Proposed Regulations on Son of Accelerated CRT

Proposed Regulations on Son of Accelerated CRT

Article posted in Regulations on 19 January 2000| comments
audience: Partnership for Philanthropic Planning, National Publication | last updated: 15 September 2012


On October 18, 1999, the IRS issued proposed Regulations on an abusive charitable remainder trust transaction the PGDC had dubbed "Son of Accelerated CRT." As the date approaches for the public hearings regarding the proposed Regulations, PGDC legal editors Emanuel J. Kallina, II, Esq. and Jonathan D. Ackerman, Esq. place the proposed rules under the magnifying glass as to their appropriateness, scope, and effect.

by: Emanuel J. Kallina, II, Esquire & Jonathan D. Ackerman, Esquire


On October 18, 1999, the Internal Revenue Service ("Service" or "IRS") issued proposed Regulations on an abusive charitable remainder trust ("CRT") transaction similar to the accelerated charitable remainder trust ("ACRT") which was initially attacked by the Service in Notice 94-78 and then completely put to bed by the new requirements for the qualification of CRTs under Code1 Section 664 enacted by Congress in the Taxpayer Relief Act of 19972 and by provisions added to the Regulations thereunder by the IRS in 1998.3 Because of its similarity to the Accelerated CRT, the transaction attacked in the October 1999 proposed Regulations has become known as "Son of Acclerated CRT" and also as the "Chutzpah Trust."

The proposed Regulations were issued under Code Sections 643 and 664. Hearings on the proposed Regulations are scheduled for February 9, 2000.4 The IRS requests comments on (i) whether there are situations where application of the proposed Regulation, as described below, would be inappropriate and (ii) an alternate approach of more directly relating the funds distributed from the CRT to the CRT asset that is the subject of the borrowings or forward sale.5

The Transaction

Like the original ACRT, the Son of ACRT transaction involves creating a short term CRT with a high payout and converting appreciated assets into cash while avoiding tax on the gain in those assets.6 As described by the IRS, the CRT borrows money, engages in a forward sale or enters into a similar transaction to obtain cash for the payout to the non-charitable beneficiary without having to sell CRT assets. The non-charitable beneficiary characterizes the distribution he or she receives from the CRT as a tax-free return of principal because the borrowing, forward sale or similar transaction does not result in income to the CRT. Distributions continue in this fashion until the end of the CRT term, which is relatively short so as to meet the 10% remainder requirement. In the final year, the CRT assets may be sold and the loan would then be repaid from the proceeds and the balance of the proceeds would be distributed to the charitable remainder beneficiary. Alternatively, the CRT assets may be distributed to the charitable remainder beneficiary subject to an obligation to complete the forward sale contract.7

Challenges to Prior Transactions

In its Notice of Proposed Rulemaking, the Service observes that if a CRT financed a distribution in a manner such as that described above prior to the effective date of the proposed Regulations, the Service may recast the entire transaction under an appropriate legal doctrine.8 As examples, the Service says the entire distribution could be recharacterized as gross income, the CRT's qualification could be challenged under Code Section 664, the self-dealing taxes under Code Section 4941 could be imposed or the unrelated business income taxation ("UBIT") rules of Code Section 512 could be applied. The Service states that it will also impose applicable penalties.9

Code Section 643 and the Proposed Regulations

As background, Code Section 643 contains definitions applicable to certain subparts of Subchapter J, the portion of the Code dealing with income taxation of estates and trusts. Code Section 643(a) defines "distributable net income" in Sections 643(a)(1) through (6) by listing modifications that are to be made to the taxable income of an estate or trust to arrive at distributable net income. The Small Business and Job Protection Act of 1996 added Code Section 643(a)(7), which authorizes the Treasury Secretary to "prescribe such regulations as may be necessary or appropriate to carry out the proposes of this part, including regulations to prevent avoidance of such purposes."

Paragraph (a) of proposed Regulation Section 1.643(a)-8 indicates that the Regulation is intended to "prevent avoidance of the purposes of the charitable remainder trust rules" and states that the Regulation should be interpreted consistently with that purpose. It is applicable to all CRTs and CRT beneficiaries10 and, more specifically, to distributions made by a CRT after October 18, 1999.11

For purposes of determining the character of amounts distributed by a CRT under Code Section 664(b), proposed Regulation Section 1.643(a)-8(b) will recharacterize certain distributions as if a portion of the CRT assets had been sold. Specifically, paragraph (b) provides that a CRT is treated as having sold a pro rata portion of the CRT assets in any year in which an annuity or unitrust payment is due to the extent that the distribution would otherwise be characterized as a return of principal under the rules of Code Section 664 and the distribution was made from an amount received by the CRT that is otherwise not a return of basis in an asset sold by the CRT or attributable to cash contributed to the CRT for which a charitable deduction was allowable under Code Section 170, 2055, 2106 or 2522.12 The CRT assets treated as having been sold would not include any cash or assets that were purchased with proceeds of CRT borrowing, forward sales or similar transactions.13 Any gain or loss that is subsequently realized would be adjusted for any gain or loss recognized under this provision.14

If a transaction has the purpose or effect of circumventing the rules under Regulation Section 1.643(a)-8(b), then it will be disregarded.15

Three examples are included in the proposed Regulation.16 The first example illustrates the deemed sale provision; the second illustrates the adjustment to be made to the CRT's basis in the assets that are deemed sold; and the third illustrates the provisions applicable to distributions of cash contributions.

