Summary of CRT "Buckets" and "Mini-Buckets". The following
summarizes Sec. 664(b)(1)-(4) after the Taxpayer Relief Act of 1997, and
the Internal Revenue Service Restructuring and Reform Act of 1998 which
reduced the holding period for the 20% capital gain rate from
more-than-18-months to more-than-one-year. Addendum / Caveat: This discussion of Sec. 664(b)
does not reflect the Tax and Trade Relief Extension Act of 1998 and IRS Notice 99-17.
Bucket 1
Ordinary
income
|
Bucket 2
Capital
gains
|
Bucket 3
Exempt
income |
Bucket 4
Return of
capital
|
Cumulative "buckets" are emptied in the order of #1, #2, #3, then #4.
Depreciation recapture on sales to the extent such gain is classified as ordinary income is included in Bucket #1.
Bucket #2: Capital gain "mini-buckets" below are depleted in the order of
2A, 2B, 2C, then 2D, which can result in gains being distributed in other
than a chronological order. In the following discussion, if collectibles
or realty depreciation are not factors, one can ignore #3 of 2B, 2C and
the "Note" in the heading of 2D.
| 2A: |
Short-term capital gains on assets held one year or less. |
| 2B: | 28% long-term capital gains.
1.1/1/97-5/6/97: Gains from assets held more than one year.
2.7/29/97-12/31/97: Gains from assets held more than one year up to 18 months.
3.1997 and later: Collectibles held more than one year. |
| 2C: |
25% realty depreciation that is otherwise treated as LT capital gain is
now subject to a special 25% rate.
1. 5/7/97-7/28/97 and (due to 1998 Act) post-1997: Realty held more than one year.
2. 7/29/97-12/31/97: Realty held more than 18 months. |
| 2D: |
20% long-term capital gains (or 10% for low-bracket taxpayers if gain would otherwise be taxed at 15% ordinary income bracket). Note: Items #2 & #3 below
could be subject to the exceptions for collectibles (28% rate under 2B, #3), or realty depreciation
(25% rate under 2C).
1. Pre-1997: Gains from assets held more than one year (even
though the rate was 28% at the time, IRS Notice 98-20).
2. 5/7/97-7/28/97 and (due to 1998 Act) post-1997: Gains from assets held more than one year.
3. 7/29/97-12/31/97: Gains from assets held more than 18 months. |
In taxable years beginning after the year 2000, lesser rates may apply if the asset is held more than five years. Special rules apply to sales of "small business stock."
Netting rules according to IRS Notice 97-59, 1997-45 IRB, p. 1, and
apparently the 1998 Act, may be generally summarized as follows.
Short-term capital losses are applied first to reduce short-term capital
gains. A net short-term capital loss is then applied to reduce any net
long-term gain from the 28-percent group, then the 25% group, and finally
the 20% group. Netting within the three long-term groups occurs first,
then a net loss from the 28% group is used first to reduce gain from the
25% group, then reduce net gain from the 20% group. There are only gains
within the 25% group. A net loss from the 20% group first reduces net
gain from the 28% group, then gain from the 25% group. In a CRT context,
these netting rules would apply to "mini-buckets." An overall net
long-term loss could offset short-term gains. Apparently netting is
required annually at year end. IRS Notice 98-20, and Regs. 1.664-1(d)(1)
(i)(b).
Mitigating the 10% minimum charitable value rule. If a beneficiary
is young so that the 10% minimum charitable remainder value rule is
violated, an option would be a trust for a term of years (20 year maximum).
Could the grantor instead name the individual as beneficiary for life
subject to a proviso that the trust would in any event terminate after X
years (or a specified date) more than 20 years distant? In effect, can
the trust be tailored to a life expectancy of exactly 90% (or 89.9%) as
to the noncharitable income interest? Mr. Edward Ahrens, Esq., Seattle,
reports that the IRS National Office indicated it would rule favorably.
It is not certain whether there will eventually be a private letter ruling
on the issue. The IRS' response seems reasonable and hopefully this will
be an important general approach to mitigate the minimum charitable value
rule. Apparently the IRS did not view the approach as tantamount to a
term-of-years trust which terminated with the death of the beneficiary,
since that would exceed the 20 year maximum term.
