Guidance Regarding Charitable Remainder Trusts

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 25

[REG-209823-96]

RIN 1545-AU25

Guidance Regarding Charitable Remainder Trusts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed amendments to the regulations

under section 664 of the Internal Revenue Code of 1986 relating to

charitable remainder trusts and under section 2702 relating to special

valuation rules for transfers of interests in trusts. The proposed

amendments contain rules on the conditions under which the governing

instrument may provide for a change in the method of calculating the

unitrust amount, the date by which the annuity amount or the unitrust

amount under the fixed percentage method must be paid to the recipient,

who is required to value unmarketable assets, and when section 2702

applies to certain charitable remainder unitrusts. The proposed

regulations clarify existing law that prohibits allocating

precontribution capital gain to trust income. The proposed amendments

also contain an example illustrating how the ordering rule of section

664(b) applies to distributions from a charitable remainder unitrust

using an income exception method to calculate the unitrust amount. This

document also provides notice of a public hearing on these proposed

regulations.

DATES: Comments and outlines of topics to be discussed at the public

hearing scheduled for September 9, 1997, at 10 a.m. must be received by

August 19, 1997.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-209823-96), room

5228, Internal Revenue Service, POB 7604, Ben Franklin Station,

[[Page 19073]]

Washington, DC 20044. Submissions may also be hand delivered between

the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-209823-96),

Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,

Washington, DC. Alternatively, taxpayers may submit comments

electronically via the internet by selecting the ``Tax Regs'' option on

the IRS Home Page, or by submitting comments directly to the IRS

internet site at http://www.irs.ustreas.gov/prod/tax/regs/

comments.html.

The public hearing will be held in the IRS Auditorium, Internal

Revenue Building, 1111 Constitution Avenue, NW., Washington, D.C.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Jeffrey A.

Erickson or Mary Beth Collins, (202) 622-3070; concerning submissions

and the hearing, Evangelista Lee, (202) 622-7190 (not toll-free

numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act of 1995 (44

U.S.C. 3507(d)). Comments on the collection of information should be

sent to the Office of Management and Budget, Attn: Desk Officer for the

Department of the Treasury, Office of Information and Regulatory

Affairs, Washington, DC 20503, with copies to the Internal Revenue

Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, DC

20224. Comments on the collection of information should be received by

July 17, 1997. Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the

proper performance of the functions of the Internal Revenue Service,

including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed

collection of information;

How the quality, utility, and clarity of the information to be

collected may be enhanced;

How the burden of complying with the proposed collection of

information may be minimized, including through the application of

automated collection techniques or other forms of information

technology; and

Estimates of capital or start-up costs and costs of operation,

maintenance, and purchase of service to provide information.

The collection of information in this proposed regulation is in

Sec. 1.664-1(a)(7). This information is required to allow taxpayers

alternative means of valuing a charitable remainder trust's hard-to-

value assets. This information will be used to determine if a taxpayer

properly claimed a charitable deduction for a contribution to a

charitable remainder trust and if assets in the charitable remainder

trust are properly valued each year. The collection of information is

voluntary. The likely respondents are for-profit entities.

Estimated total annual recordkeeping burden: 75 hours.

Estimated average annual burden hours per respondent: .5 hours.

Estimated number of respondents: 150.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless it displays a valid

control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax return information are confidential, as required by 26 U.S.C. 6103.

Background

This document proposes amendments to 26 CFR parts 1 and 25 to

provide additional rules under sections 664 and 2702. Section 664,

added to the Internal Revenue Code by section 201 of the Tax Reform Act

of 1969 (Pub. L. 91-172), contains the rules for charitable remainder

trusts. In general, a charitable remainder trust provides for a

specified periodic distribution to one or more noncharitable

beneficiaries for life or for a term of years with an irrevocable

remainder interest held for the benefit of charity. Section 664(c)

provides that a charitable remainder trust is exempt from all taxes

under subtitle A of the Code for any taxable year except a taxable year

in which the trust has unrelated business taxable income under section

512.

There are two types of charitable remainder trusts. A charitable

remainder annuity trust (a CRAT) pays a sum certain at least annually

to one or more noncharitable beneficiaries. A charitable remainder

unitrust (a CRUT) pays a unitrust amount at least annually to one or

more noncharitable beneficiaries. The unitrust amount is generally a

fixed percentage of the net fair market value of the CRUT's assets

valued annually (the fixed percentage method). The unitrust amount can

instead be the lesser of the fixed percentage amount or the trust's net

income (the net income method). Alternatively, the unitrust amount can

be the amount determined under the net income method plus any amount of

income that exceeds the current year's fixed percentage amount to

``make up'' for any shortfall in distributions in prior years when the

trust income was less than the fixed percentage amount (the NIMCRUT

method).

