Proposed Regs Identify Charitable Remainder Annuity Trusts as Listed Transactions

(Parker Tax Publishing April 2024)

The IRS issued proposed regulations that identify certain charitable remainder annuity trust (CRAT) transactions and substantially similar transactions as listed transactions, a type of reportable transaction. The proposed regulations affect participants in these transactions as well as material advisors but provide that certain organizations whose only role or interest in the transaction is as a charitable remainderman will not be treated as participants in the transaction or as parties to a prohibited tax shelter transaction subject to excise taxes and disclosure requirements. REG-108761-22.

Charitable Remainder Annuity Trusts (CRATs)

Under Code Sec. 664(d)(1), a charitable remainder annuity trust (CRAT) is a trust: (1) from which a "sum certain" of the initial net fair market value of all property placed in the trust (not less than 5 percent nor more than 50 percent) is to be paid at least annually to one or more persons for a term of years (not more than 20 years) or for the life of such individual(s); (2) from which the remainder interest (must be at least 10 percent of the initial fair market value (FMV) of all property placed in the trust) is to be transferred to or for the use of a Code Sec. 170(c) charitable organization after the termination of those payments; and (3) from which no other payments may be made.

Code Sec. 664(b) provides that amounts distributed by a CRAT are considered as having the following characteristics in the hands of a beneficiary to whom the annuity is paid: (1) first, as amounts of income (other than gains, and amounts treated as gains, from the sale or other disposition of capital assets) includible in gross income to the extent of such income of the trust for the year and such undistributed income of the trust for prior years; (2) second, as a capital gain to the extent of the capital gain of the trust for the year and the undistributed capital gain of the trust for prior years; (3) third, as other income to the extent of such income of the trust for the year and such undistributed income of the trust for prior years; and (4) fourth, as a distribution of trust corpus.

Under Code Sec. 664(c), a CRAT is not subject to income tax, but it is liable for an excise tax if it has unrelated business taxable income.

Tax Avoidance Transactions Using a CRAT

According to the IRS, in certain transactions taxpayers attempt to use a CRAT and a single premium immediate annuity (SPIA) to permanently avoid recognition of ordinary income and/or capital gain. Taxpayers engaging in these transactions claim that distributions from the trust are not taxable to the beneficiaries as ordinary income or capital gain under Code Sec. 664(b) because the distributions constitute the trust's unrecovered investment in the SPIA, thus claiming that a significant portion of the distributions is excluded from gross income under Code Sec. 72(b)(2). Taxpayers also claim that the trust qualifies as a CRAT and thus is not subject to tax on the trust's realized ordinary income or capital gain under Code Sec. 664(c)(1), even though the trust may not meet all of the requirements of Code Sec. 664(d)(1).

In these transactions, a grantor creates a trust purporting to qualify as a CRAT under Code Sec. 664. Generally, the grantor funds the trust with property having a FMV in excess of its basis (appreciated property) such as interests in a closely-held business, and/or assets used or produced in a trade or business. The trust then sells the appreciated property and uses some or all of the proceeds from the sale of the contributed property to purchase an annuity. The beneficiary of the trust treats the annuity amount payable from the trust as if it were, in whole or in part, an annuity payment subject to Code Sec. 72, instead of as carrying out to the beneficiary amounts in the ordinary income and capital gain tiers of the trust in accordance with Code Sec. 664(b).

As result of treating Code Sec. 72 as applying to the amounts received (typically paid by an insurance company) as part of the annuity amount, the beneficiary reports as income only a small portion of the amount the beneficiary received from the SPIA. The beneficiary treats the balance of the annuity amount as an excluded portion representing a return of investment. The beneficiary thus claims that the beneficiary is taxed as if the beneficiary were the owner of the SPIA, rather than the SPIA being an asset owned by the CRAT, which the trustee purchased to fund the annuity amount payable from the trust. Under the beneficiary's theory, until the entire investment in the SPIA has been recovered, the only portion of the annuity amount includable in the beneficiary's income is that portion of the SPIA annuity required to be included in income under Code Sec. 72. The beneficiary also maintains that the distribution is not subject to Code Sec. 664(b), which would treat a substantial portion of the annuity amount as gain attributable to the sale of the appreciated property contributed to the CRAT.

