What if the Estate Tax Is Repealed? - Part II

What if the Estate Tax Is Repealed? - Part II

The Charitable Planner Looks at 2010 and the Interim
Article posted in Transfer Taxes on 24 June 2003| comments
audience: National Publication | last updated: 16 September 2012
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Summary

In part one of this article, Michael Pusey, CPA speculated that estate tax repeal could have the inadvertent affect of disqualifying testamentary CRTs and additions to them. In part two, he roles up his sleeves to discuss in detail the technical issues and current IRS positions that will need to be addressed to resolve this problem.

by J. Michael Pusey, CPA

Editor's Note: Click here to read Part I of this article.

In Part I of this article, we stated that the repeal of the estate tax could have the inadvertent result of "disqualifying" testamentary charitable remainder trusts (CRTs), and possibly testamentary additions to inter vivos charitable remainder unitrusts (CRUTs).

No Deduction, No Trust?

A qualified CRT under Sec. 664 is "a trust with respect to which a deduction is allowable under section 170, 2055, 2106, or 2522..." and which otherwise satisfies the definition of a CRAT or CRUT.1

A testamentary transfer to a CRT would not sustain a deduction under any of these Code provisions if the estate tax were repealed. What if the decedent died in the last year there was an estate tax but the testamentary CRT is funded in a year when there is no estate tax? The regulations provide that for purposes of the estate tax charitable deduction, the CRT is normally "deemed" to be created at death.2 For income tax purposes, the trust doesn't come into existence until it is at least partially funded (and the grantor trust rules don't apply).3

So for purposes of worrying about whether you have a qualified testamentary CRT, the focus is on whether the individual dies in a year in which there is an estate tax.

What if the individual dies after the repeal of the estate tax but there are no testamentary transfers? Assume the donor is the only income recipient of an inter vivos CRUT or CRAT. While the estate tax is in place, the CRT's assets are to some degree included in the estate but offset by the estate tax charitable deduction.4 It is possible for less than 100% of the trust to be included depending on the relationship of the income interest and the IRS interest rates. Sec. 2038 may also apply.

After the repeal of the estate tax, there are no "string provisions" to pull assets into the estate. So the answer would appear to be that there is no way to construe a possible "transfer" to the CRT after the repeal of the estate tax unless there is a transfer to a testamentary CRT or testamentary addition to an inter vivos CRUT. A CRAT is not permitted to receive additional contributions. So the question of needing a deduction for each "transfer" seems not a problem for this very common scenario - the purely inter vivos CRT where the donor retains the income interest. But note that a relatively small testamentary addition could lose the trust its exempt status as it winds down and then distributes its assets to charity.

The scope of the problem seems limited to the person who dies in a year in which there is no estate tax and there are testamentary transfers to a CRT.

Is a deduction necessary to have a qualified CRT? The IRS appears to answer in the affirmative. No deduction, no qualified CRT, and each transfer has to qualify for some deduction; this seems to be their general position as "announced" in private letter rulings discussed below.

Qualified v. Exempt

What do we mean by a "qualified" charitable remainder trust? A qualified CRT is one that meets the requirements of Section 664. Typically, a qualified CRT is also exempt from income tax.5 However, if it realizes unrelated business taxable income, it could lose its exempt status in a particular year without losing its "qualified" status. For example, an inter vivos CRUT might be funded in year one, realize UBTI in year three and lose its exempt status only in such year, and receive testamentary additions in the fifth year of its existence, the year the grantor dies. The testamentary addition should still qualify for the estate tax charitable deduction because the trust remains "qualified." If the decedent retained the annuity or unitrust interest, at least part of the assets in the inter vivos trust would be brought back into the estate.6 The estate tax charitable deduction for the remainder interest should be available as to assets in the trust which are brought into the gross estate and the testamentary transfer to the CRT. The estate tax charitable deduction(s) should be available whether the trust lost its exempt status in year three or year five (or both).

Our focus is on whether the CRT is qualified, not necessarily whether the CRT is exempt in a particular year, although being qualified and exempt normally go hand-in-hand.

