Analysis of Proposed CRT Regulations

Analysis of Proposed CRT Regulations

Article posted in Regulations on 16 December 2003| comments
audience: National Publication | last updated: 18 May 2011
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Summary

On November 19, 2003, the IRS issued proposed regulations regarding the application of recently modified tax rates applicable to various classes of income to the taxation of distributions from charitable remainder trusts. In this article, Ted Batson, CPA of Renaissance, Inc. reviews the new rules, provides examples of their application to the four-tier accounting regime, uncovers conflicts with existing tax form instructions, and highlights issues left unaddressed.

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

Special thanks to Temo Arjani, CPA for editorial review.

Introduction

On November 19, 2003 the IRS issued proposed regulations updating the ordering rules that govern the taxation of charitable remainder trust distributions. The proposed regulations accomplish three specific goals:

1. They provide immediate guidance as to the proper treatment of qualified dividend income (subject to the new 15% maximum tax rate);

2. The incorporate the capital gain and loss netting rules previously promulgated in Revenue Notices 97-59, 98-20, and 99-17 and give those rules the authority of regulations; and

3. They create a conceptual framework for dealing with the barrage of tax rate changes and targeted treatment of earnings of specific types that have peppered the various tax acts enacted since 1997. They also attempt to provide a mechanism for dealing with "now you see it, now you don't" sunset provisions. For example, §303 of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) sunsets the repeal of qualified 5-year gains on December 31, 2008.

These regulations represent the first comprehensive revision to the four-tier rules since they were issued in 1972. Despite the comprehensive nature of the revisions, the traditional "four tiers" (or categories as they are called in the regulations) are preserved using the same nomenclature:

Tier 1 is ordinary income;

Tier 2 is capital gains;

Tier 3 is other income (basically tax-exempt income); and

Tier 4 is trust corpus or principal.

Within each tier, income is further divided into "classes" that reflect the differing tax rates associated with those classes. Classes of income are relieved in the order of their effective tax rate--starting with the highest tax rate class and progressing to the next highest tax rate class, until all of the tax rate classes in the tier are exhausted.

One feature of the new classification system is that a new tax rate class will automatically spring into existence upon the introduction of a new tax rate applicable to a subset of a tier. This new tax rate class will exist as a separate class as long as it is part of the Internal Revenue Code. Income that is assigned to a tax rate class that is no longer applicable because of a change in the Internal Revenue Code or the sunsetting of the provision that created the class, will fold back into the appropriate remaining tax rate class.

Both EGTRRA and JGTRRA have included sunset provisions that roll back all or significant portions of their changes in the Internal Revenue Code. Tax rate classes that disappear, but are due to return at a later date because of a sunset provision, are frozen until the sunset provision takes effect. This freezing of the class prevents additions to the class, but does not prevent the class from being tapped for the characterization of income recipient distributions. A tax rate class that is subject to this provision falls into order based on the rate that will apply when the sunset occurs.

The Ordinary Income Tier

In the ordinary income tier there will currently be two tax rate classes:

  • Gross income that is not a qualified dividend or capital gain; and
  • Qualified Dividend Income.

The first tax rate class will include such items as interest, non-qualified dividends, rents, royalties, annuity payments, etc. that are taxed at an income recipient's marginal tax rate. The second tax rate class will be taxed under the special rules applicable to qualified dividends that are taxed at 5% or 15% depending on the recipient's marginal tax rate.

Note that the regulations require that income also be tracked according to type and passed out according to type. When there is more than one type of income in a tax rate class, income is passed out by type on a pro-rata basis. So, for example, if a trust earns income from the following class/income types during 2003, a $5,000 unitrust amount will be characterized for tax purposes in the hands of the income recipient as follows:

Example 1







Ordinary Income Tier
Income Earned
Proration Factor
K-1 Reporting
Carryforward to 2004
Other Ordinary Income:







Interest
$ 4,000
4K/10K
$ 2,000
$ 2,000
Non-Qualified Dividends
3,000
3K/10K
1,500
1,500
Rents
2,000
2K/10K
1,000
1,000
Royalties
1,000
1K/10K
500
500
Subtotal
10,000


5,000
5,000









Qualified Dividends Class
2,000


0
2,000









Total Tier 1
$ 12,000


$ 5,000
$ 7,000


Note that all of the qualified dividends are carried forward to 2004. No qualified dividends would have been distributed in this example unless the unitrust amount had exceeded $10,000.

One item of interest is that any dividend balances carried forward to 2003 from a prior year will be treated as non-qualified dividends.

