New CRT regs.

On Dec. 10, 1998, the Treasury published final regulations on several aspects of charitable remainder trusts (CRTs) and the special valuation rules for transfers of interests to these trusts, including income beneficiary payment timing, appraising unmarketable assets, application of Sec. 2702 to certain CRTs and allocation of precontribution gain. The most important part of the new regulations is the pro-taxpayer expansion of flip unitrust use.

Background

A CRT provides for a specified periodic distribution to one or more beneficiaries (at least one of whom is a noncharitable beneficiary) for life or for a term of years (not in excess of 20), with an irrevocable remainder interest held for the benefit of charity. There are two basic types of CRTs--charitable remainder annuity trusts (CRATs) and charitable remainder unitrusts (CRUTs). A CRAT pays a sum certain at least annually to the beneficiaries (i.e., the annuity amount); a CRUT pays a unitrust amount at least annually to the beneficiaries.

Generally, the unitrust amount is a fixed percentage of the net fair market value (FMV) of the CRUT's assets valued annually (fixed-percentage CRUT). The unitrust amount can instead be calculated under one of two income exception methods (income exception CRUT). Under the first method, the unitrust amount is the lesser of the fixed percentage amount or the trust's annual net income (net income method). Under the second method, the unitrust amount is determined under the net income method plus any amount of income that exceeds the current year's fixed percentage amount, to make up for any shortfall in payments from prior years when trust income was less than the fixed percentage amount (NIMCRUT method). The shortfall in payments from prior years is commonly referred to as the "make-up amount."

Payment Provisions: Tax Years Ending after April 18, 1997

In the mid-1990s, the IRS became concerned with perceived abuses associated with the use of accelerated CRTs. In response, on April 18, 1997, it proposed regulations under Secs. 664 and 2702. These proposed regulations provided that the payment of the annuity or unitrust amount determined under the fixed-percentage method must be made by the close of the tax year in which it is due. Since the proposed regulations were issued, the Service issued Notice 97-68, providing guidance on complying with the proposed rules for the 1997 tax year. The new regulations supersede Notice 97-68.

The final regulations adopt rules similar to those in Notice 97-68 with certain modifications and are effective for tax years ending after April 18, 1997. For CRATs and fixed-percentage CRUTs, the annuity or unitrust amount may be paid within a reasonable time after the close of the year for which it is due if (1) the character of the annuity or unitrust amount in the recipient's hands is income under Sec. 664(b)(1), (2) or (3) or (2) the trust distributes property (other than cash) that it owned as of the close of the tax year to pay the annuity or unitrust amount and the trustee elects (on Form 5227, Split-Interest Trust Information Return) to treat any income generated by the distribution as occurring on the last day of the tax year for which the amount is due. For all tax years, Regs. Sec. 1.664-2(a)(1)(i)(c) continues to define reasonable time as "not ordinarily extend[ing] beyond the date by which the trustee is required to file Form 5227 Split-Interest Trust Information Return (including extensions) for the taxable year."

Payment Provisions: Tax Years Ending before April 18, 1997 and Trusts Created before Dec. 10, 1998

For tax years ending before April 18, 1997 and for any trust created before Dec. 10, 1998, the new regulations require the annuity or unitrust amount to be paid within a reasonable time after the close of the tax year for which it is due, if the percentage used to calculate the annuity or unitrust amount is 15% or less. Most "old" trusts will not be affected, because generally they have been written to adhere to the 15%-or-less requirement.

Flip Unitrusts: Triggering Events 

The greatest change from the proposed regulations to the final regulations was the expansion of the availability of the flip unitrust concept. The new regulations allow the governing instrument of a CRUT to provide that the CRUT will convert once from one of the income exception methods to the fixed-percentage method for calculating the unitrust amount, if the date or event triggering the conversion is outside the control of the trustees or any other persons.

The final regulations include examples of permissible and impermissible triggering events. For example, permissible triggering events with respect to any individual include:

* Marriage;

* Divorce;

* Death;

* Reaching a certain age;

* Birth of a child; and

* Sale of an unmarketable asset, such as real estate, closely held stock or an unregistered security for which there is no available exemption permitting public sale.

