The IRS has issued proposed regulations under the uniform basis rules that are intended to prevent a transaction (originally described in Notice 2008-99 and identified as a "transaction of interest") in which a sale or other disposition of all of the interests in a charitable remainder trust take place (including both the noncharitable and charitable interests), resulting in the grantor or other noncharitable recipient receiving the value of that person's annuity or unitrust in the charitable remainder trust while recognizing little or no taxable gain.
The IRS has issued proposed regulations that provide rules for determining the tax basis of a noncharitable beneficiary's term interest (i.e., the annuity or unitrust interest) in a charitable remainder trust (CRT) where the noncharitable beneficiary of the CRT and its charitable remainder beneficiary join together in the sale of their respective interests to a third party. REG-154890-03 (January 16, 2013). The proposed regulations are the IRS's response to a transaction that is designed to allow a taxpayer to contribute appreciated assets to a CRT and later sell his annuity or unitrust interest in the CRT at little or no taxable gain. The transaction avoids the application of IRC § 1001(e)(1), under which the term interest would otherwise have a zero basis when sold, and takes advantage of the uniform basis rules where there is a joint sale of both the term interest and remainder interest of a trust to a third party. The result sought to be achieved is much more favorable than where a term interest in a CRT alone is sold by a noncharitable beneficiary, separate and apart from the remainder interest, where any gain recognized on the sale is equal to the total amount of the proceeds because the term interest in such a case has no tax basis. This very transaction was previously identified as a “transaction of interest” by the IRS in Notice 2008-99 (October 31, 2008), which noted that as a result of the claimed tax treatment of the transaction, the gain on the sale of appreciated assets is never taxed and that “the IRS and the Treasury Department are concerned about the manipulation of the uniform basis ruled to avoid tax on gain from the sale of other disposition of appreciated assets.”
Background on Uniform Basis Rule
Property acquired by a trust from a decedent or as a gift generally has a uniform basis. This means that the property has a single basis even though more than one person has an interest in that property. See Reg. §§ 1.1014-4(a)(1) and 1.1015-1(b). Generally, the uniform basis of assets transferred to a trust is determined under IRC § 1015 for assets transferred by lifetime gift, or under IRC §§ 1014 or 1022 for assets transferred from a decedent. Adjustments to uniform basis for items such as depreciation are made even though more than one person holds an interest in the property (adjusted uniform basis). When a taxable trust sells assets, any gain is taxed currently to the trust, to one or more beneficiaries, or apportioned among the trust and its beneficiaries. If the trust reinvests the proceeds from the sale in new assets, the trust's basis in the newly purchased assets is the cost of the new assets. IRC § 1012. Thus, the adjusted uniform basis of the trust is attributable to the basis obtained with proceeds from sales that were subject to income tax. Although a CRT is exempt from tax, its basis in newly purchased assets is also the cost basis of the new assets, and income realized by the CRT is only recognized when it is deemed to be distributed out to the noncharitable beneficiary in the form annuity or unitrust payments, based upon the IRC § 664 four-tier category and class system.
Basis in Term and Remainder Interests in a CRT
IRC § 1001(e)(1) governs the determination of gain or loss from the sale or disposition of a term interest in property, such as a life or term interest in a CRT. In general, IRC § 1001(e)(1) provides that the portion of the adjusted basis of a term interest in property is disregarded in determining gain or loss from the sale or other disposition of such term interest. See also Reg. § 1.1014-5(b). Thus, the seller of a term interest generally must disregard that portion of the basis in the transferred interest in computing gain or loss. When a noncharitable beneficiary of a CRT sells his annuity or unitrust interest, therefore, the basis in that interest under IRC § 1001(e)(1) is zero, and the entire amount of the proceeds constitutes a capital gain. IRC § 1001(e)(3), however, provides that IRC § 1001(e)(1) does not apply to a sale or other disposition that is part of a transaction in which the entire interest in property is transferred. Therefore, in the case of a sale or other disposition that is part of a transaction in which all interests in a trust are transferred, i.e., both the term and remainder interests, under IRC § 1001(e)(3), the capital gain or loss of each seller of an interest is the excess of the amount realized from the sale of that interest over the seller's basis in that interest. Each seller's basis is the seller's portion of the adjusted uniform basis assignable to the interest so transferred. The basis of a term or remainder interest in a trust at the time of its sale or other disposition is determined under the rules provided in Reg. § 1.1014-5. Specifically, Reg. § 1.1014-5(a)(3) provides that, in determining the basis in a term or remainder interest in property at the time of the interest's sale or disposition, the adjusted uniform basis is allocated using the factors for valuing life estates and remainder interests under Reg. § 20.2031-7. Thus, the portions of the adjusted uniform basis attributable to the interests of the annuity or unitrust beneficiary and the remainderman are adjusted to reflect the change in the relative values of such interests due to the lapse of time.
