Dealing With the Self-Dealing Rules

Dealing With the Self-Dealing Rules

Article posted in Compliance on 14 July 1999| comments
audience: National Publication | last updated: 16 September 2012
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Summary

"In this week's edition of Gift Planner's Digest, Los Angeles attorney David Wheeler Newman reviews the private foundation excise tax rules regarding prohibited acts of self-dealing and how they apply to charitable remainder trusts and charitable lead trusts."

by David Wheeler Newman

Ancient History

Prior to the Tax Reform Act of 1969, the Internal Revenue Code did not distinguish between public charities and private foundations. All tax-exempt charitable organizations were prohibited from engaging in specific acts with individuals that we would now consider to be disqualified persons. An arm's-length test was used to gauge the propriety of loans, payment of compensation, purchase transactions, and use of the assets of the tax-exempt organization. The principal sanction for violation of these rules was the loss of the organization's tax-exempt status.

Tax Reform Act of 1969

For the first time, the concept of a private foundation as a separate class of tax-exempt charitable organization was introduced into the Code as part of the sweeping 1969 tax reforms affecting tax-exempt organizations and charitable giving. In addressing restricted or prohibited conduct by private foundations, Congress determined that the arm's-length standard under prior law required an unreasonable amount of enforcement resources and produced unpredictable results. The self-dealing rules, along with the other private foundation excise tax rules, represented an effort to replace an ambiguous standard with a flat prohibition on certain types of activity, and to devise a penalty (in the form of an excise tax) that would effectively discourage the prohibited conduct without requiring the ultimate sanction of the loss of tax-exemption.

Application of the Self-Dealing Rules to Charitable Trusts

IRC § 4947(a)(2) applies the self-dealing taxes of §4941 to split-interest trusts, which are defined to include charitable remainder trusts and charitable lead trusts.

For purposes of the self-dealing rules, CRTs and CLTs are treated as private foundations (PF). A disqualified person (DP) has a specifically defined relationship with the private foundation. The act in question must be described in IRC § 4941 and the regulations thereunder.

Disqualified Persons include --

  • Substantial Contributors

Any person who contributed or bequeathed more than $5,000 to the private foundation, if that amount is more than 2% of total contributions and bequests received by the private foundation up to that point is considered a substantial contributor.1 Disqualified persons include the creator of a trust.2 It is always safe to assume that the donor of a lead trust or CRT is a disqualified person. Once a person is a substantial contributor, he or she will retain that status even if he or she might not be so classified if the determination were made at some later date.

  • Foundation Managers

An officer, director, or trustee of a private foundation. A trustee of a charitable lead trust or charitable remainder trust is a disqualified person.3

  • Twenty-Percent Owners

The owner of more than 20% of a corporation, partnership, or trust that is a disqualified person is also a DP.4

  • Family Members

A member of the family of a substantial contributor, a foundation manager or a 20% owner is a disqualified person.5 For this purpose, members of the family include the individual's spouse, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren. Siblings are not included.6

  • Corporations and Other Entities

Corporations and partnerships are disqualified persons if more than 35% of the voting power or profits interest is owned by disqualified persons.7 A trust or estate will be a disqualified person if more than 35% of the beneficial interests are owned by disqualified persons. It is always safe to assume that an income beneficiary of a CRT is a disqualified person.

  • Government Officials8

Exceptions and Special Rules

  • For purposes of the self-dealing rules, disqualified persons do not include any charitable organization.9
  • For purposes of determining the voting power of a corporation, profits interest of a partnership, and beneficial interest in an estate or trust, ownership attribution rules apply.10 A disqualified person participates in an act of self-dealing, and is thus exposed to liability for the tax, if he or she takes part in the transaction, alone or with others, or directs any person to do so.
  • Participation includes silence or inaction of a foundation manager, as well as his or her affirmative acts. A manager has not participated, when he or she has opposed the act in a manner consistent with fulfillment of his or her foundation responsibilities.

Self-Dealing Transactions

Sale or Exchange of Property

Any sale or exchange of property between a disqualified person and a private foundation is self-dealing.11 As with most of the defined categories of self-dealing, sales or exchanges of property are flatly prohibited, rather than being judged by an arm's-length standard or eligible for a de minimus exception.

The transfer of property by a disqualified person to a private foundation is treated as a sale or exchange if the private foundation assumes a mortgage, or takes subject to a mortgage that was placed on the property, within the 10-year period ending on the date of the transfer of the property to the private foundation.12

Leasing of Property

In general, any lease of property between a disqualified person and a private foundation is self-dealing.13 A lease of property by a disqualified person to a private foundation without charge is not self-dealing.14

Extension of Credit

Generally, any extension of credit between a disqualified person and a private foundation is self-dealing.15

Example: A museum that is a private foundation has hired a new executive director, who will be a disqualified person. As part of his compensation package, the private foundation agrees to make the disqualified person a below-market interest loan to assist in the purchase of a personal residence. In Private Letter Ruling 9343034, the IRS ruled that no act of self-dealing would result from the loan. However, in PLR 9417018, the IRS announced that it was reconsidering the prior ruling. It appears that no exception would take this situation out of the normal rule that an extension of credit from the private foundation to the disqualified person is prohibited self-dealing. This is an odd result since, if the private foundation purchased the residence and provided its use to the disqualified person as part of his compensation package, this would clearly be exempt from the self-dealing rules under a special exception in Treas. Reg. § 4941(d)-2(d)(2), provided the compensation package, viewed as a whole, is reasonable in amount.

A loan without interest by a disqualified person to a private foundation is not an act of self-dealing if the proceeds of the loan are used exclusively for purposes described in IRC § 501(c)(3). 16

An act of self-dealing occurs where a third party purchases a property and assumes a mortgage, the mortgagee of which is a private foundation, and subsequently the third party transfers the property to a disqualified person, who either assumes the liability under the mortgage or takes the property subject to the mortgage.17

An act of self-dealing occurs where a note, the obligor of which is a disqualified person, is transferred by a third party to a PF which becomes the creditor under the note.18

Furnishing of Goods, Services, or Facilities

The general rule is that the furnishing of goods, services, or facilities between a private foundation and a disqualified person is self-dealing.19 If the goods, services, or facilities are furnished by a disqualified person to the private foundation, self-dealing will not result if furnished without charge and used exclusively for IRC § 501(c)(3) purposes.20 If these are furnished by the private foundation to a disqualified person, it will not be self-dealing if furnished on a basis no more favorable than made available to the general public.21

Payment of Compensation by a Private Foundation to a Disqualified Person

In general, the payment of compensation, payment, or reimbursement of expenses by a PF to a disqualified person is self-dealing.22 Except for government officials, payment of compensation by a private foundation to a disqualified person for personal services which are reasonable and necessary to carry out the exempt purposes of the private foundation is not self-dealing if the compensation is not excessive.23

The regulations take a broad view of what services are reasonable and necessary to carry out the exempt purpose of the PF. Favorable examples include investment counseling services and legal services performed for private foundations by disqualified persons.24

Transfer to, or Use by, a Disqualified Person of the Income or Assets of a Private Foundation 25

The guarantee by a PF of a loan to a disqualified person is an act of self-dealing.26 The purchase or sale of securities by a PF is self-dealing if the purchase or sale is made in an attempt to manipulate the price of the securities to the advantage of a disqualified person.27 On the other hand, ownership by the disqualified person of the same class of securities or partnership interests as that owned by the PF, with the same voting and liquidation rights, by itself, should not be self-dealing. To be on the safe side, it is best if the disqualified person and the PF buy and sell their interests at the same time, to avoid any inference that the transaction by the PF is manipulating price in a way that benefits the disqualified person.

