Invasion of CRUT to Pay Donor's Taxes Would Constitute Self-Dealing

Invasion of CRUT to Pay Donor's Taxes Would Constitute Self-Dealing

News story posted in Field Service Advice on 12 June 2000| comments
audience: National Publication | last updated: 18 May 2011
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Summary

In Field Service Advice 200022005, the IRS recommended rejection of a proposed settlement agreement involving the invasion of a charitable remainder trust to pay the donor's federal tax liability.

FSA 200022005

PGDC SUMMARY:

Taxpayer participated in a tax shelter in Years 1 through 12, and Years 15 and 16. In Year 14, Taxpayer created a charitable remainder unitrust ("Trust") and funded same with stock. Pursuant to its terms, Trust's unitrust amount is distributed to Taxpayer in quarterly installments and the remainder is to be paid to a contingent charitable beneficiary. Within a short time after funding Trust, Trust sold the stock and used the proceeds to purchase a variable annuity contract with Taxpayer as the annuitant. Taxpayer and the IRS entered into a closing agreement regarding tax deficiency and the IRS made an assessment against Taxpayer. In Year 17, the United States filed suit against Taxpayer alleging his transfer of stock to Trust was intended to defraud the government and seeking to foreclose on Taxpayer's interest in the annuity contract held by Trust. Taxpayer filed a voluntary chapter 7 bankruptcy petition and proposed to settle any tax liabilities by having the bankruptcy trustee invade the Trust corpus and use such funds to pay the claims of the government.

Taking note that the Trust is a separate legal entity apart from Taxpayer and that a charity has a vested interest in the Trust's remainder, the Service concluded, in part, (i) only Trust's interest, and not the entire corpus, is currently the property of the bankruptcy estate, (ii) a distribution of Trust's assets in excess of the unitrust amount to or for Taxpayer would be an act of self-dealing and would constitute a taxable expenditure. For this and other reasons, the IRS recommended rejection of the proposed settlement agreement.

POINTS TO PONDER:

If the government is successful in court with its fraudulent conveyances argument, does the charity still get its remainder interest? If the government is not successful in having the transfer to the Trust declared fraudulent, what alternatives other than the one proposed here might be available for reaching the donor's interest in the Trust?

FULL TEXT:
UILC: 53.4941.00, 53.4945.00, 9999.98-00
Release Date: 6/2/2000
Date: February 25, 2000

Refer Reply to: CC:DOM:FS:P&SI
GL-802255-98
INTERNAL REVENUE SERVICE NATIONAL OFFICE FIELD SERVICE ADVICE
MEMORANDUM FOR
NORTHERN CALIFORNIA DISTRICT COUNSEL
FROM:
Assistant Chief Counsel (Field Service)
CC:DOM:FS
SUBJECT:
Settlement of tax Liabilities

This Field Service Advice responds to your memorandum dated October 26, 1999. Field Service Advice is not binding on Examination or Appeals and is not a final case determination. This document is not to be cited as precedent.

LEGEND:
T = * * *
B = * * *
C = * * *
D = * * *
E = * * *
Year 1 = * * *
Year 12 = * * *
Year 14 = * * *
Year 15 = * * *
Year 16 = * * *
Year 17 = * * *
Year 18 = * * *

ISSUES

1. Whether excise and transfer taxes would be applicable if the corpus of C were invaded to pay the personal tax liability of T.

2. Whether the Service's self-imposed administrative stay of collection prohibits the Department of Justice from foreclosing the tax lien in the absence of jeopardy.

3. If the Service's administrative stay of collection does not prohibit the Department of Justice from foreclosing the tax lien, whether the proposed settlement should be accepted.

CONCLUSIONS

1. Excise and transfer taxes would be applicable under the proposed distribution, to the extent the distribution exceeds the unitrust amount.

2. The administrative stay of collection does not prohibit the Department of Justice from foreclosing the tax lien.

3. The proposed settlement offer should not be accepted.

FACTS

In Years 1 through 12 and Years 15 and 16, T participated in a tax shelter promoted by B. On September 22, Year 14, T created C, a charitable remainder unitrust, and on October 10, Year 14, funded it with stock. Pursuant to the terms of the trust, the unitrust amount must be distributed in quarterly installments to T and the remainder paid to a contingent charitable beneficiary. Shortly after being funded, C sold the stock and used the proceeds to purchase a variable annuity contract with T as the annuitants. The charitable remainder unitrust is administered by D, and E is named as the contingent charitable beneficiary remainderman. It is likely that the transfer of stock to C rendered T insolvent.