If the trust is not qualified, an inter vivos transfer to a CRT fails to qualify for an income tax deduction. Also, as we discussed in connection with nonqualified trusts in Part I, an inter vivos transfer doesn't have the shelter of the gift tax charitable deduction, so if the charitable remainder is a completed gift, the donor can incur a gift tax on a transfer to charity. As we also noted in Part I, the grantor can in some circumstances effectively incur a gift tax on the annuity or unitrust interest that was retained by the donor in circumstances that would normally be sheltered from this problem if the trust were qualified.7

The issue of needing a deduction to have a qualified CRT comes to the fore with the prospect of the repeal of the estate tax and the estate tax charitable deduction, but the IRS' interpretation has broad implications for the charitable planner.

It may overstate the IRS' position a bit to say it requires that a deduction be "sustained." For example, presumably the IRS would agree that an estate tax deduction is "allowable" even if a particular asset that funded a testamentary CRT never hit a Form 706 estate tax return because the estate was too small. Nor would one anticipate a problem if the estate tax deduction is claimed but there is no estate tax regardless of the charitable deduction. But it is clear the IRS' focus is asset specific rather than merely looking to the nature of the trust.

This author has long believed the CRT regulations should not be interpreted as requiring a deduction because this approach looks beyond the nature of the trust, and introduces arbitrary results and factors that may not even be known by the trustee who is charged with filing the trust's tax return.

Related Use

For example, assume Ms. Bradley makes an inter vivos transfer of a zero-basis painting to a CRT and reserves the right to change the charities named to receive the assets upon termination of the trust. If Ms. Bradley is an art dealer or received the painting as a gift of the artist who created the painting, its sale would result in ordinary income.8 The basic income tax deduction rule here is fair market value, less hypothetical ordinary income or short-term gain.9 Since Ms. Bradley would realize ordinary income on a sale and has zero basis, her charitable income tax deduction is zero.10

In some circumstances, a donation of tangible personal property to a CRT may yield a deduction, albeit delayed. One might be hopeful here that a delayed deduction does not trigger the same concerns; i.e., precluding the qualification of the trust. The deduction turns on the qualification of the trust, and the IRS has allowed a delayed deduction limited to basis when a musical instrument was donated to a CRT but its use was considered unrelated.11

As indicated, if it is ordinary income property (such as the grocer's can of beans), the income tax deduction for the donation of tangible personal property generally is limited to basis.12 If the gain on the sale of tangible personal property would be long-term capital gain, the taxpayer may have a delayed deduction of fair market value, or basis if the use is unrelated to that of the charity.13 For a transfer to a CRT, the deduction is partial, so the issue would be whether fair market value or basis is the beginning point in calculating the deduction for the charitable remainder interest. In a CRT context, can one argue for use related to an exempt purpose borrowing from the charitable remainderman's exempt goals, and if so, under what circumstances? See Regs. 1.170A-4(b)(3)(i), which asks, "if the use by the trust is one which would have been unrelated if made by the charitable organization." But one could also envision circumstances where the use by the named charity (or charities) might be related, but there is a significant risk that the charity's interest might be revoked in favor of another type of charity. Also, the definition of a CRT effectively prohibits it from operating as a charity, so "use" by a CRT may be less likely.

Opinions vary on when, if ever, the CRT can "borrow" the charity's exempt purpose. In a CRT context, it would normally be contemplated that tangible personal property would be sold to raise funds, and a sale to raise funds is an unrelated use. Also note that some commentators have argued that because of the delay in the deduction until sale, the donation should be construed as a gift of the cash proceeds rather than tangible personal property.

The related-use question affects the measure of the deduction, assuming a public charity.14 But in any event, there is no immediate deduction because of the rule that says if there is a future interest in tangible personal property, the deduction, if available, is delayed until the tangible personal property is sold.15

A preamble to a regulation discussed below states: "Whether a trust qualifies as a charitable remainder trust is determined at the time property is transferred to the trust."16

Under the best of circumstances, the transfer of tangible personal property would seem to yield only a delayed deduction, which generally assumes the sale of the donated asset by the CRT, which would normally be contemplated but may not be an absolute certainty. Although there is a favorable ruling on a donation of a musical instrument to a CRT, one would worry that pressed to the extreme, if the CRT's qualified status is determined at the time of funding and there is no immediate deduction for a transfer of tangible personal property to a CRT even in the best of circumstances, one could not have a qualified CRT if there were any donations of tangible personal property. There is always some delay in that the transfer precedes the sale, although one could theoretically sell tangible personal property on the day it is transferred to the CRT (perhaps at some risk of raising an anticipatory assignment of income problem). If a delayed deduction is a problem, is "sell as soon as possible" good advice because the delay is negligible?

