New Final Regulations Reviewed

New Final Regulations Reviewed

Article posted in Regulations on 11 December 1998| comments
audience: Partnership for Philanthropic Planning, National Publication | last updated: 16 September 2012


In this edition of Planned Giving Online, PGDC Editorial Review Panel member Jonathan D. Ackerman, Esq. provides a detailed review of the newly issued final regulations under IRC Sections 664 and 2702.

Planned Giving Online
Treasury and IRS Promote Planned Giving -
Favorable Final CRT Regulations Issued

By: Jonathan D. Ackerman,
Esquire Member, PGDC Editorial Review Panel

On December 10, 1998, the Internal Revenue Service issued final Regulations under Internal Revenue Code1 Sections 664 and 2702 as outlined in Treasury Decision 8791. In addition to the explanatory material discussing the proposed Regulations in the Notice of Proposed Rulemaking published in the Federal Register on April 18, 1997, the IRS included a discussion of the proposed Regulations in Chapter P, "Thirty Years After the 1969 TRA - Recent Developments Under Chapter 42," in the Exempt Organizations Continuing Professional Education Text for Fiscal Year 1999. These background materials indicate that the Service developed these Regulations in part to deal with concerns it had about the "accelerated" charitable remainder trust, which was the target of IRS Notice 94-782, and certain self-dealing issues.

The new final Regulations to Code Sections 664 and 2702 include provisions on appraising hard to value assets, characterizing the unitrust amount, timing the payment of the unitrust or annuity amount, authorizing and expanding the use of "flip" unitrusts, prohibiting the allocation of pre-contribution gain to fiduciary income, and valuing retained interests. The following is a detailed discussion of these provisions.

Appraising Unmarketable Assets

As a matter of historical background, the Code does not contain a provision regarding the valuation of unmarketable assets. However, the 1969 legislative history to Section 664 suggests that Congress believed an independent trustee would be needed to value unmarketable assets if the donor was to obtain a charitable deduction.3 The IRS noted that it had received questions from numerous practitioners, including Erik Dryburgh, Esq., of San Francisco, California, as to whether an independent trustee is even necessary, because the substantiation rules had been passed subsequent to 1969 TRA and the enactment of the statutorily-approved charitable remainder trust. According to the IRS, the purpose of the Proposed Regulation was to clarify how unmarketable assets are to be valued. The Final Regulations have accomplished that stated purpose.

Final Regulation Section 1.664-1(a)(1)(iii)(a) provides special rules when unmarketable assets are transferred to or held by a charitable remainder trust. The Final Regulations clarify that a charitable remainder trust holding unmarketable assets will be disqualified unless, whenever the trust is required to value such assets, the valuation is (i) performed by an independent trustee or (ii) determined by a current qualified appraisal under Regulation Section 1.170A-13(c)(3) by a qualified appraiser defined under Regulation Section 1.170A-13(c)(5). The Final Regulations also clarify the definition of an "independent trustee" and "unmarketable assets."

An independent trustee is a person who is not the grantor of the trust, a noncharitable beneficiary, or a related or subordinate party (within the meaning of Section 672(c) and the applicable regulations) to the grantor, the grantor's spouse, or a noncharitable beneficiary. Unmarketable assets are assets that are not cash, cash equivalents, or other assets that can be readily sold or exchanged for cash or cash equivalents. For example, unmarketable assets include real property, closely-held stock, and an unregistered security for which there is no available exemption permitting public sale. Thus, stock, the sale of which is restricted under S.E.C. Rule 144, will generally be deemed to be an unmarketable asset.

Regulation Section 1.664-1(f)(4) states that these rules are applicable for trusts created on or after December 10, 1998. For a trust in existence on such date, whose governing instrument requires that an independent trustee value the trust's unmarketable assets may be amended or reformed to permit a valuation method that satisfies the requirements of these rules for taxable years beginning on or after December 10, 1998.

Example Illustrating Rule for Characterizing Distributions from CRUTs

Final Regulation Section 1.664-1(d)(1)(iii) includes an example of how the payout is characterized for a net income with makeup charitable remainder unitrust with undistributed capital gains. This example illustrates the method for calculating the unitrust amount for a NIMCRUT and the tax character of the income received by the income beneficiaries based upon the 4-tier system. In the example, a net income with makeup charitable remainder unitrust has a payout of the lesser of trust income or 6% of the net fair market value of the trust assets valued annually. During 1996, the trust had net income of $7,500, all of which consisted of tax exempt income. The net fair market of the trust assets was $150,000 on the 1996 valuation date. The trust had undistributed capital gains of $30,000 and undistributed tax exempt income of $2,500 from prior years.

