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Testamentary CRTs: Opportunities and Issues in Lifetime Planning and Post-Mortem Administration
Charitable remainder trusts are most commonly thought of as a lifetime planning vehicle. However, CRTs are also very effectively used on testamentary basis. In this edition of Gift Planner's Digest, Rancho Santa Fe, California attorneys James M. Cowley and Ellen L. van Hoften identify the opportunities and issues that surround the creation and post-mortem administration of testamentary CRTs.
Why use a testamentary CRT?
The inter vivos charitable remainder trust (CRT) is seen today by many clients as an attractive vehicle for minimizing income tax because of the IRC §170 income tax deduction and the possibility of avoiding income taxation of pre-gift and post-gift appreciation. Although incorporating a testamentary CRT in an estate plan does not offer an income tax deduction and, under current law, is not necessary to avoid income taxation of pre-death appreciation, it does offer significant benefits.
An estate tax deduction will be available for the present value of the charitable remainder interest. Depending on the ages of the income beneficiaries of the CRT and the payout rate, the result can be a significant reduction in estate tax and a consequent net benefit to the beneficiaries.
Like the inter vivos CRT, the testamentary CRT can avoid capital gains tax on the sale of assets. If the CRT continues for a number of years, the tax-free appreciation within the CRT can be significant. Moreover, if the estate tax value of the assets bequeathed to the CRT is adjusted for lack of marketability or control, significant potential post-mortem gain (to be realized when such assets are liquidated) may be "built into" the assets held by the CRT.
The testamentary CRT can be used to maintain control of a closely held business after death. Conversely, if the business is to be sold, capital gains tax on post-death gains can be avoided if the sale is made by the CRT.1
Especially where retirement plan assets comprise a substantial part of the estate, consider a testamentary CRT with the surviving spouse as the income beneficiary as an alternative to a QTIP with a remainder to charity.2
Clients may be deterred from using an inter vivos CRT to fund a family foundation with appreciated property because IRC §170(b) imposes stricter limitations on the income tax deduction for contributions to a private nonoperating foundation than for those made to public charities, supporting organizations, and private operating foundations, and currently permits no deduction for the gain in appreciated property other than publicly traded stock. The remainder deduction for the testamentary CRT is the same whether it funds a private nonoperating foundation or a public charity.
The testamentary CRT may also be an ideal vehicle to provide for dependent family members, such as parents or less comfortable siblings, who will need income but not capital, after the grantor's death. For the client whose asset mix or income tax situation during life does not justify an inter vivos CRT, or who does not wish to relinquish assets prior to death, but who nevertheless is charitably inclined, the testamentary CRT may be an appropriate part of the estate plan.
Post-mortem administration: The need to anticipate issues. Post-mortem administration often involves challenging issues. For instance, the fiduciary may have to value difficult assets, allocate to and fund subtrusts, make tax elections affecting beneficiaries, determine the optimum timing of distributions, and plan fiduciary income tax strategies. Certain administrative issues become even more interesting when the beneficiaries of an estate or of a post-mortem trust include a CRT.
Living (and dying) with uncertainty. In a number of areas affecting the funding of testamentary CRTs, the law is unsettled, suggesting the need for clarifying guidance. In other areas, the law appears settled but unsatisfactory. This article explores selected issues arising in the post-mortem administration of estates and trusts that fund testamentary CRTs, or make testamentary additions to inter vivos charitable remainder unitrusts (CRUTs), including both charitable remainder annuity trusts (CRATs) and CRUTs. Although much of its perspective is post-mortem, identifying these challenges arising after death will also highlight issues that may be anticipated and addressed by pre-death planning.
Summary of Relevant Characteristics of Testamentary Charitable Remainder Trusts
- The trust must comply with the requirements of IRC §664 and the Regulations thereunder.
- The CRT will be exempt from federal income tax, except for any year in which it has any unrelated business taxable income.3
- The bequest to the CRT will be part of the taxable estate of the decedent.
- The decedent's estate will be entitled to a charitable deduction under IRC §2055 for the present value of the charitable remainder interest in the trust.4
- Unless the income beneficiary of the CRT is the decedent's spouse, the present value of the income interest will be taxable.5
- If the estate tax on the bequest to the CRT is payable from that bequest, the computation of the tax and the charitable deduction for the remainder interest will be interrelated.
- The CRT will be subject to certain of the Chapter 42 excise tax provisions applicable to private foundations, specifically IRC §4941 (self-dealing) and IRC §4945 (taxable expenditures).6
Overview of Post-Mortem Income Tax Structure
Because a CRT is a tax-exempt entity, generally it will be beneficial to have it, rather than the post-mortem administrative entity, receive the taxable income generated by the bequest to it during administration. Achieving this goal, even in part, presents a number of challenges.
The post-mortem entity. The entity that funds the testamentary CRT will be either a probate estate or a revocable inter vivos trust that has become irrevocable at the settlor's death. Pending ultimate distribution, such a trust is called an "administrative trust." Either vehicle operates as a separate tax entity during the period between the settlor's death and final distribution to the beneficiaries. Now that an administrative trust may elect under IRC §645 to be treated as part of (or like) an estate for income tax purposes, the distinctions between the two types of post-mortem entities are less significant than previously, and for many purposes whether the entity is an estate or an administrative trust is irrelevant. The IRC §645 election may not be made in every case, however, and is not necessarily effective throughout the entire period of post-mortem administration. Where the election is not made or is no longer in effect, then in certain instances, such as the determination of whether an IRC §642(c) charitable income tax deduction is available to the entity, the distinction may still be significant.
Where the type of vehicle used for administration is not significant, reference will be made simply to the "post-mortem entity" or the "entity." Where it is significant, the distinction between an "estate" and an "administrative trust" will be emphasized for those cases where the IRC election is not made or may no longer be in effect.
General Review Of Income Taxation Of The Post-Mortem Entity
Subchapter J. The post-mortem entity is subject to income taxation under the rules of Subchapter J of Chapter 1 of the Internal Revenue Code. Section 641(b) taxes its income in the same manner as in the case of an individual, except as specifically otherwise provided. Thus, except to the extent its income is offset by an allowable deduction, the post-mortem entity itself is taxed on the income it earns each year.
Complex trust. The post-mortem entity will be treated as a complex rather than a simple trust, governed by IRC §§661 and 662 rather than by IRC §§651 and 652.
Conduit system. The underlying concept of Subchapter J is that the entity is substantially a conduit through which income is distributed to, and taxed to, the beneficiaries to the extent of the entity's distributable net income (DNI).
Under this concept, tracing of actual distributions of income is not required; all distributions are presumed to be of income, up to the amount of the entity's DNI. An exception to the "no tracing" policy is found in the requirement that amounts distributable to charity must be paid from income to qualify for the IRC §642(c) charitable deduction.
These principles of the conduit system are implemented through the interaction of IRC §§661 and 662, which ensure that income distributed to the beneficiaries is taxed to them, with the same character it had in the entity, while income retained in the post-mortem entity is taxed to the entity.
In contrast, distributions from a CRT are characterized in the hands of the beneficiaries under the "tier system" of IRC §664(b) and Treas. Regs. §1.664-1(d)(1)(i) rather than under IRC §662(b).
Tax-exempt status of CRT. The CRT itself will not be subject to income tax provided it has no unrelated business taxable income (UBTI) for the taxable year.7 UBTI and the need to keep items of UBTI out of the CRT are discussed below. Except for that discussion, this article assumes the CRT to be funded from the post-mortem entity will not have any UBTI, and hence will not be subject to income tax.
