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Sunday, January 19, 2014


In Notice 2008-99, the IRS signaled its concern about a planning arrangement involving sales of interests in charitable trusts that could give rise to tax-free increases in basis. Treasury has now issued proposed regulations specifically addressed at avoiding such a step-up in basis.

Several years ago, the IRS became aware of an interesting planning arrangement whereunder holders of a term interest in a charitable remainder unitrust or annuity trust could claim and benefit from a basis step-up in their term interest without anyone paying taxes on the increased amount. In Notice 2008-99, the IRS designated the methodology as a “transaction of interest” that is subject to enhanced disclosure requirements.

The Treasury Department has now issued proposed regulations that revise Treas. Regs. §1.1014-5 to provide special basis adjustment rules to eliminate this basis step-up. To best understand the proposed regulations, let’s start with the steps of the abuse that the regulations address:

A. A charitable remainder annuity or unitrust (“charitable trust”) is funded with appreciated assets. The grantor retains a term interest with a charity as the remainder beneficiary. The grantor recognizes no gain or loss on the funding, and receives a charitable deduction for the portion of the assets allocable to the charitable remainder.

B. The charitable trust sells the appreciated assets and reinvests them. As a charitable trust, the trust recognizes no gain on the sale. As distributions are made to the term interest holder, the term interest holder will eventually be taxable on such gains, but that is in the future (and as described below, may never occur if the sale described below occurs prior to such distributions).

C. The term interest holder and the charitable trust sell their trust interests to an unrelated third party. The term interest holder has an amount realized equal to what he or she will receive for the interest. What is the basis of the term interest holder in the sold term interest for purposes of computing his or her gain?

     1. Generally, under Treas. Regs. §1.1014-5(a) (commonly referred to as the uniform basis rules), a term interest beneficiary in a trust will be allocated a portion of the trust’s basis in its assets, based on the actuarial portion of the value allocable to the term interest beneficiary.

     2. Notwithstanding that general rule, Code §1014(e)(1) will impose a $0 basis on such a term interest that is acquired by gift or a transfer in trust (or by transfers from a decedent or under Code §1041). Thus, at this point in the analysis, it appears that the selling term interest beneficiary has a $0 basis and will recognize 100% of the sales price as gain.

     3. However, it is likely that our beneficiary will seek to apply Code §1014(e)(3). This provision is an exception to the $0 basis rule of Code §1014(e)(1) above. It will reimpose the general basis allocation rule described in 1. above if the sale is “part of a transaction in which the entire interest in property is transferred to any person or persons.”

D. So where are we? The selling taxpayer will likely assert that under Code §1014(e)(3), he or she has a portion of the trust’s basis in its assets (based on the term interest holder’s actuarial share of the trust value). Since the trust has a fair market value basis in its assets or something close to that (having recently sold the contributed appreciated assets and reinvested the sale proceeds), if the term interest is sold for its fair market actuarial value the seller recognizes no gain on the sale. Since the trust is merged out of existence in the hands of the buyer, there will be no further distributions on the term interest – thus the opportunity for the government to receive taxable income from the trust’s prior sale of the appreciated property is lost forever, and the term interest holder effectively receives a free step-up in basis.

Pretty neat! Perhaps the IRS has no tools to foreclose such treatment for transactions to date, but the new proposed regulations will avoid the above result if and when the regulations are finalized. The proposed regulations will initially apply the foregoing allocation of trust basis to the term interest holder, but under a modification to Treas. Regs. §1.1014-5 will then reduce that basis by the term interest holder’s actuarial percentage of the trust’s undistributed net ordinary income and undistribute net capital gains under Code §§664(b)(1) & (2) and Treas. Regs. §§1.664-1(d)(1)(ii)(a)(1) & (2).

The fix is a fairly simple method for Treasury to close the loophole without radical revision of the uniform basis rules. To the extent there has been trust income that is undistributed, the term interest holder will have his or her basis reduced on a sale or other disposition of that interest. Thus, to the extent the trust has incurred tax-free gain or income and not distributed out that income, no basis step-up from that income occurs to the term holder.

As most regulations drafted to address a specific abuse do, it will catch in its net taxpayers that did not enter into abusive planning. For example, these rules will apply to all charitable trusts, including those that were not funded with appreciated property and that did not do a quick turnaround sale of the term interest. Thus, it will apply to all combined term and remainder interests and will reduce basis to the term interest holder for any undistributed income, even where there was no tax avoidance motive or planning.

Helpfully, the new rules are slated to only apply to charitable remainder annuity trusts and charitable remainder unitrusts, although the IRS has asked for comments on expansion to other charitable trusts. Thus, the rules are of no concern on dispositions of interests in noncharitable trusts. This is as it should be, since there is no avoidance of tax on the income of the trust via charitable status, which is what gives rise to the potential for a tax-free step-up in basis.a

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