CHARITABLE REMAINDER TRUSTS FUNDED WITH PARTNERSHIP AND CORPORATION ASSETS QUALIFY
Reference:
Section 664 -- Charitable Remainder Trusts
UIL Number(s) 0664.03-02, 4941.00-00, 4943.00-00
Full Text:
Date: May 13, 1996
Refer Reply to: CC:DOM:P&SI:3 TR-31-438-95
LEGEND:
TP = * * *
SP = * * *
GP = * * *
Corp = * * *
CR = * * *
State = * * *
a = * * *
b = * * *
c = * * *
d = * * *
e = * * *
Dear * * *
[1] This letter responds to a letter from your authorized representative dated February 14, 1995, as amended and supplemented by information subsequently submitted, as well as by materials and documents previously submitted for two earlier cases (TR-31-925-93 and TR-31-2789-94). These submissions request rulings on various tax consequences of creating and funding two trusts intended to qualify as charitable remainder unitrusts under section 664 of the Internal Revenue Code. The taxpayer represents the facts as follows.
FACTS
[2] TP and SP have a real estate business, in which they are assisted by their children in various capacities. The family currently carries on the business through three entities: a general partnership (GP), a closely held corporation (Corp), and a limited partnership (not discussed further in this ruling letter).
[3] GP is an State general partnership in which TP and SP are equal partners. GP's activities will consist of passive rental activity and the investment of assets in public liquid markets, as opposed to engaging in the real estate business. GP will own interests in real estate, such as shopping centers, apartment complexes, and nursing homes, which will be leased to a management company. The management company will remit to GP rent which will not be determined on the basis of income or profits derived by the management company, but which may be based on a fixed percentage or percentages of the management company's receipts from properties under management. Officers, directors, and shareholders of the management company will not be disqualified persons with respect to the trusts as defined in section 4946 of the Code.
[4] Neither a trust nor GP, an interest in which is held by a trust, will own assets encumbered by debt at the time of creation or at any time thereafter or will itself incur any debt.
[5] Corp is a State corporation, subject to federal income taxation under subchapter C of the Code. Corp has two classes of shares outstanding: Class A voting and Class B nonvoting. TP owns a Class A shares and SP owns b Class A shares. No other person or entity owns any Class A shares. TP owns c Class B shares and SP owns d Class B shares. A separate trust for each of the children owns e Class B shares. No other person or entity owns any Class B shares.
[6] TP proposes to create under State law two essentially identical trusts, each intended to qualify as a charitable remainder unitrust under section 664(d)(2) of the Code. TP will serve as the trustee of each trust, SP will serve as the successor trustee, and two of the children will serve as the second successor co-trustees. An independent bank, trust company, or individual will serve as the valuation trustee, with exclusive authority to perform the annual valuation of all assets held in the trusts.
[7] CR will be the charitable remainder beneficiary of each trust. The trustee will have the authority to change the charitable remainderman, which must be an organization qualified as tax exempt under section 501(c)(3) of the Code and may be an organization classified as a private foundation under section 509(a).
[8] TP will fund one trust with his interest in GP (Trust 1) and one with his shares in Corp (Trust 2). Each of these trusts will pay annually to TP for his lifetime the lesser of 5 percent of the net fair market value of trust assets, determined annually on the valuation date, or the net income of the trust for the year. Any amount not paid in any year because the trust's net income is less than 5 percent of the trust's net fair market value will be paid in any year the trust's net income exceeds the trust's net fair market value, to the extent of that excess. After TP's death, this unitrust amount will be paid annually to SP for her lifetime. After SP's death, the unitrust amount will be paid annually in equal parts to their children who are still living. When neither TP nor SP nor one of their children is living, the trust will terminate and all remaining trust assets will be paid to the charitable remainderman. TP may revoke by will the interest of any noncharitable beneficiary named therein.
[9] For purposes of determining the unitrust amount each year, the fair market value of trust assets will be reduced by the amount of any deficiency in unitrust payments in prior years. Such reduction, however, will not exceed the amount that would be characterized as income under the terms of the governing instrument and local law if, as of the valuation date, the partnership distributed cash to the trust or the trust sold all its assets.