Nature of bequest to CRT. The extent to which the post-mortem entity's income will be distributed to the CRT during administration depends on the nature of the bequest and the terms of the governing instrument or applicable law. Where the governing instrument does not indicate a contrary intention, for example, under current California law:8
- A specific bequest of a particular asset carries with it the income earned on that asset from the date of death, less expenses attributable to that asset during administration.9
- Where the bequest to the CRT is a bequest of a specified dollar amount (that is, a "general pecuniary" bequest, such as "$1 million"), it does not carry out the income earned on such sum; that income, instead, will ultimately be distributed to the residuary beneficiaries (who are probably not tax-exempt).10
- Neither a general pecuniary bequest nor a bequest of specific property carries out the DNI of the post-mortem entity.11
- Satisfaction of a general pecuniary bequest with property that has appreciated since date of death will realize gain in the post-mortem entity.12
- Where the bequest is of the residue or a fraction of the residue (or passes under intestacy), income earned during administration not otherwise devised is to be distributed pro rata among the residuary beneficiaries.13
Planning considerations: Except for items of IRD, testamentary CRTs are usually not funded with specific assets. In most cases the settlor or testator will have in mind a dollar amount or a portion of the estate, so that the planner's choice will be between: 1) a general pecuniary bequest; and 2) a fraction of the residue.
Objective: Shift taxable income to CRT. The general objective is usually to reduce the overall amount of income tax by distributing income earned by the post-mortem entity to the CRT, to the extent permitted and possible, so that it will be taxed to the latter, which is tax-exempt, rather than to the former, which is taxable. If the post-mortem entity can deduct these distributions because they qualify for the charitable deduction under IRC §642(c), its own taxable income will be reduced accordingly. Alternatively, if the post-mortem entity can deduct them under IRC §661(a), they will be included in the CRT's income under IRC §662(a), and because the CRT is tax-exempt, these amounts distributed, except to the extent paid out to the income beneficiary, will escape income tax.
This objective may become even more important when the income earned by the post-mortem entity includes significant capital gains as well as ordinary income. As discussed above, the fiduciary's ability to distribute income to the CRT depends in part on the nature of the bequest; the CRT can only receive the income to which it is entitled.
Thus, the threshold issue with respect to the income taxation of the post-mortem entity is whether distributions from that entity to a CRT will be deductible under either IRC §642(c) or IRC §661(a).
Charitable Deduction Under IRC §642(c)
Section 642(c) authorizes a deduction to the post-mortem entity for amounts of gross income that are paid (or, in the case of an estate [or a post-mortem trust treated like an estate by virtue of the IRC §645 election], set aside or used), pursuant to the governing instrument, for charitable purposes.14 To the extent this IRC §642(c) charitable deduction is allowed, no IRC §661(a) distributions deduction is needed. To the extent the IRC §642(c) charitable deduction is denied, on the other hand, the IRC §661(a) distributions deduction must be available in order for the post-mortem entity to escape taxation on its capital gains. Yet, the availability of the IRC §661(a) deduction itself turns in part on whether distributions to the CRT fit within the parameters of IRC §642(c), an issue that is not entirely resolved. Therefore, before examining the IRC §661(a) deduction, this article first examines the requirements of IRC §642(c) itself and whether they are met where the charitable beneficiary is a CRT.
Estate versus trust. A probate estate is allowed a broader charitable deduction than is a non-electing administrative trust.15 In the case of a non-electing administrative trust, the amounts allowed must be "paid" for charitable purposes in either: 1) the taxable year for which deducted; or 2) by the end of the following taxable year if so elected.16
In the case of an estate (and certain trusts created on or before October 9, 1969, as well as electing trusts), the deduction is authorized not only for amounts that are "paid," but also for those that are "permanently set aside for a purpose specified in Section 170(c), or to be used exclusively for [charitable] purposes."17
The post-1969 continuation of the broader IRC §642(c)(2) "set-aside" deduction only for probate estates may have recognized that post-mortem administration of decedents' estates would necessarily preclude prompt "payments," but that amounts of income could be "set aside" for charitable purposes during administration.18 Now that revocable living trusts so often supplant the will as the primary testamentary instrument, the IRC §645 election is useful, but it would seem that this distinction in post-mortem entities could be eliminated entirely and the IRC §642(c)(2) "set-aside" deduction allowed to all administrative trusts as well as to probate estates. Again, because not all revocable trusts will make the IRC §645 election, and there is the possibility it will not be in effect throughout the funding process, the distinction currently remains and must be considered when selecting the vehicle by which a testamentary CRT will be funded.
Section 642(c). The elements of the charitable deduction under IRC §642(c) can be identified as: an amount of gross income that pursuant to the governing instrument is paid (or, in the case of estates, permanently set aside or used exclusively) for a purpose specified in IRC §170(c) (determined without regard to IRC §170(c)(2)(A)).
Amount of the gross income. Although one of the objectives of Subchapter J is to avoid tracing, IRC §642(c) contains an exception to that policy: The requirement that distributions to charity be made from gross income does require tracing the source of those distributions from either income or corpus and excluding those made from corpus.
Pursuant to the terms of the governing instrument. The distribution of the income to charity must not only be authorized, but also required by the governing instrument or local law.
For a purpose specified in IRC §170(c). Arguably, and logically, this element of the IRC §642(c) deduction can never be satisfied where the charitable recipient is a CRT, which necessarily has both charitable and non-charitable purposes and beneficiaries.
As noted above, distributions from a non-electing administrative trust are eligible for the IRC §642(c) deduction only under IRC §642(c)(1); that is, only if those amounts are "paid" for a charitable purpose; distributions from an estate (or certain old trusts as well as an electing administrative trust), on the other hand, can qualify if they were either paid19 or permanently set aside or to be used exclusively for certain charitable purposes.20
Some unfortunate language in the Regulations, however, has given rise to a theory, perpetuated by some commentators and the IRS, that a set-aside deduction may be available for capital gains of an estate that ultimately are to be distributed to an income-only unitrust. Treas. Regs. §1.642(c)-2(d) provides in pertinent part:
"No amount will be considered to be permanently set aside, or to be used, for a [charitable] purpose unless under the terms of the governing instrument and the circumstances of the particular case the possibility that the amount set aside, or to be used, will not be devoted to such purpose or use is so remote as to be negligible. Thus, for example, where there is possibility of the invasion of the corpus of a charitable remainder trust in order to make payment of the annuity amount or unitrust amount, no deduction will be allowed in respect of any amount set aside by an estate for distribution to such a charitable remainder trust."
The IRS has perpetuated this idea by purporting to apply this "possibility of invasion" standard on a factual, case-by-case basis.21 However, it apparently has never found the standard to be satisfied.
Even under such a case-by-case application of the "possibility of invasion" standard, it has been argued that an IRC §642(c) deduction should be allowed for distributions of capital gains added to the corpus of an income-only CRUT. Yet, even in an income-only CRUT there is a possibility that capital gains distributed to the CRUT during administration might later be used to "settle up" with the noncharitable beneficiary, as noted in Ltr. Ruls. 8810006 and 8341001.
More significantly, the "possibility of invasion" test of Treas. Regs. §1.642(c)-2(d) is not necessarily the only standard for determining whether amounts of income qualify for the IRC §642(c) deduction. In fact, it is really only an example of the standard set forth in the first sentence of the Regulation: Will the amount be "devoted" to charitable purposes? In the case of capital gains distributed from a post-mortem entity to a CRT, the answer should be, "no." Even if there were no possibility of invasion of the CRT's corpus, charity would not actually receive the full use of the capital gains paid to any CRT until the termination of the income beneficiary's interest.
Where capital gains are set aside for a charitable beneficiary that is not a CRT, and are allocated to corpus, all the income earned on those capital gains following such distribution also is added to corpus and accrues for the benefit of the charitable beneficiary. (In fact, it would seem that this concept should be inherent in the "set-aside" deduction itself: The income earned from the time such amounts are "set aside" for the charitable beneficiary must also benefit that charity as necessarily will income earned on amounts actually paid.)
In the case of a CRT, however, although capital gains allocated to corpus eventually will be used for a charitable purpose, during the often lengthy term of the trust a substantial portion, if not all, of the income generated by those gains will be paid to the income beneficiary, not to the charitable beneficiary. Thus, even though the capital gains themselves will not be paid to the noncharitable beneficiary, neither are they "devoted" to charitable purposes at the time of distribution, as required by the first sentence of Treas. Regs. §1.642(c)-2(d), because the charitable beneficiary will not be entitled to the income generated by those capital gains until after the termination of the trust.