Co-Tenancy and Other Forms of Co-Ownership

PLR 9114025 created concern that ownership by a charitable remainder trust and the donor of partial interests in the same property might be self-dealing, since the private letter ruling implied (but did not rule) that this would be the result. But the formal IRS position remains that the ownership of property as tenants in common by private foundations and disqualified persons is not per se self-dealing.28 On the other hand, officials at the Treasury and the national office of the IRS have recently expressed their view privately that co-ownership of an asset is enough to result in self-dealing under § 4941(d)(l)(E). This view, if correct, would have a negative impact on the popular strategy of dealing with a CRT to be funded with encumbered property by having the donor transfer a partial interest in the property to the CRT while retaining a partial interest and indemnifying the CRT against any liability on the debt. When called upon to rule in an actual situation, however, in real property (i.e., co-owned property) held by a PF and disqualified person did not constitute self-dealing.29 To minimize the risk of self-dealing in this situation, the donor should enter into a written cotenancy agreement with the trustee of the CRT in which the indemnity is documented, and in which the donor/DP is prohibited from using the partial interest in the property which is held by the CRT.

CRT Funded with Residence

More than one gift planning guru has observed that you can't live in your unitrust, meaning that if a CRT is funded with a residence, the use of the residence by the donor (e.g., pending sale of the house) is self-dealing. Contrary to oft-repeated myth, there is no de minimus exception to this rule. For this reason, a residence is an appropriate asset to be used to fund a CRT only if the donor is prepared to move out immediately.

Exceptions and Special Rules -- Charitable Organizations

As noted above, for purposes of self-dealing rules, disqualified persons do not include any charitable organization. For this reason, none of the acts or transactions described above will be self-dealing if the party involved with the private foundation or CRT is a charitable organization.

Example: A donor owns real property adjacent to a hospital campus that the hospital would like to acquire. The parties would like to use the property to fund a charitable remainder trust to provide income to the donor for his life with the remainder to the hospital. The hospital agrees to serve as trustee of the trust, and plans to purchase the real property from the trust. Even though the hospital would generally be a disqualified person due to its status as a foundation manager (as well as its beneficial interest in the trust), it is not treated as a disqualified person for purposes of the self-dealing rules and, therefore, no self-dealing transaction will result from this plan.

Indirect Self-Dealing

Generally, a self-dealing transaction between a disqualified person and an organization controlled by a private foundation is indirect self-dealing.

Example: A CRT owns a majority interest in a corporation that owns and operates several apartment buildings. One of the apartments is occupied by the son of the donor. Since the son is a disqualified person, use of the apartment will be an act of indirect self-dealing, even if the son pays rent to the corporation.

Control Test

An organization is controlled by the private foundation if the PF, or one, or more, of its foundation managers may require the organization to engage in a transaction which, if engaged indirectly by the private foundation, would constitute self-dealing.30 An organization may also be treated as controlled by the private foundation in the case of a transaction between the organization and a disqualified person if the disqualified person, together with one or more persons who are also disqualified persons due to their relationship with the disqualified person, may require the organization to engage in the transaction. The controlled organization need not be a tax-exempt organization.

Exceptions and Special Rules

  • Certain retail transactions with controlled entities involving $5,000 or less are exempt from the indirect self-dealing rules.
  • Any transaction in which the private foundation could have engaged directly, under the general self-dealing rules, will not be indirect self-dealing. For example, a controlled organization may pay reasonable compensation to a disqualified person for personal services rendered.
  • A transaction with a controlled organization will not be an act of indirect self-dealing if:
  1. the transaction results from a preexisting business relationship;
  2. the transaction was at least as favorable to the controlled organization as an arms-length transaction with an unrelated party; and either:
  3. the controlled organization could have engaged in the transaction with someone other than the disqualified person only at a severe economic hardship to the controlled organization, or because of the unique nature of the product or services provided by the controlled organization, the disqualified person could not have engaged in the transaction with anyone else. [31]


Self-Dealing Penalties

Calculation -- Amount Involved

The taxes described below are imposed on the "amount involved" in the self-dealing transaction.31 Generally, this is the greater of the money or fair market value of other property given, or the money, or value of other property received.

For compensation paid to disqualified persons (other than government officials), the amount involved is only the compensation in excess of that which would be reasonable, i.e., the excessive portion.

When the use of property is involved, the amount involved is the greater of the payment or fair market value (FMV) for its use. For property, the FMV for its use is its rental value, and for money, it is the interest that would reasonably be charged or earned.

Example: DP borrows $100,000 from private foundation at 6% interest. The market rate for this type of loan is 10%. Six months later, disqualified person repays the loan of $100,000 principal plus $3,000 interest (6% for ½ year). The amount involved with respect to the act of self-dealing is $5,000 (10% interest for ½ year).

Initial Tax--Disqualified Person

Imposed at 5% of the amount involved for each year in the taxable period (which begins on the date the transaction occurs and ends on the earliest of the date of mailing by the IRS of a notice of deficiency with respect to the initial tax, the date the initial tax is assessed, or the date when the correction of the transaction is completed). The initial tax may be imposed on a disqualified person who had no knowledge at the time that the act was one of self-dealing.

Initial Tax--Foundation Manager

A tax at the rate of 2½% of the amount involved is imposed on a foundation manager (e.g., a trustee) who knowingly participates in the act of self-dealing. The tax paid by the foundation manager may not exceed $10,000.

Additional Tax--Disqualified Person

If the initial tax is imposed, and the self-dealing act is not corrected in a timely manner, an additional tax is imposed in an amount equal to 200% of the amount involved. This tax must be paid by the disqualified person who participated in the act of self-dealing. The additional tax is abated if the self-dealing act is corrected during the correction period, which ends 90 days after a deficiency notice for the additional tax is mailed.

Additional Tax--Foundation Manager

An additional tax of 50% of the amount involved, up to $10,000, is imposed on a foundation manager who refuses to agree to part or all of the correction.

Correction

An act of self-dealing is corrected by undoing the transaction to the extent possible, but placing the private foundation in a financial position no worse than that in which it would be if the disqualified person was dealing under the highest fiduciary standards.32

Example: The disqualified person is the son of the donor that funded a CRT with stock in a closely-held family business. In 1994, the disqualified person purchased the stock from the CRT for $1 million. In 1995, the disqualified person sold the stock for $1,800,000. In anticipation of an IRS examination, the disqualified person wishes to correct the act of self-dealing in 1996, when the stock is worth $2,400,000. The disqualified person must pay the CRT $1,400,000 ($2,400,000--the fair market value at the time of correction, less $1,000,000, the amount which would have been returned to disqualified person if rescission had been required).

Sale of Property

If the act of self-dealing is a sale of property by a private foundation to a disqualified person for cash, a correction of the transaction would be a rescission of the sale, return of the cash to the private foundation, and payment to the PF of any net profits realized from the property by the disqualified person.