The Capital Gains Tier

With respect to the capital gains category, the following tax rate classes are contemplated based on current law:

  • Short-term capital gains
  • 28% rate gains (i.e. collectibles gain)
  • Unrecaptured §1250 gain
  • Other Long-term gains
  • Qualified 5-year gains

Before the issuance of these regulations, the general rule governing the tax character of CRT distributions was that dollars were passed out of the CRT on a strict worst-rate to best-rate basis--the so-called WIFO, or worst-in-first-out rule. However, because short-term capital gains remain a part of the capital gains tier, an anomalous situation arises. Qualified dividends (taxed at 5% or 15%) are passed out before short-term capital gains (which are taxed at the recipient's marginal tax rate).

The preferential treatment afforded qualified 5-year gains was repealed by JGTRRA, but is scheduled to return on January 1, 2009. Therefore, if this tax rate class contained a balance at the end of 2002, nothing would be added to this balance from May 6, 2003 until after December 31, 2008. Qualified 5-year gains are relieved after other long-term gains because after December 31, 2008 they will be taxed at a preferential rate that is lower than that generally applied to long-term capital gains.

Capital Gain/Loss Netting Rules

The new regulations incorporate a series of capital gain/loss netting rules that had been promulgated previously in Notices 97-59, 98-20, and 99-17. Those notices were published originally to provide guidance as to how capital losses in the 28% (the mid-term gain and collectibles classes), 25% (unrecaptured §1250 gain), and 20% (long-term gains) rate classes were to be netted against each other and against short-term capital gains. In general, the new regulations follow these same guidelines.

In the application of the netting rules across capital gain tax rate classes, current year activity must first be netted against any carryforward gains or losses within the same tax rate class. In other words, if there is a $10 short-term capital gain carryforward from prior years and a $15 current year short-term capital loss, these two amounts must be netted together (for a $5 net short-term capital loss) before the rules described below are applied.

The rules essentially require that a net loss in the short-term capital gain tax rate class to be netted first against the highest long-term capital gain tax rate class, and then against each subsequent long-term capital gain tax rate class in descending tax rate order. If the short-term loss is large enough to absorb all long-term gains, the remaining loss then carries forward to offset short-term gains in future years.

Similarly, a loss in one of the long-term capital gain tax rate classes is first applied against the highest long-term capital gains tax rate class and then against each subsequent long-term capital gain tax rate class in descending tax rate order. If there remains a net loss in the long-term capital gains tax rate class, the loss is applied to the short-term capital gain tax rate class.

These netting rules are applied before relieving the classes for distribution characterization purposes.

Example 2

As of December 31, 2003, the Z trust had the following capital gain items:

Short-Term Capital Gains $3,500
28% Rate Gains ($1,000)
Unrecaptured §1250 Gains <$500
Other Long-Term Capital Gains
(not including qualified 5-year gains)
$5,000


The remaining unitrust amount (after taking into account ordinary income tier items) is $12,000.

The table below summarizes how this activity is to be categorized under the proposed regulations.

Capital Gain Tier
Carry-forward from 2002
2003 Class Additions
Allocation of Losses*
K-1 Reporting
Carry-forward to 2004
Short-Term Capital Gains


$ 3,500


$ 3,500
$ 0











Long-Term Capital Gains









28% Rate Gains


(1,000)
$ 1,000



Unrecaptured §1250 Gains


500
(500)



Other Long-Term Gains
$ 200,000
5,000
(500)
8,500
196,000
Qualified 5-Year Gains
1,500






1,500
Subtotal
201,500
4,500
0
8,500
197,500











Total Tier 2
$ 201,500
$ 8,000
$ 0
$ 12,000
$197,500


* The $1,000 28% Rate Loss is allocated first to the Unrecaptured §1250 Gains because they are taxed at 25%, and then to the Other Long-Term Gains which are taxed at 15%.

Note: The proposed regulations (and Notice 97-59) state that a net short-term capital loss is applied to the long-term capital gain tax rate classes before a net long-term capital loss in a higher tax rate class is applied to any net long-term capital gain in a lower tax rate class. This differs from the approach described in the 2002 Instructions to Form 5227. The Form 5227 Instructions specify that a net long-term loss is netted against other net long-term gains before a net short-term capital loss is applied to net long-term capital gains. Resolution of this difference is sure to be the subject of comments to Treasury.

Ordinary Income Tier Losses

Losses assigned to the ordinary income tier follow a netting regime similar to that utilized in the capital gain tier. First, carryforward balances by tax rate class are netted against current year activity in the same tax rate class. Then, if any tax rate class still has a loss balance, this balance is applied against the highest ordinary tier tax rate class and then against each subsequent ordinary income tier tax rate class in descending tax rate order.

