Exiting the Underproductive CRT

8/11/2019 Exiting the Underproductive CRT

1/23

Exiting the Underproductive CRT

by Russell A. Willis III, J.D., LL.M.current events editor

https://www.charitableplannin.co!

When I ave a si!ilar tal" at the national con#erence in $incinnati in %ctober o# &''(, we were )ustco!in out o# a rather brie# recession that had #ollowed the *irrational e+uberance* o# the --'s and thepea" o# the socalled dot.co! bubble in &0.

While the e1uities !ar"ets had beun to recover so!e o# the round they had lost, the #ederal #unds ratehad dropped to .' pct. #ro! a hih o# 2.3 pct. in May o# &''', and the section 43&' rate, on whichannuity and unitrust interests are valued #or ta+ purposes, had #allen to a thenhistoric low o# (.' pct. #ro!a hih o# 5.& pct. in March o# &''', and was only beinnin to cli!b bac", eventually pea"in at 2.& pct.in Auust o# &''2.

6oday, !ore than #our years a#ter the #inancial collapse o# &''5, while the e1uities !ar"ets, aain, haverecovered al!ost all o# their lost round, the #ederal #unds rate, which had cli!bed bac" to 3.&3 pct. inJune o# &''2, is now e+pressed as a *taret rane* so!ewhere around or even below '.&3 pct., and the7ederal Reserve has entered at least its third round o# *1uantitative easin,* buyin up loner ter! andsellin o## shorter ter! 6reasuries to put downward pressure on lon ter! interest rates.

6he section 43&' rate hit yet another historic low at .' pct. in Auust o# &'&, and as this paper oes topress, the announced rate #or 8epte!ber is aain .' pct.

9et asset values in charitable re!ainder trusts have also #allen, althouh the available data areinco!plete. Accordin to IR8 statistics o# inco!e reports, the decline in &''- was about .4 pct. inunitrusts and about 3.2 pct. in annuity trusts. In &'', unitrust net asset values #ell another &.3 pct., #or an

areate loss since &''5 o# .5 pct.

9et asset values in annuity trusts actually increased !arinally in &'', but the absolute nu!ber o#annuity trusts #ell by nearly twelve pct. over those two years, so it is possible these #iures re#lect the #actthat so!e nu!ber o# $RA6s si!ply crashed.

As net asset values #all, o# course, unitrust payouts will su##er correspondin declines. And the da!ae a#i+ed annuity payout can do to a trust in a #allin !ar"et !ay be irreparable.

Meanwhile, the recession has also ta"en a toll on charities the!selves. A study published earlier this yearby the 9ational Association o# $ollee and ;niversity


2/23

And althouh &' saw a sliht rebound #ro! two years o# sharp declines, total contributions were stilldown nearly #our pct. #ro! &''4 in current dollars, and !ore than eleven pct. a#ter ad)ustin #or in#lation.6he Indiana ;niversity $enter on ?hilanthropy predicted it !iht ta"e *!ore than a decade to et bac" towhere we were* be#ore the #inancial collapse.

%ur conversation today about *e+itin the underproductive $R6* ta"es place in this conte+t.

What we are talking about

In &''(, I introduced !y tal" with a little story, to #ra!e the discussion. I tried to "eep it si!ple, evenna!in the characters Richard and Jane.

I had Richard in an eiht pct. 9IM$R;6 #unded with an illi1uid property. ?ostcontribution ains werede#ined as inco!e, so when the property sold not lon a#ter the trust was set up, the !odest accu!ulatedarrearae, or !a"eup a!ount, was distributed.


3/23

the reduced li#e e+pectancy o# a continent successor inco!e bene#iciary =albeitnot the current bene#iciary, #or reasons we will e+plore shortly>,

and o# course

the i!!ediate needs o# the charitable re!ainder!an supersedin those o# the

inco!e bene#iciary.

An aside

%ur conversation in &''( was to so!e e+tent #ocused on this latter transaction, i.e., the surrender ine+chane #or a i#t annuity, which had then been the sub)ect o# a recent letter rulin. We put so!enu!bers to it, and we will put so!e nu!bers to it today, but let !e )ust !ention at the outset that a coupleo# thins have chaned.

In the continuin a#ter!ath o# the #inancial !eltdown o# &''5, the A!erican $ouncil on @i#t Annuitieshas lowered its reco!!ended i#t annuity rates several ti!es.


4/23

=a> assu!in Richard had not created the split interest trust #or the purpose o#evadin the partial interest rule o# section 4'=#>=(>=A>, and

=b> assu!in there is no reason to believe RichardCs li#e e+pectancy at the ti!e o#the transaction is less than would be indicated #or a person o# the sa!e ae under the

tables set #orth at Re. .4&-, then

in the case o# a surrenderE

=c> i# Richard were to surrender a portion or all o# his unitrust interest to there!ainder charity outriht, then

=d> he could clai! a charitable contributions deduction, both #or inco!e ta+purposes and #or i#t ta+ purposes, in the a!ount o# the present value o# the surrenderedinterest, deter!ined usin the *section 43&'* rate in e##ect at the ti!e o# the surrender,and

=e> he would not reconiBe undistributed ains accu!ulated in prior years, or

in the case o# a co!!utationE

=#> i# instead Richard too" distribution o# the present value o# his unitrust interest,deter!ined usin the *section 43&'* rate in e##ect at the ti!e o# the trans#er, or o# aportion o# that interest, and the re!ainder charity too" distribution o# the present value o#the re!ainder, or o# a correspondin portion o# the re!ainder,