Use of Assets

In the case of a use of assets by a disqualified person, a correction would be the termination of the use of the property, and payment by the disqualified person of the FMV for use of the property (or the excess of the FMV for use of the property over the amount actually paid to the private foundation for use of the property).

Excess Compensation

Undoing the transaction requires the disqualified person to pay to the foundation any compensation that is excessive. Note that termination of employment, or the independent contractor relationship, is not required.33

Further Self-Dealing

Action taken in the manner described in the regulations to correct an act of self-dealing shall not by itself constitute a further act of self-dealing.34 However, care must be taken in correcting acts of self-dealing:

Example: A disqualified person intended to correct a self-dealing transaction in the form of a loan to the disqualified person from a private foundation. The disqualified person proposed to transfer to the private foundation a parcel of real estate with a FMV equal to the amount of the loan.

The IRS held that the transfer of property to the private foundation would constitute self-dealing since the disqualified person's debt to the private foundation would be cancelled and the transaction would be treated as a sale of the property by the disqualified person to the private foundation. The service further held that minimum standard for correction would not be met because the foundation would be left in a less advantageous situation, with property, than it would be if the loan were repaid with cash. Thus, the proposed correction, by itself, was an act of self-dealing. The IRS noted, however, that a transfer of property might be an acceptable correction of a self-dealing loan, if the property had substantially appreciated in value, and could be easily converted into an amount of cash in excess of the debt and accrued interest.35

Recent Developments Involving Charitable Remainder Unitrusts

IRS EP/EO Continuing Professional Education Program

Each year, the IRS Exempt Organizations Division publishes its exempt organizations' continuing professional education technical instruction program textbook. The purpose of the textbook is to educate the government's exempt organization specialists on relevant topics in light of recent developments in the EO area. The textbook for use during the 1996 fiscal year contains an article (Exhibit A) discussing self-dealing and other tax issues involving charitable remainder trusts, which was written in the wake of Notice 94-78, 1994-2 CB 555, pertaining to accelerated charitable remainder trusts. The article stresses the view of the government that the self-dealing rules should be applied to a charitable remainder trust in which the timing of the sale of assets may effect the character for tax purposes of distributions by the trust to the income beneficiary.

IRS Audit Program

The IRS EP/EO CPE FY'96 textbook article states that the IRS is in the process of identifying and examining accelerated CRTs, and lists the criteria which should be identified in the examination process to select a CRT for audit.

Deferral NIMCRUTs

The National Office of the IRS has expressed its concern on more than one occasion about the timing of income of net income unitrusts to control distributions. The EP/EO CPE FY'97 textbook contained an article provocatively titled, Charitable Remainder Trusts: The Income Deferral Abuse and Other Issues (Exhibit B), in which the authors suggested that the use of a NIMCRUT to time income to match the needs of the income beneficiary could constitute self-dealing. The self-dealing analysis of deferral NIMCRUTs by the Service has focused on investment by the trust in two specific assets, which are frequently used to control the timing of trust accounting income--commercial deferred annuity contracts and partnership interests.

TAM 9825001

In a Technical Advice Memorandum issued in January 1998, the National Office considered a deferral NIMCRUT invested in commercial deferred annuities (Exhibit C). The IRES thoroughly analyzed the self-dealing issue and concluded that the donor received no current benefit as a result of the trust investment in the annuity contract. Moreover, the fact that the trustee could determine the timing of trust distributions by timing withdrawals did not change this result. The TAM unequivocally concludes that no self-dealing arises from this type of deferral NIMCRUT. This result is discussed (and validated in the IRS EP/EO CPE FY'99 textbook).

Exhibit A

Excerpt from the IRS EP/EO Continuing Professional Education Program Textbook (FY'96):

6. Notice 94-78, 1994-32 I.R.B. 15--A Questionable Scheme: Accelerated Unitrusts

The Service, in Notice 94-78, states that charitable remainder unitrusts are being used as vehicles to avoid a substantial portion of the tax on the gain of appreciated assets. The scheme to accomplish this goal is as follows:

Illustration: On the first day of year one, a unitrust is created by Jane Smith, who then donates stocks to that unitrust. The stocks are the sole assets of the unitrust. The stocks' net fair market value at the date of transfer is $1 million with a zero basis, and the stocks do not pay dividends. The trust instrument provides that: 1) John Doe is the trustee; 2) Jane Smith is to be the sole beneficiary of the unitrust income; 3) an annual payment is made for a fixed period of two years, and the unitrust legally terminates thereafter; 4) the amount of the annual payment to the non-charitable beneficiary is fixed at 80% of the net fair market value of the unitrust assets as valued annually; and 5) the remainder goes to an IRC 50l(c)(3) organization.

At the end of year one, the stocks are valued at $1 million, and the trustee, as planned, does not make the annual payment to the beneficiary. On the second day of year two, the trustee sells the stock for $1 million, and distributes 80% of the proceeds ($800,000) before April 15, year two, to the donor so as to satisfy the distribution requirement for the first year. At the end of year two, the trustee distributes $160,000 (80% of the $200,000 unitrust corpus) to the beneficiary and $40,000 to the section 50l(c)(3) organization, and thereafter the unitrust is dissolved. The beneficiary in her tax return does not list the $800,000 as capital gains because she claims that the payment received for year one is a return of trust corpus. As to the $160,000, she pays $44,800 in capital gains taxes ($160,000 x 28%).

[Notice 94-78 contains an example that illustrates this scheme. Although the facts in that example are different from the example herein, the strategy is basically the same]

This scheme is based on the supposition that because no assets are distributed to the donor during year one (but are distributed before April 15, year two), the unitrust amount for the first year is characterized as a distribution of trust corpus under IRC 664(b)(4) to the extent the distribution exceeds any ordinary or other income earned (or not earned, as in this illustration) by the trust during year one. If the appreciated assets are sold or distributed in year one, this scheme does not work because the $800,000 would be treated as capital gains and be subject to a 28% tax. If all the assets are sold in year one, the trust would realize a $1,000,000 capital gains, and, under IRC 664(b)(2), the $800,000 would also be capital gains income in the hands of the donor. If the payments were made to the donor in year one, the net cash the donor received for the two years would be $691,200 ($800,000 § $224,000 [capital gains tax]) + ($160,000 § $44,800 [capital gains tax]) rather than $915,200 ($800,000 for year one + $115,200 for year two).

The Service states in Notice 94-78 that it disapproves of this usage of unitrusts, and may impose, depending upon the facts and circumstances, IRC 4941 taxes upon the creator/donor, trustee, and/or other appropriate persons for such exploitation. Furthermore, the Service will challenge these transactions under one or more of the following legal doctrines: 1) substance vs. form doctrine; 2) assignment of income doctrine; and 3) challenging trust's qualification as a charitable remainder unitrust under IRC 664.

A. Application of IRC 4941

The Service considers the transactions between the creator/donor and the unitrust outlined in the above illustration as acts of self-dealing, and the creator/donor, and trustee, may be subject to IRC 4941 taxes for such improper use of the unitrust's assets. As discussed in section 3 of this article, unitrusts are treated as if they were private foundations for certain purposes. One of these purposes is the self-dealing rules under IRC 4941, and the creator/donor and trustee are disqualified persons because the donor is the substantial contributor to and the creator of the unitrust. The latter is a disqualified person because he is a trustee, or has authority, or responsibility to make administrative decisions for the unitrust. In order for the above discussed scheme to work, there must be planning, coordination, and cooperation between the creator/donor and trustee. Thus, the creator/donor's and trustee's knowledge of, or willingness to participate in this scheme, would be hard to dispute.

