Tax Law

Taxation of Charitable Remainder Trust Beneficiaries on Sale of Trust Interests

A charitable remainder annuity trust is required to pay out a fixed dollar amount to the income beneficiary or beneficiaries. A charitable remainder unitrust must in general pay out to the income beneficiary or beneficiaries a fixed percentage of the annually redetermined net fair market value of the trust assets. These distributions have tax consequences for the income beneficiaries. In August, the Treasury and Internal Revenue Service issued final regulations that provide guidance for determining the basis of a taxable beneficiary in a term interest in a charitable remainder trust upon a sale or other disposition of all interests in the trust to the extent that basis consists of a share of adjusted uniform basis. [T.D. 9729, 80 FR 48249 (Aug. 12, 2015).]…

Taxation of Beneficiaries of Charitable Remainder Trusts

Characterization of Distributions. Specific rules govern the characterization of the annuity or unitrust amounts distributed by charitable remainder trusts to the income beneficiaries. These rules are applicable even if the trust is not exempt from tax because it has unrelated business taxable income. [Treas. Reg. § 1.664-1(c).]    

If the trust must pay income tax in the tax year due to the fact that it has unrelated business taxable income, the amount of the tax payable cannot be taken into consideration in determining the characterization of the distributions. [ Treas. Reg. § 1.664-1(d)(2) .]    

The character of distributions by charitable remainder trusts are affected by the capital gains rate structure. Charitable remainder trusts are expected to follow the netting rules when determining net short-term and net long-term capital gains. The underlying policy in the ordering rule of I.R.C. Section 664(b) and the existing regulations thereunder is that a charitable remainder trust distribution is deemed to consist first of income that is subject to the highest federal income tax rate in effect at the time of distribution and then of income that is subject to progressively lower (or no) federal income tax rates in effect at the time of distribution. [Notice 98-20, 1998-1 C.B. 776, modified by, Notice 99-17, 1999-1 C.B. 871.] Final regulations for characterizing a charitable remainder trust distribution take into account differences in the federal income tax rates applicable to items of income that are assigned to the same category under distribution characterization rules applicable to charitable remainder trusts under I.R.C. Section 664(b). The trust's income, for the year it is required to be taken into account by the trust, is assigned to one of three categories: the ordinary income, the capital gains category, or the other income. Within the ordinary income and capital gains categories, items are also assigned to different classes based on the income tax rate applicable to each type of income in the category. [Treas. Reg. § 1.664-1(d)(1)(i).] A charitable remainder trust distribution is treated as being made from the categories in the following order: ordinary income, capital gain, other income, and trust corpus. Within the ordinary income and capital gains categories, income is treated as distributed from the classes of income in that category beginning with the class subject to the highest income tax rate and ending with the class subject to the lowest income tax rate. [Treas. Reg. § 1.664-1(d)(1)(ii).] Therefore, income from a group that is subject to a higher federal income tax rate is deemed distributed before other income from a group, within the same category, that is subject to a lower federal income tax rate.

Allocation of Deductions. Items of deduction of a charitable remainder trust for the tax year, which are directly attributable to any class of items within an income category or to corpus, must be allocated to such classes of income or corpus. For allocation purposes, the following deductions, normally permissible in the case of a trust, are not allowed: the personal exemption (I.R.C. Section 642(b)), the charitable deduction (I.R.C. Section 642(c)), and the distribution deduction (I.R.C. Section 661). After allocating the deductions which are directly attributable to any classes of items within an income category, all other allowable deductions which are not directly attributable must be allocated among the classes of income category items in the proportion that the gross income of each class of items in the category, reduced by directly attributable deductions allocated to the classes, bears to all income of the category. The amount of expenses allocated to any class of income items may not exceed the income of that class for the taxable year. Items of deduction which are not allocable under the above rules (except for the personal exemption, the charitable deduction and the distribution deduction) can be allocated in any manner.  [Treas. Reg. § 1.664-1(d)(2) .]

New Final Regulations. In August, the Internal Revenue Service and Treasury issued final regulations that affect taxable beneficiaries of charitable remainder trusts. The final regulations provide rules for determining a taxable beneficiary's basis in a term interest in a charitable remainder trust upon a sale or other disposition of all interests in the trust to the extent that basis consists of a share of adjusted uniform basis. [Preamble, T.D. 9729, 80 FR 48249 (Aug. 12, 2015).] The final regulations apply to sales and other dispositions of interests in CRTs occurring on or after January 16, 2014, except for sales or dispositions occurring pursuant to a binding commitment entered into before January 16, 2014. [Id.]

Information referenced herein is provided for educational purposes only. For legal advice applicable to the facts of your particular situation, you should obtain the services of a qualified attorney licensed to practice law in your state.

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