Prevention of Abuse of Charitable Remainder Trusts

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-116125-99]

RIN 1545-AX62

Prevention of Abuse of Charitable Remainder Trusts

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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

SUMMARY: This document contains proposed regulations that modify the

application of the rules governing the character of certain

distributions from a charitable remainder trust. These regulations are

necessary to prevent taxpayers from using charitable remainder trusts

to achieve inappropriate tax avoidance. The regulations affect

charitable remainder trusts described in section 664 and certain

beneficiaries of those trusts. This document also provides a notice of

public hearing on these proposed regulations.

DATES: Written comments must be received by January 19, 2000. Requests

to speak (with outlines of oral comments) at the public hearing

scheduled for February 9, 2000, at 10 a.m. must be submitted by January

19, 2000.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-116125-99), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. In the alternative, submissions may be hand

delivered Monday through Friday between the hours of 8 a.m. and 5 p.m.

to: CC:DOM:CORP:R (REG-116125-99), 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 of the IRS Home Page, or by

submitting comments directly to the IRS Internet site at: http://

www.irs.ustreas.gov/tax__regs/regslist.html. The public hearing will be

held in room 2615, Internal Revenue Building, 1111 Constitution Avenue,

NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Catherine

Moore, (202) 622-3070; concerning submissions of comments, the hearing,

and/or to be placed on the building access list to attend the hearing,

Guy Traynor, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: This document proposes to amend sections 643

and 664 of the Income Tax Regulations (26 CFR part 1) to provide

additional rules regarding charitable remainder trusts.

Background

Section 664, added to the Internal Revenue Code (Code) by section

201(e) of the Tax Reform Act of 1969 (Public Law 91-172 (83 Stat. 487,

562-64)), 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. The amount distributed to the noncharitable

beneficiaries may be either a sum certain, in the case of a charitable

remainder annuity trust, or a fixed percentage of the net fair market

value of the trust's assets valued annually, in the case of a

charitable remainder unitrust. Section 664(b) provides rules for

determining the character of amounts distributed by a charitable

remainder trust in the hands of the beneficiary to whom the

distribution is made. In general, a distribution is taxable to the

beneficiary if it represents a distribution of ordinary income or

capital gain of the trust. A distribution generally is not taxable to

the beneficiary if it represents a distribution of tax-exempt income of

the trust or of trust corpus. 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.

Section 643(a)(7), added to the Code by section 1906(b) of the

Small Business Job Protection Act of 1996 (Public Law 104-188 (110

Stat. 1755, 1915)), authorizes the Secretary of the Treasury to issue

regulations that may be necessary or appropriate to carry out the

purposes of the rules applicable to estates, trusts, and beneficiaries,

including regulations to prevent the avoidance of those purposes.

Explanation of Provisions

A. Tax-Avoidance Arrangements Using Charitable Remainder Trusts

The IRS and the Treasury Department are aware of certain abusive

transactions that attempt to use a section 664 charitable remainder

trust to convert appreciated assets into cash while avoiding tax on the

gain from the disposition of the assets. In these transactions, a

taxpayer typically contributes highly appreciated assets to a

charitable remainder trust having a relatively short term and

relatively high payout rate. Rather than sell the assets to obtain cash

to pay the annuity or unitrust amount to the beneficiary, the trustee

borrows money, enters into a forward sale of the assets, or engages in

some similar transaction. Because the borrowing, forward sale, or other

similar transaction does not result in current income to the trust, the

parties attempt to characterize the distribution of cash to the

beneficiary as a tax-free return of corpus under section 664(b)(4).

Distributions may continue to be funded in this manner for the duration

of the trust term (which is usually short, so as to meet the 10-percent

remainder requirement of section 664(d)(1)(D) or 664(d)(2)(D)). The

appreciated assets may be sold and the transaction closed out (e.g.,

the loan is repaid) in the last year of the trust, or the trustee may

distribute the appreciated assets, subject to a contractual obligation

to complete the transaction (e.g., the forward sale contract), to the

charitable beneficiary.

A mechanical and literal application of rules and regulations that

would yield a result inconsistent with the purposes of the charitable

remainder trust provisions will not be respected. When section 664 was

amended by the Revenue Reconciliation Act of 1997, Congress indicated

that a scheme that, in effect, attempts to convert appreciated assets

to a tax-free cash distribution to the non-charitable beneficiary is

``abusive and is inconsistent with the purpose of the charitable

remainder trust rules.'' S.

[[Page 56719]]

Rep. No. 33, 105th Cong., 1st Sess. 201 (1997). Although the particular

scheme that was the focus of Congress's attention in 1997 involved an

attempt to exploit the interplay of rules under section 664 governing

the timing of income and the character of trust distributions, the

attempted result of the scheme (commonly referred to as an

``accelerated charitable remainder trust'') was the same as that

claimed by the promoters of the transactions described above--that is,

a literal application of rules governing trust distributions in an

attempt to convert appreciated trust assets into tax-free cash in the

hands of the non-charitable beneficiary. The latest schemes involving

charitable remainder trusts are no less ``abusive'' or ``inconsistent

with the purpose of the charitable remainder trust rules'' than were

the accelerated charitable remainder trust schemes addressed by

Congress in 1997.