On February 2, Year 18, the Internal Revenue Service Chief Operations Officer issued a memorandum unilaterally and voluntarily suspending collection action against investors for assessments flowing from adjustments to partnerships promoted by B, except for jeopardy situations. On May 24, Year 18, the Chief Operations Officer issued a memorandum clarifying the February 2, Year 18, memorandum. The May 24, Year 18, memorandum clarifies that the administrative stay of collection only applies to notices of levy and seizures and does not apply to actions such as defending and filing suits.

Pursuant to adjustments made on account of T's participation in the tax shelter, deficiencies were determined, and on December 3, Year 15, T and the government entered into a closing agreement. On April 28, Year 16, an assessment was made against T.

On May 19, Year 16, the Service filed a Notice of Tax Lien with respect to the tax assessments. On September 28, Year 17, the United States filed an action to reduce Tax Assessments to Judgment; Set Aside Fraudulent Conveyances; and Foreclose Federal Tax Liens. The action alleged that T's transfer of stock to C was intended to hinder, delay, or defraud the United States of present and future lawful taxes and that the transfers were made without fair consideration or in exchange for reasonably equivalent value and rendered T insolvent. Thus, the transfers were fraudulent and of no effect as to the United States. Accordingly, the United States seeks to foreclose on T's interest in the annuity contract held by C. T contended that they had legitimate reasons to establish the charitable remainder unitrust, including the avoidance of substantial capital gains on the sale of stock.

On January 22, Year 17, T filed a voluntary chapter 7 bankruptcy petition. Through the bankruptcy trustee, T has proposed to settle any tax liabilities by having the bankruptcy trustee invade the trust corpus and use such funds to pay the claims of the government. T would not be liable for any tax liability associated with such a distribution, such as recognition of capital gain or excise taxes imposed for self-dealing. In addition, the charitable contribution deduction claimed by T in Year 14 for the contribution of stock to C would not be disallowed in whole or in part. Finally, the parties would agree that T committed no fraud.

LAW AND ANALYSIS

1. INVASION OF TRUST CORPUS

Through the bankruptcy trustee, T has proposed to settle any tax liabilities by having the bankruptcy trustee invade the trust corpus and use such funds to pay the claims of the government. The proposed settlement includes a provision that T would not be liable for any tax liability associated with such a distribution, such as excise taxes imposed for self-dealing. A charitable remainder unitrust is a trust from which a fixed percentage, /1/ valued annually, is to be paid not less than annually to one or more persons (at least one of which is not an organization described in section 170(c) and, in the case of individuals, only to an individual who is living at the creation of the trust) for a term of years (not in excess of 20 years) or for the life or lives of such individuals. I.R.C. section 664(d)(2)(A), (B). The payments are referred to as the "unitrust" amount. Following the termination of the unitrust payments, the remainder interest in the trust is transferred to, or for the use of, an organization described in section 170(c)(2). I.R.C. section 664(d)(2)(C).

No amount other than the unitrust amount may be paid to or for the use of any person other than an organization described in section 170(c). I.R.C. section 664(d)(2)(B); Treas. Reg. section 1.664-3(a)(2). The trust may not be subject to a power to invade, alter, amend, or revoke for the beneficial use of a person other than an organization described in section 170(c). Treas. Reg. section 1.664-3(a)(4).

A charitable remainder unitrust is subject to tax only with respect to unrelated business taxable income. I.R.C. section 664(c). Accordingly, C did not pay any capital gains tax upon the sale of the stock contributed to C by T.

