Guidance Regarding Charitable Remainder Trusts and Special Valuation Rules for Transfers of Interests in Trusts

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1, 25, and 602

[TD 8791]

RIN 1545-AU25

Guidance Regarding Charitable Remainder Trusts and Special

Valuation Rules for Transfers of Interests in Trusts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to

charitable remainder trusts and to special valuation rules for

transfers of interests in trusts. The final regulations provide

additional guidance regarding charitable remainder trusts. The final

regulations affect charitable remainder trusts and their beneficiaries.

DATES: Effective date: These regulations are effective December 10,

1998.

Applicability dates: For dates of applicability of these

regulations, see the explanations under SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: Mary Beth Collins or Jeff Erickson,

(202) 622-3080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

[[Page 68189]]

Paperwork Reduction Act

The collection of information contained in these final regulations

has been reviewed and approved by the Office of Management and Budget

in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under

control number 1545-1536. Responses to this collection of information

are required to allow taxpayers alternative means of valuing a

charitable remainder trust's unmarketable assets.

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

to respond to, a collection of information unless the collection of

information displays a valid control number.

The estimated annual burden per respondent varies from .25 to .75

hours, depending on individual circumstances, with an estimated average

of .5 hours.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP,

Washington, DC 20224, and 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.

Books or records relating to this 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

On April 18, 1997, the IRS published in the Federal Register (62 FR

19072) a notice of proposed rulemaking (REG-209823-96) regarding

sections 664 and 2702. Comments responding to the proposed regulations

were received, and a public hearing was held on November 18, 1997.

After considering the comments received and the statements made at the

public hearing, the proposed regulations are adopted as revised by this

Treasury decision.

Explanation of Provisions

This document amends 26 CFR parts 1 and 25 to provide additional

rules under sections 664 and 2702. Section 664 contains the rules for

charitable remainder trusts (CRTs). In general, a CRT provides for a

specified periodic distribution to one or more beneficiaries (at least

one of whom is a noncharitable beneficiary) for life or for a term of

years with an irrevocable remainder interest held for the benefit of

charity.

There are two types of CRTs: a charitable remainder annuity trust

(CRAT) and a charitable remainder unitrust (CRUT). A CRAT pays a sum

certain at least annually to the beneficiaries (the annuity amount). A

CRUT pays a unitrust amount at least annually to the beneficiaries.

Generally, the unitrust amount is a fixed percentage of the net fair

market value of the CRUT's assets valued annually (fixed percentage

CRUT). The unitrust amount can instead be calculated under one of two

income exception methods (income exception CRUT). Under the first

method, the unitrust amount is the lesser of the fixed percentage

amount or the trust's annual net income (net income method). Under the

second method, the unitrust amount is 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 payments from prior

years when the trust income was less than the fixed percentage amount

(NIMCRUT method). The shortfall in payments from prior years is

commonly referred to as the ``make-up amount.''

The revisions to the proposed regulations are discussed below.

I. Flip Unitrusts

A. Triggering Events

The proposed regulations provide specific rules for when a trust

may convert from one of the income exception methods of computing the

unitrust amount to the fixed percentage method (flip unitrust). The

proposed rule was designed for taxpayers who ultimately wanted the

unitrust amount to be computed on the fixed percentage method but

funded the trust with unmarketable assets that generate little annual

income. A number of commentators agreed with the policy underlying the

proposed rule. Some commentators requested that we permit flip

unitrusts for all income exception CRUTs regardless of the

marketability of the trust assets. Other commentators suggested that

the final regulations clarify whether the proposed rule was a safe

harbor or the exclusive circumstance for which a flip unitrust would be

permitted.

In response, the final regulations expand the availability of the

flip unitrust to certain other situations that the IRS and Treasury

believe are consistent with the legislative history indicating that a

trustee should not have discretion to change the method used to

calculate the unitrust amount. H.R. Conf. Rep. No. 782, 91st Cong., 1st

Sess. 296 (1969), 1969-3 C.B. 644, 655.

