Taxpayers' Attempt to Exclude Income and Defer Gain Using CRATs Falls Short

(Parker Tax Publishing May 2023)

The Tax Court held that members of a family who contributed appreciated property to charitable remainder annuity trusts (CRATs), which then sold the properties and purchased single premium immediate annuities with the proceeds, could not exclude the annuity payments from income because the payments were taxable as ordinary income under Code Sec. 664 and Code Sec. 1245. The court also held that Code Sec. 1245 precluded deferral of gain realized from the disposition of property in a Code Sec. 1031 like-kind exchange. Gerhardt v. Comm'r, 160 T.C. No. 9 (2023).

Background

In 2015, members of the Gerhardt family created charitable lead annuity trusts (CRATs) and contributed appreciated property to the CRATs. The CRATs sold the contributed property and purchased five-year single premium immediate annuities (SPIAs) with most of the proceeds, naming the Gerhardts as recipients of the annuity payments. On their 2016 and 2017 tax returns, the Gerhardts took the position that the payments they received from the CRAT-funded SPIAs were not subject to tax, with the exception of small amounts they reported as interest. The IRS determined deficiencies, taking the position that the annuity payments were distributions from the CRATs and taxable as ordinary income.

Two members of the Gerhardt family, Jack and Shelley, separately relinquished the Armstrong Site, a property located in Armstrong, Iowa, comprised of hog buildings, equipment, and land, plus cash in exchange for other property in 2017. On their tax return for 2017, Jack and Shelley the took the position that gain from the disposition of the relinquished property should be deferred because the transaction qualified as a like-kind exchange under Code Sec. 1031.

Charitable Remainder Annuity Trust

A CRAT is a type of charitable remainder trust which is often used by taxpayers with substantial appreciated capital gain property, a charitable intent, and a need for a stream of income during their lifetimes. As a general rule, the grantor recognizes no gain when transferring appreciated property to a CRAT. Moreover, Code Sec. 664(c) provides that, because CRATs are exempt from income tax, a CRAT can sell appreciated property without itself paying tax on the sale. However, that does not mean that the grantor or other noncharitable CRAT beneficiaries do not have to pay tax with respect to CRAT distributions. This is so because Code Sec. 1015 provides that when property is transferred to a CRAT, its basis in the CRAT's hands is generally the same as it would be in the hands of the grantor.

In addition, under Code Sec. 1001 and Reg. Sec. 1.664-1(d)(1)(i) when the CRAT sells the contributed property, it realizes gain to the extent the amount realized from the sale exceeds its adjusted basis. Although not taxable to the CRAT, that gain must be tracked and affects the treatment of distributions from the CRAT. Code Sec. 664(b)(1) through (4) provide ordering rules that govern the characterization and reporting of annuity amounts distributed by a CRAT to its income beneficiaries. The distributions are characterized in the following order: (1) ordinary income, (2) capital gains, (3) other income, and (4) trust corpus.

Section 1031 Exchange

Typically, under Code Sec. 1031, no gain or loss is recognized on a like-kind exchange of property if all requirements of Code Sec. 1031 are met. But, if property described in Code Sec. 1245(a)(3) (Section 1245 property) is disposed of in a Code Sec. 1031 like-kind exchange, then gain from the disposition of that property may be recognized as ordinary income. Section 1245 property is defined in Code Sec. 1245(a)(3) as "property which is or has been property of a character subject to the allowance for depreciation provided in section 167" that, as relevant here, is either (1) personal property or (2) a single-purpose agricultural or horticultural structure.

Under Code Sec. 1245(a) and (b), the amount recognized generally is limited to the amount by which the lesser of (1) the depreciation deductions claimed with respect to the property and (2) the amount realized in the transaction exceeds the taxpayer's adjusted basis in the property. Reg. Sec. 1.1245-1(a)(5) provides that, if both Section 1245 property and non-Section 1245 property are disposed of in the same transaction, then gain is allocated between the Section 1245 property and the non-Section 1245 property in proportion to their respective fair market values.

Analysis

The Tax Court held that the Gerhardts' annuity payments from the CRAT-funded SPIAs in 2016 and 2017 were distributions from the CRATs and taxable to them as ordinary income under Code Sec. 664. The court further also held that Jack and Shelley failed to show any error in the IRS's determination that Code Sec. 1245 precluded deferral of the gain realized from the disposition of the Armstrong Site.

In the words of the Tax Court, the "gain disappearing act" the Gerhardts attributed to the CRATs was "worthy of a Penn and Teller magic show" but found no support in the Code, regulations, or caselaw. The court noted that in Furrer v. Comm'r, T.C. Memo. 2022-100, it considered facts and arguments nearly identical to those in the case before it now and reached the same conclusion. The court said that the Gerhardts' failure to distinguish this case from Furrer confirmed the court's view that the reasoning in Furrer applied with equal force here.

The Gerhardts were arguing, in the court's view, that the bases of assets donated to a CRAT are equal to their fair market values. However, the court found that Code Sec. 1015 flatly contradicts that position. Code Sec. 1015(a) governs transfers by gift, and Code Sec. 1015(b) governs transfers in trust (other than transfers in trust by gift). The court found that under either provision, the basis in the property "shall be the same as it would be in the hands of the donor" under Code Sec. 1015(a) or "in the hands of the grantor" under Code Sec. 1015(b). The Gerhardts' claim that Code Sec. 1015 does not govern transfers to CRATs because it does not specifically mention them was, in the view of the court, meritless.

The court noted that the Gerhardts also sought shelter in the rules governing the taxation of annuities under Code Sec. 72. But the court responded that if one respects the form of the transactions the Gerhardts chose, the Gerhardts did not but any annuities from Symetra. The CRATs did so and directed how payments under the annuities were to be made. Thus, the court concluded that any amounts paid by Symetra by the CRATs constituted amounts distributed by the CRATs for purposes of Code Sec. 664(b). Nothing in Code Sec. 72, the court said, overrides the Gerhardts' obligation to comply with the rules of Code Sec. 664(b) with respect to those amounts.

The Tax Court also held that Jack and Shelley failed to show that the IRS erred in determining that Code Sec. 1245 precluded deferral of the gain realized from the disposition of the Armstrong Site. The court found that, aside from their broad assertion that the buildings on the Armstrong Site were "incidental to the property and part of the property," Jack and Shelley offered no arguments with respect to the IRS's determination that the Armstrong Site was depreciated Code Sec. 1245 property. Nor did they contend that the limitations in Code Sec. 1245(b)(4) assisted them. In the court's view, to the extent Jack and Shelley were arguing that their gain from the Armstrong Site was allocable primarily to non-Code Sec. 1245 property, they did not set forth any facts supporting that view.

For a discussion of charitable remainder annuity trusts, see Parker Tax ¶57,110. For a discussion of like-kind exchanges, see Parker Tax ¶113,100.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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