The example states that the payout to the income beneficiaries for 1996 was equal to the net income of $7,500, because the net income for the year was less than $9,000 (6% times $150,000). All of the $7,500 distribution was characterized as capital gain because the payout was less than the $30,000 of undistributed capital gains from prior years. At the beginning of 1997, the trust had undistributed capital gain of $22,500 ($30,000 less $7,500) and undistributed tax exempt income of $10,000 ($7,500 plus $2,500).

Time for Paying the Annuity Amount or Unitrust Amount

Proposed Regulation Section 1.664-2(a)(1)(i) would have eliminated the post-year-end grace period for the payment of the annuity amount with respect to charitable remainder annuity trusts. For taxable years ending after April 18, 1997, the annuity trust payout must be made by the close of the taxable year. Proposed Regulation Section 1.664-3(a)(1)(i)(e) would have likewise eliminated the grace period for the payment of the unitrust amount from a standard charitable remainder unitrust for taxable years ending after April 18, 1997. Proposed Regulation Section 1.664-3(a)(1)(i)(f) would have continued the grace period for income exception charitable remainder unitrusts.

In the Notice of Proposed Rulemaking, the IRS observed that the intent of these changes was to address the problem of the accelerated charitable remainder trust as outlined in Notice 94-78.4 As the Service indicated, the transaction described in Notice 94-78 would only work with a standard charitable remainder unitrust paying a fixed percentage or with a charitable remainder annuity trust. Subsequent legislation enacted by Congress also addressed the abusive scenario created by the accelerated charitable remainder trust.5

The aftermath of the accelerated CRT left many trustees and administrators of standard charitable remainder unitrusts and charitable remainder annuity trusts increasingly nervous as 1998 came to a close. Would the Proposed Regulations remain intact and the payout be required prior to the close of year end? Notice 94-78 (1994-2 CB 555) only provided relief for 1997.

However, Treasury and the IRS have provided permanent relief in permitting the payment to the income beneficiaries of a SCRUT or a CRAT within a reasonable time after the close of the taxable year for which it is due, under two circumstances, (i) if the entire annuity or unitrust amount in the hands of the income beneficiary is characterized as either tier-1, tier-2, or tier-3 income or (ii) if the trust distributes property in kind that it owned at the close of the taxable year to meet the annuity or unitrust amount payout, the trustee elects to treat any income generated by the distribution as occurring on the last day of the taxable year in which the annuity or unitrust amount is due. The attack on the accelerated CRT essentially forces a taxable event to the income beneficiary in the year in which the annuity or unitrust amount was due.

In addition, for these trusts created prior to December 10, 1998, the unitrust or annuity trust payment may be made within a reasonable time after the close of the taxable year if the payout rate is 15% or less.

The Final Regulations provide an example to highlight the application of these rules and defines "reasonable time." In the example, a charitable remainder trust is required to make a $100 distribution to the income beneficiary in year 1. The trust distributes on April 15th of year two, $95 of cash and a capital asset worth $5, with a $2 tax basis. The asset was owned by the trust at the end of the prior year. The distribution is treated as a sale by the trust resulting in a $3 capital gain. The trustee elects to treat the capital gain as occurring extend beyond in the year one. The distribution after the close of the taxable year did not cause the trust to commit an act of self-dealing, to have unrelated debt financed income, to have received an additional contribution or to have failed to function exclusively as a charitable remainder trust. "Reasonable time" will not ordinarily extend beyond the date by which the trustee is required to file Form 5227 (including extensions) for the taxable year.

Flip Unitrust

The creation of the flip unitrust under the Proposed Regulations and the re-invention of the flip unitrust in the Final Regulations provide the most intriguing and favorable change for gift planners. Both Proposed and Final Regulation Section 1.664-3(a)(1)(i)(c) include provisions allowing an income exception charitable remainder unitrust to "flip" to a standard charitable remainder unitrust if specific conditions are met. However, the conditions have been expanded dramatically under the Final Regulations.

