The Internal Revenue Service recently issued Proposed Regulations (proposed regulations) Section 1.6011-15, which are intended to limit the abuse of certain charitable remainder trust funds. In particular, the proposed rules target CRATs funded with appreciated assets, which are then sold, and the proceeds of the sale are used to purchase a single premium immediate annuity (SPIA). The proposed rules seek to identify these transactions as “listed transactions.”

To prevent deals that are “abusive” to the US tax system, the Internal Revenue Code allows the IRS to treat them as “reportable transactions.” As the name implies, taxpayers must report these transactions to the IRS or face heavy penalties. Advisors or promoters who recommend these transactions may also be subject to special reporting requirements and penalties. The “reportable transactions” category includes arrangements that the IRS identifies as “listed transactions.”

How are CRATs taxed?

The IRC provides special tax treatment for charitable remainder trusts (CRTs), which include CRATs. Among other attributes, KRRTs are entirely exempt from income tax (although they face a 100% excise tax on any unrelated business income they receive or are charged). However, IRC Section 664(b) treats distributions from a CRT (other than charity) as first consisting of ordinary income experienced by the trust, then capital gains, then tax-exempt income, and finally corpus of faith. These trusts are typically used to defer the imposition of income tax on individuals, not to avoid tax entirely. It is perceived that income tax deferral provides individuals with an expanded wealth base from which to draw future income. When the trust ends, which cannot be later than 20 years or the death of the individual beneficiaries identified in the trust when it begins, the trust assets (ie, the remainder) must pass to charity.

How CRAT distributions are taxed

IRC Section 72 also provides a special regime for the taxation of distributions from a CRAT. Generally, distributions are deemed to consist of the investment in the CRAT (which may not be subject to income tax) plus capital gains (if any, on the property used to purchase the annuity contract) and gain on the arrangement (taxed as ordinary income). The ability to have distributions made up of these elements means that income tax can be deferred rather than treated as currently included in the annuitant's gross income.

The transaction identified as a listed transaction

Under Prop. Reg. 1.6011-15, a transaction will be identified as a listed transaction if:

1. The grantor creates a trust that purports to qualify as a CRAT under IRC Section 664;
2. The grantor finances the trust with property that has a fair market value that exceeds its basis (contributed property);
3. The trustee sells the contributed property;
4. The trustee uses some or all of the proceeds from the sale of the contributed property to purchase a SPIA; AND
5. On a federal income tax return, the beneficiary of the trust treats the amount payable by the trust as if it were, in whole or in part, an annuity payment subject to section 72 instead of paying the beneficiary ordinary income amounts and capital gains. of good faith pursuant to section 664(b).

The preamble to the proposed regulations states that those involved in the above transaction (including, in some cases, the charitable remainder beneficiary) face special penalties and reporting requirements (which, if not met, may result in penalties of additional important). They should also keep separate records.

Avoid this or similar transactions and advise any customer to do so.