In the first example, a donor contributes stock with a basis of $400,000 and a fair market value of $2 million to a CRT. The CRT is a unitrust with a 50% payout and a two-year term. The CRT has dividend income of $20,000 in year one and the CRT assets are worth $2,020,000 on the valuation date. To make the unitrust distribution of $1,010,000 before the end of year one, the CRT borrows $990,000 against the value of the stock.

Under Code Section 664(b), $20,000 of the distribution is characterized as dividend income in the hands of the non-charitable beneficiary. Under proposed Regulation Section 1.643(a)-8, $792,000 is characterized as capital gain and $198,000 is characterized as return of principal. In other words, the CRT is treated as having sold $990,000 of stock in year one, of which $198,000 is a return of basis and of which $792,000 is capital gain. The example reaches this conclusion because the $990,000 does not come from a return of basis in any asset sold by the CRT or a cash contribution to the CRT for which a charitable deduction was allowable. The stock was not purchased with borrowings of the CRT so it is a trust asset for purposes of Regulation Section 1.643(a)-8(b).17

The second example uses the same facts as the first example for year one. During year two, the CRT sells the stock for $2,100,000. A portion of the sales proceeds are used to pay back the loan plus the accrued interest. The CRT's basis in the stock is $1,192,000, which consists of the initial basis of $400,000 plus the gain of $792,000 recognized in year one. As a result, the CRT has capital gain of $908,000 in year two.18

The third example involves a three-year CRT with an annuity payment. Proceeds of a life insurance policy on the life of D are payable to the CRT upon D's death. Commencing with D's death, the annuity is payable to D's child for three years and then the remainder of the CRT goes to charity. In year one, the CRT has no income and the annuity payment is paid from the insurance proceeds received. The distribution is characterized as a return of principal in the child's hands because it was made from a cash contribution for which a charitable deduction was allowable.19

A proposed Regulation under Code Section 664 was also issued on October 18, 1999.20 This proposed Regulation simply contains a cross reference to the application of the anti-abuse rules of Code Section 643(a)(7) to distributions under proposed Regulation Section 1.643(a)-8.

Comments on the Proposed Regulations

Although the Son of ACRT falls within the CRT rules when those rules are viewed very literally, it is clear that the transaction is abusive. The Son of ACRT is inconsistent with the public policy goals of encouraging charitable giving that underlie the rules allowing tax deductions for CRTs and other charitable gifts. While the charitable deduction taken for the contribution to the Son of ACRT would arguably take into account the relatively high payout and short term of the trust, there is little donative intent behind the transaction. The real goal of the transaction is to allow the non-charitable beneficiary to receive cash equal to a large portion of the value of the assets contributed to the Son of ACRT while the bulk of the gain on those assets is not taxed to anyone.

With this in mind, most of us would agree that something should be done to end the promotion and use of the Son of ACRT. The question that should be asked when considering responses to the IRS's request for comments for the hearing is whether the proposed Regulations go too far and possibly cause adverse results for perfectly legitimate transactions. If so, the comments should suggest alternate, more direct approaches to the Son of ACRT problem. Although the proposed Regulations are essentially very good, a few suggestions for narrowing them down a bit come to mind.

For example, the National Committee on Planned Giving ("NCPG") made several interesting suggestions in its written comments on the proposed Regulation. NCPG would support a clearer statement of intent in proposed Regulation Section 1.643(a)-8(a) specifically describing the abusive transaction (Son of ACRT) which is being curtailed with the promulgation of this Regulation. Therefore, if an unexpected and inconsistent application of the Regulation should arise, the application of this Regulation would be limited to that specific intent but would nevertheless quell the abusive transaction.

NCPG also raises the possible inconsistency between the UBIT rules and the proposed Regulation. For instance, if a deemed sale arises due to the application of the proposed Regulation and the UBIT rules also apply to that deemed sale, there may be some confusion over how the trust accounting rules would work. If the proposed Regulation applies, the taxable gain and the allocation of that gain to the second tier under Code Section 664(b) will cause the desired taxable event to the non-charitable beneficiary. However, if the deemed sale generates UBIT, the rules under Regulation Section 1.664-1(d) may apply. In that case, the CRT is essentially treated as a Subchapter J complex trust for that year and is taxable on all of its income. Under the general Subchapter J rules, the CRT would not use the four-tier system under Code Section 664(b) but it would instead be entitled to a distribution deduction for distributions to the non-charitable beneficiary and the non-charitable beneficiary would be subject to tax on a pro rata allocation of the items of taxable income. Although in many situations the ultimate result of applying either set of trust accounting rules may be the same, the proposed Regulation should likely override any application of the UBIT rules.

