Can Charitable Remainder Trust Assets be Sold Under a Prearranged Plan Without Triggering Capital Gains Tax to the Donor?
Yes. An example of a qualified prearranged plan would be the so-called Letter of Intent. Unlike a Purchase and Sale Contract, a qualified prearranged plan is not contractually binding. There is no legal obligation included in the plan.
Therefore, a Donor who donates assets to a Charitable Remainder Trust (CRT) and, pursuant to a prearranged plan, sells the assets from the CRT, does not realize income as a result of the redemption. The IRS will treat the sale proceeds as capital gains income to the Donor only if the CRT Trustee is legally bound or can be compelled by the Donor to sell the CRT assets.
The IRS has issued many favorable Private Letter Rulings to CRTs concerning this question. All of these PLRs incorporate references to Revenue Ruling 78-197 (that involved a Private Foundation). This Revenue Ruling is reproduced in its entity.
Rev. Rul. 78-197, 1978-1 C.B. 83
IRS Headnote Redemption; charitable contribution followed by a prearranged redemption. A taxpayer with voting control of a corporation and an exempt private foundation who donates shares of the corporation’s stock to the foundation and, pursuant to a prearranged plan, causes the corporation to redeem the shares from the foundation does not realize income as a result of the redemption. The Service will treat the proceeds as income to the donor under facts similar to those in the Palmer decision only if the donee is legally bound, or can be compelled by the corporation to surrender the shares for redemption.
Full Text of Rev. Rul. 78-197 In Palmer v. Commissioner, 62 T.C. 684 (1974), aff’d on another issue, 523 F.2d 1308 (8th Cir. 1975), the United States Tax Court held that the IRS incorrectly treated a gift of stock to an organization exempt from income taxation pursuant to section 511(c)(3) of the Internal Revenue Code of 1954, followed by a prearranged redemption of the stock, as a redemption of the stock from the donor followed by a gift of the redemption proceeds to the donee. The Service will follow Palmer on this issue, acq., page 6, this Bulletin.
In Palmer, the taxpayer had voting control of both a corporation and a tax-exempt private foundation. Pursuant to a single plan, the taxpayer donated shares of the corporation’s stock to the foundation and then caused the corporation to redeem the stock from the foundation. It was the position of the Service that the substance of the transaction was a redemption of the stock from the taxpayer, taxable under section 301 of the Code, followed by a gift of the redemption proceeds by the taxpayer to the foundation. The United States Tax Court rejected this argument and treated the transaction according to its form because the foundation was not a sham, the transfer of stock to the foundation was a valid gift, and the foundation was not bound to go through with the redemption at the time it received title to the shares.
Also see, Grove v. Commissioner, 490 F.2d 241 (2nd Cir. 1973); Behrend v. United States, No. 72-1153, 72-1156 (4th Cir. 1972); and Carrington v. Commissioner, 467 F.2d 704 (5th Cir. 1973).
The service will treat the proceeds of a redemption of stock under facts similar to those in Palmer as income to the donor only if the donee is legally bound, or can be compelled by the corporation, to surrender the shares for redemption.
Can I Fund a Charitable Remainder Trust with Encumbered Property?
Assuming you have done the math to determine the debt portion is not too large, the answer is, generally, yes. For many charitable gift planners, funding Charitable Remainder Trusts (CRT) with encumbered property has become more challenging since the IRS issues PLR 9015049.
Even before PLR 9015049, donors were not able to easily transfer old and cold property (i.e., the debt was placed on the property five years before the gift, and the donor had previously owned the property for five years). However, planners can implement the following techniques which have become even more popular in the aftermath of PLR 9015049.
When a donor wants to transfer encumbered property to a CRT, ask two questions:
1. Is the property old and cold?
2. Will the donor be free from personal liability for the debt following the funding of the CRT?
If the answer to both questions is yes, the property can be transferred to the CRT subject to the debt encumbering the property, and the bargain/sale gift rules (to compute the charitable remainder interest) will apply.