The final regulations allow the governing instrument of a CRUT to

provide that the CRUT will convert once from one of the income

exception methods to the fixed percentage method for calculating the

unitrust amount if the date or event triggering the conversion is

outside the control of the trustees or any other persons. The final

regulations include examples of permissible and impermissible

triggering events. For example, permissible triggering events with

respect to any individual include marriage, divorce, death, or birth of

a child. Also, the sale of an unmarketable asset such as real estate is

a permissible triggering event. Examples of impermissible triggering

events include the sale of marketable assets and a request from the

unitrust recipient or the unitrust recipient's financial advisor that

the trust convert to the fixed percentage method.

The final regulations also provide that the conversion to the fixed

percentage method occurs at the beginning of the taxable year that

immediately follows the taxable year in which the triggering date or

event occurs. Any make-up amount described in section 664(d)(3)(B) is

forfeited when the trust converts to the fixed percentage method.

The proposed regulations define unmarketable assets as assets other

than cash, cash equivalents, or marketable securities (within the

meaning of section 731(c)). Commentators asked for clarification of the

term unmarketable assets and recommended changing the scope of this

class of assets. In response, the final regulations define unmarketable

assets as assets other than cash, cash equivalents, or assets that can

be readily sold or exchanged for cash or cash equivalents. For example,

unmarketable assets include real property, closely-held stock, and

unregistered securities for which there is no available exemption

permitting public sale.

Commentators requested that the final regulations permit

conversions from the fixed percentage method to one of the income

exception methods and conversions from a CRAT to a CRUT. The flip

unitrust allowed in the final regulations is the only type of

permissible conversion. Thus, a CRAT cannot convert to a CRUT without

losing its status as a CRT. Similarly, a CRUT using the fixed

percentage method cannot convert to an income exception method without

losing its status as a CRT.

B. Effective Date and Transitional Rules

The rules for flip unitrusts are effective for CRUTs created on or

after December 10, 1998. The proposed regulations allowed reformations

in

[[Page 68190]]

limited circumstances. In response to comments, the final regulations

expand the circumstances in which reformation is available. The final

regulations allow income exception CRUTs to be reformed to add

provisions allowing a conversion to the fixed percentage method

provided the triggering event does not occur in a year prior to the

year in which the court issues the order reforming the trust. Adding

the conversion provisions will not cause the CRUT to fail to function

exclusively as a CRT and will not be an act of self-dealing under

section 4941 if the trustee initiates legal proceedings to reform the

trust by June 8, 1999.

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

The proposed regulations 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. The rules were proposed in response to abuses associated with the

use of accelerated CRTs described in Notice 94-78 (1994-2 C.B. 555).

After receiving a significant number of comments on the proposed rules,

the IRS issued Notice 97-68 (1997-48 I.R.B. 11), which provided

guidance on complying with the proposed rules for the 1997 taxable

year.

One commentator recommended applying the proposed rules only to

trusts created after the date the final regulations are published.

Another commentator suggested adopting the rules in Notice 97-68 for

all trusts created after a certain date. Although recent legislative

changes have reduced the potential tax benefits of accelerated CRTs,

the IRS and Treasury continue to be concerned about the potential abuse

of the post-year-end grace period to produce a tax-free return of

appreciation in the assets contributed to a CRAT or a fixed percentage

CRUT. Therefore, the final regulations adopt rules similar to those in

Notice 97-68 with certain modifications. The rules are effective for

taxable years ending after April 18, 1997.

For CRATs and fixed percentage CRUTs, the annuity or unitrust

amount may be paid within a reasonable time after the close of the year

for which it is due if (a) the character of the annuity or unitrust

amount in the recipient's hands is income under section 664(b)(1), (2),

or (3); and/or (b) the trust distributes property (other than cash)

that it owned as of the close of the taxable year to pay the annuity or

unitrust amount and the trustee elects on Form 5227, ``Split-Interest

Trust Information Return,'' to treat any income generated by the

distribution as occurring on the last day of the taxable year for which

the amount is due. In addition, for CRATs and fixed percentage CRUTs

that were created before December 10, 1998, the annuity or unitrust

amount may be paid within a reasonable time after the close of the

taxable year for which it is due if the percentage used to calculate

the annuity or unitrust amount is 15 percent or less.