The critical issue is whether the timing of the sale, and the distribution of the assets constitute acts of self-dealing; that is, whether the unitrust assets are used for the benefit of a disqualified person. As described in the above illustration, sales of the unitrust assets and payment of the unitrust amount to the creator/donor, Ms. Jane Smith, for year one must be delayed by the trustee until year two, and any action taken to make the payment must likewise be delayed until early year two. The purpose of this delay and, in fact, the entire scheme is to benefit the creator/donor (i.e., substantially reducing Ms. Smith's capital gains taxes). Such use constitutes the use of the unitrust assets for the benefit of the creator/donor, the disqualified person. See e.g., Rev. Rul. 74-600, 1974-2 C.B. 385 (states that the placing of paintings owned by a private foundation in the residence of a substantial contributor, a disqualified person, constitutes an act of self-dealing).

In the illustration, Ms. Smith, the disqualified person, did not take physical possession of the unitrust property and use it for her own benefit. The self-dealing act was in preventing the property from being used to benefit both the charitable and the non-charitable interests until the property was sold. The timing of the sale was to seek the maximum financial benefit for the disqualified person. Although Ms. Smith, the disqualified person, was also the income beneficiary of the property and presumably did not mind the diminution of her income interest, the charitable remainderman's interests also suffered. For example, had the property been sold on day one, the proceeds might have been invested in such a way as to increase the value of the remainder interest. Because the trustee was not free to benefit both of the interests that he was obligated to serve, the self-dealing was the functional equivalent of the use of the property of a disqualified person. Hence, IRC 4941 taxes may be imposed upon Ms. Smith and/or Mr. Doe, the trustee.

Even if the property transferred to the unitrust consisted of real property, the amount involved for IRC 4941 purposes should be determined using a fair interest rate for use of the money. This is because the disqualified person did not take possession of the property. Delaying the sale to benefit the disqualified person caused the trust to forgo interest or other earnings that it might have had on an immediate sale.

Correction

Under IRC 4941(e)(l), the taxable period for an act of self-dealing continues until the earliest of three events occurs: 1) the mailing of the notice of deficiency for the first level tax; 2) payment of the first level tax by the disqualified person; or 3) correction of the act of self-dealing is completed.

Correcting an act of self-dealing terminated the taxable period (ending the accrual of the first level tax) and eliminates any potential liability for the second level tax only when all the necessary elements of correction have been completed. In the illustration, selling the property by the trustee in year two did not complete the correction. The disqualified persons, Ms. Smith and the trustee, would still need to make the unitrust whole. She and he would need to make up for the use of the proceeds that were foregone during the year the trust held the property to benefit the donor/disqualified person.

C. Legal Doctrines--Challenging Treatment of the Gain

1) Substance vs. Form

In appropriate circumstances, the Service will not respect the form of the transaction as a sale by a tax-exempt charitable remainder trust, under the form vs. substance doctrine. Under this doctrine, a transaction is examined to determine whether there is economic substance as opposed to mere tax avoidance. That is, the transaction conducted is designed solely to avoid taxes and has no legitimate non-tax business reasons. See Gregory v. Helvering, 293 U.S. 465 (1935). As discussed in section 6 of this article, the purpose and design of the scheme is to shield a substantial portion of the payment received by the beneficiary from capital gains taxes. Furthermore, there is no indication that this scheme has any purpose or legitimate business reason other than to avoid capital gains taxes. Consequently, the substance of this scheme is tax avoidance, and the unitrust amount the beneficiary received for year one will not be treated as return of corpus, and the gains would be taxed. See Notice 94-78.

2) Assignment of Income

The Service may tax all the gains or the sale of trust assets to the donor, not to the trust, under the doctrine that one cannot assign his income to another. See Commissioner v. Court Holding Co., 324 U.S. 331 (1945). In the above discussed scheme, the donor contributes appreciated assets to the unitrust, and the trustee has an obligation to execute the trust in accordance with its terms. The trustee must dispose of the appreciated assets in a taxable transaction in order to make distributions to the donor/beneficiary. The unitrust is thus used as a conduit to receive technical title of the appreciated assets while returning the proceeds to the donor/beneficiary once the appreciated assets are sold. Thus, in substance, the donor/beneficiary has given the trustee the proceeds of the sale of the appreciated property, which the trustee is required to distribute back to her. Consequently, gains realized upon the sale of the assets by the unitrust may be attributed to the donor/beneficiary as gross income under IRC 61(a)(3). See Estate of Applestein v. Commissioner, 90 T.C. 331(1983). If the payment is characterized as trust corpus under this scheme, the tax on the proceeds of sale would be shifted away from the person receiving the economic benefits of the proceeds.

3) Not a Charitable Remainder Unitrust

Finally, the Service may tax the income earned from the sale of the appreciated assets to the trust because it is not exempt from federal income tax under TRC 664(c). That income is not exempt because the trust does not qualify as a charitable remainder unitrust under IRC 664. Reg. l.664-l(a)(4) provides that a trust must function exclusively as a charitable remainder trust from the creation of the trust. As discussed in section 6, the unitrust has been created, structured and operated primarily to avoid the donor's capital gains taxes. This use is inconsistent with the requirement that the trust function exclusively as a charitable remainder trust as provided for in Reg. l.664-1(a)(4), and, consequently, the trust is not a charitable remainder unitrust.

7. Identification and Examination of Unitrusts

The Service is in the process of identifying and examining accelerated unitrusts that have been used in the above discussed scheme. This scheme usually has the following key elements:

  1. the unitrust has a short period of legal life, usually two or three years;
  2. a very high fixed percentage, usually around 80%, is used to determine the payment to the non-charitable beneficiary/donor;
  3. the assets transferred to the unitrust are comprised of appreciated assets (such as stocks, land, etc.);
  4. the assets usually produce little or no ordinary income;
  5. payment to the beneficiary for the first year is not made during that first year of the unitrust's legal life;
  6. the assets are sold for cash at the beginning of the second year of the unitrust's legal life; and
  7. payment to the beneficiary for the first year is made in the second year, but before the April 15 deadline for filing Form 5227, Split-Interest Trust Information Return.


These elements can be identified by reviewing certain key information contained in a unitrust's Form 5227, Split-Interest Trust Information Return. The key information in the Form 5227 is as follows:

  1. Section B--Type of Entity: This scheme can be utilized only by charitable remainder unitrusts [Box (3)].
  2. Section D--Date the Trust was Created: This scheme occurs in first year of the trust (consequently, the Form 5227 is needed for the first year). Furthermore, this scheme only works if trust is created in beginning of year one, otherwise, unitrust payment is prorated.
  3. Part I--the information contained herein indicates whether ordinary income or capital gains were earned. Under this scheme, little or no income, and no capital gains will be earned.
  4. Part III--This section identifies the recipient of the unitrust payment, and the amount and the character of that payment. Look for a large payment in the first year that is listed as corpus in column (e) or as nontaxable income in column (d).
  5. Part IV--This section identifies the nature of the assets, whether they are cash, land, stocks, etc.
  6. Part V-B 51a--Unitrust Fixed Percentage to be Paid to the Recipients--This section identifies the percentage of the net fair market value assets that is used to determine the amount of the payment to the recipient. Look for a very high percentage.
  7. Part V-B--Total accrued distribution deficiencies from previous years--This section indicates whether there were payments made to the recipient in the previous year.