Explanation of Provisions

I. Flip Unitrusts

A. General Explanation

The governing instrument of a CRUT must specify the method of

computing the unitrust payments. Section 664(d)(3) provides that the

income exception methods (either the net income method or the NIMCRUT

method) may be used to pay the unitrust amount ``for any year.'' The

legislative history, however, provides that the method used to

determine the unitrust amount may not be discretionary with the

trustee. H.R. Conf. Rep. No. 782, 91st Cong., 1st Sess. 296 (1969),

1969-3 C.B. 644, 655.

Some donors may fund a CRUT with unmarketable assets that produce

little or no income. These donors often want the income beneficiary or

beneficiaries of the CRUT to receive a steady stream of payments based

on the total return available from the value of the assets. The donors

recognize, however, that the CRUT cannot make these payments until it

can convert the unmarketable assets into liquid assets that can be used

to pay the fixed percentage amount. These donors establish CRUTs that

use one of the income exception methods to calculate the unitrust

amount until the unmarketable assets are sold. Following the sale, the

donors may prefer that the CRUT use the fixed percentage method to

calculate the unitrust amount. A trust using such a combination of

methods would be a ``flip unitrust.''

The proposed regulations provide that a donor may establish a flip

unitrust that qualifies as a CRUT if the following conditions are

satisfied. First, to ensure that the CRUT has substantially all

unmarketable assets prior to the switch in methods, at least 90 percent

of the fair market value of the assets held in the trust immediately

after the initial contribution or any subsequent contribution (prior to

the switch in methods) must consist of unmarketable assets.

Unmarketable assets are assets that are not cash, cash equivalents, or

marketable securities (within the meaning of section 731(c)).

Second, because the legislative history indicates that a trustee

should

[[Page 19074]]

not have discretion to change the method used to calculate the unitrust

amount, the governing instrument must provide that the CRUT will use an

income exception method until the earlier of (a) the sale of a

specified unmarketable asset or group of unmarketable assets

contributed at the time the trust was created or (b) the sale of

unmarketable assets such that immediately following the sale, any

remaining unmarketable assets total 50 percent or less of the fair

market value of the trust's assets. For making this determination, the

remaining unmarketable assets are valued as of the most recent

valuation date.

Third, to ensure that the CRUT will use the fixed percentage method

after the unmarketable assets are sold, the CRUT must switch

exclusively to the fixed percentage method for calculating all

remaining unitrust amounts payable to any income beneficiary at the

beginning of the first taxable year following the year in which the

earlier of the above events occurs.

Finally, because the fixed percentage method does not provide for a

makeup amount, any makeup amount described in section 664(d)(3)(B) is

forfeited when the trust switches to the fixed percentage method.

The IRS and Treasury request comments on whether there are

additional circumstances under which a combination of methods should be

addressed in regulations.

B. Proposed Effective Date and Transitional Rules

The amendments allowing a flip unitrust are proposed to be

effective for CRUTs created on or after the date the final regulations

are published in the Federal Register.

If a trust was created before the effective date of this amendment

and its governing instrument contains a flip provision other than the

one permitted by the regulations, the trust may be amended or reformed

to comply with the final regulations. If a trust is created after the

effective date of this amendment and has a flip provision not expressly

permitted by the regulations, the trust will qualify as a CRUT if it is

amended or reformed to use the initial method for computing the

unitrust amount throughout the term of the trust. If a qualified CRUT

is created before or after the effective date of this amendment and its

governing instrument does not contain a flip provision, the trust will

not continue to qualify as a CRUT if it is amended or reformed to add a

flip provision.

The IRS and Treasury invite comments on the least burdensome

methods of changing the terms of a trust's governing instrument.

II. Time for Paying the Annuity Amount or the Unitrust Amount

A. General Explanation

The regulatory provisions permitting a trustee of a charitable

remainder trust to pay the annuity or unitrust amount within a

reasonable period of time following the close of the trust's taxable

year were intended as an administrative convenience for trustees. Under

the income exception methods, the trustee may not be able to determine

the amount of trust income and, thus, the amount to be distributed for

a trust's taxable year until after the close of that year. Therefore, a

trustee may need the additional time to pay the unitrust amount if a

CRUT uses one of the income exception methods.

In contrast, a trustee of a CRAT or a CRUT using the fixed

percentage method can easily determine the annuity or unitrust amount

and pay it before the close of the taxable year to which it relates.