=> he would reconiBe lonter! capital ain in the #ull a!ount he received,treatin his basis in the unitrust interest as Bero, or

in the case o# a surrender in e+chane #or a i#t annuityE

=h> i# instead Richard surrendered his unitrust interest to the re!ainder charity ine+chane #or a i#t annuity,

=i> he would reconiBe lonter! capital ain under the *barain sale* rules o#section '=b> in the a!ount o# the present value o# the i#t annuity, ratably over theperiod o# years !easured by the e+pected return !ultiple, #ro! that portion o# the annuitypayout that was treated as a return o# his invest!ent in the contract, i.e., the present valueo# the unitrust interest, deter!ined usin the *section 43&'* rate in e##ect at the ti!e o#the trans#er.

In addition, althouh the point was not covered in any o# the rulins, we speculated that

=)> i# the interest Richard was surrenderin was in an annuity trust rather than aunitrust, his deduction probably would be li!ited to the lesser o# the present value o# theune+pired annuity or the current principal balance o# the trust,

Willis pae


5/23

c#. Re. &3.43&'(6=b>=&>=v>, e+a!ple 3, illustratin the calculation o# the value o# an annuity where thepayout e+pressed as a percentae o# corpus e+ceeds the thencurrent section 43&' rate.

in the case o# a partial surrender or co!!utationE

In the case o# a partial surrender or co!!utation, several rulins cited Re. .22(=a>=> as in e##ect

re1uirin that

="> the assets surrendered or distributed be *#airly representative* o# the ad)ustedbasis o# all assets in the trust.

6he reulation per!its the trust instru!ent to provide #or current distributions, apart #ro! the unitrustpayout, to an e+e!pt entity, provided that i# the distribution is !ade in "ind, *the ad)usted basis o# theproperty distributed is #airly representative o# the ad)usted basis o# the property available #or pay!ent onthe date o# pay!ent.* 6here is a si!ilar provision at Re. .22&=a>=> with respect to annuity trusts.

The net income limitation

At the ti!e, there was e+actly one rulin, ?LR &''&'3''5 ='/&(/'>, suestin that

=l> i# the 9IM$R;6 had not #lipped to a straiht $R;6, RichardCs deduction on asurrender o# his interest to the re!ainder charity !iht have been li!ited to the lesser o#the present value o# the speci#ied eiht pct. unitrust payout or o# a straiht inco!einterest, deter!ined usin the *section 43&'* rate in e##ect at the ti!e o# the surrender ortrans#er.

6here were at least two earlier rulins in which this *lesser o#* li!itation had not been !entioned ?LR-33''&2 ='-/5/-3>, a partial surrender o# a nine pct. net inco!e trust without !a"eup, and ?LR -4&'='&/-/-4>, a #ull surrender o# a #ive pct. net inco!e trust with !a"eup but then, at the ti!e each o#these rulins was re1uested, the section 43&' rate was hiher than the stated unitrust payout rate.

8o it was perhaps pre!ature to speculate. And over the ne+t #ew years, there were several rulinsconcernin net inco!e trusts that did not e+pressly i!pose such a li!itation even in the conte+t o# aco!!utation, where the 1uestion, as we shall see, beco!es one o# sel#dealin. 8peci#ically,

e. in ?LR &''&'5'(- =/&-/'>, the 8ervice ruled that the proposed )udicial co!!utation o# aneiht pct. 9I$R;6 =without !a"eup>, with actuarial values calculated *usin the !ethodoloy undersection .22 o# the reulations,* would not be an act o# sel#dealin. *6he critical 1uestion,* the rulinsaid,

is whether early ter!ination !ay be e+pected to result in a reater allocation o# the trustassets to the inco!e bene#iciary, to the detri!ent o# the charitable bene#iciary, than a non

early ter!ination. 6he possibility o# a!es!anship by the inco!e bene#iciary andwhipsawin o# the 8ervice e+ists here.

9onetheless, the rulin concluded that this concern was su##iciently addressed by a##idavits #ro! both thebene#iciary and his physician that he had no !edical condition that would suest a shorter li#ee+pectancy than set #orth in the Re. .4&- tables.

Willis pae 3


6/23

6o put the re#erences to *a!es!anship* and *whipsawin* in so!e conte+t:

when the rulin was re1uested in June o# &''', the section 43&' rate was still ateiht pct., but

it #ell to 4.2 pct. two !onths later, and it was down to #ive pct. when the letter

was #inally issued in 9ove!ber o# &'', the ta+payer was the last survivor o# several successive inco!e bene#iciaries,

and !ost sini#icantly, the trust was invested #or total return and was yieldin less than three pct.

current inco!e.