A Form 5227 has been reproduced in Appendix I, and Notice 94-78 has been reproduced in Appendix II.

8. Conclusion

In the tax year 1994, approximately 53,303 Forms 5227 were filed by charitable split-interest trusts. Thus, there is immense potential that many charitable remainder unitrusts are being utilized as devices to avoid capital gains taxes. After identifying and examining such unitrusts, exempt organizations examiners should use the above discussed remedies--IRC 4941 and/or taxation of the gain--to negate the result of this scheme. In determining whether IRC 4941 can be used to penalize the appropriate participants in this scheme, exempt organizations examiners should consider all the facts and circumstances of the particular ease. In determining whether the gain should be taxed under the legal doctrines that were discussed, they should also consider all the facts and circumstances of the particular case.

Exhibit B

Excerpt from the IRS EP/EO Continuing Professional Education Program Textbook (FY'97), Charitable Remainder Trusts: The Income Deferral Abuse and Other Issues:

3. NIMCRUTS and the Self-Dealing Provisions

Analytically, the self-dealing issues for both charitable remainder unitrusts used as tax shelters and for the income deferral NIMCRUTS are similar. In both cases, unitrust assets must be managed in a particular way if the desired result is to be achieved. For Trust X, the way is to hold the stock of M off the market until year eleven in order to defer tax during years one through ten. Whether this is an act of self-dealing depends on whether it can be characterized as "transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation," as that phase is used in IRC 4941(d)(1)(E).

A classic example of the use of foundation assets to benefit a disqualified person may be found in Rev. Rul. 74-600, 1974-2 C.B. 385. Rev. Rul. 74-600 states that the placing of paintings owned by a private foundation in the residence of a substantial contributor/disqualified person constitutes an act of self-dealing.

As early as 1969, the Joint Committee on Taxation realized that self-dealing could involved something other than a transfer of the asset between the parties. The General Explanation of the Tax Reform Act of 1969 states at p. 31 that:

A self-dealing transaction may occur even thought there has been no transfer of money or property between the foundation and any disqualified person. For example, securities purchases or sales by the foundation to manipulate the prices of the securities to the advantage of the disqualified person constitute a "use by or for the benefit of a disqualified person of the income or assets of a private foundation."

This conclusion was echoed in the regulations. Reg. 53.4941(d)-2(f)(1) provides in part that "the purchase or sale of stock or other securities by a private foundation shall be an act of self-dealing if such purchase or sale is made in an attempt to manipulate the price of the stock or other securities to the advantage of a disqualified person."

One point that the regulation makes quite clear is that for a stock manipulation to be considered a "use by or for the benefic of a disqualified person," it must be intentional. In the words of the regulation, it must be "made in an attempt to mainputlate" the price of the stock. (Emphasis added.)

Although the manipulation must be intentional, the individuals involved need not know that engaging in such manipulation may constitute self-dealing. Reg. 53.4941(a)-1(a)(1) provides that the excise tax shall be imposed on a disqualified person even though he had no knowledge at the time of the act that the act constituted self-dealing. See also G.C.M. 37731 (October 26, 1978).

Also consider the case of a private foundation that receives from an estate as a bequest three secured mortgage notes carrying a rate of interest described as excellent. The obligor under the notes is a partnership that is a disqualified person with respect to the private foundation. The loan was made at an earlier date, but is less than 10 years old. It was not contemplated that the notes would be transferred to the foundation. Reg. 53.4941(d)-2(a)(2) provides that if a private foundation assumes a mortgage that a disqualified person placed on the property within 10 years, the transfer will be considered self-dealing under 4941(d)(1)(B).

As asset manipulation intended to provide an economic benefit (the maximum tax deferral) for a NIMCRUT's income beneficiary, therefore, may be involved in self-dealing where the beneficiary is a disqualified person. In 4941 terms, it may be a use that is for the benefit of a disqualified person.

In the earlier example, Trust X may be involved in self-dealing, because the stock of M intentionally has been managed in such a way as to obtain a benefit (the maximum tax deferral) for A, a disqualified person. The issue then becomes whether it is the kind of benefit that is appropriate for a noncharitable beneficiary under IRC 4947(a)(2).

Charitable remainder unitrusts are unlike tax exempt private foundations in that they partially serve noncharitable interests. To rationally apply IRES 4941 to charitable remainder unitrusts, there has to be some way to draw the distinction between legitimate charitable and noncharitable interests.

For split interest trusts, that method is suggested in Reg. 53.4947-1©(2)(I). The regulation provides that the income beneficiaries under the terms of the trust are excepted from self-dealing with respect to unitrust distributions providing that these payments are not made from amounts for which a deduction was allowed. (Emphasis added.) This exception, found at IRC 4947(a)(2)(A), is obviously necessary to preclude the application of the self-dealing rules where a trust makes a payout to the noncharitable income beneficiary. Without such a provision, the charitable remainder trust is not possible.

It also suggests that the remainder interest must be negatively affected in order for a transaction to be characterized self-dealing.

The IRM makes the obvious point that "Payments to private beneficiaries in excess of proper unitrust or annuity amounts are subject to IRC 4941..." IRM 7752:(18)73(2). However, excessive payments made to disqualified persons are not the only form of self-dealing.

Under IRC 4941(d)(1)(B), a loan of foundation assets to a disqualified person is an act of self-dealing. Rev. Rul. 74-600, discussed earlier, illustrated this. If unitrust assets were lent to a disqualified person, the issue then becomes how it affects the remainder interest. Is it a use of the assets that ultimately affects the amount for which a deduction was allowed under Reg. 53.4947-1(c)(2)(i)?

If unitrust assets were paintings and the paintings were placed in the residence of a noncharitable beneficiary/disqualified person, the value of the remainder interest could certainly be affected if the paintings were lost or stolen. For instance, the insurance proceeds could be invested in such a way as to produce a lesser return than might have been the case had the paintings remained in the possession of the unitrust. In that circumstance, the remainderman assumes a risk so that the noncharitable beneficiary/disqualified person may benefit.

In the unitrust format, the noncharitable beneficiary is only entitled to a stream or income. In the hypothetical, the noncharitable beneficiary/disqualified person receives something (the use of assets in a situation where he is only entitled to an income stream) that does not fall within the self-dealing exception of Reg. 53.4947-1(c)(2)(I).

Where, in the loaned painting hypothetical, a noncharitable beneficiary/disqualified person receives a benefit that puts the value of the remainder interest at risk, self-dealing questions arise. If the benefit is not excepted by Reg. 53.4947-1(c)(2)(i), self-dealing in fact occurs.

If both interests are served equally by a particular transaction, there would be no self-dealing. If, for example, a trustee were to sell an appreciated asset when the trustee believed the market was favorable, no self-dealing would occur because one interest would not intentionally be served at the expense of the other.

Clearly, the maximization of the noncharitable beneficiary/disqualified person's tax deferral is not a benefit excepted from the self-dealing rules under Reg. 53.494-1(c)(2)(1). The question becomes how holding an asset off the market adversely affects a charitable remainder interest for which a deduction is allowed. Relating to the example at the beginning of the article, suppose that M stock, which funded Trust X, did not rise in value as fast as the general market Suppose that, as is often the case, the products that M produced were not technology leaders as was originally thought, but played only a secondary role. By withholding from the market a stock that pays no current dividend, the trustees of Trust X were not taking advantage of market conditions that would have benefited the charitable remaindermen of Trust X.