The annuity amount is fixed and determinable as of the date the trust

is created. The fixed percentage unitrust amount is fixed and

determinable as of the annual valuation date, which is specified in the

governing instrument or on the initial Form 5227, Split-Interest Trust

Information Return. The valuation date can be set well before the end

of the taxable year.

The IRS and Treasury believe that certain trustees of charitable

remainder trusts have attempted to abuse the provisions in the current

regulations that permit a trustee to pay the annuity or unitrust amount

within a reasonable time after the close of the taxable year for which

the payment is due. The IRS and Treasury are especially concerned about

accelerated charitable remainder trusts described in Notice 94-78

(1994-2 C.B. 555). Therefore, the regulations propose to amend

Secs. 1.664-2(a)(1)(i) and 1.664-3(a)(1)(i) to provide that the payment

of the annuity amount or the unitrust amount determined under the fixed

percentage method must be made by the close of the taxable year in

which it is due. These proposed amendments should not require the

amendment or reformation of governing instruments of existing

charitable remainder trusts that allow a trustee to pay the unitrust or

annuity amount after the close of the taxable year. The trustees of

such trusts can comply with the proposed regulations by actually paying

the annuity or unitrust amount within the time permitted by the

proposed amendments.

For CRUTs using an income exception method, the regulations

continue to provide that if the CRUT pays the unitrust amount within a

reasonable time after the close of the trust's taxable year, the trust

is not deemed to have engaged in an act of self-dealing, to have

unrelated debt-financed income, to have received an additional

contribution, or to have failed to function exclusively as a charitable

remainder trust.

B. Proposed Effective Date

These amendments are proposed to be effective for taxable years

ending after April 18, 1997.

The IRS will continue to challenge the purported tax consequences

of accelerated charitable remainder trusts as described in Notice 94-

78.

III. Appraising Unmarketable Assets

A. General Explanation

Under Sec. 1.664-1(a)(1)(iii)(a), a trust may qualify as a

charitable remainder trust only if a deduction is allowable under

sections 170, 2055, 2106, or 2522 for transfers to the trust. The

legislative history of section 664 indicates that Congress contemplated

denying a charitable contribution deduction to a donor who transferred

unmarketable assets to a charitable remainder trust unless an

independent trustee valued the assets. H.R. Rep. No. 413, 91st Cong.,

1st Sess. 60 (1969), 1969-3 C.B. 200, 239. Because the statute does not

contain a corresponding provision, many practitioners have asked

whether a charitable remainder trust that holds unmarketable assets

must have an independent trustee value the assets.

The proposed regulations provide that if a charitable remainder

trust holds unmarketable assets and the trustee is the grantor of the

charitable remainder trust, a noncharitable beneficiary, or a related

or subordinate party to the grantor or the noncharitable beneficiary

within the meaning of section 672(c) and the applicable regulations,

the trustee must use a current qualified appraisal, as defined in

Sec. 1.170A-13(c)(3), from a qualified appraiser, as defined in

Sec. 1.170A-13(c)(5), to value those assets. A trustee who is not the

grantor, a noncharitable beneficiary, or a related or subordinate party

does not have to use a qualified appraisal from a qualified appraiser

to value the unmarketable assets. Therefore, the grantor, a

noncharitable beneficiary, or a related or subordinate party may be the

sole trustee of a charitable remainder trust if the trustee uses a

current qualified appraisal from a qualified appraiser to compute the

fair

[[Page 19075]]

market value of the trust's unmarketable assets.

B. Proposed Effective Date

The amendments are proposed to be effective for trusts created on

or after the date on which the final regulations are published in the

Federal Register. If the governing instrument of an existing trust

created before the effective date of this amendment already requires an

independent trustee to value the trust's unmarketable assets, the

governing instrument may be amended or reformed to conform with this

provision.

IV. Application of Section 2702 to Certain Charitable Remainder

Unitrusts

A. General Explanation

Section 2702 provides special rules to determine the amount of the

gift when an individual makes a transfer in trust to or for the benefit

of a family member and the individual or an applicable family member

retains an interest in the trust. Under section 2702(a), the retained

interest in these situations is generally valued at zero unless the

interest is a qualified interest. Under section 2702(b), a qualified

interest includes the right to receive fixed payments at least annually

and the right to receive amounts at least annually that are a fixed

percentage of the annual fair market value of the property in the

trust.