For example, any tangible personal property in the donation of a building could, theoretically, destroy the qualified status of the CRT. Seemingly, you might have the trustee of the CRT having to resolve whether the chandelier or some borderline asset is tangible personal property or realty under the circumstances and perhaps local law, else he or she doesn't know what tax return to file.

Returning to our assumed worst-case scenario, Ms. Bradley clearly has no charitable income tax deduction. So are we to conclude the CRT is not qualified? If the answer is "No," then seemingly, the tax advisor might save the day (and the gift) by advising Ms. Bradley to draft the trust so there is some charitable gift tax deduction. She could make a portion of the remainder interest payable to one of the charities in all cases, then Ms. Bradley has made a completed charitable gift, sustains a charitable gift tax deduction, and the trust rises to the level of a qualified trust under Sec. 664. The rule delaying the deduction in the case of transfers of tangible personal property to charitable remainder trusts does not apply for gift tax purposes.

Seemingly, the IRS' position is that some deduction must be "allowable," so attaining only a charitable gift tax deduction seems sufficient to achieve a qualified CRT, even if the transfer doesn't yield an income tax deduction.

A last-ditch argument: If Ms. Bradley had no gift tax charitable deduction and no income tax deduction but retained the income interest, one could argue that if she died while there was an estate tax, the earlier transfer would eventually yield an estate tax deduction of some amount. One would have to assert a delayed-deduction argument, perhaps argue there is a matching of the earlier "transfer" and the string provisions that bring assets of the trust into the estate at a later date, and perhaps get into the actuarial probability of her passing during a year in which there is an estate tax.

It seems highly strained to argue the trust is not a qualified CRT in the first instance, but it becomes a qualified CRT merely by making part of the charitable remainder a completed gift.

The income tax deduction is limited to the charitable remainder. However, the gift tax charitable deduction rules are more lenient in allowing a deduction for the charity sharing in the annuity or unitrust amount.17 So another approach to sustaining a charitable gift tax deduction in an inter vivos context would be to allow the charity to share in the annuity or unitrust interest, while wasting any income tax deduction for such gift.

If you press this concept to its extreme and require a deduction for each transfer, an apartment owner donating a building and furnishings to a CRT fails to have a qualified trust if a single lamp is fully depreciated. Assume the lamp's fair market value is $200 but because it is fully depreciated, the Section 1245 recapture on a hypothetical sale of the lamp results in zero charitable deduction.18 If the only deduction attained on an inter vivos transfer is the income tax deduction and not the gift tax deduction, one would still have to worry about the delayed-deduction issue even if the tangible personal property is not fully depreciated.

Pressed to another extreme, a transfer of an asset with a $1 basis to a CRT could yield a qualified trust, whereas a zero basis asset results in a nonqualified trust. For example, if the artist who created the zero-basis painting gives it to Ms. Bradley and there is a gift tax, the ordinary income problem carries over to the donee,19 but the donee now has some basis for the gift tax paid.20 Since the donee now has some basis and some charitable income tax deduction (will $1 do?), arguably the nonqualified CRT is now a qualified CRT (if you get past the issue of the deduction being delayed).

In this author's judgment, these kinds of distinctions were never meant to resolve the qualified status of a trust under Sec. 664.

The "allowable deduction" regulation should be interpreted focusing on the nature of the trust - is a deduction "allowable" looking to the nature of the trust? If "Yes," the donor should not be precluded from having a qualified CRT. The legislative history of the 1969 Act speaks of transfers of "property" to a CRT and gives illustrations of stock and realty, but it does not indicate that a CRT cannot be funded with tangible personal property.21

The issue has a rather complicated history, but the IRS seems entrenched in a current interpretation that asks if there is a deduction for the transfer to the CRT.

