Transfers of Crops to CRATs Are Not Deductible as Charitable Contributions

(Parker Tax Publishing October 2022)

The Tax Court held that a married couple, engaged in the business of farming, was not entitled to noncash charitable contribution deductions for 2015 and 2016 for portions of crops transferred to charitable remainder annuity trusts (CRATs). Further, the court found that annuity distributions from the CRATs were taxable to the couple as ordinary income for 2015 - 2017 rather than capital gains as the couple had argued. Furrer v. Comm'r, T.C. Memo. 2022-100.

Background

During 2015 - 2017, Donald Furrer and his wife, Rita, were actively engaged in the farming business, growing and selling corn and soybeans. In July 2015, after seeing an advertisement in a farming magazine, the couple formed the Donald & Rita Furrer Charitable Remainder Annuity Trust of 2015 (CRAT I), of which their son was named trustee. The trust instrument designated the couple as life beneficiaries and three eligible Code Sec. 501(c)(3) charities as remaindermen.

When forming CRAT I, the Furrers transferred to it 100,000 bushels of corn and 10,000 bushels of soybeans grown on their farm. In August 2015, CRAT I sold the crops for $469,003. The sales were effected by Co-Alliance LLP, a grain marketing and storage facility in Avon, Indiana, where the couple stored the crops. CRAT I distributed $47,000 of the proceeds to the charitable remaindermen and used most of the balance to purchase a Single Premium Immediate Annuity (SPIA) from Symetra Life Insurance Co. (Symetra). The SPIA made annual annuity payments of $84,368 to the couple in 2015 - 2017.

For each year Symetra issued to the trustee a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. These forms listed the annuity payments as "gross distributions" and showed a small amount of interest as the "taxable amount."

On January 13, 2016, the Furrers created the Donald & Rita Furrer Charitable Remainder Annuity Trust of 2016 (CRAT II). Following the previous pattern, the couple designated themselves as life beneficiaries, with the remainder going to seven eligible Code Sec. 501(c)(3) charities. They funded CRAT II by transferring to it 111,335 bushels of corn and 31,064 bushels of soybeans grown on their farm.

In April 2016, CRAT II sold the crops for $691,827. The sales were again effected by Co-Alliance LLP, the grain marketing and storage facility where the Furrers stored the crops. CRAT II distributed $69,294 of the proceeds to the charitable remaindermen and used the balance to purchase another SPIA from Symetra. This SPIA made annual annuity payments of $124,921 to the Furrers in 2016 and 2017. Symetra again issued a Form 1099-R to the trustee, listing the annuity payments as "gross distributions" and showing a small amount of interest as the "tax-able amount."

The couple timely filed joint federal income tax returns for 2015 - 2017. For those years, the Furrers attached to each return a Schedule F, Profit or Loss From Farming, reporting farming income of approximately $1.050 million, $295,000, and $160,000, respectively, and expenses of approximately $1.058 million, $247,000, and $152,000, respectively.

On their 2015 and 2016 returns, the Furrers claimed charitable contribution deductions for cash gifts but claimed no deductions for their in-kind crop transfers to the CRATs. On each return they reported interest income from the SPIA as shown on the Form 1099-R issued to the trustee. But they did not report the balance of the annuity distributions, taking the position that these payments constituted a nontaxable return of corpus under Code Sec. 664(b)(4). For 2015 and 2016, Donald filed Forms 709, United States Gift (and Generation-Skipping Transfer) Tax Return. On the 2015 return, he reported that the couple had contributed to CRAT I corn and soybeans with a fair market value (FMV) of $469,003 and a cost basis of zero. On the 2016 return, he reported that the couple had contributed to CRAT II corn and soybeans with an FMV of $666,975 and a cost basis of zero.

For each year, the trustee filed for each CRAT a Form 5227, Split-Interest Trust Information Return. The trustee attached to each of the 2015 and 2016 information returns a Form 4797, Sales of Business Property, reporting the sale of the crops contributed by the Furrers. For 2015, he reported that CRAT I had received proceeds of $469,003 from sale of crops with a basis of $471,000, for a loss of $1,997. For 2016, he reported that CRAT II had received proceeds of $691,827 from sale of crops with a basis of $666,975, for a gain of $24,852.