Section 2702(a)(3)(A)(iii) was added by section 1702(f)(11)(A)(iv)

of the Small Business Job Protection Act of 1996 (Pub. L. 104-188) as a

technical correction to the Revenue Reconciliation Act of 1990 (Public

Law 101-508). Section 2702(a)(3)(A)(iii) provides that section 2702(a)

shall not apply to any transfer to the extent regulations provide that

such transfer is not inconsistent with the purposes of the section.

According to the legislative history, the regulatory authority could be

used to create an exception from the application of section 2702 for a

qualified charitable remainder trust that does not otherwise create an

opportunity for transferring property to a family member free of

transfer tax. H.R. Rep. No. 586, 104th Cong., 2d Sess. 155-56 (1996).

Under Sec. 25.2702-1(c)(3) of the Gift Tax Regulations, section 2702

does not apply to CRUTs or CRATs.

Some taxpayers have created CRUTs using an income exception method

to take advantage of the section 2702 exclusion granted to charitable

remainder trusts in the regulations. These taxpayers attempt to use

this exclusion and the income exception feature of a CRUT to pass

substantial assets to family members with minimal transfer tax

consequences.

For example, a donor establishes a NIMCRUT to pay the lesser of

trust income or a fixed percentage to the donor for a term of 15 years

or his life, whichever is shorter, and then to the donor's daughter for

her life. If the tables under section 7520 are used to value the

donor's retained interest and the donor's gift to the daughter, the

amount of the donor's gift to the daughter is relatively small compared

to the amount the daughter may actually receive. To illustrate, the

trustee may invest in assets that produce little or no trust income

while the donor retains the unitrust interest, creating a substantial

makeup amount. At the end of the donor's interest, the trustee alters

the NIMCRUT's investments to generate significant amounts of trust

income. The trustee then uses the income to pay to the donor's daughter

the current fixed percentage amount and the makeup amount, which

includes the makeup amount accumulated while the donor was the unitrust

recipient.

The use of a CRUT as described in the above example permits the

shifting of a beneficial interest in the trust from the donor to

another family member and, thus, creates an opportunity for

transferring property to a family member free of transfer tax that is

contrary to section 2702(a)(3)(A)(iii). Therefore, the proposed

regulations will amend Sec. 25.2702-1(c)(3) to provide that the

unitrust interests in a CRUT using an income exception method retained

by the donor or any applicable family member will be valued at zero

when someone other than (1) the donor, (2) the donor's spouse, or (3)

both the donor and the donor's spouse (who is a citizen of the U.S.) is

a noncharitable beneficiary of the trust. In these situations, the

value of the donor's gift is the fair market value of all the property

transferred to the CRUT. The present value of the remainder interest

passing to the charitable organization will qualify for the deduction

under section 2522. Accordingly, the amount used to calculate the

donor's gift tax liability is the value of the property transferred to

the trust less the value of the interest passing to charity.

Section 25.2702-1(c)(3) will continue to exclude from the

application of section 2702 transfers to pooled income funds described

in section 642(c)(5) and to CRATs and CRUTs that pay the unitrust

amount under the fixed percentage method.

B. Proposed Effective Date

This amendment is proposed to be effective for transfers in trust

made on or after May 19, 1997.

V. Prohibition on Allocating Precontribution Gain to Trust Income

A. General Explanation

When assets are transferred to a charitable remainder trust, the

amount of the donor's charitable deduction is generally based in part

on the fair market value of the property transferred to the trust.

Although an income exception CRUT provides a different method for

calculating the unitrust amount than a fixed percentage CRUT, any

charitable deduction for an income exception CRUT is calculated as if

the fixed percentage is distributed each year. Allocating amounts to

trust income that are part of the fair market value of the contributed

property on which the charitable deduction was based would be

inconsistent with Congress's intent to assure that the amount claimed

as a charitable deduction for the contribution to the trust relates to

the projected growth of the assets contributed less the expected

distributions to the income beneficiaries. H.R. Rep. No. 413, 91st

Cong., 1st Sess. 58-59 (1969), 1969-3 C.B. 200, 237-38; S. Rep. No.

552, 91st Cong., 1st Sess. 87 (1969), 1969-3 C.B. 423, 479. Therefore,

the regulations clarify that the proceeds from the sale of an income

exception CRUT's assets, at least to the extent of the fair market

value of the asset when contributed to the trust, must be allocated to

principal.

B. Proposed Effective Date

This amendment is proposed to be effective for sales or exchanges

after April 18, 1997. For sales or exchanges on or before the effective

date of this amendment, the Service will continue to challenge any

attempt to allocate precontribution gain to trust income as being

fundamentally inconsistent with applicable local law and with the

amount of the charitable deduction claimed.