This "delay factor," after all, is considered for individual grantors, who are permitted a charitable income tax deduction under IRC §170(b) only for the actuarially calculated present value of the remainder interest because that interest is not distributed to the charity until termination of the trust.22 Similarly, it would make sense to allow an IRC §642(c) deduction to a post-mortem entity, if at all, only for the present value of the remainder interest of distributed income that will be allocated to the corpus of the CRT. As Congress has explicitly chosen instead to allow an "all or nothing" charitable deduction for trusts and estates, instead of the deduction for the present value of the remainder interest allowed to individual donors, it would seem that no amounts paid to or set aside for a CRT should qualify for the IRC §642(c) deduction because the amounts are not actually set aside or paid for a charitable purpose until the end of the CRT term.23
Distributions Deduction Under IRC §661(a): Treas. Regs. §1.663(a)-2
Relationship with IRC §642(c). As noted above, whether distributions from the post-mortem entity to the CRT qualify for the IRC §642(c) charitable deduction is directly relevant to a determination of whether they qualify for the IRC §661(a) distributions deduction.
If such distributions from the post-mortem entity were eligible for the IRC §642(c) deduction, whether or not they also qualified for the IRC §661(a) deduction would be moot. In fact, IRC §663(a)(2) ensures that the same amounts are not deductible under both IRC §642(c) and IRC §661(a) by clearly excluding from the distribution rules of IRC §661 and 662 "any amount paid or permanently set aside or otherwise qualifying for the deduction provided in IRC §642(c)."
Under this plain language, it would appear that the only payments to charitable organizations excluded from the operation of IRC §661 and 662 are those actually qualifying for the IRC §642(c) charitable deduction. If so, then amounts distributed by the post-mortem entity to a CRT, which amounts should not qualify under IRC §642(c), should be eligible for the deduction allowed by IRC §661(a).
Section 663(a)(2). This interpretation is supported by the legislative history of IRC §663(a)(2), which makes it clear that the purpose of the statute is only to deny a double deduction under both IRC §642(c) and IRC §661(a). "[S]ince the estate or trust is allowed a deduction under Section 642(c) for amounts paid, permanently set aside, or otherwise qualifying for the deduction provided in that section, such amounts are not allowed as an additional deduction for distributions."24
This interpretation is also consistent with the first sentence of Treas. Regs. §1.663(a)-2, which states: "Any amount paid, permanently set aside, or to be used for the charitable, etc., purposes specified in IRC §642(c) and that is allowable as a deduction under that Section is not allowed as a deduction to an estate or trust under IRC §661 or treated as an amount distributed for purposes of determining the amounts includible in gross income of beneficiaries under IRC §662." From this it would appear that, as provided in the Code, the only amounts not deductible under IRC §661(a) are those actually allowable as a deduction under IRC §642(c).
Treas. Regs. §1.663(a)-2 and Mott v. U.S. The next sentence of the Regulation, however, provides: "Amounts paid, permanently set aside, or to be used for charitable, etc., purposes are deductible by estates or trusts only as provided in IRC §642(c)." It is this second sentence that has been cited, analyzed, and specifically upheld by several courts in denying the IRC §661(a) deduction for amounts distributed to charities even where the IRC §642(c) deduction itself is disallowed.
The lead case denying the IRC §661(a) deduction is Mott v. U.S., 462 F.2d 512 (Ct. Cl. 1972), cert. denied, 409 U.S. 1108 (1973). In Mott the decedent had left two-thirds of his estate to a private foundation and the residue (including all income earned during administration) in trust for a life income beneficiary and specified noncharitable remaindermen. During the year in question, the estate claimed an IRC §661(a) deduction for distributions of over $13 million to the foundation as a partial funding of that bequest. The estate and the government agreed that the distributions were not deductible under IRC §642(c), because they were made from corpus rather than from the estate's gross income. The parties also agreed that the Code Section itself, IRC §663(a)(2), was inapplicable because the amounts did not qualify under IRC §642(c) for the charitable deduction.
Nevertheless, the IRS argued, and the court agreed, that Treas. Reg. §1.663(a)-2 clearly denied an IRC §661(a) deduction for any amounts distributed to a charitable beneficiary except as permitted by IRC §642(c). The Mott court concluded that denying the deductibility of distributions to tax-exempt beneficiaries was in accord with "an implied Congressional intent to prevent all charitable distributions, whether or not deductible under 642(c), from entering into the operation of the distribution rules." Even though the distributions could not be deducted under IRC §642(c), neither could they be deducted under IRC §661(a).
Mott may have been decided on the facts as much as on the law: If the estate in that case had been allowed a deduction for its large distributions of corpus to the tax-exempt charitable beneficiary, that distribution would have drawn out most of the estate's DNI, with a significantly reduced tax burden for both the income beneficiary and the estate.
Subsequent cases that have followed Mott in denying an IRC §661(a) deduction for distributions to charitable organizations on the basis of Treas. Regs. §1.663(a)-2 seem poorly reasoned.
In Pullen v. U.S., 80-1 USTC, 9105 (D. Neb. 1979) [unpublished], aff'd. mem., 634 F.2d 632 (8th Cir. 1980), where corpus transferred during administration to a private foundation in satisfaction of a bequest could not qualify for the IRC §642(c) deduction, the court based its denial of the IRC §661(a) deduction on an analysis of "symmetry," reasoning that contributions to charitable organizations should result in only one tax benefit, either an estate tax deduction for contributions of corpus under IRC §2055, or an income tax deduction for contributions of income under IRC §642(c).
Under the facts of the case, this rationale might be valid; an estate tax deduction had been allowed for the value of the corpus, and, arguably, an additional distributions deduction should not be permitted for the same property.
Where the distribution is made from income, however, and the IRC §642(c) deduction disallowed on other grounds (for instance, because it was not paid pursuant to the governing instrument, as in Mott and the other three cases noted here), the Pullen rationale for denying the IRC §661(a) deduction makes little sense.
Perhaps this is why the Tax Court in the case of Rebecca K. Crown Income Charitable Fund v. Com'r., 98 T.C. 327 (1992), aff'd., 8 F.3d 571 (7th Cir. 1993), where the IRC §642(c) deduction was denied because the amounts transferred were not clearly transferred pursuant to the terms of the trust, denied the IRC §661(a) deduction as well with the simple statement, without analysis, "We will not reverse our prior position." This may also explain the court's confusion in U.S. Trust Co. v. IRS, 803 F.2d 1363 (5th Cir. 1986).
The IRC §642(c) deduction was denied in Estate of O'Connor v. Com'r., 69 T.C. 165 (1977), appeal dismissed (2d Cir. 1980) because the distributions were not made "pursuant to the governing instrument.
In denying the IRC §661(a) deduction as well, the O'Connor court, like that in Mott, relied in part on implied Congressional intent to permit an IRC §661(a) deduction only for distributions to taxable beneficiaries.
If that had been Congress' intent, however, it would have drafted IRC §661(a) accordingly, to limit its availability.25
The better view is that Treas. Regs. §1.663(a)-2 is intended to deny only a double deduction; amounts distributed to charitable organizations that do not actually qualify for the IRC §642(c) deduction should be eligible for the deduction under IRC §661(a). This is also the view of most commentators, who have criticized the Mott holding as unnecessarily broad.26
IRS position. Not only are Mott and its progeny neither consistent nor soundly reasoned; even the IRS appears to agree that neither these cases nor Treas. Regs. §1.663(a)-2 itself applies in the context of split-interest trusts. Neither Mott nor any of the cases following it, nor Rev. Rul. 68-667, involved a split-interest trust. In fact, in several instances, the IRS itself has specifically refused to apply Treas. Regs. §1.663(a)-2 in the context of split-interest trusts.
GCM 39707 and TAM 8810006 involved a charitable remainder annuity trust that was to pay the life income beneficiary the greater of a specified dollar amount or a percentage of the trust's initial value. The prevailing interest rates and the annuitant's age made it unlikely that principal would be invaded to pay the annuity. Nevertheless, the IRS ruled that because of the possibility that principal might be invaded to pay the annuity to the noncharitable beneficiary, the capital gains distributed to the CRAT, even though they were allocable to the CRAT's corpus, were not "amounts paid, permanently set aside, or to be used, for exclusively charitable purposes."
