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IRS Approves Income Deferral CRT Funded With Tax Deferred Annuities
Ever since last April when Treasury issued proposed regulations calling for commentary regarding the use of various investment strategies that enable the trustee of a NIMCRUT to control the receipt of distributable income by the trust, and concurrently announced in Rev. Proc. 97-23 in which it stated that it would not issue any rulings on the subject, the use of tax deferred annuities and investment limited partnerships in NIMCRUTs as methods of facilitating the deferral of income distributions has come to a screeching halt.
In November of 1997, IRS and Treasury held public hearings at which the comments on this issue were overwhelmingly in favor of permitting income deferral in CRTs. We have now heard the first word from the Service since those hearings and the word is good.
In 1990, an individual created an 8% NIMCRUT with a portion of the stock in his closely-held corporation. The trust named the Trustor and his spouse as life income recipients and the Trustor's nephew as Primary Trustee. Additionally, the Trust provides for a special independent trustee to deal with hard-to-value assets such as the business. In 1991, the company was sold and with it the stock from the trust. As is common with many business sales, to aid in the transition, the seller entered into a five-year employment agreement and covenant not to compete that provided him with significant compensation over the five-year period.
Understanding that the Seller / Trustor did not need any additional income during the following five years, the Special Independent Trustee of the CRT used the sale proceeds to purchase two tax deferred annuity contracts from a commercial insurance company. The intent of the Trustee was to defer income distributions from the trust for the first five years, then reevaluate the income needs of the income recipients at that time. There was at least one major problem, however. The unitrust instrument had not anticipated the ownership by the Trust of a tax deferred annuity contract for fiduciary accounting purposes; therefore, it failed to provide any guidance to the Trustee with respect to whether or not income and appreciation within the annuity contract could be deferred or would be required to be distributed in the year in which it was earned. State law was also silent on the issue; hence, the dilemma. Did local law, in conjunction with the trust instrument, permit the deferral of the receipt of trust accounting income related to the annuity contracts until cash was actually received by trustee?
A second concern involved the IRS's then current thinking regarding whether income deferral constituted a use of trust assets for the benefit of a disqualified person and, thereby a prohibited act of self-dealing. In connection with a subsequent income tax audit of the CRT, the local IRS District Office referred the following questions to the IRS National Office:
- Does the purchase of the deferred annuity policies from a commercial insurance company constitute acts of self-dealing when the named annuitants are disqualified persons?
- 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?
- Would the annuity's withdrawal provision result in income to the Trust, within the meaning of section 643(b)?
On January 9, 1998, the IRS issued a Technical Advice Memorandum 9825001.
The Service advised:
- The purchase of the deferred annuity policies, based on the particular facts of this case, does not constitute an act of self-dealing under section 4941 of the Code.
- The purchase of the deferred annuity contracts does not adversely affect the Trust's qualification as a charitable remainder trust under section 664 of the Code and the current regulations thereunder for federal income tax purposes.
- 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.
The discussion related to the self-dealing issue was nothing short of profound. Following are excerpts:
"We have examined the transaction with the intention of ascertaining whether the B (the Trustee), acting in concert with A (the Trustor) 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."
"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."
"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."
"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."
With respect to whether or not the Trust's right to receive either the cash value or the surrender value of the contracts creating trust accounting income under section 643(b) of the Code, a little background is in order.
Letter Ruling 9009047 offered the first guidance regarding the use of tax deferred annuities as trust investments. In that ruling, the Service ruled that with respect to the ownership of a tax deferred annuity, a charitable remainder trust cannot act as an agent for a natural person under IRC sec. 72(u). This meant that a tax-deferred annuity owned by a CRT loses its tax-deferred status. All income earned by the annuity contract is taxable to the CRT in the year in which it is earned regardless of whether or not the Trustee makes a withdrawal from the annuity contract. No tax is paid by the trust, however, unless it has UBTI from other sources that would otherwise cause it to lose its tax-exempt status.
In the 1990 ruling, the trust instrument expanded its definition of trust income to include "distributions from a life insurance or annuity contract." This provision gave clear guidance to the Trustee that only withdrawals from the annuity contract were distributable income. Because annuity withdrawals are treated for income tax purposes as being made on a last-in-first-out (LIFO) basis, any withdrawals, to the extent they exceeded the cost basis of the contract would be distributable income, to the extent of the unitrust amount and any outstanding deficiency account balance. If no cash withdrawals were made, the trust would have nothing to distribute.
In the immediate case, the trust instrument was silent and state law was ambiguous on the treatment of income withdrawals from the annuity contracts. The Service stated:
"The applicable state law, the Uniform Principal and Income Act of State, 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 XXX Code Ann. Section XXXXX and section XXXXX (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."
The implications of this TAM are significant. First, those Trustors that have entered into these types of arrangements can sigh in relief that, even though a TAM cannot be used as tax precedent, the current sentiment of the Service favors these arrangements. The TAM also suggests that even if the trust instrument has not anticipated income deferral arrangements, they may be permissible provided they are compatible with state law. One can also speculate that this ruling may offer a sneak preview of the final regulations, if Treasury chooses to include this issue.