Let’s examine the second question, “Will the donor be free from personal liability?” It’s possible that the donor will not be liable for the obligation if it is non-recourse by contract or by statute. An obligation is non-recourse if the lender may recover the amount owed only from the property securing the loan, without personal recourse to the property owner. So, in the event of a default, the lender may only recover its debt by foreclosing and obtaining the sale proceeds from the collateral to reduce the amount owed. The lender may not obtain a judgment against the borrower for any amount beyond the value of the encumbered property; that amount beyond the value is called deficiency. Most states have some type of anti-deficiency legislation, so it is important to do some research and review the loan agreement or promissory note.
What if the answer to either question is no? Your planning solution may be to structure a Co-Tenancy Agreement. The following pages include a commentary on the Co-Tenancy Agreement technique.
Funding a CRT with Real Property Encumbered by a Mortgage Loan
There are some tax issues involved in funding a CRT with encumbered property, and a proposed structure for this gift that should successfully resolve those issues in favor of the trust, the charitable remainder beneficiary and the donor.
The donor should fund the trust with an undivided fractional interest in the property. For example, if the value of the property is 100, and it is encumbered with a mortgage loan of 30, the donor might transfer to the CRT an undivided 70% interest in the property, retaining for herself an undivided 30% interest in the property. The donor and the trustee would enter into a co-tenancy agreement describing the rights and obligations of the donor and trustee as co-owners of the property. For example, the co-tenancy agreement might provide that all net operating income and expenses of the property (other than debt service) would be divided proportionately between the co-tenants. One provision of the co-tenancy agreement would be an indemnity by the donor, holding the trust harmless from any liability to make payments of interest or principal on the mortgage loan. If payments on the loan are required prior to sale, the donor alone would make payments on the loan. When the property is sold, the mortgage obligation would be satisfied from the portion of the sale proceeds allocable to the donor (30% in our example).
A CRT funded with encumbered property raises several difficult tax issues. Summarized below are the primary tax issues:
- Grantor Trust Rules
- Unrelated Business Taxable Income
- Charitable Contribution Deduction
- Capital Gain Recognition
Does CTAC Prepare Tax Returns?
CTAC prepares, signs and files most Tax Returns and Attorney General filings that are required for Charitable Trusts, Foundations, and Gift Annuities administered by CTAC. Because CTAC is not qualified to prepare and file certain returns, CTAC does not prepare certain returns (i.e., IRS Form 1023, all individual Federal and State Income Tax Returns, all individual Federal and State Gift and/or Estate Tax Returns, and IRS Form 8283).
CTAC will advise you on what forms CTAC will prepare, sign and file and what forms you and your advisor must prepare and file for your situation. For example, IRS may require that tax returns be filed in a certain way for the first year that a charitable trust is in existence. Additionally, CTAC will provide income tax charitable deduction reports and explanations to include with your tax returns.
For more information, please email email@example.com or call CTAC at (800) 562-2045.
Does CTAC Provide Investment Management Services or Act as Trustee?
No. CTAC is not licensed and qualified to provide investment management services. CTAC analyzes financial statements and investment activities for compliance, accounting and tax reporting purposes.
CTAC does not act as Trustee and instead works for the Trustee as a third-party charitable trust administrator.
How do I Move My Charitable Trust to CTAC?
CTAC provides you with the Trust Transmittal Form (below) for this purpose. Simply send CTAC the information requested on the Form and CTAC will take it from there and be in touch with you to complete the move of your Charitable Trust to CTAC.
Trust Transmittal Form
- A copy of the signed trust document
- Current Address, Social Security Number(s) and date(s) of birth for all income beneficiaries
- A copy of the most recent Federal and State trust tax returns
- A copy of the most recent annual report for the trust
- Copies of all current year monthly statements for assets held by the trust
- Cost basis and purchase dates of all assets currently held by trust
Please mail this information to:
7029 Pearl Rd
Cleveland, Ohio 44130
If you have any questions please call us at (800) 562-2045 or email us at firstname.lastname@example.org. Thank you very much!