To this extent, the ruling was the same as in Mott, Rebecca K Crown, U.S. Trust Co., Pullen, and O'Connor, above: The estate was denied the IRC §642(c) charitable deduction.
The IRS expressly distinguished this situation from those cases, however, concluding that because the distributions did not fit within the language of Treas. Reg. §1.663(a)-2, the prohibition of that Section should not apply. Thus, the estate was entitled to an IRC §661(a) deduction for the distributions to the CRAT.
TAM 8603002 involved a charitable lead unitrust to be funded with one-half the residue of the decedent's estate. During the year in question, the estate made distributions to the charitable lead trust and deducted those distributions, up to the estate's distributable net income, under IRC §661(a).
The IRS found that because prevailing interest rates were above the unitrust interest rate, there was more than a remote possibility that these distributions would be in excess of the amounts required to be paid to the charitable income beneficiary, and would, therefore, be added to the trust's corpus and distributed at the end of the trust term to the noncharitable remainder beneficiaries.
As a result, "an amount distributed to [a charitable lead trust] is not paid or permanently set aside for charitable purposes" within the meaning of Treas. Regs. §1.663(a)-2. That Section of the Regulations, therefore, does not apply to deny an IRC §661(a) distribution.
The ruling specifically distinguished this situation from those of Mott and O'Connor.
Ltr. Rul. 8341001 involved a split-interest trust in which the issue was not whether Treas. Regs. §1.663(a)-2 would preclude an IRC §661(a) deduction, but whether an IRC §642(c) set-aside deduction would be available for amounts of income distributed by an estate to a CRAT.
The IRS's ruling was that it would not be, because of the possibility that corpus would be invaded after full funding of the CRAT, to make the deferred annuity payments not made or otherwise provided for by the estate.27
In thus denying the IRC §642(c) deduction because of that possibility of invasion, the IRS added, "Amounts distributed by the estate that do not qualify for the set aside deduction because of the possibility of invasion are treated under Sections 661 and 662 of the Code."
Although Treas. Regs. §1.663(a)-2 was not specifically addressed in the letter ruling, and although no further analysis was offered, this ruling does indicate once more that the IRS does not intend to follow the Mott interpretation of the language of that Section of the Regulations. Reading the ruling literally, the IRS's criterion for determining the availability of the IRC §661(a) deduction is not whether or not the amounts distributed are actually "set aside," but whether or not the amounts "qualify" for the IRC §642(c) deduction.
These releases confirm the IRS's position that amounts of gross income that are paid pursuant to the governing instrument, but cannot be deemed exclusively devoted to charitable purposes, thus meeting two, but not three, of the elements of IRC §642(c) and thereby not qualifying under that section, are deductible under IRC §661(a), in spite of Treas. Regs. §1.663(a)-2.
Inclusion Of Capital Gains In DNI
Limitation of DNI. Even if Treas. Regs. §1.663(a)-2 does not apply to distributions to a CRT, with the result that an IRC §661(a) deduction is allowable, the only amounts of income distributed to the CRT that actually will be deductible by the post-mortem entity under IRC §661(a) are those that are included in the entity's distributable net income for the taxable year of distribution.
This limitation on deductions appears in the flush language of IRC §661(a): "[B]ut such [distributions] deduction shall not exceed the distributable net income of the estate or trust."
As a result, amounts distributed to the CRT will be deductible under IRC §661(a) only to the extent they are included in the post-mortem entity's DNI for the year of distribution. Any amounts distributed to the CRT that do not enter into the entity's DNI will be taxed to the entity, not to the tax-exempt CRT.
IRC §643(a) defines DNI as the entity's taxable income, with certain modifications, including the addition of tax-exempt income and the exclusion, in most circumstances, of capital gains.28 Thus, when distributions of ordinary income are made from the post-mortem entity to the CRT, the amount of that ordinary income should be included in the entity's DNI.
Because capital gains are usually excluded from the entity's DNI, however, even if they are distributed to the CRT, they will not necessarily qualify for the IRC §661(a) deduction.
Treas. Regs. §1.643(a)-3(a). Section 643(a)(3) excludes capital gains from DNI "to the extent they are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (B) paid, permanently set aside, or to be used for the purposes specified in Section 642(c)." Treas. Reg. §1.643(a)-3(a) sets forth the specific circumstances under which capital gains are included in DNI. The gains must be:
- Allocated to income under the terms of the governing instrument or local law by the fiduciary on its books or by notice to the beneficiary,
- allocated to corpus and actually distributed to beneficiaries during the taxable year, or
- utilized (pursuant to the terms of the governing instrument or the practice followed by the fiduciary) in determining the amount that is distributed or required to be distributed.
However, if capital gains are paid, permanently set aside, or to be used for the purposes specified in Section 642(c), so that a charitable deduction is allowed under that Section in respect of the gains, they must be included in the computation of distributable net income.
Allocated to corpus. The most appropriate of these would appear to be Subsection (2), "allocated to corpus and actually distributed to beneficiaries during the taxable year." Although this phrase seems clear on the surface, however, the IRS has embellished it by ruling that for capital gains to be included in DNI under this subsection, they must be not only "actually distributed," but also distributed in "a distribution required by the terms of the governing instrument upon the happening of a specified event."29
Query: Where the testamentary vehicle is a revocable living trust the terms of which mandate distribution upon the settlor's death, could that death constitute the "specified event" necessary to have distributed capital gains included in DNI?
Inapplicable Subsections. The situations described in Subsection (3) i.e., establishing a "practice" of allocating gains to income and the flush language of Treas. Regs. §1.643(a)-3(a) are not likely to apply in the context of post-mortem administration.
Only in unusual circumstances is the instrument governing post-mortem administration likely to provide any situation in which capital gains are to be utilized in calculating required distributions.30 Even if this provision applied to the sale of a particular asset, however, it seems that it would result in increased income for the beneficiary, but not necessarily in the allocation to income of all of the capital gains.
With respect to "the practice followed by the fiduciary," the IRS has ruled privately in this context that "for an act to be carried out pursuant to a practice, the act must be performed in a consistent, repeated fashion."31 Clearly, this Subsection will be of no help with respect to the first year in which capital gains are realized, and, in fact, the IRS maintains that such a "practice" cannot be established in the first year of post-mortem administration.32 The IRS has also suggested that no estate can ever establish such a practice because of its short duration.33 Presumably it would take the same position with regard to an electing or non-electing post-mortem administrative trust.
The flush language of the Regulation includes capital gains in DNI if they were allowed as a charitable deduction under IRC §642(c), in order to ensure that distributions to both charitable and noncharitable beneficiaries reflect the proportionate character of the distributing entity's DNI. As noted earlier, if the gains were deductible under IRC §642(c), which they should not be when distributed to a split-interest trust, no IRC §661(a) deduction would be allowed, and the includibility of the gains in DNI would not be an issue.
Termination of the post-mortem entity. Example 4 of Treas. Regs. §1.643(a)-3(d) provides clearly that "all capital gains realized in the year of termination will be included in distributable net income." Thus, when faced with realized capital gains for which an IRC §661(a) distributions deduction is desirable, consider terminating the post-mortem entity in the year such gains were realized.
Reasonable reserve. Treas. Regs. §1.641(b)-3(a) and 1.641(b)-3(b) deem post-mortem entities terminated "when all the assets have been distributed except for a reasonable amount that is set aside in good faith for the payment of unascertained or contingent liabilities and expenses (not including a claim by a beneficiary in the capacity of beneficiary)." However, there is some basis for concern that if a trust retains a reserve large enough to cover potential additional taxes, the IRS may assert that it has not terminated.