III. Appraising Unmarketable Assets

Under section 664(d)(2)(A), a CRUT must value its assets annually.

The proposed regulations provide that, if a CRT holds unmarketable

assets and the only trustee is the grantor, 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 value those assets using 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).

The final regulations follow the proposed regulations and provide

that the trust's unmarketable assets must be valued by an independent

trustee, or by a qualified appraisal from a qualified appraiser. The

proposed regulations define an independent trustee as a person who is

not the grantor, 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 final regulations add the grantor's spouse to the list of persons

to whom an independent trustee cannot be related or subordinate. A co-

trustee who is an independent trustee may value the trust's

unmarketable assets.

Finally, in response to comments, the final regulations define

unmarketable assets as assets other than cash, cash equivalents, or

assets that can be readily sold or exchanged for cash or cash

equivalents. For example, unmarketable assets include real property,

closely-held stock, and unregistered securities for which there is no

available exemption permitting public sale.

The rules for valuing unmarketable assets are effective for trusts

created on or after December 10, 1998.

IV. Application of Section 2702 to Certain CRUTs

Under the proposed regulations, unitrust interests in an income

exception CRUT that are retained by the donor or any applicable family

member will be valued at zero when a noncharitable beneficiary of the

trust is someone other than (1) the donor, (2) the donor's U.S. citizen

spouse, or (3) both the donor and the donor's U.S. citizen spouse.

Commentators stated that income exception CRUTs without a make-up

provision should be exempt from section 2702. The IRS and Treasury

believe that, in addition to the NIMCRUT method, the net income method

can be used to circumvent the intent of section 2702. Therefore, the

final regulations do not exempt from section 2702 CRUTs that use only

the net income method.

Commentators also stated that the proposed rule encompassed other

transfers that section 2702 was not intended to include. A commentator

noted that the proposed rule would value a transferor's interest at

zero even though the transferor merely retained a secondary life

estate. The final regulations clarify that section 2702 will not apply

when there are only two consecutive noncharitable beneficial interests

and the transferor holds the second of the two interests.

Commentators also asked whether section 2702 may apply to flip

unitrusts. The potential abuse associated with income exception CRUTs

also exists with flip unitrusts. Therefore, under the final

regulations, section 2702 applies to a flip unitrust if the CRUT does

not fall within one of the exemptions.

V. Prohibition on Allocating Precontribution Gain to Trust Income

and Make-up Amount as a Liability

The proposed 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 assets when contributed to the trust, must be

allocated to trust principal. Some commentators stated that the rule is

inconsistent with the rule concerning income under section 643(b).

Other commentators questioned whether the make-up amount under the

NIMCRUT method should be treated as a liability when valuing the

trust's assets.

The final regulations maintain the prohibition on allocating

precontribution gain to trust income for an income exception CRUT.

However, the governing instrument, if permitted under applicable local

law, may allow the allocation of post-contribution capital gains to

trust income. Taxpayers do not have to treat the make-up amount as a

liability when valuing the assets of a NIMCRUT.

VI. Example Illustrating Rule for Characterizing Distributions From

CRUTs

The proposed regulations contain an example of how the ordering

rule under section 664(b) operates when the

[[Page 68191]]

unitrust amount is computed under an income exception method. No

comments were received on this example. Thus, the final regulations

adopt the example without any changes.

Effect on Other Documents

Notice 97-68 (1997-48 I.R.B. 11) is obsolete as of December 10,

1998.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

does not apply to these regulations, and because the regulation does

not impose a collection of information on small entities, the

Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply.

Therefore, a Regulatory Flexibility Analysis is not required. Pursuant

to section 7805(f), the notice of proposed rulemaking preceding these

regulations was submitted to the Chief Counsel for Advocacy of the

Small Business Administration for comment on its impact on small

business.