8i!ilarly,

#. in ?LR &''(''&3 ='/&(/'&>, the )oint settlors o# a #ive pct. 9IM$R;6 =with !a"eup> hadpartitioned the trust into two trusts, allocatin assets e1ually between the! in a !anner that wasrepresented to be *#airly representative o# ad)usted basis,* and they proposed to co!!ute their unitrustinterests in one o# these trusts, with actuarial values calculated *usin the !ethodoloy under section

.22 o# the reulations.*

When the rulin was re1uested in January o# &''&, the section 43&' rate was 3. pct., but by the ti!e therulin was issued in %ctober it had #allen to .& pct. 6he 8ervice ruled the co!!utation would not be anact o# sel#dealin. 9othin was said about *a!es!anship* or *whipsawin.*

Fowever, althouh the ta+payers had apparently not as"ed, the 8ervice did also rule that the transactionwould be treated as a sale o# their unitrust interests to the re!ainder!an, that their basis was Bero, andthat they there#ore would reconiBe lonter! capital ain in the #ull a!ount that they were to receive inthe transaction.

9o #or!al authority was cited #or these conclusions. 8ee the discussion o# *co!!utation as a capital

transaction,* below.

In the conte+t o# outriht surrenders,

. in ?LR &''3&' ='(/3/'3>, the settlor o# ten pct. 9IM$R;6 =with !a"eup> proposed todivide the trust into two trusts, allocatin assets proportionately between the! in a !anner that wasrepresented to be *#airly representative o# the areate ad)usted bases o# the trustCsE assets and theiroverall appreciation or depreciation,* and to accelerate the re!ainder o# one o# the trusts to a privateoperatin #oundation o# which he was both a !anaer and a substantial contributor.

6he 8ervice ruled:

=> that the re#or!ation o# the trust instru!ent necessary to acco!plish thetransaction would not dis1uali#y the trust under 22=d>=&>,

=&> that the ta+payer could clai! charitable contributions deductions #or bothinco!e and i#t ta+ purposes in the a!ount o# the present value o# his unitrust interest,

=(> that the ta+payer would not reconiBe undistributed ains accu!ulated inprior years, and

Willis pae 2


7/23

=> that the transaction would not be treated as a direct or indirect act o# sel#dealin.

9othin was said about the ta+payerCs li#e e+pectancy, and nothin was said about the spread between thestated unitrust payout rate and the section 43&' rate, which was considerably lower than ten pct. Instead,the rulin concluded si!ply:

we e+press no opinion as to the !ethod o# deter!inin the present value o# the unitrustinterest E #or purposes o# calculatin the a!ount o# the inco!e and i#t ta+ charitabledeductions.E

h. an essentially identical rulin, ?LR &''3&3''5 ='(/3/'3>, substituted the ender o# thepersonal pronouns throuhout.

8i!ilarly,

i. in ?LR &''5'5'5 =/'4/'4>, the ta+payer had created a seven pct. #lip$R;6 =with !a"eup>,apparently #or a ter! o# years, with a continent payout at his death to a *#a!ily trust.* 6he trierin

event had apparently not yet occurred. Aain, the ta+payer proposed to partition the trust and toaccelerate one o# the trusts to the re!ainder!an, in this case a public charity. 6he *#a!ily trust* was tosee" approval o# a state court to renounce its interest.

Aain, the 8ervice ruled the ta+payer would be entitled to clai! inco!e and i#t ta+ deductions in thea!ount o# the present value o# the unitrust interest, but aain it e+pressly withheld co!!ent on how thatvalue was to be calculated, concludin nonetheless that the transaction would not constitute an act o# sel#dealin.

Selfdealing of the third kind

A series o# three related rulins brouht the 1uestion o# sel#dealin into sharper relie#.

6he #acts as recited in ?LR &''3&3' ='(/('/'3> involved a #i#teen pct. 9I$R;6 =without !a"eup>payable to the settlors #or their )oint lives, with the re!ainder to a private nonoperatin #oundation o#which they were substantial contributors, sub)ect to a reserved power to redesinate.

6he ta+payers proposed to e##ect a )udicial co!!utation, with the consent o# the state attorney eneral,*usin the !ethodoloy under Re.E .22* to value the inco!e and re!ainder interests. 6he closelyheld stoc" with which the trust had been #unded had been sold, and *the purpose o# the trust,E to provide!anae!ent over the trust assets, no loner e+istedE.*

6he ta+payers conceded that the transaction was to be treated as a sale o# their unitrust interests to there!ainder charity, and that the entire proceeds would be reconiBed as lon ter! ain, with no o##settin

basis.

9othin was said about the trust not havin been created #or the purpose o# evadin the partial interestrule.


8/23

6he 8ervice ruled that the proposed co!!utation would not constitute an act o# sel#dealin by thetrustee, by either settlor with respect to either the trust or the #oundation, or by any #oundation !anaer,and that no #oundation ter!ination ta+ would be incurred.

9ine !onths later, the rulin was revo"ed by ?LR &''2'(& ='/'-/'2>, with no e+planation iven, andreplaced by ?LR &''22'(3 ='/&3/'2>, recitin so!ewhat con#usinly altered #acts there was now

only one settlor and a sinle li#e payout, and the reserved power to redesinate the re!ainder bene#iciaryhad been e+ercised in #avor o# a nu!ber o# public charities. Apparently it was this latter chane thatallowed #avorable rulins on the sel#dealin issues.

6his series o# rulins !iht have been understood to i!ply a deter!ination that a dee!ed sale to a privatenonoperatin #oundation with respect to which the re!ainder trust bene#iciary is a dis1uali#ied person isper sesel#dealin, #or which purpose it is *i!!aterial whether the transaction results in a bene#it or adetri!ent to the private #oundation,* per Re. 3(.-=d>, despite the e+ception at Re. 3(.-4=c>=&>#or a!ounts payable under the ter!s o# a split interest trust to the noncharitable bene#iciary.