Post-funding recovery from CRT. A logical alternative to a reserve would be to have the beneficiaries be responsible for paying such contingent, post-termination liabilities, and expenses. Under the theory of transferee liability, each distributee is liable for the entire amount of estate tax due, at least up to the value of the property distributed to such beneficiary.34 Noncharitable beneficiaries of the post-mortem should be willing to pay, personally, any additional estate taxes and expenses that become due after final distribution and termination of the entity, but there appears to be an issue whether post-termination payments by the CRT might disqualify it as a charitable remainder trust.
If this is the IRS's position, it seems extreme, and one cannot help wondering whether a testamentary CRT that incurred transferee liability for a post-termination estate tax adjustment, deviating from the estate tax return as filed, would really lose in court if the IRS tried to disqualify it for this reason. In Ltr. Rul. 8003153, the IRS ruled that the proposed return to the estate by a testamentary CRT of an "over-distribution" to enable the estate to pay estate taxes and administration expenses, as well as cash bequests, would not be an act of self-dealing under IRC §4941 or a taxable expenditure under IRC §4945. The ruling says nothing about disqualification of the CRT as a result of its reimbursing the estate for the over distribution. However, the ruling obtained would probably have been a Pyrrhic victory if the CRT was to be disqualified, and it seems unlikely that the IRS simply missed the issue.
Use of two entities. Not infrequently, a post-mortem administration may involve both an estate and a revocable trust. In that situation, if the revocable trust has not made the §645 election to be treated as part of the estate, it may be possible to terminate the entity that realized the capital gains and let the other entity handle any subsequent issues and expenses that arise. The tax clauses typically included in a pour-over will and a revocable trust usually provide sufficient fiduciary discretion to shift funds, if necessary, from the entity being terminated to the other to cover possible future tax liabilities.
Allocated to income. From a planning perspective, it may be advisable, when a CRT is a residuary beneficiary, to grant the fiduciary power to allocate capital gains to income to enable these gains to be included in computing DNI under Treas. Regs. §1.643(a)-3(1).
In the absence of a contrary provision in the governing instrument, allocation of receipts will be governed by state law, which usually allocates capital gains to principal rather than to income. This is the case under the Revised Uniform Principal and Income Act. If this is the applicable law and the governing instrument does not override it, the fiduciary may not allocate capital gains to income during post-mortem administration. Therefore, consider whether it is desirable to give the fiduciary discretion to allocate capital gains to income.
Advance Payments of Annuity or Unitrust Amounts During Post-Mortem Administration
Mandatory deferral provision. Treas. Regs. §1.664-1(a)(5)(i) provides that, for purposes of IRC §2055, a testamentary CRT is deemed to be created as of the date of death of the decedent, even though the trust is not yet funded and even though no payments will be made by the trust until the end of a reasonable period of estate administration. This rule allows a deferral in commencement of the annuity or unitrust payments until the CRT is fully funded, provided the obligation to pay begins at death and either local law or the governing instrument authorizes the delay.35
To satisfy that obligation to pay, which begins at death, most instruments permit advance payments of the annuity or unitrust amounts to be made to the noncharitable beneficiaries of the CRT by the post-mortem entity before the CRT is funded.
All instruments creating a testamentary CRT must also permit deferral of those payments until after the CRT is fully funded. Although the language of the Regulations suggests such a deferral provision is optional, the IRS made it clear in Rev. Rul. 80-123 that the provision is mandatory if the unitrust is to qualify under §2055 and 664. Also, Rev. Procs. 90-30, 1990-1 C.B. 534, 90-31, 1990-1 C.B. 539, and 90-32, 1990-1 C.B. 546 incorporate such a provision in each sample testamentary CRT instrument.
Thus, assuming the post-mortem entity is authorized, but not required to make the annuity or unitrust payments to the CRT's noncharitable beneficiaries before the CRT is fully funded, the issue is whether it should do so.
Considerations. The anticipated length and complexity of post-mortem administration, the particular assets held in the post-mortem entity (including their income-producing potential and plans for their sale by the CRT), and the needs of the noncharitable beneficiaries (as well as the grantor's intent to satisfy those needs), are among the factors to be considered.
Disclaimers. In any event, no advance payments should be made at least until nine months after death, unless the noncharitable beneficiaries of the CRT irrevocably relinquish their right to disclaim a portion of their income interests. A qualified disclaimer requires that the disclaimant not have accepted any benefits of the disclaimed interest.36 If the noncharitable beneficiaries of the CRT had already received annuity or unitrust payments, a subsequent disclaimer would not be qualified because of their prior acceptance of the payments.
Taxation of advance payments. The Regulations on the subject specify that such advance payments made by the post-mortem entity are to be taxed under the ordinary rules of Subchapter J, and not under the tier system of IRC §664(b).
Nevertheless, in GCM 39707 and the resulting TAM 8810006, the IRS commented that because the payments received by the income beneficiary discharge the legal obligation of the CRT to make those payments, even when paid by the estate, those payments "are governed by the character presumptions set forth in Section 664(b)" (the tier system) rather than by the conduit principles of Subchapter J. The tax treatment of those advance payments was not an issue in the TAM, but this conclusion by the IRS is nevertheless significant because it is directly contrary to that expressed in the Regulations.
Advantages. Assuming these payments made by the post-mortem entity are taxed under the rules of Subchapter J other than IRC §664, making such payments prior to the full funding of the CRT can be advantageous.
Post-funding "settle-up." Whether or not the post-mortem entity makes annuity or unitrust payments to the CRT's noncharitable beneficiaries, unless every dollar due them is paid during post-mortem administration, some amount of "settling up" will be required after the CRT is fully funded. The formula provided in the Regulations for calculating the deferred unitrust payments due after full funding may not be appropriate where the CRT is an income-only CRUT, however. Although the challenge of how to "settle up" will face the trustee of the income-only CRUT rather than the fiduciary of the post-mortem entity, it is worth addressing here briefly.
Treas. Regs. §1.664-1(a)(5) provides two formulae for this purpose. The first, Treas. Regs §1.664-1(a)(5)(i), is the "settle-up" requirement itself, which is a governing instrument requirement.
The Regulation states that these "amounts payable" of Treas. Regs. §1.664-1(a)(5)(i)(b) shall be retroactively determined by using the taxable year, valuation method, and valuation dates that are ultimately adopted by the charitable remainder trust. Treas. Regs. §1.664-1(a)(5)(ii) then offers a formula, based on the amount ultimately received by the CRUT, which "may" be included in the governing instrument of a unitrust for such retroactive determination of the Treas. Regs. §1.664-1(a)(5)(i)(b) "amounts payable."
Is the Treas. Regs. §1.664-1(a)(5)(ii) formula mandatory? Apparently not.
This formula of Treas. Regs. §1.664-1(a)(5)(ii) arguably may not be appropriate for income-only CRUTs, because it does not take into account the fact that the "amounts" actually "payable" by an income-only CRUT will not necessarily be those determined by the percentage payout rate specified in the instrument.
Arguably, for an income-only CRUT funded with a specific or a residuary bequest, a calculation should be made, not only of the amounts payable under the percentage payout rate (presumably by use of the Treas. Regs. §1.664-1(a)(5)(ii) formula), but also of what might be termed the "surrogate income" attributable to the CRUT's assets during the pre-funding period. (Where the CRUT includes a "make-up" provision, the calculations might also have to take into account years in which the "surrogate income" exceeds the percentage payout rate.) The lesser of that "surrogate income" or the result under the formula then would be used as the "amounts payable" for purposes of Treas. Regs. §1.664-1(a)(5)(i)(b).
The alternative to calculating "surrogate income" would be to ignore the income-only limitation and determine the "amounts payable" of Treas. Regs. §1.664-1(a)(5)(i)(b) simply on the basis of the percentage payout rates under the formula of Treas. Regs. §1.664-1(a)(5)(ii), so that the unitrust amount beginning at death would be the specified percentage of the value of the later-funded CRUT. This would effectively ignore the income-only feature of the unitrust. The analysis of Rev. Rul. 80-123 suggests that this is the correct procedure.
If the CRUT's income-only feature is ignored, consider the possible objections of the charitable remainderman when the CRUT is not funded for several years, the specified payout rate is high, the actual income earned during administration is low, and there is no requirement of a "make-up."