[10] The assets contributed initially to the trusts constitute corpus. Therefore, the trust agreements provide that the allocation of any realized capital gains to trust income will be limited to post contribution appreciation.
[11] The following rulings were requested.
1. That each trust will qualify as a charitable remainder unitrust within the meaning of section 664 of the Code.
2. That each trust may be a general partner or a corporate shareholder without creating an act of self-dealing within the meaning of section 4941 of the Code.
3. That ownership of general partnership interests or corporate stock will not subject either of the trusts to tax under section 4943 of the Code as an excess business holding.
4. That the income from each trust will retain the same character in the hands of the recipients of the unitrust payments as in the hands of that trust.
5. That an income tax deduction will be allowed TP for the actuarial value of the interests passing to the charitable remainderman under the trusts on account of his contributions.
LAW & ANALYSIS
RULING REQUEST 1
[12] Section 664(d)(2) of the Code sets forth the requirements of a charitable remainder unitrust. Section 664(d)(2)(A) provides that the unitrust amount must be paid to one or more persons (at least one of which is not an organization described in section 170(c) and, in the case of individuals, only to an individual who is living at the time of the creation of the trust) for a term of years (not in excess of 20 years) or for the life or lives of such individual or individuals.
[13] Section 1.664-3(a)(5)(i) of the Income Tax Regulations provides that the period for which the unitrust amount is payable begins with the first year of the charitable remainder trust and continues either for the life or lives of a named individual or individuals or for a term of years not to exceed 20 years. Only an individual or organization described in section 170(c) of the Code may receive an amount for the life of an individual.
[14] Section 7701(a)(1) of the Code defines the term "person" to include an individual, trust, estate, partnership, association, company, or corporation.
[15] The unitrust amounts from TP's trusts are payable for the lives of TP and SP and their children.
[16] The governing instruments of the trusts contain provisions set forth in Rev. Rul. 72-395, 1972-2 C.B. 340, as modified by Rev. Rul. 80-123, 1980-1 C.B. 205, and Rev. Rul. 82-128, 1982-2 C.B. 71, and clarified by Rev. Rul. 82-165, 1982-2 C.B. 117.
[17] Therefore, providing that the trusts are valid trusts under local law, we conclude that TP's trusts meet the requirements for a charitable remainder unitrust under section 664 of the Code. The trusts will qualify as charitable remainder unitrusts for federal income tax purposes for any tax year in which they continue to meet the definition of, and function exclusively as, charitable remainder unitrusts. For that year, the trusts will be exempt from the taxes imposed by subtitle A of the Code, unless they have any unrelated business taxable income as defined in section 512 and the applicable regulations. See sections 1.664-1(a)(1) and (4) of the regulations.
RULING REQUEST 2
[18] Section 4947(a)(2) of the Code provides, in relevant part, that in the case of a trust which is not exempt from taxation under section 501(a), not all of the unexpired interests in which are devoted to one or more of the purposes described in section 170(c)(2)(B), and which has amounts in trust for which a deduction was allowed under section 170, 545(b)(2), 556(b)(2), 642(c), 2055, 2106(a)(2), or 2522, section 4941 (relating to taxes on self- dealing), and section 4943 (relating to taxes on excess business holdings) except as provided in (b)(3), shall apply as if such trust were a private foundation.
[19] Section 4941 of the Code imposes an excise tax on a disqualified person for each direct or indirect act of self-dealing between the disqualified person and a private foundation, based on the amount involved.
[20] Section 4941(d)(1) of the Code provides, in part, that the term "self-dealing" means any direct or indirect --
(A) sale or exchange, or leasing, of property between a private foundation and a disqualified person;
(B) lending of money or other extension of credit between a private foundation and a disqualified person;
(C) furnishing of goods, services, or facilities between a private foundation and a disqualified person;
(D) payment of compensation (or payment or reimbursement of
expenses) by a private foundation to a disqualified person; and
(E) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation.