B. The Proposed Regulations

Section 643(a)(7) authorizes the Secretary to prescribe regulations

to carry out the purposes of the provisions of the Code relating to the

taxation of estates, trusts, and beneficiaries, including regulations

to prevent avoidance of such purposes. The proposed regulations

exercise this authority by modifying the treatment of certain

distributions by charitable remainder trusts for purposes of section

664(b) to prevent a result that, as discussed above, is inconsistent

with the purposes of the charitable remainder trust rules.

The proposed regulations provide that, to the extent that a

distribution of the annuity or unitrust amount from a charitable

remainder trust is not characterized in the hands of the recipient as

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

(determined without regard to the rules in these proposed regulations)

and was made from an amount received by the trust that was neither a

return of basis in any asset sold by the trust (determined without

regard to the rules in these proposed regulations) nor attributable to

a contribution of cash to the trust with respect to which a deduction

was allowable under section 170, 2055, 2106, or 2522, the trust shall

be treated as having sold, in the year for which the distribution is

due, a pro rata portion of the trust assets. Any transaction that has

the purpose or effect of circumventing this rule will be disregarded.

For example, a return of basis in an asset sold by a charitable

remainder trust does not include basis in an asset purchased by the

charitable remainder trust from the proceeds of a borrowing secured by

previously contributed assets.

The proposed regulations include examples that illustrate the

application of the above rule. The IRS and the Treasury Department

request comments on whether there are situations where the application

of this rule would be inappropriate.

These proposed regulations adopt a pro-rata sale approach to

determine the amount of gain on the distribution of funds acquired in

advance of income recognition. The IRS and the Treasury Department also

considered an approach that more directly related the distributed funds

to the asset that is the subject of the borrowing or forward sale.

Comments are requested on this alternative approach.

C. Proposed Effective Date

The regulations are proposed to apply to distributions made by

charitable remainder trusts after October 18, 1999.

However, to the extent that a charitable remainder trust financed a

distribution to a beneficiary by borrowing funds or entering into a

forward sale or other similar transaction prior to the effective date

of these regulations, the IRS may apply an appropriate legal doctrine

to recast the entire transaction, to characterize the distribution as

gross income rather than corpus, or to challenge the qualification of

the trust under section 664. In appropriate circumstances, the IRS may

impose the tax on self-dealing transactions under section 4941.

Additionally, the trust may be treated as having unrelated business

taxable income under section 512 from the transaction. The IRS will

also apply any applicable penalties to the participants in the

transaction.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in Executive Order

12866. Therefore, a regulatory assessment is not required. It is hereby

certified that these regulations will not have a significant economic

impact on a substantial number of small entities. This certification is

based on the understanding of the IRS and Treasury Department that the

number of charitable remainder trusts engaging in transactions affected

by these regulations is not substantial, and none are small entities

within the meaning of the Regulatory Flexibility Act (5 U.S.C. chapter

6). 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 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 written comments (preferably a

signed original and eight (8) copies) that are submitted timely to the

IRS. The IRS and the Treasury Department specifically request comments

on the clarity of the proposed regulations and how they may be made

easier to understand. All comments will be available for public

inspection and copying.

A public hearing has been scheduled for February 9, 2000, at 10

a.m. in room 2615, Internal Revenue Building, 1111 Constitution Avenue

NW., Washington, DC. Due to building security procedures, visitors must

enter at the 10th Street entrance, located between Constitution and

Pennsylvania Avenues, NW. In addition, all visitors must present photo

identification to enter the building. Because of access restrictions,

visitors will not be admitted beyond the immediate entrance area more

than 15 minutes before the hearing starts. For information about having

your name placed on the building access list to attend the hearing, see

the FOR FURTHER INFORMATION CONTACT section of this preamble.

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

that wish to present oral comments at the hearing must submit timely

written comments and an outline of the topics to be discussed and the

time to be devoted to each topic (preferably a signed original and

eight (8) copies) by January 19, 2000.

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 regulations are Mary Beth Collins

and Catherine Moore, Office of Chief Counsel (Passthroughs and Special

Industries). However, other personnel from the IRS and Treasury

Department participated in their development.

[[Page 56720]]

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

an entry in numerical order to read in part as follows:

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

Section 1.643(a)-8 also issued under 26 U.S.C. 643(a)(7). * * *

Par. 2. Section 1.643(a)-8 is added to read as follows:

Sec. 1.643(a)-8 Certain distributions by charitable remainder trusts.

(a) Purpose and scope. This section is intended to prevent the

avoidance of the purposes of the charitable remainder trust rules and

should be interpreted in a manner consistent with this purpose. This

section applies to all charitable remainder trusts described in section

664 and the beneficiaries of such trusts.