Drafting Information. The principal authors of these regulations

are Mary Beth Collins and Jeff Erickson, Office of the Assistant Chief

Counsel (Passthroughs and Special Industries), IRS. However, other

personnel from 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.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, CFR parts 1, 25, and 602 are amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation 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) and (d)(1)(iii) are

added and paragraph (f)(4) is added following the concluding text of

paragraph (f)(3) to read as follows:

Sec. 1.664-1 Charitable remainder trusts.

(a) * * *

(7) Valuation of unmarketable assets--(i) In general. If

unmarketable assets are transferred to or held by a trust, the trust

will not be a trust with respect to which a deduction is available

under section 170, 2055, 2106, or 2522, or will be treated as failing

to function exclusively as a charitable remainder trust unless,

whenever the trust is required to value such assets, the valuation is--

(a) Performed exclusively by an independent trustee; or

(b) Determined by 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).

(ii) Unmarketable assets. Unmarketable assets are assets that are

not cash, cash equivalents, or other assets that can be readily sold or

exchanged for cash or cash equivalents. For example, unmarketable

assets include real property, closely-held stock, and an unregistered

security for which there is no available exemption permitting public

sale.

(iii) Independent trustee. An independent trustee is a person who

is not the grantor of the trust, a noncharitable beneficiary, or a

related or subordinate party to the grantor, the grantor's spouse, or a

noncharitable beneficiary (within the meaning of section 672(c) and the

applicable regulations).

* * * * *

(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

section 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), 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 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 applicable for trusts created on

or after December 10, 1998. A trust in existence as of December 10,

1998 whose governing instrument requires that an independent trustee

value the trust's unmarketable assets may be amended or reformed to

permit a valuation method that satisfies the requirements of paragraph

(a)(7) of this section for taxable years beginning on or after December

10, 1998.

* * * * *

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.

(a) General rule applicable to all trusts. A 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 Sec. 1.664-1(a)(4)) merely because the annuity amount is

paid after the close of the taxable year if such payment is made within

a reasonable time after the close of such taxable year and the entire

annuity amount in the hands of the recipient is characterized only as

income from the categories described in section 664(b)(1), (2), or (3),

except to the extent it is characterized as corpus described in section

664(b)(4) because--

(1) The trust distributes property (other than cash) that it owned

at the close of the taxable year to pay the annuity amount; and

(2) The trustee elects to treat any income generated by the

distribution as

[[Page 68192]]

occurring on the last day of the taxable year in which the annuity

amount is due.

(b) Special rule for trusts created before December 10, 1998. In

addition to the circumstances described in paragraph (a)(1)(i)(a) of

this section, a trust created before December 10, 1998 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 Sec. 1.664-1(a)(4)) merely because the annuity amount is

paid after the close of the taxable year if such payment is made within

a reasonable time after the close of such taxable year and the sum

certain to be paid each year as the annuity amount is 15 percent or

less of the initial net fair market value of the property irrevocably

passing in trust as determined for federal tax purposes.

(c) Reasonable time. For this paragraph (a)(1)(i), 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.

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

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

Example. X is a charitable remainder annuity trust described in

section 664(d)(1) that was created after December 10, 1998. The

prorated annuity amount payable from X for Year 1 is $100. The

trustee does not pay the annuity amount to the recipient by the

close of Year 1. At the end of Year 1, X has only $95 in the

ordinary income category under section 664(b)(1) and no income in

the capital gain or tax-exempt income categories under section

664(b)(2) or (3), respectively. By April 15 of Year 2, in addition

to $95 in cash, the trustee distributes to the recipient of the

annuity a capital asset with a $5 fair market value and a $2

adjusted basis to pay the $100 annuity amount due for Year 1. The

trust owned the asset at the end of Year 1. Under Sec. 1.664-

1(d)(5), the distribution is treated as a sale by X, resulting in X

recognizing a $3 capital gain. The trustee elects to treat the

capital gain as occurring on the last day of Year 1. Under

Sec. 1.664-1(d)(1), the character of the annuity amount for Year 1

in the recipient's hands is $95 of ordinary income, $3 of capital

gain income, and $2 of trust corpus. For Year 1, X satisfied

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

(e) Effective date. This paragraph (a)(1)(i) is applicable 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)(b)(4), (a)(1)(i)(b)(5),

and (a)(1)(i)(c) through (a)(1)(i)(l) are added.

