Category Archives: Trust taxation

So you are getting older and have been successful in life. Now you own property, perhaps real estate, that has substantially increased in value but has a low adjusted basis. If you were to liquidate that property you would incur a large tax liability.

You want to tap into that value by way of an income stream. One solution is to contribute that property to a Charitable Remainder Annuity Trust (CRAT), the CRAT then sells the property tax free and purchases an annuity. But is the receipt of the annuity income tax free (perhaps a single premium immediate annuity SPIA)? That would be too good to be true, unfortunately per Internal Revenue Code 664. Here’s how that breaks down.

What is a Charitable Remainder Annuity Trust – CRAT?

The basic concept of a CRAT involves a grantor’s transfer of property to an irrevocable trust, the terms of which provide for the payment of a specified amount, at least annually, to the grantor or other designated noncharitable beneficiaries for life or another predetermined period of time up to twenty years. I.R.C. § 664(d). What remains in the trust after the expiration of that period (which cannot be less than 10 percent of the initial net fair market value of all property placed in the trust, I.R.C. § 664(d)(1)(D)) must be transferred to one or more qualified charitable organizations or continue to be held in the trust for the benefit of such organizations. In short, unlike an immediate gift to charity, a contribution to
a CRAT blends the philanthropic intentions of a donor with his or her financial needs or the financial needs of others.

As a rule, the grantor recognizes no gain when transferring appreciated property to a CRAT. Moreover,
because CRATs are exempt from income tax, a CRAT can sell appreciated property without itself paying tax on the sale. See I.R.C. § 664(c)(1); Treas. Reg. § 1.664-1(a)(1)(i).

But that does not mean that the grantor or other noncharitable CRAT beneficiaries do not have to pay tax with respect to distributions from the CRAT. “Although a [CRAT] is itself exempt from income tax
and, therefore, pays no tax on any of its taxable income, the annuity . . . payments made to the noncharitable beneficiaries carry out taxable income that is subject to tax at the beneficiary level.” Alpha I, L.P. v. United States, 682 F.3d 1009, 1015 (Fed. Cir. 2012) (stating the rule and citing section 664(b) and (c)(1)). This is so because when property is transferred to a CRAT, the basis of the property in the CRAT’s hands generally is the same as it would be in the hands of the grantor. See I.R.C. § 1015(a) and (b); Treas. Reg. §§ 1.1015-1(a)(1), 1.1015-2(a)(1).

And when the CRAT sells the property, it realizes gain to the extent the amount realized from the sale exceeds its adjusted basis. I.R.C. § 1001; see also Treas. Reg. § 1.664-1(d)(1)(i) (discussing the assignment of income to categories at the CRAT level). Although not taxable to the CRAT, that gain must be tracked and affects the treatment of distributions from the CRAT. See, e.g., Treas. Reg. § 1.664-1(d)(1)(viii)
(providing examples illustrating the rules).

Congress has established specific ordering rules that govern the characterization and reporting of annuity amounts distributed by a CRAT to its income beneficiaries. See I.R.C. § 664(b). Under this regime, distributions from a CRAT to income beneficiaries are deemed to have the following character and to be distributed in the following order:
(1) as ordinary income, to the extent of the CRAT’s current and previously undistributed ordinary income;
(2) as capital gain, to the extent of the CRAT’s current and previously undistributed capital gain;
(3) as other income, to the extent of the CRAT’s current and previously undistributed other income; and
(4) as a nontaxable distribution of trust corpus.

CRATs are subject to strict reporting requirements to ensure compliance with the statutory ordering rules. See I.R.C. § 4947(a); Treas. Reg. § 1.664-1(a)(1)(ii). A CRAT must file an annual information return on Form 5227 reflecting its income, deductions, accumulations, and distributions for the year. See I.R.C. § 6011(a); Treas. Reg. § 53.6011-1(d). And it must issue to each income beneficiary a Schedule K–1 properly describing the tax character of all distributions. See I.R.C. § 6034A(a); Treas. Reg. § 1.6034-1(a).

For example, what CRAT earned was ordinary income because the properties the CRATs sold were subject to the rules of section 1245—hence, distributions to grantor would be ordinary income.

Charitable remainder trusts can affect capital-gain reporting, basis, Schedule K-1 income, charitable deductions, and the beneficiary’s individual tax return. These issues often arise as part of high-net-worth tax preparation and planning.

Transactions involving highly appreciated property, charitable structures, trusts, or the timing of a sale can also benefit from advance tax strategy and planning before the structure or disposition is finalized.