Mutual fund dividends. PLR 9811036, 12/10/97, and PLR 9811037,
12/10/97, held that due to the peculiarities of the taxation of mutual
funds, short-term capital gains at the mutual fund level have the
character of ordinary dividend income for DNI purposes and that this is
true even if the trustee obtains information from the mutual fund
sufficient to allocate such amounts to corpus. This would seem to
confirm that the mutual fund's ordinary income is taxable as such under
Sec. 664(b)(1) even to the degree, at the mutual fund level, it
represents short-term capital gains. On the other hand, if the trust
allocates short-term capital gains to corpus, seemingly the trustee of an
income-limitation CRUT could be required to ask the mutual fund what
portion of ordinary income on its tax reporting form represents
short-term capital gains. The issue may require review by local counsel
but the facts in these PLR's raise the issue of "piercing the veil" of
the mutual fund to measure short-term capital gains, thus increasing the
income limitation.
Trust funds CRT. A 1998 private letter ruling sanctioned an
(apparently) irrevocable trust's funding of a 20-year-term CRT. The
funding arose from the exercise of a power of appointment by the trust's
sole beneficiary. The PLR says the trust was created to "hold, manage,"
etc. for the beneficiary and that the beneficiary basically had a lifetime
power of appointment, subject to certain restrictions. It seems likely
the trust was for the life of the beneficiary, although the ruling does not
expressly state the term of the trust which named itself as beneficiary
of the CRT. PLR 9821029, 2/18/98.
It is no surprise that the CRT vehicle is available to a trust
grantor-beneficiary, since a trust, or corporation, or partnership is a
"person" under Sec. 7701. The Sec. 7701 definition of "person" has been
used by the IRS in concluding, for example, that a pet cannot be a
beneficiary of a CRT. Rev. Rul. 78-105, 1978-1 CB 295. For example, PLR
9205031, 11/5/91, allowed a corporation to fund a CRT and name itself as
beneficiary.
PLR 9253055, 10/8/92, is an example of a trust receiving distributions
from a 20-year CRT. Historically, there have been some indications that
the IRS was concerned with even a term-of-years CRT distributing to a
trust if such "sub-trust" had a term beyond the term of the CRT.
Discussing the "sub-trust" concept in depth is beyond our scope, but we
will note that PLR 9253055 may have been a signal that the IRS was not
concerned with the issue. In that PLR, the 20-year term CRT distributed
to a sub-trust with a minimum 20 year term, otherwise the sub-trust
terminated upon the earlier of a 25 year term or the deaths of the income
beneficiaries. In PLR 9253055, the trustee's power to allocate among the
beneficiaries of the sub-trust was irrelevant.
A lifeless entity,
such as a corporation or partnership, could not receive a lifetime
interest in a CRT. There are private letter rulings stating this is also
true of payments to trusts, although the IRS has allowed a politician's
"blind trust" to receive lifetime payments. PLR 9202033, 10/16/91.
In a significant reversal of more liberal rulings policy, the IRS has
announced its "current view" that a unitrust "that makes distributions
for the life of a named individual to a second trust whose only function
is to receive and administer those distributions for the benefit of the
named individual beneficiary will not qualify as a charitable remainder
unitrust unless the named individual is incompetent." The exception for
incompetence is found in Rev. Rul. 76-270, 1976-2 CB 194. Presumably,
the IRS policy applies equally to CRATs. PLR 9710008, 11/27/96, revoking
PLR 9619044, 2/7/96; PLR 9710009, 11/27/96, revoking PLR 9619042, 2/7/96;
PLR 9710010, 11/27/96, revoking PLR 9619043, 2/7/96.
In this series of ruling, the beneficiary of the trust receiving lifetime
distributions from the CRT was not the grantor but the beneficiary had
unlimited rights of withdrawal and was treated as sole owner of such
trust. In the blind trust ruling above, the politician directed the
trustee of the blind trust to actually set up the CRT. The PLR refers to
the political as "grantor" yet also refers to such individual directing
the trustee of the blind trust to "set up" the CRT. In any event, having
the trust "set up" the CRT would not seem to be a distinction that would
get around the new IRS policy.
The IRS will also apply its restrictive policy if a CRT is set up in a
testamentary context and lifetime distributions are made to a trust. See
PLR 9718030, 2/4/97, revoking PLR 9101010, 10/4/90.
Income limitation CRUTs, laws governing measurement of income. In
the March, 1998, issue of Trust Letter published by the American Banking
Association, Mr. Misheff, Esq. reports: "The National Conference of
Commissioners on Uniform State Laws (NCCUSL), at its annual conference in
Sacramento, California, July 25-August 1, 1997, adopted the Uniform
Principal and Income Act (1997) (the Act). The Act has been approved by
the American Bar Association and is now being offered for approval to the
legislatures of the 50 states...Rest assured that this is no ordinary
update of the fundamental statute governing trust accounting."
