Here We Go Again: The Son of Accelerated CRT

Here We Go Again: The Son of Accelerated CRT

Article posted in Charitable Remainder Trust on 9 April 1999| comments
audience: National Publication | last updated: 18 May 2011
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Summary

Just when you thought it was safe to use short-term charitable remainder trusts again, here comes a variation of the "Accelerated CRT" that is already creating a stir in Washington.

By: Marc D. Hoffman and Emanuel J. Kallina, II Esq.

It would seem as though since the IRS and Congress drove a regulatory and legislative stake through the heart of the "Accelerated CRT" several years ago, planners would have taken pause to understand the rationale behind their action. We were wrong. Last week the editors of the PGDC received a memorandum produced by a national accounting firm that outlines a new variation on the Accelerated CRT technique that is already raising the hackles of lawmakers, the IRS, and those interested in preserving the integrity of the charitable remainder trust. It is our understanding that at least two national accounting firms are promoting variations of the new plan.

The technique consists of a variation on the theme of the infamous "Accelerated CRT," which is credited with being the catalyst for the first corrective legislation for charitable remainder trusts since they were codified in 1969. Due to the new concept's similar theme, we have dubbed it "Son of Accelerated CRT." What is so disconcerting is that a reading of the memorandum leaves no question that its proponents are well aware of the IRS' position on the Accelerated CRT, yet they remain prepared to move forward without regard to the effect that tax litigation or corrective legislation may have on the future of the charitable remainder trust itself.

Accelerated CRTs Reviewed

In order to understand how the new concept operates, it is important to review its predecessor. In Notice 94-78, the Service announced that it would challenge transactions that attempted to use an IRC §664 charitable remainder unitrust to convert appreciated assets into cash flow while avoiding a substantial portion of the tax on the gain.

In the transactions the Service is referring to, non-income-producing appreciated assets are transferred to a short-term charitable remainder unitrust with a high percentage payout rate. The Notice offers as an example capital assets with a value of $1 million and a zero cost basis being contributed to a standard payout format unitrust on January 1 of Year 1. The measuring term of the trust is two years and the payout rate is set at 80 percent.

The unitrust amount that is required to be paid during Year 1 is $800,000; however, because of a failure on the part of the trustee to sell the contributed assets, no distributions are made to the income recipients within the first year. At the beginning of Year 2, the assets are sold for $1 million (plus or minus any gain or loss). Relying on an administrative convenience that allowed (under prior law) the trustees to distribute the unitrust amount within a reasonable time following the close of the tax year in which it is due, the first-year $800,000 unitrust amount is distributed to the donor between January 1 and April 1 of Year 2. The unitrust amount for Year 2 is $160,000 (80% multiplied by the remaining $200,000 net market value of the trust assets). At the end of 1992, the trust terminates and $40,000 is paid to the charitable remainderman.

Proponents of this transaction advocated the following tax treatment: Because no assets were sold or distributed to the donor during the first year, the entire $800,000 unitrust amount was characterized as a distribution of trust corpus under IRC §664(b)(4). The $160,000 second-year unitrust amount was characterized as capital gain, on which the donor would pay capital gains tax of $44,800 ($160,000 x 28%1). The donor was left with a total of $915,200 in cash. In addition, the donor would receive a charitable contribution income tax deduction in the amount of approximately $30,000 in the year the trust was created. Assuming the trustor could use the deduction to offset ordinary income, he or she would receive additional tax savings of $9,300 ($30,000 x 31%). The total benefit to the donor, excluding state income tax considerations, was $924,500.

Conversely, if the donor had sold the assets directly, he or she would have paid a tax of $280,000 on the $1 million capital gain and would have had net cash of $720,000. Thus, the purported charitable gift increased the after-tax benefit to the donor by $204,500.

In response to Notice 94-78, Treasury and Congress took independent steps to insure that "accelerated charitable remainder trusts," as they had come to be known, could no longer operate as advertised. Proposed regulations, announced on April 18, 1997, required all annuity trusts and standard payout format unitrusts to distribute the full annuity or unitrust amount by the close of the taxable year in which it was due. However, in response to numerous objections that such a requirement would place undue hardship on trustees of conforming trusts, the IRS issued Notice 97-68, exempting certain conforming trusts from the year-end payment for the 1997 tax year. In order to qualify for exemption, the payout or annuity rate was limited to 15 percent.