In the end, it does not matter whether a charitable remainderman gains or loses as the result of any particular transaction. The rules of IRC 4941 apply to whatever a transaction produces. As Reg. 53.4941(d)-1(a) puts it: "For purposes of this section [defining self-dealing] it is immaterial whether the transaction results in a benefit or a detriment to the private foundation.

In a general sense, presenting the manipulation of the assets of a charitable remainder trust was precisely the purpose of Congress in enacting the rules relating to split interest charitable remainder trusts as a part of the Tax Reform Act of 1969. The General Explanation of the Tax Reform Act of 1969, supra., at page 84, explained that the fixed percentage payout requirements imposed on charitable remainder trusts "... remove the flexibility of the prior provisions whereby it was possible to favor the income beneficiary over the remainder beneficiary by means of manipulating the trust's investments." The application of IRC 4941 to the split interest remainder trusts gave the Service the tools to address the problem of manipulation by deferral of income.

4. Application to Other Situations

Another issue before the National Office involves a NIMCRUT holding limited partnership interests in a partnership. The facts involve a husband and wife who transferred shares of stock to a newly formed limited family partnership. They each received in exchange therefor, a .5 percent general partnership and a 49.5 percent limited partnership interest. Both husband and wife donated their limited partnership interests to the NIMCRUT.

The stock will then be sold to purchase diversified investment assets. Both husband and wife retained the .5 percent general partnership interest and use their authority as general partners to manage the partnership investments and intake distributions. They do not foresee making any income distributions from the partnership to the NIMCRUT until many years in the future after the husband has retired from his current position that pays a significant salary.

Accordingly, the NIMCRUT will receive no income distributions from the partnership for many years and until after the husband's retirement.

The creators of the NIMCRUT are disqualified persons by virtue of being substantial contributors to the trust. IRC 4946(a)(2) and 507(d)(2). In addition, the partnership, as an entity, would also be a disqualified person by virtue of the application of the constructive ownership rules. The income interest of the husband and wife in the NIMCRUT results in the application of the attribution rules.

Treating the partnership as a disqualified person probably makes little difference in the final analysis in assuring that the decision not to distribute income to the NIMCRUT may constitute an act of self-dealing. Clearly, its purpose is to maximize the income deferral.

The missing element, using the preceding analysis, may be the absence of risk to the remainder interest. In a situation such as this, there is no risk that the remainderman assumes if the trustee chooses to accumulate the income inside of the partnership. Quite to the contrary, the value of the remainder interest should increase with the accumulation.

If, on the other hand, one takes the position that self-dealing involves any impact that this transaction has on the remainder interest whether positive or negative, then this transaction involves self-dealing.

Exhibit C

Technical Advice Memorandum 9825001:

Section 664--Charitable Remainder Trusts UIL Number 4941.04-00 Summary

Purchase of Annuity Policies Doesn't Affect Unitrust's Status

The Service has ruled in technical advice that a unitrust's purchase of deferred annuity contracts in which the trust's beneficiaries are named the annuitants doesn't adversely affect the unitrust's status and is not an act of self-dealing.

The charitable remainder unitrust pays the lesser of the trust income or 8 percent of the value of trust assets each year to the grantor until his death, then to the grantor's spouse. The trust terminates on the death of the survivor of the grantor and spouse.

The trust purchased two annuity contracts in 1991 from a commercial insurer, one named the grantor as the annuitant and the other named the spouse. The trust is the owner of the policies and is the beneficiary if the annuitants don't reach the maturity date of the policies that is age 80. The trust became the annuitant of the policies in 1997.

The Service concluded that the purchase of the deferred annuity contracts does not adversely affect the trust's qualification as a charitable remainder unitrust. Further, the Service noted that it has found an act of self-dealing under section 4941(d)(1)(E) only when a disqualified person has received a current benefit. According to the IRS, the grantor received no present value from the right to receive annuity payments, and therefore concluded the purchase of the annuity contracts was not an act of self-dealing under section 4941.

The Service also ruled that the trust's right to receive either the cash value or the surrender value of the annuity contracts does not create trust accounting income under section 643(b). The IRS relied on its reading of Tennessee law that a trust does not realize income until it actually receives possession of money or other property in reaching that conclusion.

Full Text

Date: October 29, 1997

Control No.: * * *

Taxpayer's Name: * * *

Taxpayer's Address: * * *

Taxpayer Identification Number: * * *

Number: * * *

Tax Years: * * *

Date of Conference: * * *

LEGEND:

A = * * *
B = * * *
C = * * *
R = * * *
T = * * *
V = * * *
X = * * *
m = * * *
n = * * *
o = * * *

[1] ISSUES

  1. Does the purchase of the deferred annuity policies from R constitute acts of self-dealing when the named annuitants are disqualified persons?
  2. Would the purchase of the annuity policies jeopardize the Trust's qualification as a charitable remainder unitrust under section 664 for federal income tax purposes?
  3. Would the annuity's withdrawal provision, described hereafter, result in income to the Trust, X, within the meaning of section 643(b).


FACTS

[2] X is a charitable remainder unitrust that was intended to qualify under section 664 of the Internal Revenue Code. X was created by A by a trust instrument dated June 25, 1990. The trust instrument provides that the Trustee shall pay to A, and upon A's death, to A's wife, a unitrust amount equal to the lesser of (1) the trust income for the year or (2) eight percent of the aggregate fair market value of the trust assets for the year. The Trust instrument includes a make-up provisions so that for any year that the unitrust payment is less than eight percent, the shortfall for prior years may be made-up in subsequent years when trust income exceeds eight percent. B is the trustee of X and is also the nephew of A.

[3] Upon the death of the survivor of A or A's wife, the trust shall terminate and the balance of trust assets are to be distributed to designated charities.

[4] In December, 1991, X entered into a contract to purchase two deferred annuity contracts from R, a commercial life insurance company. In one policy A is named the annuitant and in the other policy A's wife is named the annuitant. In other respects the two policies are identical. X is the owner of the policy and is beneficiary of the policies should either annuitant fail to reach the maturity date of the policies which is age 80. As a result of the endorsement of the two policies in 1997, the Trust, X, became the annuitant. Additional information relating to the policies is discussed hereafter in greater detail.

LAW AND ANALYSIS

A. Self-dealing Issue:

[5] Section 4947(a)(2) provides, in part, that in the case of a trust which is not exempt from tax under section 501(a), not all of the unexpired interests in which are devoted to one or more of the purposes described in section 170(c)(2)(B), and which has amounts in trust for which a deduction was allowed under section 170, 545(b)(2), 556(b)(2), 642(c), 2055, 2106(a)(2), or 2522, section 4941 (relating to taxes on self-dealing, section 4943 (relating to taxes on excess business holdings) except as provided in subsection (b)(3), section 4944 (relating to investments which jeopardize charitable purpose) except as provided in subsection (b)(3), and section 4945 (relating to taxes on taxable expenditures) shall apply as if such trust were a private foundation.

[6] Section 4941 imposes an excise tax on acts of self-dealing between a disqualified person, as defined in Section 4946, and a private foundation.

