The IRS Targets Some CRATs (Charitable Remainder Annuity Trusts) as Listed Transactions

The IRS Proposes Charitable Remainder Annuity Trusts (CRATs) as Listed Transaction

IRS Proposes Charitable Remainder Annuity Trusts (CRATs) as Listed Transaction

There are many different types of Charitable Trusts that taxpayers can enter into, with one of the most common types of Charitable Trusts being the Charitable Remainder Annuity Trust (CRAT). Unfortunately, in recent years the CRAT has been exploited by tax promoters in which taxpayers transfer money into a CRAT and then increase the basis (step-up basis) significantly to the Fair Market Value similar to when a person receives an asset as an inheritance. Then, once the asset is sold and the Single Premium Immediate Annuity (SPIA) is purchased, the taxpayer only pays a small amount of income tax on the amount they claim represents the portion that is not a return of basis. As you can imagine, the IRS disagrees with this position and in fact there was a recent case filed in which the U.S. government is going after tax promoters who are selling this type of promotion to taxpayers. Now, based on proposed regulations issued by the IRS, the government seeks to categorize certain Charitable Remainder Annuity Trusts as listed transactions — which will require taxpayers and others to report additional information each year about the CRAT to the IRS each year — and the failure to do so can lead to significant fines and penalties. Let’s take a look at the relevant portion of the proposed regulation below.

CRATs as Listed Transactions

Tax Avoidance Transactions Using a CRAT

• • • The Treasury Department and the IRS are aware of transactions in which 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 section 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 section 72(b)(2) of the Code. 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 section 664(c)(1), even though the trust may not meet all of the requirements of section 664(d)(1).

    • In these transactions, a grantor creates a trust purporting to qualify as a CRAT under section 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. On a Federal income tax return, 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 section 72,^[2] instead of as carrying out to the beneficiary amounts in the ordinary income and capital gain tiers of the trust in accordance with section 664(b).

    • As result of treating section 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.^[3] 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 section 72. The beneficiary also maintains that the distribution is not subject to section 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.

    • The trustee also might take the position that the transfer of the appreciated property to the purported CRAT gives those assets a step-up in basis to FMV as if they had been sold to the trust. The transfer of property to a CRAT, however, does not give those assets a step-up in basis to FMV, as if they had been sold to the trust, giving the trust a cost basis under section 1012 of the Code. Instead, the transfer to the CRAT is a gift for Federal tax purposes. When a grantor transfers appreciated property to a CRAT, the CRAT’s basis in the assets is determined under section 1015 of the Code. Under section 1015(a) and (d), property transferred by gift (whether or not in trust) retains its basis in the hands of the donor, increased (but not above FMV) by any gift tax paid on the transfer.

Explanation of Provisions

Charitable Remainder Annuity Trust Transaction

• • • Proposed §?1.6011-15(a) would identify a transaction that is the same as, or substantially similar to, the transaction described in proposed §?1.6011-15(b) as a listed transaction for purposes of §?1.6011-4(b)(2). “Substantially similar” is defined in §?1.6011-4(c)(4) to include any transaction that is expected to obtain the same or similar types of tax consequences and that is either factually similar or based on the same or a similar tax strategy.

    • A transaction is described in proposed §?1.6011-15(b) if it includes the following elements:

    • (i) The grantor creates a trust purporting to qualify as a CRAT under section 664;

    • (ii) The grantor funds the trust with property having a FMV in excess of its basis (contributed property);

    • (iii) The trustee sells the contributed property;

    • (iv) The trustee uses some or all of the proceeds from the sale of the contributed property to purchase an annuity; and

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

Participants

• • • Whether a taxpayer has participated in the listed transaction described in proposed §?1.6011-15(b) is determined under §?1.6011-4(c)(3)(i)(A). Participants include any person whose tax return reflects tax consequences or a tax strategy described in proposed §?1.6011-15(b). These tax consequences include those tax consequences described in proposed §?1.6011-15(b) that would affect any gift tax return, whether or not such gift tax return was filed. See §?25.6011-4.

    • A taxpayer also has participated in a transaction described in proposed §?1.6011-15(b) if the taxpayer knows or has reason to know that the taxpayer’s tax benefits are derived directly or indirectly from tax consequences, or a tax strategy, described in proposed §?1.6011-15(b).

Material Advisors

• • • Material advisors who make a tax statement with respect to transactions identified as listed transactions in proposed §?1.6011-15(b) would have disclosure and list maintenance obligations under sections 6111 and 6112. See §§?301.6111-3 and 301.6112-1. One of the requirements to be a material advisor under section 6111(b)(1) is that the person must directly or indirectly derive gross income in excess of the threshold amount provided in 6111(b)(1)(B) for providing material aid, assistance, or advice with respect to the listed transaction.

    • That threshold in the case of a listed transaction is reduced to $10,000 if substantially all of the tax benefits are provided to natural persons (looking through any partnerships, S corporations, or trusts), or to $25,000 for any other transaction. See §?301.6111-3(b)(3)(i)(B). The regulations under section 6111 provide that gross income includes all fees for a tax strategy, for services for advice (whether or not tax advice), and for the implementation of a reportable transaction. See §?301.6111-3(b)(2)(ii).

    • However, a fee does not include amounts paid to a person, including an advisor, in that person’s capacity as a party to the transaction. See §?301.6111-3(b)(3)(ii).

Effect of Participating in Listed Transaction Described in Proposed §?1.6011-15(b)

• • • Participants required to disclose these transactions under §?1.6011-4 who fail to do so will be subject to penalties under section 6707A. Such disclosure also must include any gift tax consequences. See §?25.6011-4. Participants required to disclose these transactions under §?1.6011-4 who fail to do so also are subject to an extended period of limitations under section 6501(c)(10). Material advisors required to disclose these transactions under section 6111 who fail to do so are subject to penalties under section 6707. Material advisors required to maintain lists of investors under section 6112 who fail to do so (or who fail to provide such lists when requested by the IRS) are subject to penalties under section 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 section 6662 or section 6662A, the penalty under section 6694 for understatements of a taxpayer’s liability by a tax return preparer, the penalty under section 6700 for promoting abusive tax shelters, and the penalty under section 6701 for aiding and abetting understatement of tax liability.

    • In addition, material advisors have disclosure requirements with regard to transactions occurring in prior years. However, notwithstanding §?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 [DATE 6 YEARS BEFORE DATE OF PUBLICATION OF FINAL RULE].

    • 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, 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.

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