Computation and Economic Impact of 100 Percent Excise Tax on UBTI of a CRT

Computation and Economic Impact of 100 Percent Excise Tax on UBTI of a CRT

Article posted in Investing on 2 April 2007| comments
audience: Leimberg Information Services, National Publication | last updated: 18 May 2011


In this article from Leimberg Information Services, distinguished estate planner and author Byrle M. Abbin points out the recent change in Code Section 664(c) from an income taxable status to an excise tax on UBTI can have an economic result ranging from "disastrous" to "no consequence." What makes the difference, Byrle tells us, is controlled by the nature of the investment and portion that is UBI. Byrle monetizes the impact of the new tax under a range of scenarios, and provides a definition of the excise tax base. If you work with CRTs, this is a MUST read analysis!

By Byrle M. Abbin
Edited by Steve Leimberg

Executive Summary

Effective as of January 1, 2007, The Tax Relief and Health Care Act of 2006 imposed a 100 percent excise tax on unrelated business income of a charitable remainder trust (CRT). This excise tax replaces the prior regime under Code Sec. 664(c) that made the CRT a taxable entity when it had any amount of unrelated business taxable income (UBTI). While commentators may debate whether this change is a panacea or a pitfall, reality is that the impact varies significantly depending on the amount of UBTI and the investment return from the investment that generates the UBTI.


The excise tax is treated as a chapter 42 tax which, under Reg. Sec. 1.664-1(d)(2), is allocated to corpus and, therefore, is not deductible in determining taxable income distributed to beneficiaries. The result is that the beneficiary of the CRT also will pay Federal and, where applicable, state income tax, on that UBTI.

The payment of the excise tax makes it more likely that the CRT will have to liquidate investments to pay the required distributions to CRT beneficiaries and thereby generate tier-two gain.

UBTI subject to 100% excise tax = gross unrelated business income less direct and indirect expenses.

UBTI may be calculated differently for excise tax purposes than for CRT tier income purposes.

New Sec. 664(c) describes the tax base for the excise tax as "UBTI within the meaning of Sec. 512".

Section 512(a)(1) and Reg. Sec. 1.512(a)-1(a) define UBTI as gross income from unrelated trade or business activities, less deductions allowed by Chapter 1 of the Code directly connected to earning such income. When there are shared "dual use" facilities or personnel that benefit both exempt activities and UBTI activities "such expenses and similar items . . . shall be allocated between the two uses on a reasonable basis." Such deductible ["indirect"] costs include direct and indirect overhead costs. Reg. Sec. 1.512(a)-1(c)


Assume that a trustee makes the only investment for a CRT of $1,000,000 in a hedge fund that generates only UBI of $100,000. Assume further that investment advisory fees related to that specific investment are 100 basis points, or $10,000, and total overhead (i.e., administrative costs including trustee's fees) are $2,000. Many if not most CRTs have the donor[s] or the charitable remainder organization as trustee, who do not charge trustee's fees.

(Note that to prevent the example from becoming too detailed and complex, we have not factored in the modifications under section 512(b) such as the $1,000 specific deduction under section 512(b)(12). These should, however, be factored into the actual computation.)

On these facts, the UBTI subject to the excise tax is $88,000. (i.e., hedge fund gross income of $100,000 less direct investment costs of $10,000 and less indirect overhead costs of $2,000).

The 100% excise tax assessed would be $88,000.

How Tier Income Taxable to Distributees is Computed under Reg. Sec. 1.664-1(d).

The rules for allocating indirect deductions under Sec. 512 are different from those under Reg. Sec. 1.664-1(d)(2), although the CRT approach can be applicable as well to UBTI if it represents a "reasonable basis", that in most situations it will.

Under Reg. Sec. 1.664-1(d)(2), direct costs are deducted in determining tier-income. In addition, Reg. Sec. 1.664-1(d)(2) provides that indirect costs are allocated among the various items of income based on "the gross income of such classes for such taxable year reduced by the deductions allocated thereto . . ."