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

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. This paragraph (a)(1)(i)(a) is applicable for

taxable years ending after April 18, 1997.

(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 paragraph (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.

(4) For this paragraph (a)(1)(i)(b), 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.

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

section are applicable for taxable years ending after April 18, 1997,

and the rule in paragraph (a)(1)(i)(b)(4) is applicable for sales or

exchanges that occur after April 18, 1997.

(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 not less often than annually 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 only if the governing

instrument provides that--

(1) The change from the method prescribed in paragraph (a)(1)(i)(b)

to the method prescribed in paragraph (a)(1)(i)(a) is triggered on a

specific date or by a single event whose occurrence is not

discretionary with, or within the control of, the trustees or any other

persons;

(2) The change from the method prescribed in paragraph (a)(1)(i)(b)

of this section to the method prescribed in paragraph (a)(1)(i)(a) of

this section occurs at the beginning of the taxable year that

immediately follows the taxable year during which the date or event

specified under paragraph (a)(1)(i)(c)(1) of this section occurs; and

(3) 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.

(d) Triggering event. For purposes of paragraph (a)(1)(i)(c)(1) of

this section, a triggering event based on the sale of unmarketable

assets as defined in Sec. 1.664-1(a)(7)(ii), or the marriage, divorce,

death, or birth of a child with respect to any individual will not be

considered discretionary with, or within the control of, the trustees

or any other persons.

(e) Examples. The following examples illustrate the rules in

paragraph (a)(1)(i)(c) of this section. For each example, assume that

the governing instrument of charitable remainder unitrust Y provides

that Y will initially pay not less often than annually the amount

described in paragraph (a)(1)(i)(b) of this section 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

and that the requirements of paragraphs (a)(1)(i)(c)(2) and (3) of this

section are satisfied. The examples are as follows:

Example 1. Y is funded with the donor's former personal

residence. The governing instrument of Y provides for the change in

method for computing the annual unitrust amount as of the first day

of the year following the year in which the trust sells the

residence. Y provides for a combination of methods that satisfies

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

Example 2. Y is funded with cash and an unregistered security

for which there is no available exemption permitting public sale

under the Securities and Exchange Commission rules. The governing

instrument of Y provides that the change in method for computing the

annual unitrust amount is triggered on the earlier of the date when

the

[[Page 68193]]

stock is sold or at the time the restrictions on its public sale

lapse or are otherwise lifted. Y provides for a combination of

methods that satisfies paragraph (a)(1)(i)(c) of this section.

Example 3. Y is funded with cash and with a security that may be

publicly traded under the Securities and Exchange Commission rules.

The governing instrument of Y provides that the change in method for

computing the annual unitrust amount is triggered when the stock is

sold. Y does not provide for a combination of methods that satisfies

the requirements of paragraph (a)(1)(i)(c) of this section because

the sale of the publicly-traded stock is within the discretion of

the trustee.

Example 4. S establishes Y for her granddaughter, G, when G is

10 years old. The governing instrument of Y provides for the change

in method for computing the annual unitrust amount as of the first

day of the year following the year in which G turns 18 years old. Y

provides for a combination of methods that satisfies paragraph

(a)(1)(i)(c) of this section.

Example 5. The governing instrument of Y provides for the change

in method for computing the annual unitrust amount as of the first

day of the year following the year in which the donor is married. Y

provides for a combination of methods that satisfies paragraph

(a)(1)(i)(c) of this section.

Example 6. The governing instrument of Y provides that if the

donor divorces, the change in method for computing the annual

unitrust amount will occur as of the first day of the year following

the year of the divorce. Y provides for a combination of methods

that satisfies paragraph (a)(1)(i)(c) of this section.