Description of Transaction Targeted in Proposed Regulations
The transaction targeted in the proposed regulations involves the contribution of appreciated assets to the CRT, upon which the settlor obtains an upfront income tax deduction generally equal to the fair market value of the assets contributed that is attributable to the charitable remainder interest (as discounted to the present value of such remainder interest). The CRT then sells the appreciated assets and, because the CRT is exempt from income tax under IRC § 664, there is no income tax imposed upon the sale, notwithstanding that the fair market value of the assets sold may substantially exceed the basis of such assets. The CRT then reinvests the sale proceeds in other assets, often a portfolio of marketable securities, which attain a tax-basis equal to their cost, so that the assets then held by the CRT are essentially stepped-up to their fair market value. The noncharitable beneficiary of the CRT and charitable remainder beneficiary subsequently sell all of their respective interests in the CRT to a third party. The noncharitable beneficiary of the CRT then takes the position that the entire interest in the CRT has been sold and, therefore, the uniform basis rules of IRC § 1001(e)(3) apply in determining the basis of the interests sold, not the rule of IRC § 1001(e) that would otherwise attribute a zero basis to the term interest sold by the noncharitable beneficiary of the CRT. And, the noncharitable beneficiary takes the position that this uniform basis is derived from the basis of the newly acquired assets by the CRT (having a newly stepped-up tax basis), rather than the settlor's basis in the assets contributed to the CRT. The results sought by the noncharitable beneficiary in this transaction, therefore, are as follows:
Thus, in this transaction, the donor is able to obtain an upfront income tax deduction, but perhaps more importantly, is able to realize sale proceeds attributable to the value of low-basis assets contributed to the CRT with little or no taxable income.
Explanation of Provisions in Proposed Regulations
In the preamble to the proposed regulations, the IRS and the Treasury Department agreed that it is inappropriate for a taxable beneficiary of a CRT to share in the uniform basis obtained through the reinvestment of income not subject to tax due to a CRT’s tax-exempt status. The proposed regulations, therefore, provide a special rule for determining the basis in certain CRT term interests in transactions to which IRC § 1001(e)(3) applies, that is, when both the annuity or unitrust interest and the remainder interest are jointly sold to a third party. In these cases, Prop. Reg. § 1.1014-5(c)(1)(ii) provides that the basis of a term interest of a taxable beneficiary of a CRT is the portion of the adjusted uniform basis assignable to that interest, reduced by the portion of the sum of the following amounts assignable to that interest:
Thus, the noncharitable beneficiary’s basis that is otherwise computed under the uniform basis rules must be reduced by the amount of undistributed ordinary income and capital gain income realized by the CRT attributable to the annuity or unitrust interest being sold. The amount of the undistributed ordinary income and capital gain attributable to the annuity or unitrust interest is determined by applying the same factor under Reg. § 20.2031-7 that is used in determining the adjusted uniform basis attributable to such interest. Prop. Reg. § 1.1014-5(c)(ii). The proposed regulations do not affect the CRT's basis in its assets. Rather, they only apply for the purpose of determining a taxable beneficiary's gain arising from a transaction described in IRC § 1001(e)(3). However, the preamble to the proposed regulations state that “the IRS and the Treasury Department may consider whether there should be any change in the treatment of the charitable remainderman participating in such a transaction.” The following are examples of the application of the proposed regulations:
Example: Grantor creates a charitable remainder unitrust (CRUT) on Date 1 in which Grantor retains a unitrust interest and irrevocably transfers the remainder interest to Charity. Grantor is an individual taxpayer subject to income tax. CRUT meets the requirements of IRC § 664 and is exempt from income tax. Grantor's basis in the shares of X stock used to fund CRUT is $10x. On Date 2, CRUT sells the X stock for $100x. The $90x of gain is exempt from income tax under IRC § 664(c)(1). On Date 3, CRUT uses the $100x proceeds from its sale of the X stock to purchase Y stock. On Date 4, CRUT sells the Y stock for $110x. The $10x of gain on the sale of the Y stock is exempt from income tax under IRC § 664(c)(1). On Date 5, CRUT uses the $110x proceeds from its sale of Y stock to buy Z stock. On Date 5, CRUT's basis in its assets is $110x and CRUT's total undistributed net capital gains are $100x.