Under the Proposed Regulations, a complex array of tests had to met in order for the flip unitrust to apply and the only event which permits the flip unitrust to apply occurs when the trust holds unmarketable assets. For instance, immediately after the initial contribution to the trust or after any subsequent contribution prior to the flip, at least 90% of the fair market value of the trust assets must consist of unmarketable assets. In addition, the trust instrument must require that the flip from an income exception unitrust to a standard unitrust occur by the earlier of (i) the sale or exchange of sufficient unmarketable assets to bring the fair market value of the remaining unmarketable assets in the trust down to 50% or less of the total fair market value of the trust assets or (ii) the sale or exchange of a specified group of assets or a specified asset that was contributed to the trust at its creation. The remaining assets in the trust must be valued as of the most recent valuation date for purposes of the latter. The flip to a standard unitrust must be effective at the beginning of the first taxable year following the year in which the earlier of these events takes place.

Isn't it hard enough to just agree on the fair market value of an unmarketable asset?

Treasury and the IRS took a common sense and practical approach to the complications surrounding the flip unitrust as proposed. It was acknowledged that Section 664 and the related Treasury Regulations, from a literal reading, specifically permit the flip concept. However, the IRS was quick to point out at the Regulations Hearing, as well as in the Proposed Regulations, that the Section 664 legislative history indicates that the trustee should not have discretion to change the method used to calculate the unitrust amount.6

The commentators at the Hearing were concerned about the nature of the percentages under the Proposed Regulations standards. However, the National Committee on Planned Giving presented the only testimony suggesting a simplified plan. Permitting a flip unitrust on a one-time basis, so long as the governing instrument provides for the specific triggering event, and the conversion cannot be controlled by any person. This analysis was akin to a qualified contingency currently permitted under Section 664. NCPG also recommended that the flip unitrust should be able to flip between a standard unitrust to a net income unitrust or from a net income unitrust to a standard unitrust; however, the IRS did not go that far. Nor did the Treasury or the IRS discuss the nature of this suggestion subsequent to the Hearings with NCPG.

Nevertheless, the Final Regulations permit only a "flip" from a net income unitrust to a standard unitrust. Any makeup account will be lost. The flip event must be (i) stated in the governing instrument, and (ii) triggered on a specific date or by a single event whose occurrence is not discretionary with or within the control of any person. Finally, the flip to the standard unitrust must occur at the beginning of the following year after the triggering event.

The Final Regulations provide ten examples of permissible and impermissible triggering events. The sale of an unmarketable asset (as defined for purposes of appraising unmarketable assets, as discussed above), such as the donor's former personal residence or an unregistered security for which there is no available exemption permitting public sale, is a permissible triggering event.

Other permissible triggering events occur when the income beneficiary reaches a certain age, when the donor gets married, when the donor divorces, when the income beneficiary's first child is born, and when the income beneficiary's father dies. The impermissible events relate to occurrences that are within the discretion of some person. For instance, the sale of publicly traded stock is not a permissible triggering event, because that decision is within the discretion of the trustee. A request by the income beneficiary or by the income beneficiary's financial advisor will likewise not be permissible events.

The final interesting aspect of this new regulatory creature is the reformation possibilities. These provisions apply to trusts created on or after December 10, 1998. If a trust created on or after such date or a noncompliant existing flip trust fails to comply with these provisions, the trust will nevertheless qualify if it is amended to use the initial method for computing the unitrust amount throughout the term of the trust or is amended pursuant to the "June 8, 1999 Window of Opportunity Rule." This tremendously flexible Rule permits a noncompliant flip trust or a net income unitrust to convert to a flip unitrust so long as the reformation proceeding is initiated by June 8, 1999. The triggering event under the reformed governing instrument may not occur in a year prior to the year in which the court issues the order reforming the trust, except for situations in which the governing instrument prior to reformation already provided for payment of the unitrust amount under a combination of methods that is not permitted under these rules and the triggering event occurred prior to the reformation.

Prohibition on Allocating Pre-contribution Gain to Trust Income and Make-up Amount as a Liability

Proposed Regulation Section 1.664-3(a)(1)(i)(b)(3) required pre-contribution gain to be allocated to principal in an income exception charitable remainder unitrust for sales and exchanges occurring after April 18, 1997.