The reader may remember the much-discussed issue of whether an option could be used to fund a CRT. The goal was to side-step the problems arising when a CRT is funded with "difficult assets," such as debt-encumbered real estate. One of the arguments the IRS used in thwarting such planning was that the trust was not qualified because there was no deduction.22 The private letter ruling states the trust is not a qualified CRT unless "each transfer to the trust during its life qualifies for a charitable deduction under one of the applicable (income, gift, estate) sections."

The "each transfer" concept raises the prospect that qualified status can be attained initially and later lost. In general, one can envision that qualified status can be lost. For example, one could have a qualified CRT initially but then have the trust lose its qualified status because it is administered so poorly that it is not really functioning as a CRT.23

Ltr. Rul. 9501004 states:

"In situations in which no tax deduction is allowable for a transfer to the trust, it appears that the donor is merely using the trust as a means to take advantage of the exemption for current income tax on the gain from the sale of the property. This use of a trust, in the absence of a charitable deduction, is inconsistent with the Congressional purpose for charitable remainder trusts."

Author's paraphrase: If the donor normally has two types of benefits - deduction(s) and exempt status of the trust - and if only one of the benefits is available in a particular case, that one benefit needs to be taken away, else the Treasury is being abused. An abusive transaction would usually have more than normal benefits. One might argue abuse in any particular circumstances, but abuse when there are fewer-than-normal benefits is an anomaly and hardly a circumstance that justifies adopting a general proposition.24 Without trying to resolve the issue of whether taxpayer should be able to use options in this fashion, this line of attack, a general proposition that Section 664 requires a deduction on an asset-by-asset basis, is poorly conceived in this author's opinion.

In an earlier ruling, the IRS had concluded that a testamentary CRAT failed to qualify for an estate tax charitable deduction due to failure of the 5% probability test, but this did not preclude the CRT from being a qualified trust. But then the IRS later concluded the trust in the earlier ruling was not a qualified trust for lack of an estate tax charitable deduction. The IRS granted some relief for income tax purposes but not generation-skipping purposes.25

Mr. Zaritsky discusses Ltr. Rul. 9501004 and opines that the "IRS has previously ruled that the donor's inability to claim a deduction does not affect the qualification of the trust. See, e.g., Rev. Ruls. 70-452, 1970-2 C.B. 199, and 77-374, 1977-2 C.B. 329." These rulings deal with CRTs where there was no deduction due to the 5% probability test.26

Opinions vary to some extent, but it is generally believed that the 5% probability test does not apply to CRUTs, so one can perhaps see some discrimination against CRATs in the IRS' interpretation of the CRT regulations.

The IRS adopted "deemed sale" regulations aimed at thwarting plans that might otherwise result in return of capital distributions from a CRT.27 These regulations ask if deductions are "allowable" with respect to contributions to the trust.28 One of the examples of these regulations refers to a testamentary CRT and transfers of life insurance proceeds for which an estate tax deduction was allowable.

The rules governing whether payment from a CRT is necessary by year end or the due date of the return incorporate the concept of whether there have been distributions of assets for which a deduction is "allowable."29

Interpreting "allowable deduction" language involves various regulations. Perhaps the issues could be resolved in working with the IRS, but technical corrections of the law may also be necessary.

The issue is obviously aggravated by the repeal of the estate tax. Perhaps the most conspicuous problem is that the IRS' interpretation leaves taxpayers wondering whether testamentary CRTs, and perhaps testamentary additions to inter vivos CRUTs, are even qualified after repeal of the estate tax.

To again stress the estate tax dilemma during the current transition period, assume the will provides for a testamentary CRT. The individual dies while there is an estate tax. The estate tax charitable deduction would be available, and the marital deduction should be available if the spouse is the only beneficiary.30 If a child is beneficiary, there will be some value subject to estate tax, as one would expect. But the CRT itself is exempt under Sec. 664(c), and the estate plan works as planned.

If the charitably-minded individual dies the first day after the repeal of the estate tax, the CRT itself may be subject to unexpected income tax if it is not exempt under Sec. 664. The trust incorporates all the safeguards of Sec. 664; e.g., prohibits invasion for emergencies. But the trust itself may not be exempt, if its qualified status depends on sustaining an estate tax deduction. There is no income or gift tax deduction, for lack of an inter vivos transfer, and no estate tax deduction because the estate tax went away.