, above a ten pct. 9IM$R;6 =with!a"eup>, re!ainder to a private nonoperatin #oundation, sub)ect to a reserved power to redesinate. 6hesettlor had proposed a non)udicial co!!utation, aain *usin the !ethodoloy under section .22 o#the reulations* to value the inco!e and re!ainder interests.


9/23

6he use o# this *special #actor,* the author suested, was *indicated* by Re. .43&'(=b>=>=ii>, whichsays the standard section 43&' rate !ay not be used to value a *restricted bene#icial interest,* de#ined as

an annuity, inco!e, re!ainder, or reversionary interest that is sub)ect to a continency,power, or other restriction, whether the restriction is provided #or by the ter!s o# thetrust, will, or other overnin instru!ent or is caused by other circu!stances.

!et another aside

It !iht be observed that the author stopped so!ewhat short o# sayin the net inco!e li!itation was in#act a *restriction* #or purposes o# Re. .43&'(=b>=>=ii>, or that a deviation #ro! the standard section43&' rate was in #act re1uired. What he said was that an advance rulin would not be issued e+cept onthe assu!ption the *special #actor* would be used.

6he e+a!ple iven at Re. .43&'(=b>=>, e+a!ple &, is the shortened li#e e+pectancy o# an individualwho has been dianosed with a ter!inal illness *and there is at least a 3' percent probability o# theindividual dyin within year.* 6his #or!ulation re#lects the substantive provision at Re. .43&'(=b>=(>, which, however, !a"es an e+ception i# the individual in #act survives the trans#er by at least eihteen

!onths.

6hese provisions were added to the reulation in --3 by 6D 52(', a#ter the IR8 #ound itsel# on thewron end o# a valuation dispute.

In Gstate o# McLendon v. $o!!issioner, (3 7.(d '4 =3th $ir. --5>, the decedent had trans#erred hisinterest in various partnerships to his son and an irrevocable trust in e+chane #or annuity contractsvalued usin the table rates, which pro)ected a li#e e+pectancy o# #i#teen years, despite the #act he wasdyin o# esophoeal cancer.

At the ti!e, the controllin authority was Rev. Rul. 5'5', -5' $.


10/23

With one e+ception, discussed below, in each o# the letter rulins we are loo"in at today the ta+payerrepresented that there was no reason to believe her li#e e+pectancy at the ti!e o# the transaction was lessthan would be indicated #or a person o# the sa!e ae under the tables set #orth at Re. .4&-. re1uires that e+ceptions #ro! the application o# the standard discountrates be prescribed by reulation, Re. .43&'(=b>=3> purports to allow #or *additional e+ceptions* #ro!those enu!erated in that reulation. , which was conditioned on the ta+payers usin the*special #actor* !ethodoloy. Althouh the stated unitrust payout rate, the aes o# the

bene#iciaries, and the applicable section 43&' rate were redacted, the te+t disclosed thateven usin the *special #actor* the ta+payers would still receive distribution o# -'.34(pct. o# the trust corpus.

1. ?LR &''5'-' =&/'2/'4>, an eleven pct. 9I$R;6 =without !a"eup> createdby a li!ited partnership, payable #or the shorter o# twenty years or the )oint lives o# thetwo partners. 6he ta+payers had conceded the *special #actor* !ethodoloy. 6hetransaction was treated as havin closed in Dece!ber o# &''2, when the section 43&' ratewas 3.5 pct., yieldin a distribution to the ta+payers, aed 44 and 45, o# .34 pct. o# thetrust corpus =versus rouhly 4&.((2 pct.>.

r. ?LR &''52'(& ='/&(/'5>, a ten pct. 9IM$R;6 =with !a"eup> #or the )oint

lives o# the settlors. Aain, the ta+payers had conceded the *special #actor* !ethodoloy.6he transaction was treated as havin closed in Dece!ber o# &''2, when the section43&' rate was 3.5 pct., yieldin a distribution to the ta+payers, aed 34 and 4', o# 4(.(5'pct. o# the trust corpus =versus rouhly 55.3( pct.>.

s. ?LR &''52'(( ='/&&/'5>, a co!panion rulin to ?LR &''52'(& ='/&(/'5>.

t. ?LR &''54'(- ='/(/'5>, a ten pct. 9IM$R;6 =with !a"eup> #or theshorter o# the )oint lives o# the settlors or twenty years. Aain, the ta+payers hadconceded the *special #actor* !ethodoloy. 6he transaction was treated as havin closedin 7ebruary o# &''5, when the section 43&' rate was .& pct., yieldin a distribution tothe ta+payers, aed 5 and 3&, o# (2.(5 pct. o# the trust corpus =versus rouhly 52.2(4

pct.>.

Willis pae '


11/23

u. ?LR &''5&4''- ='/'(/'5>, which was conditioned on the ta+payers usin the*special #actor* !ethodoloy. Althouh the stated unitrust payout rate, the aes o# thebene#iciaries, and the applicable section 43&' rate were redacted, the te+t disclosed thateven usin the *special #actor* the ta+payers would still receive distribution o# 5(.((2pct. o# the trust corpus.

and

v. ?LR &''5(('& ='3/'-/'5>, which was conditioned on the ta+payers usin the*special #actor* !ethodoloy. Althouh the stated unitrust payout rate, the aes o# thebene#iciaries, and the applicable section 43&' rate were redacted, the te+t disclosed thateven usin the *special #actor* the ta+payers would receive distribution o# 25.2(5 pct. o#the trust corpus.