Another interesting question which will likely be raised at the hearing is the possible lack of authority of the IRS to issue these Regulations under Code Section 643(a). The IRS states that Code Section 643(a)(7) authorizes the Secretary to prescribe regulations to carry out the purposes of the provisions of the Code relating to the taxation of estates, trusts, and beneficiaries, including regulations to prevent avoidance of such purposes. A literal reading of Code Section 643(a)(7) would reach the same conclusion as it specifically relates to "regulations as may be necessary or appropriate to carry out the purposes of this part..." [Emphasis Added] The use of the word "part" means Part I, Subchapter J, Chapter 1, Subtitle A, Title 26 of the United States Code and includes Code Sections 643 and 664.

However, the placement of this anti-abuse provision under Code Section 643(a)(7) is peculiar. Code Section 643 relates to definitions. As noted above, Code Section 643(a) contains the definition of distributable net income and the numbered items under (a) relate to modifications to taxable income that are made to reach distributable net income. From the placement of (a)(7) in Code Section 643(a), it would appear the application of this provision relates to abusive transactions concerning the definition of distributable net income, which generally is irrelevant to a CRT as Code Section 664 specifically addresses the taxability of a CRT and its non-charitable beneficiaries.

A final thought regarding the proposed Regulations is the combined effect of the application of the proposed Regulation and Regulation Section 1.664(d)(5). The latter Regulation causes a deemed sale by the CRT on the distribution of property in kind to the non-charitable beneficiaries in payment of the annuity or unitrust amount.


The technical mechanism proposed by the IRS to stem the Son of ACRT abuse is a little complicated and requires several readings to gain some comfort as to its effect. Instead of attacking the specific issue of the trustee producing cash by a borrowing or forward sales contract and distributing that cash as principal, the IRS has painted a broad brush approach. The proposed Regulation essentially eliminates the fourth tier of accounting under Code Section 664(b), except when cash or assets with no built-in gain are contributed to a CRT.

The charitable gift planning community welcomed the statement of legislative intent in the Revenue Reconciliation Act of 1997, in which Congress observed that a scheme that, in effect, attempts to convert appreciated assets to a tax-free cash distribution to the non-charitable beneficiary is abusive and is inconsistent with the purpose of the CRT rules. Clearly, any detriment to charity in the use of a CRT or any attempt to "wash" capital gains through a CRT are unacceptable to the charitable community. The attempt on the part of the IRS to curb this new abuse is applauded. Otherwise, Congress may respond with legislation having an even more pervasive impact, as we have seen in the past.

Although it is anticipated that the hearings on February 9, 2000, will be mostly congratulatory, we can expect a variety of comments and maybe a limitation on the application or intent of the new proposed Regulation prior to finalization.


  1. All references to the Code are to the Internal Revenue Code of 1986, as amended from time to time.
    The legislation added requirements that the annual payout must not exceed 50% and the value of the remainder interest must not be less than 10%.back

  2. The final Regulations issued on December 10, 1998, included provisions limiting the availability of the "grace period" for making the unitrust or annuity payment after the end of a CRT's taxable year under certain circumstances.back

  3. Persons wishing to speak at the hearing must provide an outline of their talks to the IRS by January 19, 2000. Persons wishing to provide written comments must submit those comments by January 13, 2000.back

  4. REG-116125-99back

  5. Id.back

  6. Id.back

  7. Id.back

  8. Id.back

  9. Prop. Treas. Reg. § 1.643(a)-8(a)back

  10. Prop. Treas. Reg. § 1.643(a)-8(d)back

  11. Prop. Treas. Reg. § 1.643(a)-8(b)(1)back

  12. Prop. Treas. Reg. § 1.643(a)-8(b)(3)back

  13. Prop. Treas. Reg. § 1.643(a)-8(b)(4)back

  14. Prop. Treas. Reg. § 1.643(a)-8(b)(2)back

  15. Prop. Treas. Reg. § 1.643(a)-8(c)back

  16. Prop. Treas. Reg. § 1.643(a)-8(c) Example 1back

  17. Prop. Treas. Reg. § 1.643(a)-8(c) Example 2back

  18. Prop. Treas. Reg. § 1.643(a)-8(c) Example 3back

  19. Prop. Treas. Reg. § 1.664-1(d)(1)(iii)back

  20. S. Rep. No. 33, 105th Cong., 1st Sess. 201 (1997)back

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