The IRS audited the couple's 2015-2017 income tax returns and determined that their characterization of the SPIA distributions as nontaxable returns of corpus under Code Sec. 664(b)(4) was improper. Rather, the IRS concluded that these distributions represented proceeds from the sale of the couples' corn and soybeans and as such were taxable to them as ordinary income. The IRS thus increased their Schedule F farm income by approximately $83,440 in 2015 and by $206,967 in 2016 and 2017.

During the audit, the Furrers contended that they had neglected to claim on their 2015 and 2016 returns, but should be allowed, noncash charitable contribution deductions for portions of their donations to the CRATs. In their view, the allowable deduction for each year was equal to the proportion of the FMV of the donated crops that was destined to the charitable remaindermen. The couple did not secure an appraisal for either donation or attach a Form 8283, Non-cash Charitable Contributions, to their 2015 or 2016 income tax return. While the examining agent agreed with their position on the charitable contribution deductions and allowed deductions of $67,788 for 2015 and $106,413 for 2016, the IRS later admitted this was a mistake. The IRS issued notices of deficiency for $55,040, $56,904, and $95,907 for 2015-2017, respectively, plus accuracy-related penalties. The Furrers disagreed with the assessment and took their case to the Tax Court.

Taxation of CRATs

A CRAT is a type of charitable remainder trust (CRT). In general, under Code Sec. 664, a CRT provides for annual distributions to the grantor (or other non-charitable life beneficiaries) and an irrevocable remainder interest designated for one or more qualified charities. As a rule, no gain is recognized by the donor upon transfer of appreciated property to a CRT. And because CRTs are exempt from income tax, appreciated property can be sold by the trust tax free. However, notwithstanding a CRT's tax-exempt status, the income earned by the trust is taxable to its income beneficiaries upon distribution.

Code Sec. 664(b) sets forth specific ordering rules that govern the characterization and reporting of annuity amounts distributed by a CRAT to its income beneficiaries. Under this regime, distributions from a CRAT to income beneficiaries are deemed to have the following character, and to be distributed in the following order: first, as ordinary income, to the extent of the trust's current and previously undistributed ordinary income; second, as capital gain, to the extent of the trust's current and previously undistributed capital gain; third, as other income, to the extent of the trust's current and previously undistributed other income; and fourth, as a nontaxable distribution of trust corpus. A CRAT must file an annual information return on Form 5227 describing the tax character of all distributions and it must maintain a record of the basis of all property contributed to it. It must also issue to each income beneficiary a Schedule K-1, Beneficiary's Share of Income, Deductions, Credits, etc., properly describing the tax character of all distributions.

Analysis

The Tax Court held that the couple was not entitled to a charitable contribution deduction for the portions of crops transferred to the CRATs and the couple recognized ordinary income on the annuity distributions. With respect to the charitable contribution deduction, which the IRS subsequently decided the taxpayers were not entitled to, the court found that the Furrers failed to meet the required substantiation provisions in Code Sec. 170(f)(11) for contribution exceeding $5,000. There was no qualified appraisal and nor were there any written records demonstrating the FMV of the property and the methodology used to determine the FMV. Further, the couple failed to attach to their 2015 or 2016 tax return a completed Form 8283, Noncash Charitable Contributions. Even if the Furrers had complied with the statutory substantiation requirements, the court said, the crops were ordinary income property and any deduction would be limited to the Furrers' cost or adjusted basis in the crops.

The court noted that the Furrers did not pay any gift tax upon their transfer of the crops to the CRATs. Under Code Sec. 1015(a), the court said, each CRAT thus acquired a basis of zero in the corn and soybeans, the same basis that the crops had in couples' hands. The FMV of the transferred crops, the court observed, is irrelevant in determining the CRATs' basis because the Furrers' basis was lower than the FMV of the crops. CRAT I and CRAT II, the court concluded, sold the corn and soybeans transferred to them for $469,003 and $691,827, respectively, and because each CRAT had a basis of zero in the crops, the Furrers realized profits of $469,003 and $691,827, respectively, on those sales.

For a discussion of the taxation of CRATs, see Parker Tax ¶57,110. For a discussion of the reporting requirements that must be met to take a charitable contribution deduction, see Parker Tax ¶84,195.

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.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com