8o!ewhat ratuitously, in ?LR &''-&'(2 =&/&&/'5>, approvin the co!!utation o# a #ive pct.9IM$R;6, the author !entioned this series o# rulins, but then noted that the *special valuation!ethodoloy* was not re1uired in the particular case *because the unitrust payout rate is not in e+cess o#the section 43&' rate #or the !onth o# the transaction.* %ddly, the author then calculated the present

value o# the unitrust interest usin the 3.2 pct. section 43&' rate #or April, &''2 rather than the statedpayout rate o# #ive pct. 6hat rulin is interestin #or other reasons, which we will e+plore under*continent or de#easible successive interests,* below.

8hortly a#ter the #irst o# these letters were released, the $o!!ittee on Gstate and @i#t 6a+ation o# the 9ewor" 8tate


12/23

6he letter rulin also cited Re. &3.&3&&=c>(=d>=&>=v>, which says the present value o# a straiht unitrustpayout is to be deter!ined

by subtractin the present value o# all interests in the trans#erred property other than theunitrust interest i.e., the re!ainderE #ro! the #air !ar"et value o# the trans#erredproperty.

In turn, Re. &3.&3&&=c>(=d>=&>=ii> says the re!ainder value is to be deter!ined under Re. .22,presu!ably subpararaph =e>=&>, which aain has been replaced by te!porary Re. .226=e>=&>, aain,e+pired.

9one o# these reulations deal speci#ically with valuin interests in a net inco!e unitrust. In short, theconclusion drawn in ?LR &''&'3''5 ='/&(/'> is si!ply an assertion, albeit a super#icially reasonableassertion.

Aain, the 1uestion !ay co!e down to whether the net inco!e li!itation is a *restriction* #or purposes o#Re. .43&'(=b>=>=ii>. , noted above under *net inco!e li!itation,

Willis pae &


13/23

?LR &''(&'(3 ='(/'/'(>, a )udicial co!!utation o# a straiht $R;6 #or theli#e o# the settlor, since deceased, plus twenty years or the earlier death o# two successorbene#iciaries,

?LR &'''('3 ='-/('/'(>, a )udicial co!!utation o# a straiht seven pct.

$R;6 #or the )oint lives o# the settlors, husband and wi#e,

?LR &'''& ='2/'/'>, a )udicial co!!utation o# a straiht ten pct. $R;6#or a twenty year ter!,

?LR &''4&4'( ='/'3/'4>, a non)udicial co!!utation o# two straiht $R;6s#or the )oint lives o# the settlors, husband and wi#e, and

?LR &''4(-'' ='2/&/'4>, a )udicial co!!utation o# a straiht $R;6 #orseveral bene#iciaries in separate shares, each share ter!inatin at the death o# thebene#iciary, re!ainder to a donor advised #und.

%# so!e interest here also is ?LR &''52'(4 ='5/&'/'5>, a non)udicial co!!utation o# a si+ pct.9IM$R;6 #or the )oint lives o# the settlors, husband and wi#e, which had been converted to a straiht$R;6.

Althouh the te+t o# the letter characteriBed the transaction as a sale, citin Rev. Rul. 2-52, -2-& $..

Rev# Rul# $%%&'( )*$%) C#+# %''

It is certainly the case that Rev. Rul. 4&&( recites that a li#e tenantCs sale o# her entire interest in atesta!entary trust to the re!ainder!an is the sale o# a capital asset. 6he rulin is in e##ect a belatedac1uiescence in , cert. den., ((';.8. 5&2 =-2>, to that e##ect.

6he appeals court rulin was a de#eat #or the $o!!issioner, who had arued that the transaction was ananticipatory assin!ent o# inco!e, and that the proceeds should be ta+ed as ordinary inco!e. 6he8econd $ircuit re)ected this aru!ent, citin


14/23

6he situation in McAllister was so!ewhat co!plicated by the #act that the ta+ code did not then include a!echanis! #or ad)ustin the li#e tenantCs basis, so that when she sold her interest to the re!ainder!an shereported a capital loss. Fad she sold her interest to a third party, the purchaser would have been able toa!ortiBe the purchase price aainst inco!e.

6he enact!ent o# section ''=e> as part o# the 6a+ Re#or! Act o# -2- was intended to address these

ano!alies.

Section ),,)-e.

What the statute literally says is

In deter!inin ain or loss #ro! the sale or other disposition o# a ter! interest inproperty, that portion o# the ad)usted basis o# such interest which is deter!ined pursuantto section ', '3, or ' =to the e+tent that such ad)usted basis is a portion o# theentire ad)usted basis o# the property> shall be disrearded.

Disrearded, entirely.

6he leislative history indicates that this provision was speci#ically intended to address a situation inwhich *a li#e estate or si!ilar interest wasE ac1uired by i#t, be1uest, or inheritance andE the li#e tenantsold his interest.* As stated in the *eneral e+planation* o# the -2- act prepared by the Joint $o!!itteeon 6a+ation, J8$24', under thene+istin law,

tEhe li#e tenant was not ta+ed on the inco!e to the e+tent o# the basis which he wastreated as havin in the li#e estate when he sold it , andE the purchaser o# the li#e estatewas not ta+ed on !ost o# the inco!e because he was allowed to reduce that inco!e bya!ortiBin his basis =the purchase price> in the li#e estate. In so!e cases #or e+a!ple,McAllisterE the sellerCs basis even e+ceeded the a!ount he received upon its sale, and, asa result, he was per!itted to ta"e a deductible loss.