How Does the Revised Uniform Principal & Income Act Affect Unitrusts?
To begin with, several states have adopted or are in the process of adopting the Revised Uniform Principal & Income Act, which was established in 1997. As of June 2000, the Act has been adopted in Arkansas, California, Connecticut, Iowa, North Dakota, Oklahoma, and Virginia, and was recently introduced in Hawaii, Kansas, Michigan, Nebraska, and Vermont.
The principal and income act of each state contains trust accounting rules that are especially important for the administration of net-income with makeup Unitrusts (NIMCRUT), net-income Unitrusts (NICRUT) and flip Unitrusts. In many states which have adopted the Act, the new rules apply to trusts already in existence.
Trustee Reallocation Power
In Section 104 of the Act, trustees are granted the power to “… adjust between principal and income to the extent the trustee considers necessary if the trustee invests and manages trust assets as a prudent investor…” This power allows trustees to invest for a total return, a portion of which may come from capital appreciation of trust assets rather than traditional income items such as interest and dividends. Therefore, the trustee is now allowed to allocate trust principal to the income beneficiary (or to reallocate a portion of the trust income to principal), even if no provision exists in the trust document allowing the trustee to do so. So, a trustee can allocate to the income of a NIMCRUT or NICRUT all or a portion of a realized capital gain, even though capital gains are allocated to principal under the normal rules, if the trustee determines that the allocation is necessary to balance the interests of the beneficiaries in the trust.
However, the power to reallocate is not unlimited. The Act lists situations in which the trustee is prohibited or restricted from exercising the power. A significant limitation prohibits the trustee from exercising the reallocation power if the trustee is a beneficiary of the trust. This limitation will not only prevent reallocation where the trustee is the grantor and income beneficiary of the trust but also where the trustee is the charity which is the remainder beneficiary of the trust. Unless a power to reallocate is specifically written into the reallocation power if the trustee is a beneficiary of the trust. This limitation will not only prevent reallocation where the trustee is the grantor and income beneficiary of the trust but also where the trustee is the charity which is the remainder beneficiary of the trust. Unless a power to reallocate is specifically written into the trust, the Act empowers only independent trustees to exercise the power. To achieve the benefits and flexibility afforded by the reallocation power, it may be necessary to appoint a special trustee to exercise the power or to modify provisions of the NIMCRUT and NICRUT concerning the removal and replacement of trustees. New NIMCRUTs and NICRUTs can include the reallocation power into the accounting provisions of the trust, making it clear that the power may be exercised by a trustee even if the trustee is also a beneficiary of the trust.
Mutual Fund Distributions
The Act distinguishes between different types of distributions from mutual funds. The general rule is that distributions from any type of entity, including a mutual fund, are income. Excluded from this general rule are long-term capital gain distributions, which are principal. But mutual funds often distribute both long-term and short-term capital gains, and short-term capital gains dividends now remain subject to the general rule — they are allocated to income.
Please note that under the Act, when a trustee elects to reinvest mutual fund dividends in additional shares of the mutual fund, the shares purchased through dividend reinvestment are principal, not income, whether they are ordinary or capital gain dividends. Additionally, the trustee remains subject to the fiduciary duty to balance the interests of income and remainder beneficiaries of the trust. To the extent that too large a portion of mutual fund distributions receipts would be allocated to income, due to the treatment of short-term capital gains, or too little, due to the reinvestment of those distributions, the trustee, under the Act, must exercise the power to allocate to balance the interests of the beneficiaries.
Zero Coupon Bonds
Unlike regular bonds, zero coupon bonds pay no interest at all — they are issued at a discount from face value and the holder realizes the equivalent of interest in the form of accrued bond discount when the bond is sold or matures and is redeemed for the full face value. Since the accrued bond discount is the investor’s equivalent of interest, it is treated as interest for income tax purposes. However, now the default treatment under the Act is that the realized bond discount is treated as principal.