Even though the formula is not mandatory, when incorporated in the governing instrument, it appears to provide a safe harbor that justifies not calculating any "surrogate income" during the period of administration. It would seem that the formula may be relied upon even though it does not take into consideration the unique situation of the income-only CRUT.
The Treas. Regs. §1.664-1(a)(5)(i) requirement that interest be paid on deferred unitrust amounts also may have an unanticipated effect on income-only CRUTs unless the settle-up formula (ignoring actual income during administration) governs the amount due the income beneficiary. Under the Revised Uniform Principal and Income Act, interest paid by the trustee is chargeable to income. As a result, any interest paid by the CRUT to the noncharitable beneficiaries on deferred unitrust payments would reduce the net income of the CRUT.
Assets used to fund an inter vivos CRT are specifically selected for that purpose. Those available to fund a testamentary residuary CRT, on the other hand, may include assets that are not suitable for such purpose. Whenever the CRT is a residuary beneficiary, the assets comprising the residue must be scrutinized early in the administration of the post-mortem entity to identify those, if any, which should not be distributed to the CRT and to determine how to deal with them.
Assets that produce income in respect of a decedent (IRD) may be more valuable to the CRT than to other beneficiaries if the tax-exempt status of the CRT shelters the IRD.
Undivided interests in property that, if distributed to the CRT, would result in the CRT's being a co-owner with a disqualified person, as defined under IRC §4946(a), present self-dealing issues.
Closely held business interests that would be held by the CRT and disqualified persons can present ongoing opportunities for self-dealing. Before distributing such an interest to the CRT, the fiduciary should try to anticipate possible future transactions that might be necessary or desirable from a business standpoint but might run afoul of IRC §4941.
Illiquid assets may need to be sold to generate cash to pay death taxes. Often, however, the only realistic buyer will be a disqualified person.
Absent very unusual circumstances, assets that if held by the CRT would produce unrelated business taxable income to the CRT need to be disposed of or diverted to other beneficiaries.
The solution to these potential problems (or opportunities) is frequently a non-pro rata distribution. However, that in itself could be an indirect act of self-dealing if disqualified persons are also affected. Alternatively, although a sale by the post-mortem entity to a third party who is not a disqualified person might avoid self-dealing, such a sale could result in the realization of capital gains, with the resulting income tax problems. The following portions expand on some of these challenges.
Avoiding Unrelated Business Taxable Income In The Charitable Remainder Trust
Review of assets. As noted at the outset, unless the anticipated term of the trust is relatively short, the most important and attractive long-term feature of the CRT from the standpoint of its creator and income beneficiary may be its exemption from income tax. That exemption is lost, however, in any taxable year in which it has any unrelated business taxable income within the meaning of IRC §512, determined as if the unrelated business income tax applied to a CRT.37
No UBTI received from entity. Fortunately, it appears that the receipt by the post-mortem entity of income that would be UBTI if received by an exempt organization does not result in the CRT's having UBTI.
Loss of exemption. There may be situations in which the temporary loss of the CRT's exempt status in the year in which it is funded by a post-mortem entity will not have a devastating financial impact, e.g., if the CRT will retain little or no ordinary income or capital gain. The IRC §1014 step-up of basis to the fair market value of the property at the date of the decedent's death may avoid the sting of taxation of capital gains to the CRT if it plans to sell the property promptly and there has been no post-mortem gain. And if the distributions to the income beneficiary will carry out all CRT income in a given year, exemption will be immaterial.
UBTI. A thorough discussion of UBTI is well beyond the scope of this article, but a brief overview of the definition of UBTI and the exceptions to that definition will be useful to illustrate and to sensitize the advisor to the likely post-mortem administration issues.
UBTI is defined as the gross income, less allowable deductions, derived by any organization from any unrelated trade or business regularly carried on by it, with certain modifications.38
As long as the CRT is not itself carrying on the business activity, but rather is a passive holder of an ownership interest, the exceptions (modifications) almost overcome the rule. They provide generally that interest, dividends, rent, royalties, and capital gains (passive income) are not UBTI.39
Debt-financed property, however, presents a major exception to the modifications. If the underlying property is debt-financed, the income from it will be taxable, at least in part, even if it is passive income.40
Section 514(b)(1) defines "debt-financed" property as property held to produce income with respect to which there is "acquisition indebtedness" at any time during the taxable year or, in the case of capital gains, at any time during the preceding 12 months.
"Acquisition indebtedness" is debt incurred by the organization in acquiring or improving the property; "but for" debt incurred before such acquisition or improvement; or "but for" debt incurred after acquisition or improvement that was reasonably foreseeable.41 It can also include pre-existing debt on property transferred to the organization, even though the organization does not assume or agree to pay it, with limited exceptions for "old" debt.42
Fortunately, the indebtedness on mortgaged property distributed to a CRT on death is not treated as acquisition indebtedness for a period of 10 years following the date of distribution.43 However, to qualify for this grace period, the CRT cannot assume and agree to pay the debt.44
Yet, this is not the end of the inquiry. The CRT must have an exit strategy to retire the debt or dispose of the asset within the grace period.
Moreover, the fiduciary must also peer into the future to determine the likelihood that the CRT will need to increase the amount of debt. Although the Code provides that extending, renewing, or refinancing a pre-existing debt is not treated as creating new debt,45 any foreseeable increase in the amount of debt is likely to be treated as acquisition indebtedness.46
If clear sailing in these areas is not a near certainty, the fiduciary should consider disposing of, or diverting the mortgaged property to, other beneficiaries during administration. As noted above, this may leave the fiduciary with the unattractive alternatives of realizing capital gains in the entity, or risking self-dealing.
Partnerships. Interests in partnerships engaged in activities that would be unrelated trades or businesses if conducted by an exempt organization, or that have income that would be debt-financed income to an exempt organization, need to be considered carefully and possibly disposed of, or diverted to, other beneficiaries during post-mortem administration. The income from such partnerships will be UBTI to the CRT.47
Self-Dealing Issues Arising During Post-Mortem Administration
As noted above, the post-mortem entity often will hold assets that are inappropriate for retention by the CRT. The solution will usually be a non-pro rata distribution or a sale during administration. Frequently, however, the other affected parties will be disqualified persons with respect to the CRT, raising the specter of self-dealing.
Section 4941. The CRT is subject to IRC §4941, penalizing self-dealing transactions with disqualified persons, just as though it were a private foundation.48
Disqualified persons. Under IRC §4946, "disqualified persons" (DPs) include:
- The decedent;
- trustees of the CRT;
- a member of the family of either of the above (defined as a spouse, ancestor, child, grandchild, or great grandchild, or a spouse of a child, grandchild, or great grandchild);
- a corporation in which persons described above hold more than 35% of the voting stock;
- a partnership in which persons described above hold more than 35% of the profits interest;
- a trust or estate in which persons described above holds more that 35% of the beneficial interest. (Thus, it appears that the post-mortem entity itself can be a DP.)
Prohibited transactions. Prohibited self-dealing transactions between a CRT and a DP include, among other things, direct or indirect sales, exchanges, leases, or loans.49 Also prohibited are the furnishing of goods, services or facilities to, or payment of compensation to a disqualified person.50 Any transfer to, or use by, or for the benefit of, a DP of the income or assets of the CRT is also prohibited.51 The "reasonableness" of the transaction is generally not relevant; the prohibition is against doing the act at all, not just unreasonably. (Limited exceptions to some of these rules are provided, but a detailed discussion of the exceptions is beyond the scope of this article except as addressed below. Moreover, most of the exceptions would not be likely to come into play in the context of a CRT.)
Indirect self-dealing. Situations in which self-dealing may arise are much more likely to arise in the testamentary context than when a lifetime gift of specific assets is being made.