Examples of impermissible triggering events include:

* Sale of marketable assets; and

* Request from the unitrust recipient or the unitrust recipient's financial adviser that the trust convert to the fixed-percentage method.

The regulations also provide that the conversion to the fixed-percentage method occurs at the beginning of the tax year immediately following the tax year in which the triggering date or event occurs. Any make-up amount described in Sec. 664(d)(3)(B) is forfeited when the trust converts to the fixed-percentage method.

The flip unitrust allowed in the regulations is the only type of permissible conversion. Thus, a CRAT cannot convert to a CRUT without losing its status as a CRT. Similarly, a CRUT using the fixed-percentage method cannot convert to an income exception method without losing CRT status. The rules for flip unitrusts are effective for CRUTs created on or after Dec. 10, 1998. The final regulations allow income exception CRUTs to be reformed to add provisions allowing a conversion to the fixed-percentage method, provided the triggering event does not occur in a year prior to the year in which the court issues the order reforming the trust. Trustees must initiate legal proceedings to reform the trust by June 8,1999.

Appraising Unmarketable Assets

Under Sec. 664(d)(2)(A), a CRUT must value its assets annually. The new regulations provide that, if a CRT holds unmarketable assets and the only trustee is the grantor, a noncharitable beneficiary, or a related or subordinate party to the grantor or the noncharitable beneficiary within the meaning of Sec. 672(c) and the associated regulations, the trustee must value those assets using a current qualified appraisal (as defined in Regs. Sec. 1.170A-13(c) (3)), from a qualified appraiser (as defined in Regs. Sec. 1.170A-13(c) (5)).

An independent trustee is a person who is not the grantor, the grantor's spouse, a noncharitable beneficiary or a related or subordinate party to the grantor, or the noncharitable beneficiary within the meaning of Sec. 672(c) and the applicable regulations. A co-trustee who is an independent trustee may value the trust's unmarketable assets.

The rules for valuing unmarketable assets are effective for trusts created on or after Dec. 10, 1998. A trust in existence as of that date, whose governing instrument requires that an independent trustee value the trust's unmarketable assets, may be amended or reformed to permit a valuation method that satisfies the new regulation's requirements for tax years beginning on or after Dec. 10, 1998. Thus, a pre-Dec. 10, 1998 trust would be allowed (but is not required) to reform a trust document to substitute a qualified appraisal for an independent trustee appraisal.

Application of Sec. 2702 to Certain CRUTs

Under the new regulations, for transfers made on or after May 19, 1997, unitrust interests in an income exception CRUT retained by the donor or any applicable family member will be valued at zero when a noncharitable trust beneficiary is someone other than the donor, the donor's U.S.-citizen spouse or both the donor and the donor's U.S.-citizen spouse. For transfers made before May 19, 1997, Sec. 2702 will not apply if the remainder interest qualifies for the gift tax deduction under Sec. 2522.

Sec. 2702 will not apply when there are only two consecutive noncharitable beneficial interests and the transferor holds the second of the two interests. Sec. 2702 does apply to NIMCRUTs and to flip unitrusts if the CRUT does not fall within one of the exemptions.

Prohibition on Allocating Precontribution Gain to Trust Income and Make-Up Amount as a Liability

The new regulations "clarify" that the proceeds from the sale of an income exception CRUT's assets, at least to the extent of the fair market value of the assets when contributed to the trust, must be allocated to trust principal. However, the governing instrument, if permitted under applicable local law, may allow the allocation of postcontribution capital gains to trust income. Taxpayers do not have to treat the make-up amount as a liability when valuing a NIMCRUT's assets. The "clarification" is applicable for sales or exchanges occurring after April 18, 1997. For sales or exchanges before that date, the IRS'S informal position (i.e., as established in letter rulings) is that the regulatory position discussed above applies to most NIMCRUTs.

FROM TERRY TURNIPSEED, ESQ., WASHINGTON, DC