The final regulations provide that the annuity or unitrust amount may be paid within a reasonable time after the close of the year for which it is due if (a) the character of the annuity or unitrust amount in the recipient's hands is income under section 664(b)(1), (2), or (3); and/or (b) the trust distributes property (other than cash) that it owned as of the close of the taxable year to pay the annuity or unitrust amount and the trustee elects on Form 5227 to treat any income generated by the distribution as occurring on the last day of the taxable year for which the amount is due. In addition, for annuity trusts and standard format unitrusts that were created before December 10, 1998, the annuity or unitrust amount may be paid within a reasonable time after the close of the taxable year for which it is due if the percentage used to calculate the annuity or unitrust amount is 15 percent or less.

In direct response to the Accelerated CRT, and during this same period, Congress drafted legislation that would amend the Internal Revenue Code to: 1) limit the maximum payout or annuity rate of a qualified charitable remainder trust to 50 percent, and 2) require the present value of the remainder interest for qualifying trusts to be at least 10 percent of the fair market value of the trust assets on the date of contribution. The new rules were included within the Taxpayer Relief Act of 1997 and were effective for trusts created, or transfers made to existing trusts, after July 28, 1997.

Variation on a Theme

Under the new technique, a trustor transfers highly appreciated assets to a "standard" charitable remainder unitrust (where the unitrust amount is first paid out of fiduciary income, and if that is not sufficient, then out of principal). The trust carries a combination of payout rate and measuring term that is designed to produce a present value of remainder interest that satisfies the 10 percent minimum remainder interest requirement. As with the Accelerated CRT, the new technique relies on the trustee holding rather than selling contributed assets during the first tax year of the trust. However, unlike the Accelerated CRT, from which no distribution was made during the first tax year, the trustee must, in order to avoid having the distribution characterized as income under the current regulations, pay the unitrust amount by the end of the tax year year in which it is due. In order to accomplish this, the trustee borrows the necessary funds from a bank or other third-party lender and makes the distribution by the end of the first tax year.

As with the Accelerated CRT, the proponents of the new technique conclude that because the unitrust produces no income or gains in year one, the distribution of the borrowed funds to the income recipient will be considered a non-taxable distribution of trust corpus.

In year two, the contributed assets could be sold with a portion of the proceeds used to repay the loan. The trust would then operate as a typical charitable remainder trust with subsequent payments to income recipients taxable under the rules of the four-tier system under IRC §664(b)(4).

Example

To illustrate the benefits of the concept, the proponents provide the following example:

  • Taxpayer transfers "unwanted" stock worth $1,000 and a basis of zero to a CRUT on January 1 of Year 1.
  • Taxpayer will receive annually for five years, a unitrust amount equal to 26 percent of the value of the trust assets as valued on December 5 of each tax year.
  • The remainder interest will be paid to a public charity at the end of the fifth year.
  • Trust's assets will be assumed to appreciate at an annual rate of 2.5 percent and produce ordinary income equal to 4.3 percent.
  • Trustee will take out a loan to pay the unitrust amount in Year 1. The interest rate on the loan is 10 percent.
  • Trustee sells original trust corpus on January 1 of Year 2 for $1,025.
  • Trustee repays the loan immediately following the sale of the corpus.

Based on these assumptions, the proponents of the plan provide the following spreadsheet of benefits:

Beg. Yr.                
  Gross FMV 4.3% Income 2.5% Appr'n Int. Pmt. Ending Value Unitrust Amount Ord. Income Cap. Gain Non- Taxable
Year                  
                   
1 $1,000.00 43.00 25.00   1,068.00 277.68 43.00   234.68
2 $790.32 33.98 19.76 4.67 839.39 218.24 33.98 184.26  
3 $621.15 26.71 15.53 663.39 172.48 26.71 145.77  
4 $490.91 21.11 12.27   524.29 136.32 21.11 115.21  
5 $387.97 16.68 9.70   414.35 107.73 16.68 91.05  
                   
Totals           $912.45 $141.68 $536.29 $234.68


Assuming a 35 percent combined ordinary income and capital gains tax bracket, the trustor will receive $675.23 in after-tax proceeds. The remainder interest to charity is projected at $306.62. In addition, the trustor will receive a charitable contribution income tax deduction in the year the trust is created in the amount of $221.90. The deduction will translate to an additional $77.67 in tax savings bringing the after-tax benefit of the plan over the five year period to $835.04. Had the taxpayer simply sold the stock on a taxable basis, he or she would have realized a $1,000 capital gain and paid tax of $200, leaving net proceeds of $800.