Zero coupon bonds have been a popular income timing device for NIMCRUTs, with which deferred income can be accrued at a predictable rate for future distribution when the bonds are sold or redeemed. To give the trustee the flexibility to pursue this investment strategy, include a specific provision in the trust document’s accounting rules allocating realized bond discount to income.
The Importance Of Trust Language
Since the Act now covers a broader array of categories of trust receipts and disbursements, it’s important for new NIMCRUTs, NICRUTs and flip Unitrusts to include the desired accounting rules, at least to the extent that the desired result is different from the Act’s default rules. The default restrictions may be overridden by a specific provision in the trust authorizing the trustee to allocate between principal and income in the manner provided in the Act, even if the trustee is also a beneficiary of the trust.
How Frequently Can Charitable Trust Income Distributions be Made?
The Charitable Trust provisions govern the frequency of income distributions. Most are set-up to pay quarterly. Other choices include annual, semi-annual, and monthly. CTAC will accommodate any distribution timing.
What are Self-Dealing Transactions?
A. Sale of Exchange of Property IRC 4941 (d)(1)(A).
- Any sale of exchange of property between a Disqualified Person (DP) and a Private Foundation (PF) is self-dealing. The self-dealing rules also apply to Charitable Remainder Trusts and Charitable Lead Trusts under IRC 4947(a)(2).
- The transfer of property by a DP to a PF is treated as a sale or exchange if the PF assumes a mortgage or takes subject to a mortgage which was placed on the property within the 10-year period ending on the date of the transfer of the property to the PF. Treas. Reg. 4941(d)-2(a)(2).
B. Leasing of Property IRC 4941(d)(1)(A).
- In general, any lease of property between a DP and a PF is self-dealing.
- A lease of property by a DP to a PF without charge is not self-dealing. Treas. Reg. 4941 (d)-2(b)(2)
C. Extension of Credit IRC 4941 (d)(1)(B).
- Generally, an extension of credit between a DP and a PF is self-dealing.
- A loan without interest by a DP to a PF is not an act of self-dealing if the proceeds of the loan are used exclusively for purposes of the loan used exclusively for purposes described in IRC 501(c)(3). IRC 4941(d)(2)(b).
- An act of self-dealing occurs where a third-party purchases property and assumes a mortgage, the mortgagee of which is a PF, and subsequently the third-party transfer the property to a DP who either assumes the liability under the mortgage or takes the property subject to the mortgage. Treas. Reg. 4941(d)-2(c)(1).
- An act of self-dealing occurs where a note, the obligor of which is a DP, is transferred by a third-party to a PF which becomes the creditor under the note.
D. Furnishing of Goods, Services, or Facilities IRC 4941(d)(1)(C).
- The general rule is that furnishing of goods, services or facilities between a PF and a DP is self-dealing.
- If the goods, services or facilities are furnished by a DP to the PF, self-dealing will not result if furnished without charge and used exclusively for IRC 501(c)(3) purposes. IRC 4941(d)(2)(C).
- If these are furnished by the PF to a DP, it would not be self-dealing if furnished on a basis no more favorable than made available to the general public. IRC 4941(d)(2)(D).
E. Payment of Compensation by a Private Foundation to a Disqualified Person IRC 4941(d)(1)(D).
- In general, the payment of compensation (or payment or reimbursement of expenses) by a PF to a DP is self-dealing.
- Except for government officials, payment of compensation by a PF or a DP for personal services which are reasonable and necessary to carry out the exempt purposes of the PF is not self-dealing if the compensation is not excessive. IRC 4941(d)(2)(E).
- The Regulations take a broad view of what services are reasonable and necessary to carry out the exempt purpose of the PF. For example, favorable examples include investment counseling services and legal services performed for PFs by DPs. Treas. Reg. 4941(d)-3(c)(2).