In general, Mr. Misheff emphasizes the Act gives "extraordinary discretion"
to trustees to "adjust" or shift receipts and expenses that have been
considered principal assets to income, and vice versa. He comments that
this discretion arises due to a perceived perception of defects in prior
law and to provide for new situations not covered by the two prior Acts,
and "there was a need to alleviate an imagined tension between the
principle of investing for total return under the Uniform Prudent Investor
Act and traditional law about what constitutes the return on a trust
portfolio traditionally thought to include interest, dividends, and rents."
In his specific comments, Mr. Misheff reports certain areas that may be
particularly relevant to CRUTS (although his discussion does not
emphasize charitable trusts):
"Depreciation of a principal asset is no longer mandatory but permissive
in the discretion of the trustee. See Section 503(b)."
"Zero-coupon bonds likewise are covered for the first time, and the
discount thereon is deemed principal unless the bond has a maturity of
less than one year. Section 412(b) and similar to the Illinois Act."
NIMCRUTs sometimes invest in zero-coupon bonds as a technique to achieve
deferral. The basic concept is that fiduciary accounting income is
defined to exclude the annual accretion but include the discount when
collected.
A final copy of the Act may be obtained for free from the NCCUSL:
211 E. Ontario St., Suite 1300, Chicago, Il 60611; Telephone
(312) 915-0195. E-mail: J.Nelson@NCCUSL.org.
Copyright: J. Michael Pusey, CPA, JMP Charitable Management Services, 606 N.
Larchmont Bl., Suite 210, Los Angeles, CA 90004, (213) 384-1566 or
(323) 469-4489, FAX (323) 469-4965, E-mail; info@jmpcms.com; Web site:
www.JMPCMS.com. No portion of the publication may be reproduced or used
without permission. While information in the quarterly letter is believed to
be accurate, it is general in nature and should not be construed as
advisery. It is sold with the understanding that the publisher is not
engaged in rendering legal, accounting or other professional service.
If such advise is required, the services of a competent professional should
be sought.
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The Charitable Remainder Trust Letter
JMP Charitable Management Services
J. Michael Pusey, Editor | Vol. 2 No. 1./Qt.
February, 1998 |
|
This issue is devoted to valuation issues. We
focus primarily on valuation issues involving control or lack thereof.
Control. The ability to control the
affairs of a business entity is generally considered an important factor in
valuing one's interest in the business or venture. One generally has to
distinguish situations that involve control premium, minority discount and
50/50 "veto" or "deadlock" scenarios that may entail some element of discount
for lack of control.
No family attribution. The IRS abandoned
the family attribution concept in Rev. Rul. 93-12, 1993-1 CB 202. The IRS
announced it will follow various cases "in not assuming that all voting power
held by family members may be aggregated for purposes of determining whether
the transferred shares should be valued as part of a controlling interest."
Basically, the courts exalted the hypothetical willing buyer / willing seller
rule as the cornerstone of valuation over one that would make various
state-of-mind inquiries. The IRS eventually, reluctantly, agreed. The
specific fact pattern in Rev. Rul. 93-12 was that the owner of 100% of the
voting stock of a corporation made simultaneous gifts of 20% to each of five
children. The IRS ruled that a minority discount would apply to each of the
gifts. Seemingly there is no family attribution between spouses, so that
blocks owned by husband and wife are each viewed separately.
Inter vivos v. testamentary transfers.
As in Rev. Rul. 93-12, inter vivos gifts "create" minority discounts. In a
testamentary context, the gross estate reflects the value at death, yet the
estate tax marital deduction would reflect control premium or minority
discount. For example, if closely held stock is included in the estate @
$100 per share, the estate tax marital deduction might nevertheless reflect a
control premium @ say $120 a share. This is sometimes called the "Chenoweth
effect." Estate of Chenoweth, 88 T.C. 1577 (1987). In a charitable context,
one is limited by Sec. 2055(d) which provides that "The amount of the (estate
tax charitable) deduction under this section for any transfer shall not
exceed the value of the transferred property required to be included in the
gross estate."
Of course, a significant benefit to an inter
vivos charitable transfer is that it yields an income tax deduction. In the
case of a charitable remainder trust, the actuarial value of the charitable
remainder yields an income tax deduction.
