The Changing Character of CRTs & Capital Gains

The Changing Character of CRTs & Capital Gains

Article posted in Legislative on 26 May 1999| comments
audience: National Publication | last updated: 18 May 2011
Print
||
Rate:

Summary

When Congress passed new capital gains tax rates and holding period rules with the Taxpayer Relief Act of 1997, it did not specify how the new rules apply to charitable remainder trust distributions. In this edition of Planned Giving Online, PGDC editorial review panel members Emil Kallina and Jon Ackerman review the subsequent legislation and IRS notices that have clarified this issue.

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

When Congress passed new capital gains tax rates and holding period rules in Code Section 1(h) with the Taxpayer Relief Act of 1997, it did not specify how the new rules apply to charitable remainder trust distributions.

A charitable remainder trust may incur a capital gain in one year but not make a distribution to the income recipient resulting in taxation of that capital gain until some later year. To clarify how the new rules would apply in such cases, the IRS then issued Notice 98-20. However, Congress subsequently made certain changes and technical corrections to the capital gains laws, in part reversing the treatment outlined by the IRS in Notice 98-20. The IRS has now followed up by issuing Notice 99-17 modifying Notice 98-20.

Considering the significant tax rate differential between capital gains (of all types) and ordinary income, income beneficiaries, as well as trustees and trust administrators, of charitable remainder trusts have become acutely aware of the application of these constantly changing rules. It appears that, at least for now, the confusion has been alleviated.

Background

The following summary of the general capital gains rules enacted by the Taxpayer Relief Act of 1997, the IRS' interpretation of those rules in Notice 98-20, the changes made to the rules in the Internal Revenue Service Restructuring and Reform Act of 1998, the technical corrections made to the rules in the Tax and Trade Relief Extension Act of 1998 and the IRS' subsequent modification of Notice 98-20 with Notice 99-17 may help to ease confusion over how to report a charitable remainder trust's capital gains distributions for 1998 and subsequent years.

To understand the rules on the new capital gains tax rates it is important to keep in mind the basic rules regarding the taxation of capital gains distributions from charitable remainder trusts. Under Code Section 664(b)(2), the income beneficiary of a charitable remainder trust includes capital gains incurred by the trust in his or her income when the gains are distributed to him or her. Section 664(b) outlines the tiering system used to determine the character of the trust distributions in the hands of the income recipient. This tiering system is sometimes referred to as the "worst in, first out" method of accounting because it assumes that distributions consist first of ordinary income, which is subject to the highest rates of tax, then capital gains, then tax-exempt income and finally corpus. Under the Treasury Regulations, capital gains under Code Section 664(b)(2) are further broken down into short-term capital gains and long-term capital gains. The trust's short-term capital gains are deemed distributed before the trust's long-term capital gains because short-term capital gains are taxed at the higher ordinary income tax rates.

The Treasury Regulations highlight the application of the ordering rules for charitable remainder trust distributions. In one example, a NIMCRUT has an annual unitrust amount equal to the lesser of the trust income or six percent of the net fair market value of the trust assets valued annually. On the valuation date in 1996, the net fair market value of the NIMCRUT assets was $150,000. During 1996, the NIMCRUT had $7,500 of income after the allocation of expenses. The NIMCRUT had no ordinary income for 1996 and had no undistributed ordinary income from prior years. It had no capital gain for 1996 but it had undistributed capital gains incurred in prior years of $30,000. It had tax-exempt income of $7,500 for 1996 and undistributed tax-exempt income from prior years of $2,500.

The Regulations conclude that the unitrust payout for 1996 was $7,500 because the NIMCRUT's 1996 income of $7,500 was less than the fixed payout percentage of $9,000 ($150,000 times six percent). Under Code Section 664(b), the entire distribution would be treated as capital gain in the hands of the recipient because there was no ordinary income and the unitrust payout was less than the NIMCRUT's undistributed capital gains. At the start of 1997, the NIMCRUT's undistributed capital gain from prior years was $22,500 ($30,000 less $7,500) and its undistributed tax-exempt income from prior years was $10,000 ($7,500 plus $2,500).

The Taxpayer Relief Act of 1997

Section 1 of the Code sets forth the rates applicable to taxable income, including under Code Section 1(h), the rates applicable to capital gains. Basically, from 1991 until May 7, 1997, a maximum 28% rate applied to most capital gains incurred on assets held for more than one year.