Example 7. The governing instrument of Y provides for the change

in method for computing the annual unitrust amount as of the first

day of the year following the year in which the noncharitable

beneficiary's first child is born. Y provides for a combination of

methods that satisfies paragraph (a)(1)(i)(c) of this section.

Example 8. The governing instrument of Y provides for the change

in method for computing the annual unitrust amount as of the first

day of the year following the year in which the noncharitable

beneficiary's father dies. Y provides for a combination of methods

that satisfies paragraph (a)(1)(i)(c) of this section.

Example 9. The governing instrument of Y provides for the change

in method for computing the annual unitrust amount as of the first

day of the year following the year in which the noncharitable

beneficiary's financial advisor determines that the beneficiary

should begin receiving payments under the second prescribed payment

method. Because the change in methods for paying the unitrust amount

is triggered by an event that is within a person's control, Y does

not provide for a combination of methods that satisfies paragraph

(a)(1)(i)(c) of this section.

Example 10. The governing instrument of Y provides for the

change in method for computing the annual unitrust amount as of the

first day of the year following the year in which the noncharitable

beneficiary submits a request to the trustee that the trust convert

to the second prescribed payment method. Because the change in

methods for paying the unitrust amount is triggered by an event that

is within a person's control, Y does not provide for a combination

of methods that satisfies paragraph (a)(1)(i)(c) of this section.

(f) Effective date--(1) General rule. Paragraphs (a)(1)(i)(c), (d),

and (e) of this section are applicable for charitable remainder trusts

created on or after December 10, 1998.

(2) General rule regarding reformations of combination of method

unitrusts. If a trust is created on or after December 10, 1998 and

contains a provision allowing a change in calculating the unitrust

amount that does not comply with the provisions of paragraph

(a)(1)(i)(c) of this section, the trust will qualify as a charitable

remainder unitrust only if it is amended or reformed to use the initial

method for computing the unitrust amount throughout the term of the

trust, or is reformed in accordance with paragraph (a)(1)(i)(f)(3) of

this section. If a trust was created before December 10, 1998 and

contains a provision allowing a change in calculating the unitrust

amount that does not comply with the provisions of paragraph

(a)(1)(i)(c) of this section, the trust may be reformed to use the

initial method for computing the unitrust amount throughout the term of

the trust without causing the trust to fail to function exclusively as

a charitable remainder unitrust under Sec. 1.664-1(a)(4), or may be

reformed in accordance with paragraph (a)(1)(i)(f)(3) of this section.

Except as provided in paragraph (a)(1)(i)(f)(3) of this section, a

qualified charitable remainder unitrust will not continue to qualify as

a charitable remainder unitrust if it is amended or reformed to add a

provision allowing a change in the method for calculating the unitrust

amount.

(3) Special rule for reformations of trusts that begin by June 8,

1999. Notwithstanding paragraph (a)(1)(i)(f)(2) of this section, if a

trust either provides for payment of the unitrust amount under a

combination of methods that is not permitted under paragraph

(a)(1)(i)(c) of this section, or provides for payment of the unitrust

amount under only the method prescribed in paragraph (a)(1)(i)(b) of

this section, then the trust may be reformed to allow for a combination

of methods permitted under paragraph (a)(1)(i)(c) of this section

without causing the trust to fail to function exclusively as a

charitable remainder unitrust under Sec. 1.664-1(a)(4) or to engage in

an act of self-dealing under section 4941 if the trustee begins legal

proceedings to reform by June 8, 1999. The triggering event under the

reformed governing instrument may not occur in a year prior to the year

in which the court issues the order reforming the trust, except for

situations in which the governing instrument prior to reformation

already provided for payment of the unitrust amount under a combination

of methods that is not permitted under paragraph (a)(1)(i)(c) of this

section and the triggering event occurred prior to the reformation.