Swing vote potential.The concept is
sometimes criticized but the IRS seems committed to the notion of
"swing vote" as a factor to enhance value. See TAM 9436005, 5/26/94,
TAM 9449001, 3/11/94, Estate of Winkler, T.C. Memo 1989-231, and Estate of
Bright, 658 F.2d 999 (CA-5, 1981). In technical advice memorandum 9436005,
the 100% owner ended up retaining 5%, giving 5% to spouse and 30% to each of
three children. In determining the value of the gifts to children, "swing
vote attributes" had to be considered. In general, the swing vote potential
will mitigate or eliminate the minority discount that would otherwise apply
to the valuation. If a gift of a small block of stock creates swing vote
potential in a large block of stock, seemingly ones looks to elimination or
mitigation of minority discount in the large block of stock to assess the
valuation effect.
There seem to be no manuals defining "swing,"
but the author would venture the following opinion on the concept's
parameters:
- Basically, it seems to ask if control can be gained in one step. In TAM 9436005, each of the 30% blocks could gain control with one step - i.e., by joining with another 30% block.
In Rev. Rul. 93-12, there were five blocks of 20% each, and seemingly there is no swing vote potential in any block because it would take two steps for any block to gain control.
- The concept seems not applicable anytime control is already present. For example, in a 51/49 scenario, one does not attribute swing vote potential to the 49% block because control is already present in the 51% block. The 49% block is simply minority. The swing vote concept is not applicable to a control block.
- One needs at least three blocks of stock to have swing vote potential anywhere (but note husband and wife are separate blocks). In a 51/25/24 scenario, despite the three blocks, there would not be swing vote potential in either the 25% or 24% blocks because one does not assume a minority block joins with a control block. Also, if the 25% and 24% blocks joined, control would not be gained.
- A mechanical application of the swing vote concept would apparently find "swing" all around in a 49/49/2 scenario. But it may be that there is an exception that does not attribute any swing vote premium to the two 49% blocks. TAM 9436005 contains the following quote from a book by Shannon P. Pratt: "(I)f two stockholders own 49 percent (of the stock) and a third owns 2 percent, the 49 percent stockholders may be on a par with each other....The 2 percent stockholder may be able to command a considerable premium over the pro-rata value for that particular block because of the swing vote power."
Does the swing vote concept have a "cousin"
that would ask: In one step, is the block able to attain not control but 50%
ownership (deadlock or veto status)? For example, if Rev. Rul. 93-12 had
involved four blocks of 25% each, would the IRS have found full minority
discount as it did in the scenario of five blocks of 20% each? No authority
or commentary has been found advancing the argument that the swing vote
concept has a "cousin," but conceptually the issue might be raised.
Indirect gift argument. In TAM 9436005,
the IRS argued that if the three blocks of 30% had been given at different
times, the "total value of the gifts would ultimately be the same..." If
there had been only one 30% block donated to a child, there would be no swing
vote potential at such point. But upon giving the second 30% block to a
different child, there was swing vote potential in the first and second
blocks of 30% and an indirect gift to the donee of the first 30% block.
"This enhancement of value with respect to the first transferee's block at
the time of the second transfer would constitute an indirect gift to that
transferee at the time of the second transfer." By the same line of
reasoning, seemingly gifts or bequests that eliminate swing vote potential
have the prospect of decreasing value among outstanding blocks. The scope
and validity of this concept is debated.
If after funding a CRT, there are gifts to
family that trigger an indirect gift to the CRT under the theory of TAM
9436005, it seems unlikely one could gain an additional charitable income tax
deduction because there is no transfer to the CRT.
QTIP. One generally should review the
specific situation as to whether interests held in QTIP will be combined with
directly owned interests to find control premium. In this analysis, consider
Estate of Bonner, 84 F. 3d 196 (CA-5, 1996), which held there was no
attribution in the circumstances. Contrast TAM 9608001, 8/18/95, and PLR
9550002, 8/31/95 where the Service took a contrary position that required
aggregation of interests owned outright with interests in QTIP.
Powers attribution. TAM 9403002,
9/17/93, aggregated directly held shares with shares held in trust "and over
which he (the decedent) possessed a power to alter the beneficial enjoyment.."
The "power" resulted in the trust assets being included in the decedent's
estate under Sec. 2038. The scope of this TAM is not clear but seemingly the
IRS would apply it when the grantor of a CRT retained the testamentary right
to revoke or reserved the right to direct the trustee to make premature
distributions to charity. Retaining the income interest causes CRT assets to
be included in the grantor's estate, but is it the type of "power"
contemplated by the TAM? Would retaining the right to change the
remainderman be the type of power contemplated by the TAM?
General planning concepts. Valuation
issues are inherently factual and we have introduced some very complex and
controversial topics with very brief introductory remarks.
In general, one would need to work through the estate plan from the perspective of valuation problems and planning opportunities.