The Taxpayer Relief Act of 1997 amended Code Section 1(h) to create new tiers of capital gains rates depending on the type of asset involved, the holding period and the date the capital gain is incurred. Under the Act, the main categories of capital gains tax rates are (i) a 28% rate applicable to assets held more than one year but not more than 18 months, (ii) a 25% rate applicable to real estate depreciation recapture that is treated as capital gain (that is, the unrecaptured Section 1250 gain) and (iii) a 20% rate applicable to capital gains incurred after July 28, 1997, on assets held more than 18 months. Under a special transitional rule, the 20% rate also applies to capital gains incurred after May 6, 1997, and before July 29, 1997, for assets held more than one year. The 28% rate continues to apply to assets sold before May 7, 1997, and held more than one year and to sales of collectibles, such as artwork, and certain qualified small business stock.

In addition to these basic rules, the Taxpayer Relief Act of 1997 also made a lower rate of 10% applicable to taxpayers in the 15% income tax bracket for assets held more than 18 months. The Act provides for a rate of 18% (or 8% for taxpayers in the lowest bracket) for assets purchased after 2000 and held for more than 5 years, not including depreciation recapture treated as capital gain or gain from collectibles and qualified small business stock. Finally, the Act allows investors to treat assets as sold on January 1, 2001, recognize the gain from the deemed sale and then qualify for the 18% rate if the asset is held until 2005.

IRS Notice 98-20

In response to the changes enacted in the Taxpayer Relief Act of 1997, the IRS issued Notice 97-59, outlining the application of the three main categories of capital gains tax rates under Code Section 1, as amended by the Taxpayer Relief Act of 1997. The IRS then issued Notice 98-20 on March 13, 1998, to provide guidance on the ordering of capital gain distributions made on or after January 1, 1998, from a charitable remainder trust under Code Section 664(b)(2).

In Notice 98-20, the IRS describes the policy of Code Section 664 by which charitable remainder trust distributions are deemed to consist first of income subject to the highest rate of tax in effect at the time of distribution. The IRS states that the same policy applies under the Treasury Regulations to distributions within one of the four tiers, such as short and long-term capital gains. As an example, the Notice assumes that a charitable remainder trust has undistributed long-term capital gains in the 28%, 25% and 20% categories and undistributed short-term capital gains for 1998. The IRS states that the short-term capital gain is distributed first. Then, the 28% long-term capital gain would be distributed, followed by the 25% gain and, finally, the 20% gain.

Because of the variety of rules applicable to capital gains before 1997, the IRS stated in the Notice that Treasury would use its regulatory power under Code Section 1(h) to treat a charitable remainder trust's undistributed pre-1997 long-term capital gains as gains within the 20% group. In addition, it provided that long-term capital gains incurred by a charitable remainder trust between January 1, 1997, and May 6, 1997, would be in the 28% group under the rules of Code Section 1(h) because the trust's taxable year is the calendar year.

IRS Restructuring and Reform Act of 1998

Congress passed the Internal Revenue Service Restructuring and Reform Act of 1998 amending Code Section 1(h) to reduce the holding period requirement of more than 18 months to a holding period requirement of more than one year for application of the 20% capital gains tax rate. This rule is applicable to sales and exchanges after December 31, 1997. Therefore, with this change, the 28% rate would apply only to certain gains incurred before 1998, gains on the sales of collectibles and certain gains on the sale or exchange of qualified small business stock.

Tax and Trade Relief Extension Act of 1998

Subsequently, the Tax and Trade Relief Extension Act of 1998 made a technical correction to Code Sections 1(h)(5)(A) and 1(h)(13) to provide that if a charitable remainder trust makes a distribution of capital gains incurred by the trust during 1997, the gains are not in the 28% group merely because the trust incurred them before May 7, 1997, or because the asset was not held more than 18 months. In other words, this Act reversed the position taken by the IRS in Notice 98-20 that long-term capital gains incurred by a charitable remainder trust between January 1, 1997, and May 6, 1997, would be in the 28% group.

IRS Notice 99-17

On March 16, 1999, the IRS issued Notice 99-17 which modifies in two respects Notice 98-20, which the IRS issued to provide guidance on the ordering of capital gain distributions made on or after January 1, 1998, from a charitable remainder trust under Code Section 664(b)(2) as described above. First, for taxable years ending after December 31, 1997, the section of Notice 98-20 dealing with pre-effective date capital gains should be ignored. Second, in Notice 98-20's example illustrating the ordering and character rules, the 28% group is changed to gains on collectibles. These modifications put the IRS's guidance in sync with Code Section 1(h)(13)(D) as added by the Tax and Trade Relief Extension Act of 1998.