VI. Example Illustrating Rule for Characterizing Distributions From

CRUTs

Section 664(b) contains the ordering rule used to determine the

character of the annuity or unitrust amount in the hands of the

recipient. The legislative history states that the ordering rule

applies to both CRATs and CRUTs. S. Rep. No. 552, 91st Cong., 1st Sess.

90 (1969), 1969-3 C.B. 423, 481. The ordering rule applies to the

unitrust amounts received from all CRUTs

[[Page 19076]]

regardless of the method used by the CRUT to determine the unitrust

amount.

Although the current regulations clearly provide that the ordering

rule of section 664(b) and Sec. 1.664-1(d)(1)(i) applies to all

unitrust amounts received from CRUTs, some practitioners have asked

whether the ordering rule applies to unitrust amounts paid under the

income exception methods. To provide taxpayers with additional

guidance, the proposed regulations add an example of how the ordering

rule operates when the unitrust amount is computed under an income

exception method.

VII. Request for Comments on Income Exception CRUTs Holding Certain

Investments

The IRS and Treasury are aware that taxpayers are using income

exception CRUTs to take advantage of the timing difference between the

receipt of trust income (as defined in section 643(b)) and income for

federal income tax purposes. For example, an income exception CRUT may

hold an interest in a partnership controlled by a trustee of the trust,

a grantor, a beneficiary, or a party related or subordinate to the

trustee, the grantor, or a beneficiary. In such a case, an interested

party controls when the trust will receive the earnings from its

partnership interest and, accordingly, when the unitrust recipient will

receive distributions from the trust. Although the income exception

CRUT has taxable income on its distributive share of partnership items,

the trust does not have trust income until it actually receives a

distribution of its share of the partnership's earnings.

The IRS and Treasury are studying whether investing the assets of

an income exception CRUT to take advantage of the timing difference

between the receipt of trust income and income for federal tax purposes

causes the trust to fail to function exclusively as a charitable

remainder trust. Therefore, the IRS and Treasury request comments on

drafting future guidance on this issue. Revenue Procedure 97-23, to be

published on April 28, 1997, in Internal Revenue Bulletin 1997-17,

provides that the IRS will not issue letter rulings on whether a trust

that will calculate the unitrust amount under section 664(d)(3)

qualifies as a section 664 charitable remainder trust when a grantor, a

trustee, a beneficiary, or a person related or subordinate to a

grantor, a trustee, or a beneficiary can control the timing of the

trust's receipt of trust income from a partnership or a deferred

annuity contract to take advantage of the difference between trust

income under section 643(b) and income for federal income tax purposes

for the benefit of the unitrust recipient.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It is hereby certified that

these regulations do not have a significant economic impact on a

substantial number of small entities. This certification is based upon

the fact that the recordkeeping requirement in these regulations does

not affect small entities. Therefore, a Regulatory Flexibility Analysis

under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not

required. Pursuant to section 7805(f) of the Internal Revenue Code,

this notice of proposed rulemaking will be submitted to the Chief

Counsel for Advocacy of the Small Business Administration for comment

on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any comments that are submitted timely

to the IRS. All comments will be available for public inspection and

copying.

A public hearing has been scheduled for September 9, 1997, at 10

a.m. in the IRS Auditorium, Internal Revenue Building, 1111

Constitution Ave, NW., Washington DC. Because of access restrictions,

visitors will not be admitted beyond the Internal Revenue Building

lobby more than 15 minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons who wish to present oral comments at the hearing must

submit comments by August 19, 1997, and submit an outline of the topics

to be discussed and the time to be devoted to each topic by August 19,

1997.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information: The principal authors of these proposed

regulations are Mary Beth Collins and Jeffrey A. Erickson, Office of

the Assistant Chief Counsel (Passthroughs and Special Industries), IRS.

However, personnel from other offices of the IRS and Treasury

Department participated in their development.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 25

Gift taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 25 are proposed to be amended as

follows:

PART 1--INCOME TAXES

Paragraph 1. The authority for part 1 continues to read in part as

follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. In Sec. 1.664-1, paragraphs (a)(7), (d)(1)(iii), and (f)(4)

are added to read as follows (paragraph (f)(4) follows the concluding

text of paragraph (f)(3)):

Sec. 1.664-1 Charitable remainder trusts.