An individual is entitled to a charitable contribution for the present value of the remainder interest of the trust. I.R.C. section 170(f)(2)(A); Treas. Reg. section 1.170A-6(b). Accordingly, in Year 14, T claimed a charitable contribution equal to the remainder interest in C. A five percent excise tax on the amount involved is imposed on each act of self-dealing between a disqualified person and a charitable remainder unitrust. I.R.C. sections 4941(a)(1), 4947(a)(2). /2/ A 2 1/2 percent excise tax is imposed on the participation of the trustee in any act of self- dealing between a disqualified person and the charitable remainder unitrust, unless such participation is not willful and due to reasonable cause. I.R.C. sections 4941(a)(2), 4947(a)(2). Additional taxes are imposed on disqualified persons or the trustee if the act of self-dealing is not corrected. I.R.C. sections 4941(b), 4947(a)(2). Self-dealing includes any direct or indirect transfer to, or use by or for the benefit of, a disqualified person, of the income or assets of a charitable remainder trust. I.R.C. sections 4941(d)(1)(E), 4947(a)(2).

A tax of ten percent of the amount involved is imposed on a charitable remainder trust for each taxable expenditure. I.R.C. sections 4945(a)(1), 4947(a)(2). A tax of 2 1/2 percent is imposed on the agreement of any trustee to the making of an expenditure, knowing it is a taxable expenditure to the extent of the amount thereof, unless such agreement is not willful and is due to reasonable cause. I.R.C. section 4945(a)(2). Additional taxes are imposed under section 4945(b). A taxable expenditure includes any amount paid or incurred by a charitable remainder trust for any purpose other than one specified in section 170(c)(2)(B). I.R.C. section 4945(d)(5). As a result of the creation of C, T irrevocably gave a contingent remainder interest to E and retained only the interest in the unitrust amount. Only this interest, and not the entire trust corpus, is currently property of the bankruptcy estate.

Because the trust is a separate taxpayer from T, and has an independent legal existence, the bankruptcy trustee cannot disregard the trust as an entity and invade the interest T relinquished in creating the trust. Any invasion, alteration, amendment, or revocation of the trust for the benefit of any person other than an organization described in section 170(c) is prohibited. Treas. Reg. section 1.664-3(a)(4). In addition, because E has a vested contingent remainder interest in the trust, any invasion of the trust corpus without adequately providing for the vested remainder interest would be invalid.

In addition, a distribution of assets from C to settle T's tax liabilities would constitute an act of self-dealing as any distribution of an amount in excess of the unitrust amount would use C's assets for the benefit of T. I.R.C. section 4941(d)(1)(E). A distribution would also constitute a taxable expenditure as a distribution of charitable assets for a purpose not described in section 170(c). I.R.C. section 4945(d)(3), (5). /3/ Accordingly, the bankruptcy trustee cannot invade the corpus of C without triggering the penalties for self-dealing and taxable expenditures. This result is inconsistent with the proposed settlement agreement.

2. EFFECT OF THE ADMINISTRATIVE STAY OF COLLECTION

On September 28, Year 17, the United States filed an action to reduce Tax Assessments to Judgment; Set Aside Fraudulent Conveyances; and Foreclose Federal Tax Liens. The action alleged that T's transfer of stock to C was intended to hinder, delay, or defraud the United States of present and future lawful taxes and that the transfers were made without fair consideration or in exchange for reasonably equivalent value and rendered T insolvent. Thus, the transfers were fraudulent and of no effect as to the United States. Accordingly, the United States seeks to foreclose on T's interest in the annuity contract held by C.

On February 2, Year 18, the Chief Operations Officer issued a memorandum suspending collection action against investors for assessments flowing from adjustments to partnerships promoted by B, except for jeopardy situations. On May 24, Year 18, the Chief Operations Officer issued a memorandum clarifying the February 2, Year 18, memorandum. Because the administrative stay only applies to notices of levy and seizures and not to actions such as defending and filing suits, the government's suit to set aside the fraudulent conveyance is not affected by the Service's administrative stay of collection. In addition, the administrative stay of collection does not invalidate or nullify collection actions taken prior to issuance of the memorandum establishing the voluntary stay.