Perhaps the worst-case scenario would be a testamentary CRT funded with an IRA or pension since the mere receipt of the assets triggers ordinary income at rates higher than the individual rates.31

There is a bright side to this exercise (or worrisome side if you're prone to worry about the government's interest). This relates to the excise tax provision. Absent an estate tax deduction, the CRT may also fall outside of the excise tax provisions, notably the self-dealing rules. The self-dealing rules are triggered when there are amounts in a CRT for which a deduction has been "allowed."32 There is also the concept in Sec. 4947 for segregating amounts for which no deduction has been allowed.

Conclusions

If the IRS' interpretation of the CRT regulations is to prevail, one obvious approach to preserving the status quo would be to adopt the concept of a hypothetical estate tax deduction. If the estate tax rules were still around and the transfer would qualify for an estate tax deduction under the laws at some particular time, then the income tax rules might be resolved by assuming the estate tax was still in place. But this would keep around a whole body of estate tax law for a rather limited purpose.

In general, the author believes the IRS' interpretation of its regulations to require a deduction for each transfer if a CRT is to be qualified does great damage to the workability of the CRT provisions. In any event, the government and charitable planners need to be discussing these matters to reach some reasonable conclusions - the notion that a testamentary CRT cannot be qualified if the estate tax is repealed is obviously unreasonable.

Proposed legislation may permit inter vivos transfers from IRAs, pensions, etc. to CRTs without triggering income but without allowing any income tax deduction. This is another circumstance where this issue needs to be kept in view.


  1. Reg. §1.664-1(a)(1)(iii)(a)back

  2. Reg. §1.664-1(a)(5)back

  3. See Reg. §§1.664-1(a)(4), 1.664-1(a)(6), Example (5)back

  4. IRC §2036back

  5. IRC §664(c)back

  6. IRC §2036back

  7. IRC §2702, Reg. §25.2702-1(c)(3)back

  8. IRC §1221back

  9. IRC §170(e)(1)(A)back

  10. IRC §170(e)(1)(A)back

  11. Ltr. Rul. 9452026, 9/29/94back

  12. IRC §170(e)back

  13. IRC §170(e)(1)(b)(i)back

  14. See IRC §170(e)(1)(B)(ii) concerning private foundations.back

  15. IRC §170(a)(3)back

  16. T.D. 8926, 1/5/01 relating to Reg. §1.643(a)-8back

  17. IRC §2522(c)(2)(B), Reg. §25.2522(c)-3(c)(2)(vi), (vii)back

  18. IRC §170(e)back

  19. IRC §1221 as it exists in years in which there is no estate tax.back

  20. IRC §1015(d).)back

  21. See, e.g., H. Rep. 91-413 (Part I) 91st Cong. (1st Sess., 1969), 1969-3 C.B. 237, 239.)back

  22. Ltr. Rul. 9501004, 9/29/94.)back

  23. See Estate of Melvine B. Atkinson, 115 T.C. 3 (2000). The decision was aff'd per curiam, No. 01-16536, 10/16/02, KTC 2002-349 (Kleinrock) (CA-11, 2002).back

  24. Private letter rulings may be cited for information purposes but they are not precedent. Sec. 6110(j)(3).)back

  25. Ltr. Rul. 9440010, 7/5/94, Ltr. Rul. 9532006, 5/4/95.back

  26. Howard M. Zaritsky, "Running With the Bulls: Estate Planning Solutions to the 'Problem' of Highly Appreciated Stock," University of Miami, 31st Institute on Estate Planning, Matthew Bender, 1997, Chapter 14, p. 14-57.)back

  27. IRC §664(b)(4).)back

  28. Reg. §1.643(a)-8.)back

  29. Reg. §1.664-2(a)(1)(i)(a)(2) and (3) (CRAT), Reg. §1.664-3(a)(1)(i)(g)(2) and (3) (CRUT)back

  30. IRC §2056(b)(8)back

  31. IRC §1back

  32. IRC §4947(a)(2)back

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