Comprehensive Example

Activity for the year ended December 31, 2003 consists of the following:

The annual unitrust amount is $53,700
The trust has the following income receipts:

Interest income $9,000
Municipal bond interest $5,500
Net rental loss ¿ ($12,000)
Non-qualified dividends $5,000
Qualified dividends $15,000
Net short-term capital losses ($6,750)
Net 28% rate gains $3,000
Unrecaptured §1250 gains $4,500
Net other long-term capital gains $25,000
Qualified 5-year gains realized between
January 1, 2003 and May 5, 2003
$600


Carryforward balances from 2002 are indicated below:



Carry-forward from 2002
2003 Class Additions
Allocation of Losses*
K-1 Reporting
Carry-forward to 2004
Ordinary Income Tier









Other Ordinary Income:









Interest


$ 9,000
($ 7,714)a
$ 1,286
$ 0
Non-Qualified Dividends


5,000
(4,286)b
714
0
Net Rental Income


(12,000)
12,000


0
Royalties


0




0
Subtotal


2,000
0
2,000
0











Qualified Dividends Class


15,000


15,000
0











Total Ordinary Income Tier


$ 17,000
$ 0
$ 17,000
$ 0











Capital Gain Tier









Short-Term Capital Gains/Losses


($ 6,750)
6,750


0











Long-Term Capital Gains/Losses









28% Rate Gains


3,000
($ 3,000)c


0
Unrecaptured §1250 Gains


4,500
(3,750)d
$ 750
0
Other Long-Term Gains
$ 10,000
25,000


35,000
0
Qualified 5-Year Gains
500
600


950e
$ 150
Subtotal
10,500
33,100
(6,750)
36,700
150











Total Capital Gains Tier
$ 10,500
$ 26,350
$ 0
$ 36,700
$ 150











Other Income (Tax Exempt) Tier
3,750
$ 5,500


$ 0
9,250











Principal Tier
$ 65,000




$ 0
$ 65,000











Total Unitrust Distribution






$ 53,700



a This amount represents 9/14ths of the $12,000 net rental loss.
b This amount represents 5/14ths of the $12,000 net rental loss.
c The short-term capital loss is first allocated to the 28% tax rate class to the extent of that class.
d The remainder of the short-term capital loss is allocated to the Unrecaptured §1250 tax rate class.
e The transitional rules applicable to qualified 5-year gains require that this full amount be reported as qualified 5-year gains. The $600 current year gain amount is added to the $500 qualified 5-year gain carryforward amount because it was realized before May 6, 2003. The resulting $1,100 total amount is used to characterize the final $950 of uncharacterized unitrust amount as qualified 5-year gains (because it was distributed in 2003). The $150 balance in the qualified 5-year gains tax rate class is carried forward to 2004 as qualified 5-year gains. If distributed after 2003 and before JGTRRA sunsets on December 31, 2008, this $150 balance will be reported on Schedule K-1 as "Other long-term capital gains" subject to the 15% rate.

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

Are There Any Surprises?

There are no real surprises in these rules. Essentially they carry on the same rules with which we have become familiar over the past 30 years. They do address the immediate need to have guidance with respect to qualified dividend income and the repeal of 5-year qualified gains. Furthermore, they create a structure that should alleviate the need to continue to provide guidance every time Congress tinkers with tax rates.

What Do They Not Say?

Given that the IRS chose to issue new regulations regarding the assignment of income to the four-tiers, the following topics should also be addressed:

  • Application of the passive loss rules to the four-tier system.
  • Application of the depreciation rules from §167(d) to a CRT and especially to the four tiers.
  • Expansion on the requirement to pass out income according to type. This deserves more prominence than was given in these regulations.
  • Include more examples; especially related to temporary classes created by short-term changes to the Internal Revenue Code, suspension of passive losses, and treatment of loss balances within a tier.
  • Address the fact that the application of all tax rate changes isn't clear cut. For example the qualified 5-year gain rules, based on acquisition date and holding period, introduced in the Taxpayer Relief Act of 1997 created two different groupings of 5-year gains for assets sold after December 31, 2005. Assets purchased prior to January 1, 2001 and held for five years were subject to preferential tax rate treatment by some income recipients, but not all. Assets purchased after December 31, 2000 (or for which a special election was made on January 1, 2001) and held for five years were uniformly eligible for preferential tax rate treatment.

Conclusion

All in all these regulations will provide for more certainty in an ever changing tax legislation environment. The guidance given is timely given the approach of a new tax-filing season. The impact of future tax rate changes can be analyzed without waiting on the Service to issue new guidance.

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