Donor takes these positions regarding the tax consequences of this transaction:
• Donor claims to recognize no gain from the Trust’s sale or liquidation of the Appreciated Assets. When Donor and Charity sell their respective interests in Trust to Xenocrates, Donor and Charity take the position that they have sold the entire interest in Trust within the meaning of IRC §1001(e)(3). Because the entire interest in Trust is sold, Donor claims that IRC §1001(e)(1), which disregards basis in the case of a sale of just the term interest, does not apply. Donor also takes the position that, under IRC §1001(a) and related provisions, the gain on the sale of Donor’s term interest is computed by taking into account the portion of uniform basis allocable to Donor’s term interest under Reg. §§1.1014-5 and 1.1015-1(b), and that this uniform basis is derived from the basis of the New Assets rather than the basis of the Appreciated Assets. (If this works, Donor has achieved Tax Nirvana – a stepped-up basis without giving his life.)
Notice 2008-99 describes a number of variations on the above theme or scheme.
Ordinary folks needn’t worry. The IRS and the Treasury aren’t concerned about the mere creation and funding of a charitable remainder trust with appreciated assets and/or the trust’s reinvestment of the contributed appreciated assets. Those events alone don’t constitute the transaction subject to Notice 2008-99.
Who Should Be Concerned?
The IRS and the Treasury “are concerned about the manipulation of the uniform basis rules to avoid tax on gain from the sale or other disposition of appreciated assets. Accordingly, the type of transaction described in [Notice 2008-99] includes a coordinated sale or other coordinated disposition of the respective interests of the [Donor] or other noncharitable recipient and the Charity in a charitable remainder trust in a transaction claimed to be described in §1001(e)(3), subsequent to the contribution of appreciated assets and the trust’s reinvestment of those assets.”
Transactions of Interest
Now for Notice 2008-99′s teeth – transactions of interest. Transactions that are the same as, or substantially similar to, those described in Notice 2008-99 “are identified as transactions of interest for purposes of §1.6011-4(b)(6) and §§6111 and 6112 effective Oct. 31, 2008. Persons entering into these transactions on or after Nov. 2, 2006, must disclose the transaction as described in §1.6011-4. Material advisors who make a tax statement on or after Nov. 2, 2006, with respect to transactions entered into on or after Nov. 2, 2006, have disclosure and list maintenance obligations under §§6111 and 6112.” A plethora of penalties will be imposed on those who are required to disclose to IRS but don’t.
Treasury and the IRS asked for public comments. Greatly abbreviated, here’s the gist of comments submitted by the American Council on Gift Annuities. I prepared them as ACGA’s pro bono counsel.
ACGA supported the Treasury’s and the IRS’s efforts to curb any abuses involving the tax treatment of charitable contributions and agreed that the capital gains avoidance described in Notice 2008-99 should be curbed. Any corrective regulation or legislation should, however, also deal fairly with and not thwart proper transactions.
In these difficult economic times, ACGA noted that some life-income recipients of charitable remainder trusts and the charitable remainder organizations wish to terminate those trusts early – the charities need funds now (instead of in the future when the trust term ends) and the life-income recipients need immediate funds (instead of piecemeal over the balance of the trust term). Improper capital gain avoidance is not on their radar.
Good Examples
The abuse under the facts detailed in Notice 2008-99 should be curbed. However, the following two examples show how it would be unfair and not in furtherance of good tax policy to reduce in all cases the basis in the life-income recipient’s interest to zero on a sale to a third party of the respective interests of the life-income recipient and the charitable remainder organization.
The examples are followed by a suggested solution to the abuse outlined in Notice 2008-99. ACGA stated that it is fair to the Treasury, the IRS, the life-income recipient, and the charitable remainder organization.