3. CONSISTENCY WITH RESOLUTION OF FRAUDULENT CONVEYANCE CASES

In Years 1 through 12 and Years 15 and 16, T participated in a tax shelter promoted by B. On September 22, Year 14, T created C, a charitable remainder unitrust and on October 10, Year 14, funded it with stock. Pursuant to adjustments made on account of T's participation in the tax shelter, deficiencies were determined, and on December 3, Year 15, T and the government entered into a closing agreement. On April 28, Year 16, an assessment was made against T. California follows the Uniform Fraudulent Transfer Act (Act). The government's complaint to set aside the fraudulent conveyance alleges actual intent to defraud pursuant to California's State Civil Code section 3439.04(a). Section 3439.04(a) provides as follows:

A transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the creditor's claim arose before or after the transfer was made or the obligation incurred, if the debtor made the transfer or incurred the obligation as follows:

(a) With actual intent to hinder, delay, or defraud any creditor of the debtor,

(b) Without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor:

(1) Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction, or

(2) Intended to incur, or believed or reasonably should have believed that he or she would incur, debts beyond his or her ability to pay as they became due.

For purposes of this analysis, it is assumed that the government can prove that the transfer of T's stock to C was a fraudulent transfer and that the government can trace the purchase of the annuity contract and the proceeds therefrom to the stock transfer. A successful suit to set aside the fraudulent transfer and to foreclose the federal tax liens would have the effect of voiding the transfer, including the transfer of the contingent charitable remainder interest. Thus, the government could foreclose its tax liens against the annuity contract or proceeds therefrom. In the Ninth Circuit, whose law is controlling in this case, the Service became a creditor as of the close of the respective taxable year at issue. Edelson v. Commissioner, 829 F.2d 828 (9th Cir. 1987) (Service becomes a creditor at the close of the taxable year). Cf. Hartman v. Lauchi, 238 F.2d 881 (8th Cir. 1956) (Service becomes a creditor on the date the return is filed); United States v. St. Mary, 334 F.Supp. 799 (E.D. Pa. 1971) (Service becomes a creditor on the date the tax return is due to be filed). At a minimum, the tax liabilities had accrued before the transfer of stock from T to C, and the fact that the transfer occurred prior to the tax liens arising and prior to the filing of notices of federal tax lien is of no consequence. Moreover, pursuant to section 3439.04, whether the claim arose before or after the fraudulent transfer was made is irrelevant. If successful in its suit to set aside the fraudulent conveyance, T's transfer of stock to C would be voided and, therefore, the United States could invade C's corpus to pay the Service's claim. In the absence of the stock having been transferred to the trust, the sale of the stock would have occurred in the hands of T. There is no Code provision that would release T from reporting capital gain upon the sale of the stock. In addition, to the extent stock was not transferred to the trust, T would not have been entitled to claim a charitable contribution deduction. Under the proposed settlement agreement, T would not be liable for any capital gain. In addition, the charitable contribution deduction claimed by T in Year 14 for the contribution of stock to C would be allowed. Finally, the parties would agree that T committed no fraud. The proposed settlement agreement is directly contrary to the tax result that should occur if the conveyance were considered fraudulent and the transfer voided. In addition, the inclusion in the proposed settlement agreement that T committed no fraud is directly contrary to the rationale upon which voiding the transfer must be based. Given these overarching and irreconcilable inconsistencies, we recommend that you do not accept the proposed settlement offer.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

* * *

Please call if you have any further questions.

By: PATRICK PUTZI
Special Counsel (Natural Resources)
Passthroughs & Special Industries Branch
Field Service Division

FOOTNOTES

/1/ At the time the trust was created, the fixed percentage could not be less than five percent. Subsequently, section 664(d)(2)(D) was amended to provide that the fixed percentage to be distributed must be no less than five percent and no greater than 50 percent, and the remainder interest in such property must be at least 10 percent of the fair market value of such property as of the date of the gift. Pub. L. No. 105-34, sec. 1089.

/2/ A charitable remainder trust which complies with section 664 and for which a deduction was allowed under section 170 is a split interest trust described in section 4947(a)(2) and subject to section 4941 and 4945 with respect to the charitable remainder interest. I.R.C. section 4947(a)(2).

/3/ The bankruptcy trustee, insofar as the trustee assumes control over the trust corpus, would literally fall within the definition of foundation manager. Participation in a court-supervised settlement of the case likely would be viewed as reasonable cause so that the bankruptcy trustee would not be liable for the section 4941(a)(2) and 4945(a)(2) taxes on foundation managers.

END OF FOOTNOTES

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