F. Transfer to, or Use by, a Disqualified Person of the Income or Assets of a Private Foundation IRC 4941(d)(1)(E).
- Common Investment Situations
a. The guarantee by a PF of a loan to a DP is an act of self-dealing. Treas. Reg. 4941(d)-2(f)(1).
b. The purchase or sale of securities by a PF is self-dealing if the purchase or sale is made in an attempt to manipulate the price of the securities to the advantage of a DP. Treas. Reg. 4941(d)-2(f)(1). On the other hand, if the DP owns the same class of securities or partnership interests as that owned by the PF, with the same voting and liquidation rights, this by itself should not be self-dealing. To be on the safe side, it is best if the DP and the PF buy and sell their interests at the same time, to avoid any inference that the transaction by the PF is manipulating price in a way that benefits the DP.
2. Co-Tenancy & Other Forms of Co-Ownership
PLR 9114025 created concern that ownership by a charitable remainder trust and the donor of partial interests in the same property might be self-dealing, since the private letter ruling implied (but did not rule) that his would be the result. But the formal IRS position remains that the ownership of property as tenants in common by PFs and DPs is not per se self-dealing. GCM 39770 (1988). On the other hand, officials at the Treasury and the national office of the IRS have expressed their view privately that co-ownership of an asset is enough to result in self-dealing under 4941(d)(1)(E). This view, if correct, would have a negative impact on the popular strategy of dealing with a CRT to be funded with encumbered property by having the donor transfer a partial interest in the property to the CRT while retaining a partial interest and indemnifying the CRT against any liability on the debt. To minimize the risk of self-dealing in this situation, the donor should enter into a written co-tenancy agreement with the trustee of the CRT in which the indemnity is documented and in which the donor/DP is prohibited from using the partial interest in the property which is held by the CRT.
What Information is Required to Prepare a CTAC Administration Agreement?
Below is a list of the basic information needed.
- Names and addresses of Trustees
- Name of the Trust and the date the Trust was created
- Besides the Trustees, the names and addresses of individuals who should be copied on CTAC correspondence sent to the Trustees
Please email this information to email@example.com or mail it to:
Plaza South Two
7029 Pearl Rd
Cleveland, Ohio 44130
If you have any questions please call us at (800) 562.2045. Thank you!
What Types of Reports Does CTAC Prepare?
CTAC usually prepares general accounting reports on a quarterly or annual basis. Reports can be customized and produced on private-labeled letterhead.
CTAC also has specialized capabilities for clients who need reports that require sub-accounting or unitization accounting.
Additionally, CTAC produces income tax charitable deduction reports for charitable trusts, gift annuities, etc.
Who are Disqualified Persons?
The self-dealing rules, transactions and taxes under IRC 4941 apply to Charitable Remainder Trusts, Charitable Lead Trusts and Private Foundations. There are two elements of self-dealing: A disqualified person and a self-dealing transaction. This FAQ describes disqualified persons.
- Substantial Contributors IRC 4946(a)(1)(A).
- Foundation Managers IRC 4946(a)(1)(B).
- 20% Owners IRC 4946(b)(2).
- Family Members IRC 4946(a)(1)(D). A member of the family of a substantial contributor, a foundation manager, or a 20% owner is a disqualified person. Family members include the individuals spouse, ancestors, children, grandchildren, great grandchildren and the spouses of children, grandchildren and great grandchildren (IRC 4946(d)). Note that siblings are not included.
- Corporations and Other Entities IRC 4946(a)(1)(E),(F) and (G).
- Government Officials IRC 4946(a)(1)(I).
- Exceptions and Special Rules.
- Disqualified persons do not include any charitable organization (Treas. Reg. 53.4946-(1)(a)(8).
- In determining the voting power of a corporation, profits interest in a partnership and beneficial interest in an estate or trust, the ownership attribution rules apply (IRC 4946(a)(3) & (4).
- A disqualified person participates in an act of self-dealing if they take part in the transaction, alone or with others, or directs any person to do so.
- Participation includes silence or inaction of a foundation manager, as well as their affirmative acts. A manager has not participated when they have opposed the act in a manner consistent with fulfillment of their foundation responsibilities.