Because the expectancy interest of the CRT in the post-mortem entity is treated as an asset of the CRT, any transaction between the entity and a DP with respect to property held in the entity may constitute an act of self-dealing.52
If the gift is all, or a portion of, the residue, and, as is often the case: 1) other residuary beneficiaries are DPs; and/or 2) DPs are co-owners of certain assets, self-dealing is almost inherent in the situation. While transactions directly between DPs and the CRT may be easily avoided, indirect transactions occurring within the post-mortem entity, or between the entity and the DPs, and CRT may be unavoidable.
"Safe harbor" of Treas. Regs. §53.4941-(d)-1(b)(3). These transactions, even if beneficial to the CRT, risk being considered indirect self-dealing, unless the testamentary indirect self-dealing "safe harbor" provisions of Treas. Reg. §53.4941(d)-1(b)(3) are satisfied.
Note that although Treas. Regs. §53.4947-1(c)(6)(ii) and (iii) prevent the application of the self-dealing rules to the post-mortem entity, those rules nevertheless apply to the testamentary CRT, which is deemed created as of the decedent's death. Thus the safe harbor is needed to exempt transactions occurring during administration from being deemed acts of indirect self-dealing by the CRT.
Note also that this safe harbor is available only for transactions that might be indirect (not direct) self-dealing.
Treas. Regs. §53.4941(d)-1(b)(3) provides:
"The term indirect self-dealing shall not include a transaction with respect to a private foundation's interest or expectancy in property held by an estate (or revocable trust, including a trust that has become irrevocable on a grantor's death), regardless of when title to the property vests under local law, if
- The administrator or executor of an estate or trustee of a revocable trust either
- Possesses a power of sale with respect to the property,
- Has the power to reallocate the property to another beneficiary, or
- Is required to sell the property under the terms of any option subject to which the property was acquired by the estate (or revocable trust);
- Such transaction is approved by the probate court having jurisdiction over the estate (or by another court having jurisdiction over the estate (or trust) or over the private foundation);
- Such transaction occurs before the estate is considered terminated for Federal income tax purposes pursuant to paragraph (a) of IRC §1.641(b)-3 of this chapter (or in the case of a revocable trust, before it is considered subject to Section 4947);
- The estate (or trust) receives an amount that equals or exceeds the fair market value of the foundation's interest or expectancy in such property at the time of the transaction, taking into account the terms of any option subject to which the property was acquired by the estate (or trust); and
With respect to transactions occurring after April 16, 1973, the transaction either,
Results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up,
Results in the foundation receiving an asset related to the active carrying out of its exempt purposes, or
Is required under the terms of any option that is binding on the estate (or trust)."
Among the transactions often encountered in post-mortem administration that can present self-dealing issues are business reorganizations, borrowing from, or selling assets to, related parties to raise money to pay death taxes, and the disposition of property leased to, or of promissory notes, from related parties.53 Fortunately, it appears that as long as its criteria can be met, the indirect self-dealing safe harbor of Treas. Reg. §53.4941(d)-1(b)(3) can be invoked with respect to these transactions. The safe harbor should also be available to protect non-pro rata distributions of a residue to a CRT and another beneficiary that is a DP.
Ironically, making a non-pro rata distribution may be necessary to avoid self-dealing that would otherwise occur or to avoid giving a CRT an asset that would cause it to have unrelated business taxable income, which could cost it its exempt status.
The IRS has taken the position that the mere holding of undivided interests in indivisible property (e.g., real estate, art) by a CRT, or private foundation and a DP, is not self-dealing per se, but that any use of the property by the DP is self-dealing.54 Ordinarily, this would mean that a pro-rata distribution of such property to a CRT and a DP must be avoided. Solutions include selling the property or allocating the entire property to the share of either the DP or the CRT. (Alternatively, it may be possible to form a partnership to co-own investment assets.)55
If, for example, the post-mortem entity holds a partnership interest that would generate UBTI in the hands of a tax-exempt entity and the interest cannot be sold (or the beneficiaries do not wish to have it sold) during administration, the CRT's interest will need to be exchanged during administration for other assets of equal value.
Elements (i) through (iv) of the safe harbor should be readily satisfied. Subsection (v)(b) is inapplicable and Subsection (v)(c) is rarely applicable. Subsection (v)(a) requires that the CRT receive as liquid an interest as it would have given up. It is possible that this fifth element of the safe harbor might not be satisfied in a non-pro rata distribution of assets, depending on which assets were distributed to each of the beneficiaries. Each case will have to be examined carefully. (The IRS has ruled that a note secured by real estate is more liquid than the real estate itself.)56
Fiduciaries will find it beneficial to obtain court approval of their administration of the post-mortem entity (thus satisfying element (ii) of the safe harbor) whenever a CRT and one or more DPs share the residue and, if the CRT receives a specific bequest, at least of specific transactions affecting the interests of both a CRT and one or more DPs. One of the purposes of a revocable trust is to avoid Probate Court, of course, but in this situation resorting to the court will be necessary.
The safe harbor as a tool. It is possible that the indirect self-dealing harbor of Treas. Regs. §53.4941(d)-1(b)(3) can be a useful tool in post-mortem estate planning. For example, it may be possible to effect a freeze of sorts by selling the CRT's undivided interest in real estate or a closely held business in return for cash and/or a promissory note. While this would be prohibited after distribution, it may be quite possible during administration, provided the safe harbor requirements are satisfied.
The Service has ruled privately that the continued holding of a DP's note created in this manner and distributed to a CRT during administration and blessed by the court is not an act of self-dealing.57
This opportunity could be a trap, however. It is important to anticipate situations that may arise as a result of a permitted relationship between a CRT and a DP that later may depart from the protection originally obtained. For example, if the CRT receives the note of a DP, consider the consequences if the DP cannot pay exactly in accordance with its terms or the parties want to modify or extend the note. Almost any action other than payment of the note in accordance with its terms would be a self-dealing transaction with no safe harbor available to save it.
Estate Tax Issues
Interrelated computations of estate tax. If the charitable remainder trust has a taxable income beneficiary, i.e., anyone other than a surviving spouse, and if the trust is funded with a residuary bequest, the determination of the amount of estate tax attributable to the bequest and the charitable deduction allowable with respect to the present value of the remainder interest will be interrelated. The fact that the estate tax is payable out of the residue diminishes the residue, which in turn diminishes the bequest to the CRT, which reduces the charitable deduction, which increases the tax and the loop starts again. Finding the point of equilibrium used to require either trial and error computations or the use of simultaneous quadratic equations known as the "Greeley Formula." Fortunately, modern technology, in the form of spreadsheets or specialized programs, has eliminated these time-consuming methods.
Effective deduction reduced for residuary CRT bequests. The effect of the interrelated computation on a residuary CRT bequest is to reduce the amount of the charitable deduction from that which would seem allowable at first blush. The amount of the reduction would be determined by the applicable estate tax rate.
Apportionment of estate tax liability between CRT and fully taxable co-beneficiary of the residue. Different approaches are arguably possible to determine the respective portions of the estate tax to be apportioned to the respective fractional shares of the residue bequeathed to a CRT and a fully taxable beneficiary. The most logical would seem to be to allocate the tax payable from the residue in proportion to the respective contributions to the taxable estate of the two bequests. For example, if the residue were allocated equally between a child and a CRT for another person, somewhat more than 50% of the tax would be allocable to the child and less than 50% would be allocable to the CRT.
Preliminary distributions: effect of non-pro rata distributions to residuary CRT and non-CRT beneficiaries. When a CRT and a fully taxable beneficiary, or a fully deductible beneficiary, share the residue, non-pro rata preliminary distributions to beneficiaries present several issues. The fractional share of the residue, after the effect of allocation of estate taxes, will shift with each distribution, which will require a revaluation of the assets each time. Ordinarily this drawback will be sufficiently serious to militate against non-pro rata preliminary distributions.