(b) Deemed sale by trust. (1) For purposes of section 664(b), a

charitable remainder trust shall be treated as having sold, in the year

for which a distribution of an annuity or unitrust amount from the

trust is due, a pro rata portion of the trust assets to the extent that

the distribution of the annuity or unitrust amount--

(i) Is not characterized in the hands of the recipient as income

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

determined without regard to this paragraph (b); and

(ii) Was made from an amount received by the trust that was not--

(A) A return of basis in any asset sold by the trust, determined

without regard to this paragraph (b); or

(B) Attributable to cash contributed to the trust with respect to

which a deduction was allowable under section 170, 2055, 2106, or 2522.

(2) Any transaction that has the purpose or effect of circumventing

the rules in this paragraph (b) shall be disregarded.

(3) For purposes of paragraph (b)(1) of this section, ``trust

assets'' do not include cash or assets purchased with the proceeds of a

trust borrowing, forward sale, or similar transaction.

(4) Proper adjustment shall be made to any gain or loss

subsequently realized for gain or loss taken into account under

paragraph (b)(1) of this section.

(c) Examples. The following examples illustrate the rules of

paragraph (b) of this section:

Example 1. Deemed sale by trust. Donor contributes stock having

a fair market value of $2 million to a charitable remainder unitrust

with a unitrust amount of 50 percent of the net fair market value of

the trust assets and a two-year term. The stock has a total basis of

$400,000. In Year 1, the trust receives dividend income of $20,000.

As of the valuation date, the trust's assets have a net fair market

value of $2,020,000 ($2 million in stock, plus $20,000 in cash). To

obtain additional cash to pay the unitrust amount to the

noncharitable beneficiary, the trustee borrows $990,000 against the

value of the stock. The trust then distributes $1,010,000 to the

beneficiary before the end of Year 1. Under section 664(b)(1),

$20,000 of the distribution is characterized in the hands of the

beneficiary as dividend income. The rest of the distribution,

$990,000, is attributable to an amount received by the trust that

did not represent either a return of basis in any asset sold by the

trust (determined without regard to paragraph (b) of this section)

or a cash contribution to the trust with respect to which a

charitable deduction was allowable. Under paragraph (b)(3) of this

section, the stock is a trust asset because it was not purchased

with the proceeds of the borrowing. Therefore, in Year 1, under

paragraph (b)(1) of this section, the trust is treated as having

sold $990,000 of stock and as having realized $792,000 of capital

gain (the trust's basis in the shares deemed sold is $198,000).

Thus, in the hands of the beneficiary, $792,000 of the distribution

is characterized as capital gain under section 664(b)(2) and

$198,000 is characterized as a tax-free return of corpus under

section 664(b)(4).

Example 2. Adjustment to trust's basis in assets deemed sold.

The facts are the same as in Example 1. During Year 2, the trust

sells the stock for $2,100,000. The trustee uses a portion of the

proceeds of the sale to repay the outstanding loan, plus accrued

interest. Under paragraph (b)(4) of this section, the trust's basis

in the stock is $1,192,000 ($400,000 plus the $792,000 of gain

recognized in Year 1). Therefore, the trust recognizes capital gain

(as described in section 664(b)(2)) in Year 2 of $908,000.

Example 3. Distribution of cash contributions. Upon the death of

D, the proceeds of a life insurance policy on D's life are payable

to T, a charitable remainder annuity trust. The terms of the trust

provide that, for a period of three years commencing upon D's death,

the trust shall pay an annuity amount equal to $x annually to A, the

child of D. After the expiration of such three-year period, the

remainder interest in the trust is to be transferred to charity Z.

In Year 1, the trust receives payment of the life insurance proceeds

and pays the appropriate pro rata portion of the $x annuity to A

from the insurance proceeds. During Year 1, the trust has no income.

Because the entire distribution is attributable to a cash

contribution (the insurance proceeds) to the trust for which a

charitable deduction was allowable under section 2055 with respect

to the present value of the remainder interest passing to charity,

the trust will not be treated as selling a pro rata portion of the

trust assets under paragraph (b)(1) of this section. Thus, the

distribution is characterized in A's hands as a tax-free return of

corpus under section 664(b)(4).

(d) Effective date. This section is applicable to distributions

made by a charitable remainder trust after October 18, 1999.

Par. 3. Section 1.664-1 is amended as follows:

1. Paragraph (d)(1)(iii) is redesignated as paragraph (d)(1)(iv).

2. New paragraph (d)(1)(iii) is added.

The addition reads as follows:

Sec. 1.664-1 Charitable remainder trusts.

* * * * *

(d) * * *

(1) * * *

(iii) Application of section 643(a)(7). For application of the

anti-abuse rule of section 643(a)(7) to distributions from charitable

remainder trusts, see Sec. 1.643(a)-8.

* * * * *

Charles O. Rossotti,

Commissioner of Internal Revenue.

[FR Doc. 99-27376 Filed 10-18-99; 11:16 am]

BILLING CODE 4830-01-P