6here is an e+ception at section ''=e>=(> #or a disposition that includes both the inco!e and re!ainderinterests, but we will postpone that discussion #or a !o!ent.

6he cross re#erences are to sections deter!inin the basis o# property ac1uired #ro! a decedent =section'>, by i#t =section '3>, and in a trans#er incident to a divorce =section '>. 6he loic o# the letterrulins centers on section '3, titled *basis o# property ac1uired by i#ts and trans#ers in trust.*

8everal o# the rulins bein by !entionin section '3=b>, which so!ewhat inconruously provides thati# property was ac1uired by a trans#er in trust *other than by a trans#er in trust by a i#t, be1uest, ordevise,* basis is to be *increased in the a!ount o# ain or decreased in the a!ount o# loss reconiBed tothe rantor on such trans#er.*

6he aru!ent would appear to be that the settlor *ac1uired* her annuity or unitrust interest *other than byi#t* and that her basis in that interest is deter!ined *pursuant to* section '3=b>.

Willis pae


15/23

Re. .'3=b> allocates basis in property trans#erred by i#t to a trust between the inco!e andre!ainder interests. 6he *uni#or!* basis o# the entire trust corpus re!ains #i+ed, sub)ect to the usualad)ust!ents, but

the value o# the proportionate parts o# the uni#or! basis represented, #or instance, by therespective interests o# the li#e tenant and re!ainder!an are ad)ustable to re#lect the

chane in the relative values o# such interest on account o# the lapse o# ti!e.

6here is a cross re#erence to Re. .'3=a>, which says the *uni#or!* basis is to be allocated betweenthe inco!e and re!ainder interests usin the actuarial #actors prescribed by Re. &'.&'(4. 8o #ar, soood.

Re. .'3=b> then oes on to say that in deter!inin ain or loss #ro! the sale or other disposition o#a ter! interest, includin a li#e estate, ter! or years, or inco!e interest, *the ad)usted basis o# which isdeter!ined pursuant, or by re#erence, to section '3,*

that part o# the ad)usted uni#or! basis assinable under the rules o# Re.E .' 3=a> tothe interest sold or otherwise disposed o# shall be disrearded to the e+tent and in the

!anner provided by section ''=e> and Re.E .''=#>.

6hese are the re#erences that are 1uoted repeatedly in the letter rulins.

8o what this all co!es down to is whether the settlorCs annuity or unitrust interest in a charitablere!ainder trust was *ac1uired by i#t* #or purposes o# section '3=a>, or whether her basis in thatinterest is to be deter!ined *pursuant to* section '3=b>.

It does see! reasonably clear that a successive annuity or unitrust interest would be *ac1uired by i#t,*and that an annuity or unitrust interest in a testa!entary re!ainder trust would be *ac1uired #ro! adecedent.*


16/23

Rev# 2roc# %,,0'( %,,0) 3#R#+# )),

In Rev. ?roc. &''5(, the IR8 announced that e##ective i!!ediately, that is, January 4, &''5, it would noloner *ordinarily* ive advance rulins on whether the ter!ination o# a $R6 in which each o# the partiesreceived its actuarial share o# the value o# the trust assets is to be treated as a sale or other disposition #orpurposes o# section ''=a>, or as a sale or e+chane o# a capital asset under section &&=a>.

*9ot ordinarily* !eans in the absence o# *uni1ue and co!pellin reasons* to )usti#y the issuance o# arulin. 6here are no clear criteria #or what !iht be *uni1ue and co!pellin reasons.*

In that sa!e revenue procedure, the 1uestion whether the transaction would cause the trust no loner to1uali#y under section 22=d> was identi#ied as an *area under study,* in which rulins would not be issueduntil the issue was resolved throuh the publication o# #or!al uidance.

6hese three ite!s have been carried #orward in succeedin annual revenue procedure updates, andstartin with Rev. ?roc. &''(, &''- $. andRe. .'3=b>, and would thus report !odest i# any ain.


17/23

In describin the transaction, the 9otice #irst presents the scenario in which the holder o# the ter! interestis the trust settlor. 6he re!ainder charity *!ay, but need not* be controlled by the settlor, who *!ay, butneed not* have reserved a power to redesinate.


18/23

Contingent or defeasible successive interests

An early rulin, ?LR 55'3'& =/'3/54>, allowed a deduction #or the partial surrender o# the settlorCsinterest in a straiht #ive pct. unitrust, but disallowed a deduction #or the partial surrender o# the spouseCssuccessive interest, because it was de#easible by the settlorCs e+ercise o# a reserved testa!entary power torevo"e.

6his !eant not only that the surrender o# the spouseCs de#easible interest did not enerate an inco!e ta+deduction, but also that the present value o# that interest was reportable as a ta+able i#t.