[7] Section 4941(d)(1) in general defines the term "self dealing," in part, to include any direct or indirect--

(E) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation.

[8] Section 4946 defines the term "disqualified person", in part, to include a person (with respect to a private foundation) who is--

  1. a substantial contributor to the foundation,
  2. a foundation manager,


[9] Under Sections 4946(a)(2) and 507(d)(2) a "substantial contributor" is defined as a person who contributes over $5000 and such amount is more than 2 percent of the total contributions, or in the case of a trust, also the creator of the trust.

[10] Section 4946(b) defines "foundation manager" to include an officer, director, or trustee of the foundation.

[11] Section 53.4941(d)-2(f)(1) of the Excise Tax Regulations provides, in part, that the purchase or sale of stock or securities by a private foundation shall be an act of self-dealing if such purchase or sale is made in an attempt to manipulate the price of stock or other securities to the advantage of a disqualified person.

[12] The Request for Technical Advice asks us to determine whether the purchase of the deferred annuity naming the donor and his wife as annuitants constitute acts of self-dealing under section 4941 of the Code.

[13] In analyzing an issue of self-dealing under section 4941(d)(1)(E) of the Code, the Service has focused on three elements. Is a property right created? Is there a transfer of such property right to a disqualified person? Does the disqualified person receive a benefit from the receipt of such property right?

[14] It is the view of the Service that a valid contract right constitutes an enforceable property interest. Michtom v. United States, 573 F.2d 58, 63 (Ct. Cl., 1978). Thus, the donor's rights under the annuity contract constitute a property interest.

[15] It has been the Service view that the prohibition against transferring or using foundation assets to disqualified persons was intended to be extremely broad. The range of transactions described under 4941(d)(1)(E) would also include transactions described under sections 4941(d)(1)(A), (B), (C), (D), or (F). Here, the property interest (the annuity right in the contract) was transferred to the donor and the donor's wife who are disqualified persons under section 4946 of the Code.

[16] The final element for consideration is whether the receipt of the right to the annuity under the contract by the Donor or his wife confers a benefit on the Donor. Certainly there is a potential benefit to the donor. If the donor and his wife reach age 80 the contract will be annuitized and the donor and his wife have the potential to receive all the payments to be made under the contract. This would leave the charitable remainder interest with nothing.

[17] However, the annuity rights in the contracts are contingent on several factors. The donor and his wife must survive to age 80 to receive annuity payments. Further, assuming that X is the owner of the policy, the right of the named annuitants can be defeated by the policy owner's rights to a partial withdrawal from the policy or the surrender of the policy in exchange for the cash value of the policy. Additionally, the owner may defeat the benefit to the named annuitants by changing the maturity date; the date when the annuity payments are to begin. The partial withdrawals and surrender of the policy are subject to some restrictions and penalties for early surrender. A change of the maturity date does require written notice to the company. Nevertheless, the owner of the policy does have the power to preempt the annuity by taking such actions.

[18] The Service has found an act of self-dealing under section 4941(d)(1)(E) only in the case where the disqualified person has received a current benefit. In Rev. Rul. 74-600, 1974-2 C.B. 385, the Service held that self-dealing occurred under section 4941(d)(1)(E) when paintings owned by a private foundation were allowed to be placed in the residence of a disqualified person. In Rev. Rul. 77-160, 1977-1 C.B. 351, the Service held that the dues paid to a church on behalf of a disqualified person in order to allow such person to retain his membership in the church was an act self-dealing.

[19] In summary, it is our position that the donor receives no present value from the contract right to receive annuity payments. We do not believe that the annuity right could be currently assigned by the donor and his wife to a third party for any significant value. The donor and his wife have recently assigned their interest in the policy as named annuitants to X. Thus, the problem is resolved for future years.

[20] An analogy in this case may also be made to an incomplete gift for purposes of the federal gift tax. In Rev. Rul. 79-243, 1979- 2 C.B. 343, the Service held that the donor made an incomplete gift to his wife of an income interest in trust by virtue of the fact that the donor retained the right to revoke the gift by will. The facts of the ruling provide that the donor created a charitable remainder trust qualifying under section 664 of the Code. The donor was to receive the unitrust amount for his life, and upon the donor's death, the wife was to receive the income interest for her life. However, the donor, in the trust instrument, reserved the right to revoke the wife's secondary interest in the unitrust amount. Authority for the Service position was based on Section 25.2511-2(c) of the Gift Tax Regulations. Part of such Regulations provide as follows:

Thus, if an estate for life is transferred but, by an exercise of a power, the estate may be terminated or cut down by the donor to one of less value, and without restriction upon the extent to which the estate may be so cut down, the transfer constitutes an incomplete gift.

[21] To the extent that X has retained the right by contract to terminate or reduce the annuity right received by the donor and his wife, the transfer of the annuity right is not a completed transfer.

[22] Our office has carefully considered another theory for asserting that an act of self-dealing under section 4941 has occurred with respect to the purchase of the deferred annuity contracts and the failure of the trust to withdraw income from the deferred annuity contracts. The following facts are relevant to the consideration of this additional ground for asserting an act of self-dealing:

At the time X was created by A, it was funded with 86 shares of stock of V, a business previously owned and managed by A. On March 7, 1997, A transferred an additional 7 shares of V to X. Consequently, X held 93 of 94 outstanding shares of V.

In the Summer of 1991, A became aware of a third party's offer to purchase V. In September or October of 1991, the trustee of X became aware of the proposal for the purchase of V, which included payment to A for a five year period pursuant an employment agreement and noncompetition agreement. Since A's income would be provided for a five year period without the need for income from X, A and the trustee had discussions with T, a tax planning consultant, about the possibility of investing X's assets in deferred annuities. Based on T's recommendations, the trustee believed investing in deferred annuities was a solid choice in light of other investment alternatives available and the flexibility it offered the trustee to defer trust income until A's employment agreement and noncompetition payments ceased.

Consequently, in December 1991, X entered into a contract to purchase two deferred annuity policies from R, a commercial life insurance company. On January 15, 1992, the following three events occurred more or less contemporaneously: (1) substantially all the assets of V were sold to an unrelated purchaser for m; (2) x's stock holdings in V were redeemed for n, which X deposited into its account; and (3) X wrote two identical checks for o for each of the annuities purchased. The representatives for the Trust made the following representations: (1) C, an attorney who is trusted by A and B, served as the sole trustee of X from the time after the stock sale was contributed to X until before the sale of such stock to the unrelated purchaser; and (2) soon after the annuity contracts were acquired by X, C resigned as trustee and B again became the trustee. In fact, C signed as trustee on the contract to purchase the two deferred annuity policies.

Both annuity policies designated X as owner and beneficiary. As stated above, one policy named A as annuitant and one policy named A's wife as annuitant. In order to eliminate the possibility of any annuity payment being made directly to A or his wife (a potential self-dealing problem) an endorsement to each deferred annuity policy was executed, in 1997, by R and X effective as of the policy date of each annuity contract. The trustee of X signed the endorsement, which apparently represents the assignment of interest of A and his wife in the policy as annuitants to X.

