Reg. §1.664-1(d)(vi).back

  4. See the next to the last sentence of Treas. Reg. §1.664-1(d)(1)(i)(b).back

  5. See the last sentence of Treas. Reg. §1.664-1(d)(1)(i)(b).back

  6. See Example 5 at Treas. Reg. §1.664-1(d)(1)(viii).back

  7. Treas. Reg. §1.664-1(d)(1)(ii).back

  8. Treas. Reg. §1.664-1(d)(1)(iii).back

  9. See the next to the last sentence of Treas. Reg. §1.664-1(d)(iii).back

  10. Treas. Reg. §1.664-1(d)(iv).back

  11. Treas. Reg. §1.664-1(d)(v).back

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