Charitable trust's receipt of UBTI caused all income to be taxable.

On Jan. 21, 1997, the Ninth Circuit affirmed the Tax Court's decision that a charitable remainder unitrust's (CRUT's) receipt of unrelated business taxable income (UBTI) from three publicly traded partnerships caused it to be taxable on all of its income for that year (Leila G. Newhall Unitrust, aff'g 104TC 236 (1995)).

The Leila G. Newhall Unitrust (Unitrust) was created in 1975 and was funded with common stock of the Newhall Land and Farming Company (Company), a publicly traded corporation. In 1983, Company entered into a partial liquidation and transferred certain real estate and mineral rights to two publicly traded limited partnerships (PTLPs). The Unitrust received units of both PTLPs from Company. In 1985, the Company completely liquidated and transferred its remaining assets to a third PTLP. The Unitrust received units of the third PTLP in exchange for its Company shares. The three PTLPs were publicly traded on the New York Stock Exchange during tax years 1988 and 1989. Petitioner did not purchase or acquire any other interests in the three PTLPs.

The Service determined deficiencies against the Unitrust for 1988 and 1989, asserting that the amounts received through the three PTLPs were UBTI, and that under Sec. 66.4(c) and Regs. Sec. 1.664-1(c), the trust's receipt of UBTI caused it to be taxable on all of its income in those years. Sec. 664(c) provides that "a charitable remainder unitrust shall, for any taxable year, not be subject to any [income tax], unless such trust, for such year, has unrelated business taxable income (within the meaning of section 512)."

Regs. Sec. 1.664-1(c) provides that "[i]f the charitable remainder trust has any unrelated business taxable income... for any taxable year, the trust is subject to all of the taxes imposed by... the Code for such taxable year."

The Tax Court ruled for the IRS, rejecting the trust's position that it should be taxable (if at all) on only its UBTI. While the trust pointed out that its income tax was approximately three times its actual UBTI, the Tax Court found Sec. 664(c) to be unambiguous and Regs. Sec. 1.664-1(c) to be a reasonable interpretation.

The Unitrust appealed, arguing that PTLPs are not "partnerships" for Sec. 512(c) purposes, but instead should be treated as corporations. The Unitrust also argued that because its investment in the PTLPs was merely passive, its income from the PTLPs should not be treated as UBTI. Finally, the Unitrust reiterated its argument that the receipt of UBTI should not cause all of its income to be taxable.

The Court of Appeals, in rejecting the first two arguments, stated that the Unitrust failed to demonstrate that the PTLPs had the minimum three of four attributes of corporations; although the PTLPs had associates and centralized management, they lacked continuity of life and limited liability. In addition, the Court of Appeals held that PTLPs, unlike corporations, are not taxed on their income. As a result, partnership distributions are fundamentally different from dividends and are not "passive" income.

The Unitrust next contended that I Sec. 664(c), which affords the trust an exemption from tax on its income unless for such year it has UBTI, is ambiguous and does not authorize taxing income other than UBTI and that Regs. Sec. 1.664-1, which subjects the entire income of a CRUT to tax for any year in which it receives "any UBTI," is therefore contrary to the statute, as well as arbitrary and capricious.

The Court of Appeals agreed with the Tax Court and found no ambiguity in the statute. In so holding, the court quoted the following language from the Tax Court opinion:

The plain language of section 664(c) states that a charitable trust will be exempt from tax "unless such trust, for such year, has unrelated business taxable income." Petitioner would have us add the phrase "then the trust will be taxable only on that unrelated business taxable income" to the above quoted phrase. We decline to do so. The word "unless" clearly conditions the previously granted exemption. No persuasive evidence has been called to our attention to show that Congress meant to continue to provide a limited exemption if the taxpayer failed to meet the terms of the complete exemption.

Because there was no basis for exempting the Unitrust, tax was properly imposed on its entire income during the years in which it had UBTI.

The Newhall decision confirms that if a CRUT receives any UBTI, it will be subject to tax for that year on all of its current undistributed income. For such year, the CRUT will be treated as a complex trust and will receive a distribution deduction for any portion of its distributable net income actually distributed to the income beneficiary. In the following year, the CRUT will again be a taxexempt entity (provided the trust does not receive any UBTI for that year).

From Dale R. Baumann, CPA, J.D., Washington, D.C.