(a) * * *

(7) Valuation of unmarketable assets. If a trust has assets that

are not cash, cash equivalents, or marketable securities (within the

meaning of section 731(c) and the applicable regulations) and the

trustee is the grantor of the charitable remainder trust, a

noncharitable beneficiary, or a related or subordinate party to the

grantor or noncharitable beneficiary within the meaning of section

672(c) and the applicable regulations, the trustee must use a current

qualified appraisal, as defined in Sec. 1.170A-13(c)(3), from a

qualified appraiser, as defined in Sec. 1.170A-13(c)(5), to value those

assets. A trustee who is not the grantor of the charitable remainder

trust, a noncharitable beneficiary, or a related or subordinate party

to the grantor or noncharitable beneficiary does not have to use a

current qualified appraisal from a qualified appraiser to value the

trust's assets.

* * * * *

(d) * * *

(1) * * *

(iii) Example. The following example illustrates the application of

this paragraph (d)(1):

Example. (i) X is a charitable remainder unitrust described in

sections 664(d)(2) and (3). The annual unitrust amount is the lesser

of the amount of trust income, as defined in Sec. 1.664-

3(a)(1)(i)(b)(3), or six percent of the net fair market value of the

trust assets valued annually. The net fair market value of the trust

assets on the valuation date in 1996 is $150,000. During 1996, X has

$7,500 of income after allocating all expenses. All of X's income

for 1996 is tax-exempt income. At the end of 1996, X's ordinary

income for the current taxable year and undistributed

[[Page 19077]]

ordinary income for prior years are both zero; X's capital gain for

the current taxable year is zero and undistributed capital gain for

prior years is $30,000; and X's tax-exempt income for the current

year is $7,500 and undistributed tax-exempt income for prior years

is $2,500.

(ii) Because the trust income of $7,500 is less than the fixed

percentage amount of $9,000, the unitrust amount for 1996 is $7,500.

The character of that amount in the hands of the recipient of the

unitrust amount is determined under section 664(b). Because the

unitrust amount is less than X's undistributed capital gain income,

the recipient of the unitrust amount treats the distribution of

$7,500 as capital gain. At the beginning of 1997, X's undistributed

capital gain for prior years is reduced to $22,500, and X's

undistributed tax-exempt income is increased to $10,000.

* * * * *

(f) * * *

(4) Valuation of unmarketable assets. The rules contained in

paragraph (a)(7) of this section are effective for trusts created on or

after the date the final regulations are published in the Federal

Register. A trust whose governing instrument requires that an

independent trustee value the trust's unmarketable assets may be

amended or reformed to permit any trustee to value those assets if the

trustee uses a current qualified appraisal, as defined in Sec. 1.170A-

13(c)(3), from a qualified appraiser, as defined in Sec. 1.170A-

13(c)(5), in the taxable years beginning on or after the date the final

regulations are published in the Federal Register.

* * * * *

Par. 3. In Sec. 1.664-2, paragraph (a)(1)(i) is revised to read as

follows:

Sec. 1.664-2 Charitable remainder annuity trust.

(a) * * *

(1) * * * (i) Payment of sum certain at least annually. The

governing instrument provides that the trust will pay a sum certain not

less often than annually to a person or persons described in paragraph

(a)(3) of this section for each taxable year of the period specified in

paragraph (a)(5) of this section. The annuity amount must be paid to

the recipient no later than the close of the taxable year for which the

payment is due. The rules contained in this paragraph (a)(1)(i) are

effective for taxable years ending after April 18, 1997.

* * * * *

Par. 4. Section 1.664-3 is amended as follows:

1. Paragraphs (a)(1)(i)(a), (a)(1)(i)(b)(1), and (a)(1)(i)(b)(2)

are revised.

2. Paragraphs (a)(1)(i)(b)(3), (a)(1)(i)(c), (a)(1)(i)(d),

(a)(1)(i)(e), and (a)(1)(i)(f) are added.

3. The third sentence of paragraph (a)(1)(iv) is revised.

4. Paragraph (a)(1)(vi) is added.

The added and revised provisions read as follows:

Sec. 1.664-3 Charitable remainder unitrust.

(a) * * *

(1) * * *

(i) * * * (a) General rule. The governing instrument provides that

the trust will pay not less often than annually a fixed percentage of

the net fair market value of the trust assets determined annually to a

person or persons described in paragraph (a)(3) of this section for

each taxable year of the period specified in paragraph (a)(5) of this

section.

(b) * * *

(1) The amount of trust income for a taxable year to the extent

that such amount is not more than the amount required to be distributed

under paragraph (a)(1)(i)(a) of this section.

(2) An amount of trust income for a taxable year that is in excess

of the amount required to be distributed under (a)(1)(i)(a) of this

section for such year to the extent that (by reason of paragraph

(a)(1)(i)(b)(1) of this section) the aggregate of the amounts paid in

prior years was less than the aggregate of such required amounts.