In the Notice of Proposed Rulemaking, the IRS states that the amount of a donor's charitable deduction for a contribution to a charitable remainder trust is based partially upon the fair market value of the property on the date of transfer. With an income exception unitrust, the charitable deduction is calculated as if the fixed percentage is distributed annually. The Service indicates that it would not be consistent with the legislative intent of Code Section 664 to allocate part of the initial fair market value of the trust assets to income. In enacting the Tax Reform Act of 1969, Congress desired to make sure that charitable deductions were consistent with the amount charity was expected to ultimately receive.7

The Final Regulations include the prohibition on allocating pre-contribution gain to fiduciary income. However, the Treasury Decision does clarify that the governing instrument, if permitted under applicable local law, may allow the allocation of post-contribution capital gains to fiduciary income. In addition, Treasury and the IRS determined that it is unnecessary to treat the makeup account as a liability in calculating the fair market value of the trust assets as suggested by the IRS in several private letter rulings.

Application of Section 2702 to Certain CRUTs

Proposed Regulation Section 25.2702-1(c)(3) no longer exempted transfers to an income exception charitable remainder unitrust made after May 18, 1997, from the rules of Section 2702 (governing valuation of retained interests) unless the only noncharitable beneficiaries of the income exception unitrust are the donor and/or the donor's spouse, and the spouse is a U.S. citizen.

The IRS indicated that it was concerned that some taxpayers were establishing income exception charitable remainder unitrusts to take advantage of the exclusion granted to charitable remainder trusts under Code Section 2702 and were passing substantial amounts of wealth to family members at little tax cost. In the Notice of Proposed Rulemaking, the IRS gives an example of a donor who created a net income with makeup charitable remainder unitrust and who retained the unitrust interest for the shorter of his life or 15 years. At the end of that time, the unitrust amount would be payable to his daughter for her life. Under the Code Section 7520 tables, the value of the donor's retained interest would cause the value of the gift to the daughter to be small relative to what she may actually receive from the trust. The Service notes that this would be especially true if the trustee invests in assets that produce little or no income until the end of the donor's interest and then converts those assets to income producing assets. The daughter would receive the unitrust amount and the makeup account accumulated while the donor was the unitrust recipient.

The Final Regulations include the change to the Treasury Regulations under Section 2702 to income exception unitrusts. With one exception, unitrust interests in an income exception unitrust that are retained by the donor or any applicable family member will be valued at zero when a noncharitable beneficiary of the trust is someone other that the donor, the donor's U.S. citizen spouse, or both the donor and the donor's U.S. citizen spouse. However, this application of Section 2702 will not apply if there are only two consecutive noncharitable beneficial interests and the transferor (donor) holds the second of the two income interests. The Final Regulations also apply Section 2702 to a flip unitrust.


Although not unexpected, it is interesting to note that the Final Regulations failed to address the "spigot trust" concept and the use of annuity contracts and partnerships to control the timing of fiduciary income. The PGDC Editorial Review Panel has extensive first-hand working knowledge in negotiating these issues with the IRS and Treasury. We expect to be keeping you abreast of the interpretations and planning opportunities created under the Final Regulations and the latest news on this issue.

  1. All references are to the Internal Revenue Code of 1986 as amended from time to time and the Treasury Regulations thereunder.back

  2. IRS Notice 94-78, 1994-32 I.R.B. 15 (In July of 1994, the IRS issued Notice 94-78 targeting charitable remainder trusts designed "to convert appreciated assets into cash while avoiding a substantial portion of the tax on the gain." The charitable remainder trust described in the Notice was an inter vivos, standard charitable remainder unitrust with a two-year term and an 80% unitrust amount. The term was unusually short and the unitrust payout rate was unusually high. Because of these features, the unitrust described in the Notice is known as an "accelerated" charitable remainder trust.).back

  3. H.R. Rep. No. 413, 91st Cong., 1st Sess. 60 (1969), 1969-3 C.B. 200.back

  4. IRS Notice 94-78, 1994-32 I.R.B. 15. Also See, fn. 2.back

  5. See Section 1089 of the Taxpayer Relief Act of 1997 (amending Code Section 664 to require that the payout from a charitable remainder trust be no more than 50% and to require that the value of the charitable remainder be at least 10%).back

  6. See H.R. Conf. Rep. No. 782, 91st Cong., 1st Sess. 296 (1969), 1969-3 C.B. 644.back

  7. See H.R. Rep. No. 413, 91st Cong., 1st Sess. 58-59 (1969), 1969-3 C.B. 423.back

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