In a CRT, there are generally conflicting
income tax and transfer tax concerns. If only H&W are the beneficiaries and
grantors, generally there is only the income tax deduction at issue since the
combination of marital and charitable deductions will eliminate gift and
estate tax. However, the "gross" valuation can potentially be an issue under
such relief provisions as Sections 303, 2032A and 6166. Also, there may be
an issue of "powers attribution" from the CRT which can indirectly affect the
valuation of business interests.
The income tax deduction is measured at the
transfer to the trust but the gift tax valuation may arise upon transfer or
at a later date. For example, the lifetime relinquishment of a testamentary
right to revoke may result in a completed gift at such time, rather than at
the funding of the trust. See Regs. 25.2511-2(f), PLR 9309041, 12/8/92
(note Sec. 2523(g) and Sec. 2056(b)(8) problems in PLR). We assume
reservation of the testamentary right to revoke avoided a completed gift at
funding because the successor beneficiary's interest followed the grantor's
lifetime interest. Rev. Rul. 79-243, 1979-2 CB 343.
In general, the CRT's assets may be brought
back into the grantor's estate to be partially or, if no successor beneficiary,
totally offset by the charitable deduction. Focusing on the estate tax
valuation of a successor beneficiary's interest, if the CRT is a CRAT, the
net inclusion in the estate (gross less charitable deduction) will be less
concern because the annuity per se is generally unaffected by the value of
the trust assets, unless there is risk the trust won't be able to sustain the
annuity. So there may be more concern with valuation issues for CRUT assets.
In general, the estate tax valuation of CRT's
assets would be measured at the entity level and this would seemingly be true
whether there are one or more noncharitable beneficiaries along with the
charitable remainderman. For example, if H&W donate swing vote blocks that
become a control block within the CRT, the estate tax valuation would
apparently reflect a control block premium for each spouse's portion of the
trust.
If business interests are to benefit only the
spouse but interests pass directly and via a CRT, consider whether minority
or control interests fund the CRT and make projections under an all
testamentary approach versus inter vivos marital gifts and/or CRT funding.
Similarly, when control and minority are to be split between spouse and
others, make projections considering any CRT transfers and inter vivos versus
testamentary alternatives. The Chenoweth effect can be an important factor
in these projections.
Copyright: J. Michael Pusey, CPA, JMP Charitable Management Services, 606 N.
Larchmont Bl., Suite 210, Los Angeles, CA 90004, (213) 384-1566 or 469-4489,
FAX 469-4965. No portion of the publication may be reproduced or used
without permission. While information in the quarterly letter is believed to
be accurate, it is general in nature and should not be construed as advisery.
It is sold with the understanding that the publisher is not engaged in
rendering legal, accounting or other professional service. If such advise is
required, the services of a competent professional should be sought.
Excerpts from newsletter of August, 1997:
Enhancing the value of the annuity or unitrust
amount. In broad brush strokes, one can enhance the value of the income
stream of the CRT by the absence of capital gains tax, deflection and
deferral. The concept of avoiding the depletion of one's base of earning
assets by transferring appreciated property to the CRT is a familiar one.
Typically, the CRT can avoid the capital gains tax because of its tax-exempt
status. Deflecting income refers to naming a low-bracket beneficiary or
low-bracket initial beneficiary, such as an elderly parent. Deferral refers
to enhancing value by deferring the beneficiary's income tax via controlling
the definition of income in a NIMCRUT. Certain aspects of the deferral
concept have become something of a gray area. See immediately preceding
item. However, the gift planner may find this a useful checklist for
enhancing the value of income interest - capital gains avoidance, deflection
and deferral.
Timing the creation of a CRT. Most
gift planners think of terms of creating a CRT during the grantor's lifetime,
which yields an income tax deduction, or at the grantor's death, which yields
no income tax deduction but the actuarial value of the charitable remainder
may qualify for the estate tax charitable deduction. Another alternative is
the QTIP-CRT alternative, which would enable the grantor to provide for the
surviving spouse without the anti-invasion restrictions of the CRT, while at
the same time controlling the disposition of the assets at the death of the
surviving spouse into, e.g., a CRT for the children. Thus, the gift planner
may want to evaluate the various aspects of creating a CRT during one's
lifetime, at death, or at the death of the surviving spouse.
Audits of CRTs by IRS seem generally light and
focused on short-term CRTs. At a meeting of the Los Angeles County Bar
Association's Exempt Organization Committee of 3/4/97, Ms. Terry Franklin,
IRS Chief Employee Plans & Exempt Organization Division, Los Angeles
District, indicated there were 34 audits of CRTs in progress, and that all
were related to the short-term trust focused on in Notice 94-78.
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