IRS SETS SIGHTS ON CHARITABLE TRUST TAX-AVOIDANCE TRANSACTIONS.

Notice 94-78

Accelerated Charitable Remainder Trust

The Internal Revenue Service is aware of proposed transactions that attempt to use a section 664 charitable remainder unitrust to convert appreciated assets into cash while avoiding a substantial portion of the tax on the gain.

In these transactions, appreciated assets are transferred to a short-term charitable remainder unitrust that has a high percentage unitrust amount. For example, assume that capital assets with a value of $1 million and a zero basis are contributed to the trust on January 1. Assume further that the assets pay no income and that the term of the trust is 2 years. The unitrust amount is set at 80% of the fair market value of the trust assets valued annually.

The unitrust amount required to be paid for the first year is $800,000, but during the first year no actual distributions are made from the trust to the donor as the recipient of the unitrust amount. At the beginning of the second year, all the assets are sold for $1 million, and the $800,000 unitrust amount for the first year is distributed to the donor between January 1 and April 15 of the second year. The unitrust amount for the second year is $160,000 (80% times the $200,000 net fair market value of the trust assets). At the end of the second year, the trust terminates, and $40,000 is paid to a charitable organization.

Proponents of this transaction contend that the tax treatment of this example would be as follows. Because no assets are actually sold or distributed to the donor during the first year, the entire $800,000 unitrust amount is characterized as a distribution of trust corpus under section 664(b)(4) of the Internal Revenue Code. The $160,000 unitrust amount for the second year is characterized as capital gain, on which the donor pays tax of $44,800 ($160,000 times the 28% tax rate for capital gains). The donor is left with net cash of $915,200 ($800,000 from the first year and $115,200 net from the second year). If the donor had sold the assets directly, the donor would have paid tax of $280,000 on the $1 million capital gain, and would have net cash of only $720,000.

Depending on the particular facts of each case, the Service will challenge transactions of this type based on one or more legal doctrines. A mechanical and literal application of regulations that would yield a result inconsistent with the purposes of the charitable remainder trust provisions may not be respected. The tax consequences to the donor vary with the legal doctrine that is applied.

In appropriate circumstances, the Service will not respect the form of the transaction as a sale by a tax-exempt charitable remainder trust. See Gregory v. Helvering, 293 U.S. 465 (1935). In order to implement the proposed transaction, the trustee must ultimately sell the assets of the trust (or distribute them in kind, a transaction treated as a sale). In addition, the donor and the trustee are likely to prearrange a delay by the trustee of the sale of the trust assets. This creates a transaction that is different in substance than in form.

In addition, gain on the sale of the trust assets in this particular type of transaction may constitute gross income to the donor, not to the trust, under the principle that the income of one person cannot be assigned to another for tax purposes. Commissioner v. Court Holding Co., 324 U.S. 331 (1945). See, e.g., Malkan v. Commissioner, 54 T.C. 1305 (1970), acq., 1971-2 C.B. 3; Estate of Applestein v. Commissioner, 80 T.C. 331 (1983). The trustee accepts the trust and the transfer of its corpus subject to a legal obligation to execute the trust in accordance with its terms. The trustee must from the outset dispose of the trust assets in a taxable transaction to satisfy the donor's unitrust entitlement. In addition, if the taxpayer's characterization of the transaction were respected, the incidence of tax on the proceeds of the sale would be shifted away from the person receiving the economic benefits of the proceeds. Consequently, under these facts and circumstances, gain realized upon the sale of the assets by the trust may be attributed to the donor as the donor's gross income under section 61(a)(3). See Rev. Rul. 60-370, 1960-2 C.B. 203, applying a similar analysis to split-interest trusts prior to the enactment of section 664 by the Tax Reform Act of 1969.

The Service also may question the qualification of the trust as a charitable remainder trust under section 664. Section 1.664- 1(a)(4) of the Income Tax Regulations requires that "in order for a trust to be a charitable remainder trust, it must meet the definition of and function exclusively as a charitable remainder trust from the creation of the trust." In the present case, the trust has been structured and operates primarily to use the section 664(c) exemption from income tax for the benefit of the donor. In this context, this primary use is inconsistent with the requirement that the trust function exclusively as a charitable remainder trust. If the trust fails to qualify as a charitable remainder trust, then none of its income qualifies as exempt under section 664(c).

Upon examination of purported charitable remainder trusts employing this type of transaction, the Service will apply an appropriate legal doctrine to recast the entire transaction, to characterize the unitrust amount as gross income rather than trust corpus, to attribute gain on the sale of trust property to the donor, or to challenge the qualification of the trust under section 664. In appropriate circumstances, the Service may impose the tax on self- dealing transactions under section 4941 because the trustee's postponement of the sale of trust assets beyond the first year may constitute a use of trust assets for the benefit of the donor, who is a disqualified person under section 4941(d)(1)(E). The Service will also apply any applicable penalties to the participants in this type of transaction. Information sufficient to identify this type of transaction is required to be filed on Form 5227, Split-Interest Trust Information Return.

The principal author of this notice is Margaret Martin of the Office of Assistant Chief Counsel (Passthroughs & Special Industries). For further information regarding this notice contact Margaret Martin on (202) 622-3080 (not a toll-free call).