Finally, Reg. Sec. 1.664-1(d)(2) states that "all taxes imposed . . . for which the trust is liable because it has unrelated business taxable income . . . shall be allocated to corpus" and, therefore, do not reduce tier income taxable to the distributee.

Assume the beneficiary is to receive a distribution equal to 9% and, for sake of simplicity, assume the value of the trust is its cost, $1,000,000 on the valuation date. This produces a mandatory distribution for the year of $90,000.

The distributee pays tax on $88,000 from current year's tier one and $2,000 from prior years undistributed income [assumed to be $18,000]. Although the corpus has been reduced by the $88,000 excise tax, tier-one income is unaffected. At a 35 percent Federal tax rate, the distributee pays $31,500 of Federal income tax on the $90,000 distribution.

The impact of UBTI on investment return depends on the ratio of UBTI to other investment income. Where the amount of UBTI is negligible, the decision to make investments generating 'tainted' income may still be appropriate based upon overall return. This also follows when the return comprising non-UBTI is higher than can be obtained from a solely non-UBTI investment.

In the past, the impact could have been more significant because all of the taxable income of the trust, after deducting distributions to the beneficiaries, would have been taxed at regular income tax rates.

If the investment is illiquid, the combination of the excise tax and the mandatory distributions may create cash flow problems for the CRT that should be considered.

The table below presents the investment return in the above example assuming that UBI is 100% of gross income, 50% of income, 10% of income and 0% of income.

100% UBTI
50% UBTI 10% UBTI 0% UBTI
Investment Return-Gross UBTI $100,000 $ 50,000 $ 10,000 $0
Direct Costs (1) (10,000) (  5,000) (  1,000) n/a
Indirect Costs (2) (  2,000) (  1,000)

Excise Tax Base
88,000 44,000

Excise Tax-100% 88,000 44,000
Net return on UBTI Investment 0 0 0 n/a
Gross Return on Non UBTI Investment  (3) 0 50,000
Rate of Return to CRT on Investment 0% 5%

Income Tax on Distributee (4) 31,500 31,500 31,500 31,500
Total of taxes on CRT and Distributee (5) 119,500 75,500 40,300 31,500
After "all taxes" return on gross income ( 19,500) 24,500 59,700 68,500
Net Return on Investment  (6) (  1.95%) 2.45% 5.97% 6.85%

(1) allocated based on investment, using 100 basis points fee on investment

(2) The CRT method is assumed to be a "reasonable basis" for reflecting indirect expenses

(3) Measured on gross receipts before expenses

(4) $90,000 times 35%

(5) Excise Tax on line five of each column plus $31,500 for each of the four columns

(6) Return after all taxes divided by $1,000,000 [in addition, each alternative has incurred $10,000 of direct and $2,000 of indirect costs]

Summary and Conclusion

Clearly the excise tax has a significant negative impact on the investment return if 100 percent or 50 percent of the income is UBI.  On the other hand, if the UBI realized from the CRT's investment in a UBI generator is only 10 percent of the total return, the impact is relatively modest. In fact, if the investment [hedge fund, leveraged real estate, etc] provides a significantly greater return than that obtainable from an investment without UBI exposure, paying a modicum of excise tax may be advisable when the return net of excise tax for example is 8 or 9%, and the best obtainable from a non-UBI investment is less, say 6 or 7%.

Clearly both investment advisors and trustees should consider these new rules in evaluating the prudence of any investment made by a CRT.


IRC Sec. 664; Reg. Sec. 1.664-1(d)(2)

Cite As:

Steve Leimberg's Charitable Planning Newsletter #118 (March 6, 2007) at Used by permission. Reproduction in Any Form or Forwarding to Any Person Prohibited - Without Express Permission. Copyright 2007 Byrle M. Abbin. Adaptation of update to Abbin, Income Taxation of Fiduciaries and Beneficiaries [CCH 2007 ed.]

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