The example sited in the memorandum is based on a payout rate of 26 percent, which the proponents stated was used only because the published present value tables available at the time the memorandum was prepared did not extend beyond that rate. They suggested, however, that if the trust's payout rate is higher (up to 50 percent in certain circumstances), the "benefit" can be even greater. Our evaluation of the technique revealed the payout rate of a five year unitrust could be increased to 36 percent payout rate and still qualify under the 10 percent remainder interest test.

Potential Legal Challenges

The proponents of the concept state that it would be "highly unlikely" that the IRS would issue a favorable private ruling because of its position on "short-term unitrusts," but that "nothing in the current or proposed regulations or other guidance specifically states that the proposed transaction is invalid in any sense."

Proponents of the plan suggest the IRS might attempt to challenge this transaction on two fronts: 1) the transaction violates the private foundation excise tax prohibition against self-dealing, and 2) the loan would cause the trust to have "acquisition indebtedness" thereby causing it to lose its tax-exemption. Such loss would cause gain from the sale of contributed assets to be taxed at rates applicable to complex trusts.

A review of the legal arguments advanced by the proponents suggests the concept might be defensible based on an interpretation of the letter of the law; however, so was the Accelerated CRT. The question is whether or not the technique is within the spirit of the law and will lead to remedial regulatory action or legislation.

Self-Dealing

Could the IRS successfully assert the transaction constitutes a direct or indirect use of trust assets for the benefit of a disqualified person under IRC §4941(d)(1)(E)?

In order to protect against self-dealing, the proponents suggest that in the event that assets that are not readily marketable, such as closely-held stock or real property, are transferred to the trust, it might be reasonable to expect the trustee will not sell such assets on a "fire sale" basis during the first year, even though such delay will produce favorable tax benefits for the income recipients.

Unrelated Business Taxable Income

Under IRC §§ 511(b) and 664(c), if a charitable remainder trust has any unrelated business taxable income in its taxable year, it loses its tax exemption for that year entirely and is subject to tax on all of its income during the entire year. In general, unrelated business income arises in two ways: namely, when there is income generated from business activities and when there is debt-financed property. The term "debt-financed property" refers to any property that is held to produce income and with respect to which there is an "acquisition indebtedness" at any time during the taxable year (or, if the property was disposed of during the taxable year, with respect to which there was an acquisition indebtedness at any time during the 12-month period ending with the date of such disposition).

IRC §514(c)(1) defines "acquisition indebtedness," with respect to any debt-financed property, as the unpaid amount of:

(A) the indebtedness incurred by the organization in acquiring or improving such property;

(B) the indebtedness incurred before the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement; and

(C) the indebtedness incurred after the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement and the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition or improvement.

Because incurring the indebtedness is a foreseeable component of the transaction, the Service could attempt to treat the debt as acquisition indebtedness. If this characterization were successful, the trust would lose its tax-exemption in any year in which it produced net debt-financed income (after deductible expenses and in excess of the $1,000 specific exemption).

It is interesting to note that even if the trust loses its tax exemption, the distributions of borrowed funds to the trust's income recipient(s) in satisfaction of the unitrust amount could still escape income taxation in the hands of the income recipients. Tax-free distributions would continue as long as the trust did not produce any net taxable income (including gain from the sale of the contributed property itself).

PGDC Example

The plan, as illustrated by the proponents' example, does not provide enough personal benefit to justify the audit risk-a mere 3.5 percent increase over a straight taxable sale. The following example better illustrates the potential for the technique.

Assume the owner of a closely-held corporation contributes company stock to a four-year standard CRUT bearing a payout rate of 46 percent. The trust will make one payment at the end of each year. It is assumed the stock will pay no dividends and will appreciate at an annual rate of eight percent. The trustee will borrow an amount sufficient to pay the unitrust amount each year and will sell only that amount of stock necessary to make the interest payments on the loan. Stock sales will be accomplished via corporate redemptions. The assumed interest rate on the loan will also be eight percent.