The full text of Notice 99-17 was reported in News Alerts on March 17, 1999.

Application of the Rules

Using some of the numbers from one of the examples in Notice 98-20, the following illustrates how the new capital gains rules now apply to the 1998 taxable year. Assume that a SCRUT has no undistributed ordinary income from past years and no current net income for 1998. Assume the SCRUT has undistributed capital gains from prior years consisting of a net short-term capital gain of $5 and a net long-term capital gain of $50. Assume that (i) $12 of the long-term gain was incurred between January 1, 1997, and May 6, 1997; (ii) $3 of the long-term gain was incurred between July 29, 1997, and December 31, 1997, from an asset held less than 18 months but more than 1 year; (iii) $5 of the long-term gain is unrecaptured Section 1250 gain falling into the 25% group; and (iv) $30 of the long-term gain was incurred before January 1, 1997. None of the gains are from collectibles or from qualified small business stock.

In 1998, assume the SCRUT distributed $25 to the income recipient. In the hands of the income recipient, the 1998 distribution will consist of $5 of short-term capital gain, $5 of long-term capital gain in the 25% group and $15 of long-term capital gain in the 20% group. The undistributed $30 of long-term capital gains would be carried forward to 1999 and all of it would fall into the 20% group. Prior to the changes made by the Tax and Trade Relief Extension Act of 1998, the gains incurred between January 1, 1997, and May 6, 1997, and after July 28, 1997, would have fallen into the 28% category.

The following two tables from Notice 99-17 serve to illustrate the rules:

                               TABLE 1
       RULES APPLICABLE TO LTCGS DISTRIBUTED IN TAX YEAR 1997
                 LTCGs realized    LTCGs realized     LTCGs realized
                     from              from               from
Pre-1997 LTCGs   1197-5697     5797-72897    72997-123197
______________   ______________    ______________    ________________
    20%         28% if property    28% for           28% if property
                held > 12 months   collectibles      held > 12 months
                                   gain              and <= 18 months
                                                     or for
                                                     collectibles
                                                     gain
                                   25% if property   25% if property
                                   held > 12 months  held > 18 months
                                   and LTCG is       and LTCG is
                                   unrecaptured      unrecaptured
                                   section 1250      section 1250
                                   gain              gain
                                   20% for all other 20% for all other
                                   property held     property held
                                   > 12 months       > 18 months
                               TABLE 2
    RULES APPLICABLE TO LTCGS DISTRIBUTED IN POST-1997 TAX YEARS
                 LTCGs realized    LTCGs realized     LTCGs realized
                     from              from               from
Pre-1997 LTCGs   1197-5697     5797-72897    72997-123197
______________   ______________    ______________    ________________
No change-20%   Change-20% if      No change-28%     Change-28% only
                property held      for               for collectibles
                > 12 months        collectibles      gain
                                   gain
                                   No change-25%     Change-25% if
                                   if property       property held
                                   held > 12         > 12 months
                                   months and        and LTCG is
                                   LTCG is           unrecaptured
                                   unrecaptured      section 1250
                                   section 1250      gain
                                   gain
                                   No change-20%     Change-20%
                                   for all other     for all other
                                   property          property held
                                   held > 12         > 12 months
                                   months


Summary

As a result of all these changes, an income recipient of a charitable remainder trust receiving distributions of capital gains in 1998 and thereafter will treat gains on most capital assets held more than one year as falling into the 20% category. Exceptions exist for gains from collectibles and certain qualified small business stock, which continue to fall into the 28% category, and for unrecaptured Section 1250 gain, which falls into the 25% category.

Add comment

Login or register to post comments

Comments

Group details

Follow

RSS

This group offers an RSS feed.
 
7520 Rates: October 2.2% September 2.4% August 2.4%

Already a member?

Learn, Share, Gain Insight, Connect, Advance

Join Today For Free!

Join the PGDC community and…

  • Learn through thousands of pages of content, newsletters and forums
  • Share by commenting on and rating content, answering questions in the forums, and writing
  • Gain insight into other disciplines in the field
  • Connect – Interact – Grow
  • Opt-in to Include your profile in our searchable national directory. By default, your identity is protected

…Market yourself to a growing industry