Miscellaneous Points To Consider
Includible portion of inter vivos CRT includible in the taxable estate of the decedent. When the decedent has established an inter vivos CRUT and retained a life interest, the corpus of the trust is includible in his taxable estate under IRC §2036. Not all of the corpus may be includible, however, if the decedent is not deemed to have retained the right to the entire income from the corpus. The includible portion will be a function of the applicable federal rate and the adjusted payout rate of the CRUT.58
Disclaimers to private foundations. Since there is no difference in the estate tax deduction for gifts to public charities and private foundations, it is not uncommon for the remainder beneficiary of a CRT to be a private foundation. Nor is it uncommon for the planning to include the possibility that the income beneficiary of the CRT may decide to disclaim a portion of his or her interest in the CRT bequest, causing the corresponding portion of the bequest to convert to an outright, fully deductible bequest to the foundation. Frequently the disclaimant is also an office and/or director of the foundation. Under these circumstances, the Service has ruled that for the disclaimer to be effective, the disclaimant must not have the ability to control the use of the funds in the hands of the ultimate recipient. Therefore, it has required that the foundation hold the disclaimed funds in a separate account over which the disclaimant can exercise no influence, even though the funds can only be used exclusively for charitable purposes.59 While this seems like an excessively broad interpretation of the disclaimer Regulations, prudence dictates compliance.
Because of the tax-exempt status of the CRT, a major objective of post-mortem administration is to have income earned during administration taxed to the beneficiaries, including the CRT, rather than to the entity. The first challenge is determining whether distributions of such income to the CRT qualify for the IRC §642(c) charitable deduction. Primarily because any amounts either paid to, or set aside for, a CRT are not "devoted" to charitable use until the end of the CRT term, even in the case of an income-only CRUT, no such deduction should be available. Although the IRS's practice is not entirely clear, in recent rulings it has recognized that, logically, the IRC §642(c) deduction should not be allowed for distributions to CRTs.
The same rulings confirm that the IRC §661(a) distributions deduction should be available, notwithstanding Mott v. U.S. The next challenge, then, is ensuring that distributed capital gains as well as ordinary income are included in the entity's DNI under one subsection or another of Treas. Regs. §1.643(a)-3(a). According to Revenue Ruling 68-392, an "actual distribution" must be one required "upon the happening of a specified event." Other feasible approaches include terminating the entity in the year the gains were recognized (while providing for payment of post-termination liabilities), or granting the fiduciary discretion to allocate capital gains to income.
A number of issues arise with respect to payment of the annuity or unitrust amounts by the post-mortem entity prior to the funding of the CRT. These include whether or not to make such "advance payments," their tax treatment, and proper application of the "settle-up" provisions of Treas. Regs. §1.664-1(a)(5), especially in the context of income-only CRUTs.
Dealing with the assets held in the post-mortem entity that are available for distribution, but that may not be suitable for holding by the CRT, presents additional challenges. Such assets must be redirected away from the CRT, often in order to avoid UBTI, without involving the CRT in self-dealing unless the safe harbor of Treas. Regs. 53.4941(d)-1(b)(3) can be invoked.
In summary, testamentary CRTs can be a valuable part of an estate plan, as long as the planner and the fiduciary anticipate the opportunities and challenges that arise during post-mortem administration.
However, neither fiduciaries nor their attorneys are likely to be familiar with the unique issues and opportunities arising during post-mortem administration of a bequest to a CRT. Therefore, it would often behoove the charitable remainderman to have qualified legal counsel monitor the administration carefully and actively protect its own interests.
Note the need to conform to the self-dealing rules of IRC §4941.back
See, e.g., "Using an IRA for Charitable Giving," Mezzullo, 41 Probate and Property, March/April 1995, 44, and, generally, "Charitable Remainder Trusts and Charitable Lead Trusts," Frimmer, Program Notes, ALI-ABA Advanced Estate Planning Techniques, 1994, 49 et seq.back
IRC §4947(a)(2) and §4947(b)(3)(B)back
Note that the California Uniform Principal and Income Act, which replaces the California Revised Uniform Principal and Income Act on January 1, 2000, modifies certain of these provisions.back
Cal. Prob. Code §2002(b), 16314back
Cal. Prob. Code §2003, 12006, 16314back
Treas. Regs. §661(a)-2(f)(1)back
Cal. Prob. Code §2006 and 16305(a)back
Non-electing is used to refer to an administrative trust that has not made the IRC §45 election or as to which the election is no longer in effect; an "electing" trust is one that is treated like an estate for income tax purposes.back
See, e.g., "Income Taxation of Charitable Remainder Trusts and Decedents' Estates: Sixty-Six Years of Astigmatism," Schmolka, 40 Tax Law Review 1, 204-207, Fall 1984.back
See, e.g., GCM 39249 (1984), Ltr. Rul. 8341001, Rev. Proc. 95-3, 1995-1 I.R.B. 85, IRC §3.01(34), and Deferred Giving, Teitell, §1.06[D].back
Treas. Regs. §1.664-4back
For a thorough and persuasive critique of these and other anomalies involved in IRC §42(c) and 664, see "Income Taxation of Charitable Remainder Trusts and Estates: Sixty-Six Years of Astigmatism," Schmolka, 40 Tax Law Review 1, 1984.back
S. Rep. No. 1622, 83d Cong., 2d Sess. 354 (1954). See also H.R. Rep. No. 1337, 83d Cong., 2d Sess., A205 (1954). See further United California Bank v. U.S., 439 U.S. 180, 183 (1978), and Statler Trust v. Com'r., 361 F.2d 128, 132 (2nd Cir. 1966).back
See Judge Sterrett's dissent in O'Connor. See also Rev. Rul. 68-667, 1968-2 C.B. 289, denying the IRC §661(a) deduction, without discussion, where the distributions did not qualify under IRC §542(c) because they were made from corpus rather than from income.back
See, for instance, Federal Income Taxation of Estates, Trusts, and Beneficiaries, Ferguson, Freeland and Ascher, 2d. ed., at IRC §5.10, and "Tax Planning for Sophisticated Charitable Transfers: The Divide Between Downright Doable and Dangerous," Baetz, 62 Taxes, The Tax Magazine, December 1984, 996, 999.back
Treas. Regs. §1.664-1(a)(5)(i)back
IRC §643(a)(5), (3)back
Rev. Rul. 68-392, 1968-2 C.B. 284back
The Revised Uniform Principal and Income Act does; see, e.g., Cal. Prob. Code §6311, providing for a portion of the proceeds of sale of under-productive property to be treated as delayed income to be distributed to the income beneficiary. (But note that the California Revised Uniform Principal and Income Act is to be replaced by the California Uniform Principal and Income Act effective January 1, 2000.)back
Ltr. Rul. 8506005back
Rev. Rul. 68-392, supra; Ltr. Rul. 8324002back
Ltr. Rul. 8105028back
IRC §6324(a)(2); Com'r. v. Baptiste, No. 94-852, S. Ct., cert. denied, February 27, 1995back
Rev. Rul. 80-123, 1980-1 C.B. 205back
IRC §2518(b)(3); Treas. Regs. §25.2518-2(d)(1)back
IRC §512(b) (1), (2), (3) and (5)back
Treas. Regs. §1.514(c)-1(c)back
IRC §4947(a)(2). Note that IRC §4947(a) also subjects the CRT to the taxable expenditures tax of IRC §4945. This should not cause a problem, however, because the CRT is already prohibited from making payments to any person other than the noncharitable beneficiary under IRC §664(d).back
IRC §4941(d)(1)(A) and (B)back
IRC §4941(d)(1)(C) and (D)back
Reis v. Com'r., 87 T.C. 1016, 1021-23 (1986)back
For a celebrated illustration, see Rockefeller v. U. S., 572 F.Supp. 9 (E.D. Ark. 1982), aff'd., 718 F.2d 290 (8th Cir. 1983), cert. denied, 466 U.S. 962 (1984).back
GCM 39770 and Ltr. Rul. 8842045 (art collection); Ltr. Rul. 9114025back
See Ltr. Rul. 9114025 and "A Limited Partnership Can Ease Real Estate Problems for Private Foundations," Vandeveer, 6 Journal of Taxation of Exempt Organizations 10, July/Aug. 1994back
Ltr. Rul. 9320041back
Ltr. Ruls. 9501038, 9434042 and 9320041back
Rev. Rul. 76-273, 1976-2 C.B. 268back
Ltr. Rul. 9235022back