Example 1. Five years ago, a donor transferred securities valued at $1 million to fund a charitable remainder unitrust. The securities were not appreciated and had a $1 million basis and the CRUT took over the donor’s basis. The CRUT retained the assets used to fund the trust. The donor, who is the life-income recipient, and the charitable remainder organization now terminate the CRUT by selling their respective interests to a third party for $1 million, the current fair market value.
The life-income recipient’s interest is now valued at 60 percent of the fair market value of the CRUT’s assets and the charity’s remainder interest is now valued at 40 percent of the CRUT’s assets. So the life-income recipient receives $600,000 and the charity receives $400,000. It would be unfair for the life-income recipient’s basis to be deemed to be zero. In this case, he hasn’t through the CRUT stepped up the basis of the assets used to fund the trust. Thus the basis of his share of the trust assets sold to the third party should be $600,000. The same rule should apply if the CRUT sold the assets originally used to fund the trust and purchased other assets and at the time the trust is terminated those new assets are also valued at $1 million (with the life-income recipient’s then interest being valued at $600,000).
Example 2. Donor funded his charitable remainder unitrust with appreciated assets that had a basis of $800,000 and a $1 million fair market value and the trust took over the donor’s basis. The funding assets were sold by the CRUT and the proceeds reinvested in new assets having a $1 million fair market value. Five years after the CRUT was created, the life-income recipient and the charitable remainder organization sell their respective interests to a third party for $1 million. At that time, the life-income recipient’s interest is worth 60 percent of the value of the CRUT’s assets and he receives $600,000. It would be unfair (not intended by Congress) for him to have no capital gain, nor would it be fair for him to have a zero basis and a $600,000 capital gain. To thicken the plot, suppose the donor as the CRUT life-income recipient was taxed on some or all of the capital gain when it was deemed distributed to him and taxable under the capital gains category of Reg. Sec. 1.664-1. This should be taken into account in determining the life-income recipient’s basis on the termination of the CRUT.
Suggested Solution
The life-income recipient’s basis is his pro rata share of the charitable remainder unitrust’s or annuity trust’s basis reduced by his pro rata share of any undistributed amounts then in the capital gains category of Reg. Sec. 1.664-1. Hereinafter, this suggested solution is called the “adjusted uniform basis rule.”
ACGA requested that the adjusted uniform basis rule should apply not only when a charitable remainder trust is terminated by the parties’ sale of their respective interests to a third party, but also to a termination of the trust with the assets being divided pro rata between the life-income recipient and the charitable remainder organization. It is not wise public policy to require the life-income recipient and the charitable remainder organization to go through the exercise and expense of finding and then selling the trust assets to a third party. If the adjusted uniform basis rule is adopted for a termination by a sale to a third party, it should also apply to a pro rata distribution of the assets between the parties. Since capital gain won’t be improperly avoided under the adjusted uniform basis rule, that rule should also be made applicable in the latter situation by guidance in the form of a revenue ruling, revenue procedure, regulations or otherwise.
Caution: The IRS has suspended issuing letter rulings on the early termination of charitable remainder unitrusts and annuity trusts. Most recently in Rev. Proc. 2009-3 under Section 5. Areas under study in which rulings or determination letters will not be issued until the IRS resolves the issue through the publication of a revenue ruling, revenue procedure, regulations or otherwise, it is stated:
.09 Section 664 – Charitable Remainder Trusts. Whether the termination of a charitable remainder trust before the end of the trust term as defined in the trust’s governing instrument, in a transaction in which the trust beneficiaries receive their actuarial shares of the value of the trust assets, causes the trust to have ceased to qualify as a charitable remainder trust within the meaning of §664.
This pronouncement can have a deep-freeze effect on non-abusive early terminations of charitable remainder trusts. And the ability to do so, as stated earlier, is important to charitable remainder organizations and life-income recipients in these troubled economic times. Thus ACGA asked that guidance be issued promptly.
Conrad Teitell is a principal at Cummings & Lockwood in Stamford, Conn. Conrad Teitell 2009