Where the holder o# the successive interest is so!eone other than a spouse, o# course, the idea behindreservin the testa!entary power to revo"e is to !a"e the trans#er inco!plete #or i#t ta+ purposes. 6hisapproach was e+plicitly validated by Rev. Rul. 4-&(, -4-& $., and ?LR-4&' ='&/-/-4>, a #ive pct. 9IM$R;6 =with !a"eup>, the ta+payers atte!pted to address theproble! by havin the holder o# the de#easible successive interest disclai!. 6hose two rulins weresilent on the 1uestion whether this stratey was e##ective.

In ?LR &''5'&'& ='-//'4>, the settlor proposed to release his reserved testa!entary power to revo"ethe spouseCs successive interest in each o# two straiht #ive pct. $R;6s, as part o# a co!plete surrender,and instead o# disclai!in, the spouse then participated in the surrender. 6he rulin e+plicitlyac"nowleded that the release co!pleted a i#t to the spouse that 1uali#ied #or a !arital deduction undersection &3&(=>.

In this connection, note Rev. Rul. 4-&-3, -4-& $. to a charity, a charitable deduction would be allowable under section &3&&=c>=&>, because

=a> the trans#er was not !ade in #urther trust and

=b> the trans#eror had no other interest in the property at or be#ore the ti!e o# thetrans#er.

6he rulin was sub)ect to the proviso that the trust had not been created #or the purpose o# evadin thepartial interest rule o# section 4'=#>=(>=A>.

8o!e rather aw"ward !aneuverin was in evidence in ?LR &''-&'(2 =&/&&/'5>, which as noted aboveapproved the co!!utation o# a #ive pct. 9IM$R;6 =with !a"eup> without re1uirin the use o# the*special valuation #actor* because the section 43&' rate was then hiher than the stated unitrust payoutrate.

Willis pae 5


19/23

6he trust had been established by a husband and wi#e, payable to the! )ointly, and a#ter the death o# thesurvivor in e1ual shares to their two sons. 9either settlor had reserved a testa!entary power to revo"e thesuccessive interests to the sons, so presu!ably those were co!pleted, ta+able i#ts.

At the ti!e o# the rulin re1uest, the husband had a shortened li#e e+pectancy, albeit not a ter!inal illness..

6he only rulins actually re1uested were that this trans#er would not constitute an act o# sel#dealin andthat it would not trier a #oundation ter!ination ta+. A #avorable rulin on these points depended onwhether the a!ount the wi#e would receive in the co!!utation was li!ited to the present value o# theinco!e interest, per Re. 3(.-4=c>=&>.

6he letter recites that the ta+payer =i.e., the wi#e> had re1uested that the calculation *not re#lect survival*#or the husband. 6hus, in !a"in the calculation, the 8ervice disrearded the husbandCs li#e, notin that

tEhe #actor #or the re!ainder interest #ollowin the re!ainin three !easurin lives is thesa!e as the #actor #or the re!ainder interest #ollowin all #our lives assu!in the #ourth ister!inally ill,E

thouh aain, the husbandCs illness was not ter!inal. In this connection it bears notin, as stated in Rev.Rul. 5'5', that the actuarial tables under Re. &'.&'(4 and Re. &'.&'(46 are not

tEhe actuarial tables are not based on data that e+clusively involve persons o# CoodC orCnor!alC health. 6hey re#lect the incidence o# death by disease and illness as well as byaccident. 6he actuarial tables are properly applicable to the vast !a)ority o# individualli#e interests, even thouh the health o# a particular individual is obviously better or

worse than that o# the CaveraeC person o# the sa!e ae and se+.

%nly occasionally, the revenue rulin went on to say, are the actual #acts o# an individualCs condition *soe+ceptional as to )usti#y departure #ro! the actuarial tables.* Althouh Rev. Rul. 5'5' was obsoleted byRev. Rul. -2(, the #act re!ains that the tables include everyone e+cept the ter!inally ill.

6houh these #our rulins do not directly illustrate the point, we should note that where circu!stanceshave e!ered to shorten the li#e e+pectancy o# the spouse or a child o# the settlor whose successiveinterest in the annuity or unitrust is continent and/or de#easible, it !ay be desirable #or the settlor toaccelerate all or part o# the re!ainder i#t and clai! an additional inco!e ta+ charitable contributionsdeduction.

Surrender in exchange for a gift annuit5

6o date, there has been e+actly one rulin, ?LR &''3&'5 ='-/&2/'>, dealin with a surrender ine+chane #or a i#t annuity. 6here, the 8ervice ruled:

Willis pae -


20/23

=a> the ta+payer would be entitled to clai! a charitable contributions deduction#or both inco!e and i#t ta+ purposes in the a!ount by which the present value o# theunitrust interest he would be surrenderin e+ceeded the present value o# the i#t annuityhe would be receivin in e+chane,

=b> because a sale o# the unitrust interest would have resulted in lonter! capital

ain, there would be no reduction in the a!ount allowable as a charitable contributionsdeduction per section 4'=e>=>, and the a!ount o# the deduction that he could ta"e in aiven year would be sub)ect to a li!itation o# thirty pct. o# his ad)usted ross inco!e,

=c> the ta+payer would not reconiBe undistributed capital ains accu!ulated inprior years as a conse1uence o# the trans#er, per Re. .22(, and

=d> the transaction would be treated as a barain sale under section '=b>, i.e.,the ta+payer would reconiBe lonter! capital ain in the a!ount o# the present value o#the i#t annuity ratably over the period o# years !easured by the e+pected return !ultipleunder the annuity contract, but only #ro! that portion o# the annuity payout that wastreated as a return o# his invest!ent in the contract.