(3) For this paragraph (a)(1)(i)(b), trust income means income as

defined under section 643(b) and the applicable regulations. Proceeds

from the sale or exchange of any assets contributed to the trust by the

donor must be allocated to principal and not to trust income at least

to the extent of the fair market value of those assets on the date of

contribution.

(c) Combination of methods. Instead of the amount described in

paragraph (a)(1)(i) (a) or (b) of this section, the governing

instrument may provide that the trust will pay the amount described in

paragraph (a)(1)(i)(b) of this section for an initial period and then

pay the amount described in paragraph (a)(1)(i)(a) of this section

(calculated using the same fixed percentage) for the remaining years of

the trust if--

(1) At least 90 percent of the fair market value of the assets held

in the trust immediately after either the initial contribution or any

subsequent contribution (prior to the change in methods) to the trust

consists of unmarketable assets;

(2) The governing instrument provides that the change of method

described in this paragraph (a)(1)(i)(c) will be triggered by the

earlier of--

(i) The sale or exchange of a specified asset or group of assets

that was contributed to the trust on its creation; or

(ii) The sale or exchange of unmarketable assets if immediately

following the sale or exchange, the fair market value of any remaining

unmarketable assets total 50 percent or less of the total fair market

value of the trust's assets. For making this determination, the

remaining unmarketable assets must be valued as of the most recent

valuation date;

(3) The change of method described in this paragraph (a)(1)(i)(c)

takes effect at the beginning of the first taxable year following the

year in which the earlier of paragraph (a)(1)(i)(c)(2) (i) or (ii) of

this section occurs; and

(4) Following the trust's conversion to the method described in

paragraph (a)(1)(i)(a) of this section, the trust will pay at least

annually to the permissible recipients the amount described only in

paragraph (a)(1)(i)(a) of this section and not any amount described in

paragraph (a)(1)(i)(b) of this section.

(5) For this paragraph (a)(1)(i)(c), unmarketable assets are assets

that are not cash, cash equivalents, or marketable securities as

defined in section 731(c) and the applicable regulations.

(d) Example. The following example illustrates the rules in

paragraph (a)(1)(i)(c) of this section:

Example. (i) On the creation of charitable remainder unitrust Y,

S contributes four assets--A, B, C, and D. A is a marketable

security under section 731(c) and the applicable regulations. B, C,

and D are unmarketable assets. The fair market value of B, C, and D

is at least 90 percent of the fair market value of all four assets

at the time of contribution.

(ii) The governing instrument of Y provides for calculating the

unitrust amount under the combination of methods described in

paragraph (a)(1)(i)(c) of this section. The initial method for

calculating the unitrust amount is the lesser of the amount of trust

income, as defined in paragraph (a)(1)(i)(b)(3) of this section, or

six percent of the net fair market value of the trust assets valued

annually. The unitrust amount also includes any amount of trust

income for any taxable year that exceeds six percent of the net fair

market value of the trust's assets valued annually to the extent the

total of the amounts paid in prior years was less than the total of

the amounts computed as six percent of the net fair market value of

Y's assets on the valuation dates. After the change in method, the

unitrust amount will equal six percent of the net fair market value

of Y's assets on the valuation dates.

(iii) The governing instrument provides that the change in

method will occur for the first taxable year beginning after both B

and C are sold or the year in which the trust has sold or exchanged

enough unmarketable assets so that the remaining unmarketable assets

total 50 percent or less of the fair market value of the trust's

assets, whichever occurs first.

[[Page 19078]]

(iv) In Year 3, the trustee of Y sells B, one of the three

unmarketable assets. After the sale of B, the fair market value of

all of Y's unmarketable assets is greater than 50 percent of the

fair market value of Y's assets. Therefore, in Year 3, the method

used to calculate the unitrust amount remains the initial method.

(v) In Year 4, the trustee sells D. After the sale of both B and

D, the fair market value of Y's unmarketable assets is 50 percent or

less of the fair market value of Y's assets. In Year 4, however, the

method used to calculate the unitrust amount remains the initial

method.

(vi) In Year 5 and for all subsequent years, the trust must pay

a unitrust amount equal only to six percent of the net fair market

value of Y's assets determined annually. The change in method occurs

in Year 5 because the fair market value of Y's unmarketable assets

totaled 50 percent or less of the fair market value of Y's assets

after the sale of both B and D. The change in method occurs even

though Y still owns C, the other unmarketable asset specified in the

governing instrument.