[23] We have examined the transaction with the intention of ascertaining whether B, acting in concert with A on an ongoing basis, manipulated the assets of X for the personal benefit of A, by furthering his income, retirement and tax planning goals. There was a concern that the entire transaction taken as a whole; the purchase of a deferred annuity, the failure to make withdrawals from the annuity policies, and the intention to subsequently make unitrust payments to A under the "make-up" provision of the Trust; could be construed as an act of self-dealing under section 4941(d)(1)(E) of the Code by virtue of the authority provided by section 53.4941(d)-2(f)(1) of the Regulations.

[24] In as much as A, a disqualified person, is entitled to receive the income interest from the trust, it is difficult to argue that the disqualified person receives an inappropriate benefit by deferring the income interest, particularly where such deferral is permitted under section 664 of the Code. The underlying problem is that the income beneficiary interest is in itself a use for the benefit of the disqualified person of the assets of the trust. Inherently, any investment decision regarding the trust assets that increases or decreases the amount of payout of this income interest is a use for the benefit of the disqualified person (assuming the disqualified person does not object). Section 4947(a)(2)(A) provides that section 4941 will not apply to any amounts payable under the terms of the trust to the income beneficiary. The amounts of income deferred by the investment decision in this case were payable to the income beneficiary under the terms of Trust X. Accordingly, these uses must be permitted under the income exception of section 4947(a)(2)(A) unless the disqualified person controls the investment decision and uses this control to unreasonably affect the charitable remainder beneficiary's interest.

[25] While section 53.4941(d)-1(a) of the regulations provides that it is immaterial whether the transaction results in a benefit or a detriment to the private foundation, the regulation is incompatible with section 4947(a)(2)(A) because, as discussed above, any investment decision regarding trust assets that results in an increase or decrease in the unitrust amount will inescapably constitute an attempted use for the benefit of the disqualified person. Therefore, rather than focusing on whether the deferral of income is a use of trust assets, the relevant question is whether the deferral of income is a permitted use. Since charitable remainder trusts by their intrinsic nature provide for a continuous use by the disqualified person of the entire trust corpus, we conclude that the presence of an unreasonable affect on the charitable remainder interest distinguishes a permissible use of trust assets from an impermissible use.

[26] In addition to failing to show harm to the charitable remainder interest, the facts of this case do not clearly show control by the disqualified person. X represented that an independent attorney/trustee signed the contract to purchase the deferred annuity policies. Moreover, even if we conclude that B, as trustee, purchased the deferred annuity policies, the facts are insufficient to demonstrate that A usurped control from the trustee or that he could compel or influence the trustee to purchase the deferred annuity policies in question. Instead, the trustee merely took into consideration the particular financial needs of A before reinvesting the proceeds from the sale of the trust assets.

B. Purchase of the Annuity and Qualification under Section 664:

[27] The purchase of the deferred annuity contracts does not adversely affect the trust's qualification as a charitable remainder unitrust under section 664 of the Code and the current regulations thereunder.

C. Trust Accounting Income Issue

[28] Under the terms of the annuity contracts, the Trustee, as owner of the contracts, can withdraw up to 10 percent of the "cash value" of each contract at the beginning of each year. The cash value equals the premiums paid, less deductions, plus accumulated interest earned. The Trustee may also surrender the contracts and receive the "surrender value" of each contract. The surrender value equals the cash value minus any applicable surrender charge. In the request for technical advice, it is argued that the Trust, a NIMCRUT, had income from the contracts because of the rights to receive the cash value and surrender value of the contracts.

[29] Under section 664(d)(2)(A), the unitrust amount is generally a fixed percentage (which is not less than 5 percent) of the net fair market value of the trust's assets valued annually. Under section 664(d)(3), however, the governing instrument may instead provide that the unitrust amount is (A) the amount of the trust income if such amount is less than the amount determined by the fixed percentage of the value of the trust's assets; and (B) any amount of trust income that is in excess of the amount required to be distributed based on the fixed percentage, to the extent that the aggregate of the amounts paid in prior years was less than the aggregate of the required amounts based on the fixed percentage of the fair market value of the trust's assets.

[30] Section 1.664-3(a)(1)(b)(1) provides that the amount of trust income for a NIMCRUT is the amount of trust income as defined in section 643(b) and the applicable regulations. Section 643(b) provides that, for section 664 purposes, among others, 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. The Trust's governing instrument uses the definition of income under section 643(b) to define income. Therefore, the applicable state law defines the Trust's income.

[31] The applicable state law, the Uniform Principal and Income Act of Tennessee, appears ambiguous on whether a trust's right to receive money is income to the trust, whether characterized as principal or income. The implication from the sections that define income and principal, however, is that a trust does not realize either until the trust actually receives possession of money or other property. See Tenn. Code Ann. section 35-6-102 and section 35-6-104 (1991). Therefore, the Trust's right to receive either the cash value or the surrender value of the contracts does not create trust accounting income under section 643(b) of the Code.

[32] CONCLUSION

  1. The purchase of the deferred annuity policies, based on the particular facts of this case as described in the preceding paragraphs, does not constitute an act of self-dealing under section 4941 of the Code.
  2. The purchase of the deferred annuity contracts does not adversely affect X's qualification as a charitable remainder trust under section 664 of the Code and the current regulations thereunder for federal income tax purposes.
  3. X's right to receive either the cash value or the surrender value of the contracts does not create trust accounting income under section 643(b) of the Code.


[33] A copy of this technical advice memorandum is to be given to the organization. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.

©1998 David Wheeler Newman


X. Rev. Rul. 81-40, 1981-1 CB 508


  1. C § 4946(a)(1)(A)back

  2. g. § l.507-6(a)(l)back

  3. C § 4946(a)(1)(B)back

  4. C § 4946(b)(2)back

  5. C § 4946(a)(1)(D)back

  6. C § 4946(d)back

  7. C § 4946(a)(1)(E), (F), and (G)back

  8. C § 4946(a)(1)(I)back

  9. g. § 53.4946-(I)(a)(8)back

  10. IRC § 4946(a)(3) & (4)back

  11. IRC § 4941(d)(l)(A)back

  12. Reg. § 4941(d)-2(a)(2)back

  13. IRC § 4941(d)(1)(A)back

  14. Reg. § 4941(d)-2(b)(2)back

  15. IRC § 4941(d)(1)(B)back

  16. IRC § 4941(d)(2)(B); Such loans may cause the organization or trust to have "acquisition indebtedness" unrelated business income, however.back

  17. Reg. § 4941(d)-2(c)(l)back

  18. Reg. § 4941(d)-2(c)(l)back

  19. IRC § 4941(d)(1)(C)back

  20. IRC § 4941 (d)(2)(C)back

  21. IRC § 4941 (d)(2)(D)back

  22. IRC § 4941(d)(1)(D)back

  23. IRC § 4941 (d)(2)(E)back

  24. Reg. § 4941(d)-3(c)(2)back

  25. IRC § 4941(d)(1)(E)back

  26. Reg. § 4941(d)-2(f)(I)back

  27. Reg. § 4941(d)-2(f)(l)back

  28. GCM 39770 (1988)back

  29. Ltr. Rul. 9651037back

  30. Reg. § 4941(d)-l(b)(5)back

  31. Reg. § 4941(d)-(l)(b)(l)back

  32. IRC § 4941(e)(2)back

  33. IRC § 4941(e)(3)back

  34. Reg. § 4941(e)-I (c)(6)back

  35. Reg. § 4941(e)-1(c)(l)back

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