In the view of the IRS, the claimed application of Code Secs. 664 and 72 to the transaction described above is incorrect. The IRS's position is that the transaction results in annual ordinary income from the annuity payments from the SPIA being added to the Code Sec. 664(b)(1) (ordinary income) tier of the CRAT's income each year, and a one-time amount being added to the Code Sec. 664(b)(2) (capital gains) tier at the time of the sale of the property by the CRAT (assuming the asset is of a kind to produce capital gain). Assuming no other activity in the CRAT, under Code Sec. 664(b), the beneficiary of the CRAT must treat the annuity amount each year as first consisting of the ordinary income portion of the annuity payments from the SPIA. The balance of the annuity amount must be treated as consisting of any accumulated ordinary income of the CRAT, then accumulated capital gain, and then other income of the CRAT, only reaching nontaxable corpus to the extent these three accounts have been exhausted.

Proposed Regulations

On March 22, the IRS issued proposed regulations that identify the charitable remainder trust transactions described in Prop. Reg. Sec. 1.6011-15(b), and substantially similar transactions, as listed transactions for purposes of Reg. Sec.1.6011-4(b)(2) and Code Secs. 6111 and 6112. In addition, they inform taxpayers that participate in these transactions, and persons who act as material advisors with respect to these transactions, that they would need to disclose the transaction in accordance with the final regulations and the regulations issued under Code Secs. 6011 and 6111. Material advisors must also maintain lists as required by Code Sec. 6112.

Compliance Tip: Form 8886, Reportable Transaction Disclosure Statement, must be attached to the taxpayer's return for each tax year for which a taxpayer participates in a reportable transaction. A copy of the disclosure statement must be sent to the IRS's Office of Tax Shelter Analysis (OTSA). Material advisors must disclose transactions on Form 8918, Material Advisor Disclosure Statement, and also file the disclosure statement with the OTSA.

A transaction is described in Prop. Reg. Sec. 1.6011-15(b) if it includes the following elements:

(1) The grantor creates a trust purporting to qualify as a CRAT under Code Sec. 664;

(2) The grantor funds the trust with property having a FMV in excess of 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 an annuity; and

(5) On a federal income tax return, the beneficiary of the trust treats the amount payable from the trust as if it were, in whole or in part, an annuity payment subject to Code Sec. 72, instead of as carrying out to the beneficiary amounts in the ordinary income and capital gain tiers of the trust in accordance with Code Sec. 664(b).

Participants required to disclose these transactions under Reg. Sec. 1.6011-4 who fail to do so will be subject to penalties under Code Sec. 6707A and are subject to an extended period of limitations under Code Sec. 6501(c)(10). Material advisors required to disclose these transactions under Code Sec. 6111 who fail to do so are subject to penalties under Code Sec. 6707. Material advisors required to maintain lists of investors under Code Sec. 6112 who fail to do so (or who fail to provide such lists when requested by the IRS) are subject to penalties under Code Sec. 6708(a). In addition, the IRS may impose other penalties on persons involved in these transactions or substantially similar transactions, including accuracy-related penalties under Code Sec. 6662 or Code Sec. 6662A, the penalty under Code Sec. 6694 for understatements of a taxpayer's liability by a tax return preparer, the penalty under Code Sec. 6700 for promoting abusive tax shelters, and the penalty under Code Sec. 6701 for aiding and abetting understatement of tax liability. Further, material advisors have disclosure requirements with regard to transactions occurring in prior years. However, notwithstanding Reg. Sec. 301.6111-3(b)(4)(i) and (iii), material advisors are required to disclose only if they have made a tax statement on or after the date that is 6 years before the date of publication of final regulations.

Because the IRS will take the position that taxpayers are not entitled to the purported tax benefits of the listed transactions described in the proposed regulations, the IRS advises that taxpayers who have filed tax returns taking the position that they were entitled to the purported tax benefits should consider filing amended returns or otherwise ensure that their transactions are disclosed properly.

Under the proposed regulations, a Code Sec. 170(c) organization that the purported CRAT designates as the recipient of the remainder interest will not be treated as a party for purposes of the excise tax under Code Sec. 4965 or as a participant in the listed transaction described in Prop. Reg. Sec. 1.6011-15 solely by reason of its status as a charitable remainderman. The IRS requests comments on whether the charitable remainderman ever provides material aid, assistance, or advice with respect to the transactions described in Prop. Reg. Sec. 1.611-15(b) and thus would qualify as a material advisor.

For a discussion of charitable remainder annuity trusts, see Parker Tax ¶57,110. For a discussion of listed transactions, see Parker Tax ¶250,140. For a discussion of disclosures required for material advisors, see Parker Tax ¶253,101.

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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