(vii) By the end of Year 4, Y's total trust income had been less

than the sum of the unitrust amounts based on six percent of the net

fair market value of Y's assets determined annually, leaving a

balance of $1,000. The $1,000 balance can never be distributed to

the unitrust recipient after the change to the fixed percentage

method.

(e) Payment under general rule. When the unitrust amount is

computed under paragraph (a)(1)(i)(a) of this section, the unitrust

amount must be paid to the recipient no later than the close of the

taxable year of the trust for which the payment is due.

(f) Payment under income exception. When the unitrust amount is

computed under paragraph (a)(1)(i)(b) of this section, the unitrust

amount may be paid to the recipient after the close of the taxable year

of the trust for which the payment is due if paid within a reasonable

time after the close of such taxable year. The trust will not be deemed

to have engaged in an act of self-dealing (within the meaning of

section 4941), to have unrelated debt-financed income (within the

meaning of section 514), to have received an additional contribution

(within the meaning of paragraph (b) of this section), or to have

failed to function exclusively as a charitable remainder trust (within

the meaning of paragraph (a)(4) of this section) merely because payment

of the unitrust amount is made after the close of the taxable year if

such payment is made within a reasonable time after the close of such

taxable year. For this paragraph (a)(1)(i)(f), a reasonable time will

not ordinarily extend beyond the date by which the trustee is required

to file Form 5227, Split-Interest Trust Information Return, (including

extensions) for the taxable year.

* * * * *

(iv) * * * If the governing instrument does not specify the

valuation date or dates, the trustee must select such date or dates and

indicate the selection on the first return on Form 5227, Split-Interest

Trust Information Return, that the trust must file. * * *

* * * * *

(vi) Effective date and reformations. (a) The rules in paragraph

(a)(1)(i)(a) of this section are effective for taxable years ending

after April 18, 1997.

(b) The rules in paragraphs (a)(1)(i) (c) and (d) of this section

are effective for charitable remainder unitrusts created on or after

the date the final regulations are published in the Federal Register.

If a trust was created before the effective date of paragraph

(a)(1)(i)(c) of this section and contains a provision allowing a change

in calculating the unitrust method, the trust may be amended or

reformed to comply with the provisions of paragraph (a)(1)(i)(c) of

this section. If a trust is created after the effective date of

paragraph (a)(1)(i)(c) of this section and contains a provision

allowing a change in calculating the unitrust method that does not

comply with the provisions of paragraph (a)(1)(i)(c) of this section,

the trust will continue to qualify as a charitable remainder unitrust

if it is amended or reformed to use the initial method for computing

the unitrust amount throughout the term of the trust. A qualified

charitable remainder unitrust created before or after the effective

date of paragraph (a)(1)(i)(c) of this section will not continue to

qualify as a charitable remainder unitrust if its governing instrument

is amended or reformed to add a provision allowing a change in the

method for calculating the unitrust amount.

(c) The rules in paragraphs (a)(1)(i)(b) (1), (2), and (3) of this

section are effective for taxable years ending after April 18, 1997 and

for sales or exchanges described in paragraph (a)(1)(i)(b)(3) of this

section that occur after April 18, 1997.

(d) The rules in paragraphs (a)(1)(i) (e) and (f) of this section

are effective for taxable years ending after April 18, 1997.

* * * * *

PART 25--GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954

Par. 5. The authority for part 25 continues to read in part as

follows:

Authority: 26 U.S.C. 7805 * * *

Par. 6. In Sec. 25.2702-1, paragraph (c)(3) is revised to read as

follows:

Sec. 25.2702-1 Special valuation rules in the case of transfers of

interests in trust.

* * * * *

(c) * * *

(3) Charitable remainder trust. (i) For transfers made on or after

May 19, 1997, a transfer to a pooled income fund described in section

642(c)(5); a transfer to a charitable remainder annuity trust described

in section 664(d) (1); a transfer to a charitable remainder annuity

trust described in section 664(d) (2) if under the terms of the

governing instrument the unitrust amount is computed only under section

664(d)(2)(A); and a transfer to a charitable remainder unitrust

described in sections 664(d) (2) and (3) if the only permitted

recipients of the unitrust amount are the donor, the donor's spouse, or

both the donor and the donor's spouse who is a citizen of the United

States.

(ii) For transfers made before May 19, 1997, a transfer in trust if

the remainder interest in the trust qualifies for a deduction under

section 2522.

* * * * *

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 97-9810 Filed 4-17-97; 8:45 am]

BILLING CODE 4830-01-P