Under this scenario, it is assumed that all realized gains arising from the redemptions are offset by the interest deduction; thus, the entire unitrust amount could continue to be considered a tax-free distribution of corpus. Assuming an effective marginal income tax rate of the donors and income recipients of 50 percent, the results could be as follows:

          EOY EOY   EOY
  Beg. Yr. Gross FMV Beg. Yr. Net FMV Unitrust Amount Annual Net Income Value (Before Interest) Loan Balance Loan Interest Paid FMV (After Interest)
Year                
                 
1 $1,000.00 $1,000.00 $460.00 $0.00 $1,080.00 $460.00 $0.00 $1,080.00
2 1,080.00 620.00 285.20 0.00 1,166.40 745.20 36.80 1,129.60
3 1,129.60 384.40 176.82 0.00 1,219.97 922.02 59.62 1,160.35
4 1,160.35 238.33 109.63 0.00 1,253.18 1,031.65 73.76 1,179.42
                 
Totals $1,179.42 $147.76 $1,031.65       $170.18  


Perhaps with some additional work, the numbers could be refined to achieve a greater economic benefit to the donor than shown above. The point of this analysis is to show the upside of the transaction from the donor's perspective. Conversely, if the appreciation rate of the stock falls below 1.3 percent, the outstanding loan amount will exceed the fair market value of the stock upon termination of the trust leaving nothing for charity.

In the above case, the trustee sells only enough of the contributed property (in this case, divisible stock) to make the interest payments. However, another candidate for the plan would be income-producing property, such as investment real estate. In such case, the income could be used to service the annual interest payments with the same tax result.

What if, during the term of the trust, valuations went awry and the trustee could no longer borrow to satisfy the unitrust amount? Or what if the trust indeed lost its tax exemption and risked paying a large capital gains tax on the sale of trust property? Would there be a safety valve for the trustor? Yes, the trustor could simply accelerate the payment of the remainder interest to charity by contributing his or her remaining income interest and possibly walk away with yet another, albeit relatively small, income tax deduction for the present value of the remaining income interest. The charitable remainderman would then be left to dispose of a potentially illiquid asset at its own expense.

Editorial Opinion

It is the policy of the Planned Giving Design Center to strive to offer objective, unbiased reporting of news items of interest to charitable gift planners. However, given the deleterious potential of this technique, we are formalizing our opposition to it.

The Accelerated CRT and its new variation share two things in common: little if any donative intent, and the manipulation of our tax laws in order to produce a result for the donors, regardless of the consequences to the charitable community.

In Notice 94-78, the Service stated in part, "Depending on the particular facts of each case, the Service will challenge transactions of this type based on one or more legal doctrines. A mechanical and literal application of the regulations that would yield a result inconsistent with the purposes of the charitable remainder trust provisions may not be respected. The tax consequences to the donor vary with the legal doctrine that is applied."..."In addition, the donor and the trustee are likely to prearrange a delay by the trustee of the sale of the trust assets. This creates a transaction that is different in substance than in form."

As previously mentioned, the proponents of the memorandum speculate the IRS could challenge the concept based on violations of the self-dealing rules and production of unrelated business taxable income; however, we believe that corrective action could extend well beyond the technique itself and damage legitimate uses of the charitable remainder trust.

Staffers of our tax writing committees in Washington are aware of this technique and are already considering ways of combating it. What action might they take? Might we see a further reduction in qualifying payout or annuity rates, or an increase in the minimum qualifying present value of remainder interest? Or might they may take an entirely different track altogether and reverse decades of tax precedent by overruling the Tax Court in Palmer v. Commissioner and the IRS's acquiescense in Rev. Rul. 78-197? This possibility has also been discussed.

The stakes are significant. If Congress did reverse the decision in Palmer, no longer could certain non-cash gifts be made to charity with the expectation the charity would sell the gift property and use the proceeds to promote its charitable purposes. No longer would charities be allowed to use donations in a fashion which the donors and charity agreed upon, at least not without the donor being taxed on the appreciation inherent in the contributed asset.

In the event the IRS and courts are unsuccessful in overturning this plan based on the application of current law, we would hope that rather than damage legitimate charitable giving, Staffers of the tax writing committees and Congress would find solutions that are sensitive to philanthropy. For example, if any legislation were in the offing, we would suggest a provision that would treat debt-financed distributions from a charitable remainder trust as though the trustee had sold trust assets in an amount necessary to make the distribution. Income and gain would be determined in the same ratio the distributed amount bore to the entire value of the trust. This deemed sale treatment would be the same as currently applies to in-kind distributions of trust property.2 Such a rule would offer a laser-beam approach that would leave the legitimate uses of charitable remainder trusts intact.



  1. The maximum federal capital gains tax bracket that existed at the time of the transaction was 28 percent.back

  2. Ltr. Rul. 8834039; Reg. §1.1014-4(a)(3); Rev. Rul. 68-392, 1968-2 C.B. 284back

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