(g) Payment under general rule for fixed percentage trusts. When

the unitrust amount is computed under paragraph (a)(1)(i)(a) of this

section, a 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 Sec. 1.664-1(a)(4)) merely

because the unitrust amount is paid after the close of the taxable year

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

such taxable year and the entire unitrust amount in the hands of the

recipient is characterized only as income from the categories described

in section 664(b)(1), (2), or (3), except to the extent it is

characterized as corpus described in section 664(b)(4) because--

(1) The trust distributes property (other than cash) that it owned

at the close of the taxable year to pay the unitrust amount; and

(2) The trustee elects to treat any income generated by the

distribution as occurring on the last day of the taxable year for which

the unitrust amount is due.

(h) Special rule for fixed percentage trusts created before

December 10, 1998. When the unitrust amount is computed under paragraph

(a)(1)(i)(a) of this section, a trust created before December 10, 1998

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 Sec. 1.664-1(a)(4)) merely because the unitrust

amount is paid after the close of the taxable year if such payment is

made within a reasonable time after the close of such taxable year and

the fixed percentage to be paid each year as the unitrust amount is 15

percent or less of the net fair market value of the trust assets as

determined under paragraph (a)(1)(iv) of this section.

[[Page 68194]]

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

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

Example. X is a charitable remainder unitrust that calculates

the unitrust amount under paragraph (a)(1)(i)(a) of this section. X

was created after December 10, 1998. The prorated unitrust amount

payable from X for Year 1 is $100. The trustee does not pay the

unitrust amount to the recipient by the end of the Year 1. At the

end of Year 1, X has only $95 in the ordinary income category under

section 664(b)(1) and no income in the capital gain or tax-exempt

income categories under section 664(b) (2) or (3), respectively. By

April 15 of Year 2, in addition to $95 in cash, the trustee

distributes to the unitrust recipient a capital asset with a $5 fair

market value and a $2 adjusted basis to pay the $100 unitrust amount

due for Year 1. The trust owned the asset at the end of Year 1.

Under Sec. 1.664-1(d)(5), the distribution is treated as a sale by

X, resulting in X recognizing a $3 capital gain. The trustee elects

to treat the capital gain as occurring on the last day of Year 1.

Under Sec. 1.664-1(d)(1), the character of the unitrust amount for

Year 1 in the recipient's hands is $95 of ordinary income, $3 of

capital gain income, and $2 of trust corpus. For Year 1, X satisfied

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

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

computed under paragraph (a)(1)(i)(b) of this section, a 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 Sec. 1.664-1(a)(4)) 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.

(k) Reasonable time. For paragraphs (a)(1)(i) (g), (h), and (j) of

this section, 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.

(l) Effective date. Paragraphs (a)(1)(i) (g), (h), (i), (j), and

(k) of this section are applicable for taxable years ending after April

18, 1997.

* * * * *

(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. * * *

* * * * *

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

Par. 5. The authority citation 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 unitrust

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

instrument the unitrust amount can be computed only under section

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

under the terms of the governing instrument the unitrust amount can be

computed under section 664(d)(2) and (3) and either there are only two

consecutive noncharitable beneficial interests and the transferor holds

the second of the two interests, or the only permissible recipients of

the unitrust amount are the transferor, the transferor's U.S. citizen

spouse, or both the transferor and the transferor's U.S. citizen

spouse.

(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.

* * * * *

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 7. The authority citation for part 602 continues to read as

follows:

Authority: 26 U.S.C. 7805.

Par. 8. In Sec. 602.101, paragraph (c) is amended by adding a new

entry in numerical order to the table to read as follows:

Sec. 602.101 OMB Control numbers.

* * * * *

(c) * * *

------------------------------------------------------------------------

CFR part or section where identified

and described Current OMB control No.

------------------------------------------------------------------------

* * * * *

1.664-1(a)(7)....................... 1545-1536

* * * * *

------------------------------------------------------------------------

Approved: December 1, 1998.

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

Donald C. Lubick,

Assistant Secretary of the Treasury (Tax Policy).

[FR Doc. 98-32559 Filed 12-9-98; 8:45 am]

BILLING CODE 4830-01-P