Later, when the fair market value of CRUT's assets is $150x and CRUT has no undistributed net ordinary income, Grantor and Charity sell all of their interests in CRUT to a third person. Grantor receives $100x for the retained unitrust interest, and Charity receives $50x for its interest. Because the entire interest in CRUT is transferred to the third person, IRC § 1001(e)(3) prevents IRC § 1001(e)(1) from applying to the transaction. Therefore, Grantor's gain on the sale of the retained unitrust interest in CRUT is determined under IRC § 1001(a), which provides that Grantor's gain on the sale of that interest is the excess of the amount realized, $100x, over Grantor's adjusted basis in the interest. Grantor's adjusted basis in the unitrust interest in CRUT is that portion of CRUT's adjusted uniform basis that is assignable to Grantor's interest under Reg. § 1.1014-5, which is Grantor's actuarial share of the adjusted uniform basis. In this case, CRUT's adjusted uniform basis in its sole asset, the Z stock, is $110x. However, Prop. Reg. § 1.1014-5(c)(1)(ii) applies to the transaction. Therefore, Grantor's actuarial share of the CRUT's adjusted uniform basis determined by applying the factors set forth in the tables contained in Reg. § 20.2031-7 is reduced by an amount determined by applying the same factors to the sum of CRUT's $0 of undistributed net ordinary income and its $100x of undistributed net capital gains. Therefore, if by applying the Reg. § 20.2031-7 factors, the unitrust interest in a CRUT was equal to 66.66%, then the $110x basis is Z stock allocable to such unitrust interest would be equal to $73.33x. Such $73.33x basis would then be reduced by 66.66% of the $100x of the undistributed net capital gains, or $66.66x. As a result, the basis of the unitrust interest would be reduced from $73.33x to $6.67x and the Grantor’s would realize a gain equal to $100x minus $6.67x, or $93.33. Without the application of the proposed regulations, the gain would have been equal to $100x minus $73.33x, or $26.67x, a substantially lesser amount than the $93.33x gain computed based on the application of the proposed regulations.
Example: Grantor creates a charitable remainder annuity trust (CRAT) on Date 1 in which Grantor retains an annuity interest and irrevocably transfers the remainder interest to Charity. Grantor is an individual taxpayer subject to income tax. CRAT meets the requirements of IRC § 664 and is exempt from income tax. Grantor funds CRAT with shares of X stock having a basis of $50x. On Date 2, CRAT sells the X stock for $150x. The $100x of gain is exempt from income tax under section 664(c)(1). On Date 3, CRAT distributes $10x to Grantor, and uses the remaining $140x of net proceeds from its sale of the X stock to purchase Y stock. Grantor treats the $10x distribution as capital gain, so that CRAT's remaining undistributed net capital gains amount is $90x. On Date 4, when the fair market value of CRAT's assets, which consist entirely of the Y stock, is still $140x, which also has a basis of $140x, Grantor and Charity sell all of their interests in CRAT to a third person. Grantor receives $126x for the retained annuity interest, and Charity receives $14x for its remainder interest. Because the entire interest in CRAT is transferred to the third person, IRC § 1001(e)(3) prevents IRC § 1001(e)(1) from applying to the transaction. Therefore, Grantor's gain on the sale of the retained annuity interest in CRAT is determined under IRC § 1001(a), which provides that Grantor's gain on the sale of that interest is the excess of the amount realized, $126x, over Grantor's adjusted basis in that interest.
Grantor's adjusted basis in the annuity interest in CRAT is that portion of CRAT's adjusted uniform basis that is assignable to Grantor's interest under Reg. § 1.1014-5, which is Grantor's actuarial share of the adjusted uniform basis. In this case, CRAT's adjusted uniform basis in its sole asset, the Y stock, is $140x. However, Prop. Reg. § 1.1014-5(c)(1)(ii) applies to the transaction. Therefore, Grantor's actuarial share of CRAT's adjusted uniform basis determined by applying the factors set forth in the tables contained in Reg. § 20.2031-7 is reduced by an amount determined by applying the same factors to the sum of CRAT's $0x of undistributed net ordinary income and its $90x of undistributed net capital gains. Therefore, if by applying the Reg. § 20.2031-7 factors, the annuity interest in a CRAT was equal to 90%, then the $140X basis is Z stock allocable to such unitrust interest would be equal to $126x. Such $126x basis would then be reduced by 90% of the $90x of the undistributed net capital gains, or $81x. As a result, the basis of the unitrust interest would be reduced from $126x to $45x and the Grantor would realize a gain equal to $126 minus $45x, or $81x. Without the application of the proposed regulations, the gain would have been equal to $126x minus $126x, or $0, thereby resulting in no gain realized on the sale of the annuity trust interest.
Effective Date of Proposed Regulations
The proposed regulations apply to sales and other dispositions of interests in CRTs occurring on or after January 16, 2014, except for sales or dispositions occurring pursuant to a binding commitment entered into before that date.
IRS Cautions That Pre-January 16, 2014 Transactions Still Subject to Challenge
The IRS has cautioned in the preamble to the proposed regulations that the inapplicability of the proposed regulations to an excepted sale or disposition, i.e., as a result of it occurring before January 16, 2014, does not preclude the IRS from applying other legal arguments to contest the claimed tax treatment of the transaction. Although not identified in the preamble, one potential attacked could be based on the step-transaction, particularly where the transfer of appreciated assets to a CRT is followed relatively shortly after by the sale of the term and remainder interests, whereby the IRS simply ignores the existence of the CRT and attributes the sale of assets and related tax consequences to the grantor. In such a situation, the only tax consequence of the charity’s participation in the transaction is that any cash that ends up with the charity is treated as a charitable contribution from the grantor to the charity. All other tax consequences are determined as if the CRT was never created, thereby causing the grantor to recognize capital gain on the sale of any appreciated assets by the CRT. Taxpayers who engaged in this type of transaction after Notice 2008-99 was issued back on October 31, 2008 did so at their own risk.
