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IRS targets certain charitable remainder annuity trust transactions

The IRS continually refines tax regulations to deal with abusive or potentially abusive transactions. Recent proposed regulations by the IRS target certain transactions involving charitable remainder annuity trusts (CRATs), intending to label them as listed transactions, a type of reportable transaction. Before becoming final, the IRS is seeking public comment on the proposed regulations and will have a public hearing on July 11, 2024. In the meantime, it is important for taxpayers, material advisors and charitable organizations involved in these transactions to understand the implications of these proposed regulations.

Overview of CRAT taxation

Under Internal Revenue Code (IRC) section 664(b), the tax character of a noncharitable beneficiary’s distribution from a CRAT is determined by treating the distribution as having been made:

  • First, from ordinary income to the extent of the CRAT’s undistributed ordinary income,
  • Second, from capital gains to the extent of the CRAT’s undistributed capital gains,
  • Third, from other income to the extent of the CRAT’s undistributed other income, and
  • Fourth, from the CRAT’s corpus (or principal).

In effect, the least favorable tax attributes are carried out first. For example, if a CRAT initially funded with a zero-basis long-term capital asset valued at $500,000 sells the asset and invests the proceeds in tax-exempt bonds that generate tax-exempt income of $20,000 annually, the tax-exempt income is categorized as “other income”. If the trust is required to distribute $27,000 to the noncharitable beneficiary, the distribution is deemed to come from the capital gain category first until that category is exhausted. Consequently, the noncharitable beneficiary is taxed on the $27,000 distribution at long-term capital gains rates. This will continue with future distributions until the $500,000 capital gain is exhausted.

Targeted transaction

The proposed regulations aim at transactions where taxpayers endeavor to use a CRAT and a single premium immediate annuity (SPIA) in an attempt to avoid recognizing capital gain. Taxpayers in these transactions create a trust claiming to qualify as a CRAT and fund it with appreciated property, which is subsequently sold by the trust. The trust uses some or all of the proceeds to purchase a SPIA. Unlike the example above, however, the noncharitable beneficiary does not treat any portion of the CRAT distributions as gain from the sale of the appreciated property under IRC section 664(b). This would result in a substantial portion of the distribution being taxable. Instead, the noncharitable beneficiary treats distributions as annuity payments under IRC section 72, with only a small portion reported as income. The majority of the distribution is considered a nontaxable return of investment.

The IRS contends this application of IRC sections 664 and 72 is incorrect. Correct application of these rules dictates that the income portion of the SPIA payments be added to the ordinary income category under IRC section 664(b)(1), while the gain from the sale of the appreciated property be added to the capital gains category under IRC section 664(b)(2). Consequently, CRAT distributions would comprise ordinary income and capital gains, with nontaxable corpus reached only after these categories are exhausted.

Implications for taxpayers, material advisors and charitable organizations

Taxpayers, material advisors and charitable organizations that have participated in a transaction that is identical or substantially similar to the transaction described in the proposed regulations must disclose the transaction to the IRS. Moreover, since the IRS will take the position that taxpayers engaged in these transactions are not entitled to the purported tax benefits, such taxpayers should discuss with their tax advisors to consider filing amended returns or otherwise properly disclosing their transactions. Failure to properly disclose can result in significant penalties and an extended statute of limitations period.

It is important to note that the proposed regulations specify that a charitable remainderman will not be treated as a party to the reportable transaction solely due to their charitable remainderman status. This is because CRAT charitable remainderman are often unaware of their status until they receive a distribution.

Reach out to your Baker Tilly advisor if you have any questions on how this may impact you.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments. Baker Tilly US, LLP does not practice law, nor does it give legal advice, and makes no representations regarding questions of legal interpretation.

Michael Lum
Director, J.D.
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