Aain, #or purposes o# calculatin ain, the ta+payerCs basis in his unitrust interest was to be treated asBero, ostensibly pursuant to section ''=e>.

Let us ta"e a loo" at what this transaction !iht loo" li"e today, with the section 43&' rates at recordlows, and with the A$@A reco!!ended i#t annuity rates havin been reduced several ti!es.

7irst, usin a section 43&' rate o# . pct., rouhly the averae rate over the last twelve !onths, anannuity at the reco!!ended rate, paid 1uarterly at the end o# the 1uarter, would not !eet the additionalre1uire!ent A$@A has recently i!posed, that the present value o# the residuu! o# the i#t annuity be atleast twenty pct., #or an annuitant youner than 2'. 6he reco!!ended rate #or an annuitant aed 2' is .pct.

With the section 43&' rate all the way down to .' pct., the younest ae that would !eet the twenty pct.residuu! re1uire!ent is ae 2&, with an annuity rate o# .3 pct. 8o #or convenience, letCs say Richard isnow 2& years old.

And this ti!e we will put Richard in a #ive pct. straiht unitrust, rather than eiht. Aain, payable1uarterly at the end o# the 1uarter. I# the section 43&' rate is . pct., the present value o# his unitrustinterest is 3-.'& pct. I# the section 43&' rate is .' pct., the present value o# his unitrust interest is3-.5( pct. 6his is as ood a place as any to note that depressed section 43&' rates have not all that !uche##ect on the valuation o# interests in a unitrust.

I# the unitrust is holdin !illion, Richard is receivin a payout o# 3'", and the present value o# his

unitrust interest is so!ewhere north o# 3-". I# he were to surrender his unitrust interest in e+chane #ora i#t annuity payin .3 pct., we are loo"in at a payout o# so!ethin less than &4" per year, o# whichnot 1uite &'" would be ta+ed as lonter! ain and a little over 2" would be ta+ed as ordinary inco!e#or the ne+t twentythree years, a#ter which the entire payout would be ta+ed as ordinary inco!e.

Willis pae &'


21/23

I# Richard has reserved a power to redesinate the re!ainder!an, he !iht be able to persuade theissuin charity to treat the entire !illion, or at least so!e larer portion o# it, as #undin the annuity, orotherwise to deviate #ro! the A$@A reco!!ended rate.

0eepin in !ind, o# course, that i# the issuance o# annuity contracts constituted a *substantial part* o# theactivities o# an otherwise e+e!pt oraniBation, this would be treated as an unrelated trade or business,

were is not #or the e+ception at section 3'=!>=3> #or i#t annuities. 6hat e+ception applies only i# theannuity contacts con#or! to the re1uire!ents o# section 3=c>=3> reardin *unrelated debt#inancedinco!e* in the #or! o# *ac1uisition indebtedness.*

7or this purpose, the present value o# the annuity cannot be !ore than -' pct. o# the value o# the propertyreceived by the charity in the e+chane. Re. .3=c> de#ines this li!itation in ter!s o# *the value o#the prior ownerCs e1uity* in the property received =an e!bellish!ent o# the statute, which does not use theword *e1uity*>. And #or inco!e ta+ purposes, Richard not only has no basis in the re!ainder, he has noproperty interest in it at all =unless so!e value were to be ascribed to his reserved power to redesinatethe re!ainder charity>.

!ust be represented.

Willis pae &


22/23

Where the identities or shares o# the charitable re!ainder!en are inde#inite, either because the settlor hasreserved a power to desinate the re!ainder!en or because a si!ilar power has been ranted to thetrustee or to one or !ore individual bene#iciaries, it will al!ost certainly be necessary to )oin the stateattorney eneral in a )udicial !odi#ication or ter!ination proceedin.

Russell A. Willis III, J.D., LL.M.(''( 9G 0nott 8treet, ;nit


23/23

2ostscript

6he se!inal rulin underlyin everythin we have tal"ed about here is Rev. Rul. 522', -52 $.=(>=A> and this was "ey to the rulin, in that the ta+payer was treated as havin trans#erred her entire interestin the trust to the charity, without reard to the #act that she had earlier owned other interests in theproperty co!prisin the trust corpus. 6here#ore, the 8ervice ruled, the trans#er 1uali#ied #or a charitablecontributions deduction #or both inco!e and i#t ta+ purposes. 6he !ethod o# calculatin the a!ount o#the deduction was not discussed.

In the second situation =*situation &*>, the annuity was to have continued #or the li#e o# the ta+payerCs

spouse, i# he survived her. initially created thetrust #or the purpose o# evadin the partial interest rule was "ey, because in this circu!stance the trans#ero# the ta+payerCs annuity interest, standin alone, would not otherwise have 1uali#ied #or the charitablecontributions deduction, in that she had also !ade a trans#er #or private =i.e., noncharitable> purposes: theannuity to her spouse, i# he survived her.

6he rulin also concluded that the trans#er by the spouse o# his annuity interest to the re!ainder!an1uali#ied, thouh it was not in the #or! o# a charitable lead annuity trust, because it was the only interestin the property he had ever had.

Willis pae &(

Exiting the Underproductive CRT

Documents

Transcript of Exiting the Underproductive CRT