[21] Section 4946(a)(1) of the Code defines disqualified persons to include all substantial contributors, all foundation managers, and members of the family of each substantial contributor or foundation manager. Section 4946(b)(1) provides, in part, that the term "foundation manager" means, with respect to any private foundation an officer, director, or trustee of a foundation. Section 4946(d) defines as family members an individuals spouse, ancestors, children and their spouses, grandchildren and their spouses, and great-grandchildren and their spouses. A substantial contributor is defined with reference to section 507(d)(2).
[22] Section 507(d)(2) of the Code provides that a substantial contributor includes any person who has contributed more than 2 percent of the total contributions received by a private foundation as of the close of any year (provided that person's contributions to the foundation exceed $5,000). A creator of a trust is also a substantial contributor. In determining whether an individual is a substantial contributor, contributions made by his or her spouse are also included.
[23] TP is a disqualified person with respect to each trust under section 4946(a)(1) of the Code. However, contributing stock and general partnership interests to the trusts generally is not a transaction that could be considered an act of self-dealing within the meaning of section 4941. Thus, the proposed transaction of donating stock and general partnership interests to the trusts is not an act of self-dealing within the meaning of section 4941.
[24] However, this conclusion as to the absence of self-dealing is limited to the initial funding of the trusts and does not address any future transactions between disqualifying persons and the trusts. We specifically do not rule on the applicability of section 4941 to any trust transactions beyond initial trust funding.
RULING REQUEST 3
[25] Section 4943 of the Code imposes a tax annually on the value of a private foundation's excess holdings in a business enterprise. Excess business holdings are generally determined with reference to a foundation's own holdings and the holdings of all of its disqualified persons, a term defined in section 4946.
[26] Section 4947(b)(3) of the Code provides, in part, that section 4943 shall not apply to a charitable remainder unitrust if a deduction was allowed under section 170, 545(b)(2), 556(b)(2), 642(c), 2055, 2106(a)(2), or 2522, for amounts payable under the terms of such trust to every remainder beneficiary, but not to any income beneficiary.
[27] Thus, a charitable remainder unitrust is subject to the tax on excess business holdings by reason of section 4947 of the Code. However, the tax on excess business holdings does not apply to a charitable remainder unitrust if the charity's only interest in the trust is as remainderman; in this instance, the income from the trust is not deductible while the remainder amount is presently deductible. Therefore, if no deductions are allowed on the income from the trust, then there can be no excess business holdings under section 4943 by reason of section 4947(b)(3).
RULING REQUEST 4
[28] Section 664(b) of the Code provides that amounts distributed by a charitable remainder unitrust have the following characteristics in the hands of a beneficiary to whom is distributed a payment described in section 664(d)(2)(A):
(1) first, as amounts of income (other than gains, and amounts treated as gains, from the sale or other disposition of capital assets) includable in gross income to the extent of such income of the trust for the year and such undistributed income of the trust for prior years;
(2) second, as a capital gain to the extent of the capital gain of the trust for the year and the undistributed capital gain of the trust for prior years, with the amount of the undistributed capital gain to be determined on a cumulative net basis;
(3) third, as other income to the extent of such income of the trust for the year and such undistributed income of the trust for prior years; and
(4) fourth, as a distribution of trust corpus.
[29] Section 1.664-1(d)(1)(i) of the regulations provides that the distribution characterization rule of section 664(b) of the Code applies whether or not the trust is exempt.
[30] According to section 1.664-1(d)(1)(ii) of the regulations, the character of amounts distributed is determined at the end of the trust's tax year. Amounts treated as paid from one of the categories of income in section 664(b) of the Code will be treated as consisting of the same proportion of each class of items included in the category as the total of the current and accumulated income of each class bears to the total of the current and accumulated income for that category.
[31] Under section 1.664-1(d)(3) of the regulations, if there are two or more recipients, each will be treated as receiving a pro rata portion of the categories of income and corpus.
[32] Therefore, whether or not the trusts are exempt from federal income taxation, the character of the unitrust payments in the hands of the recipients will be determined in accordance with section 664(b) and the regulations thereunder.
[33] Section 511 of the Code imposes a tax on the unrelated business taxable income of organizations exempt from federal income tax under sections 401(a) and 501(c) by reason of section 501(a).
[34] Section 664(c) of the Code provides that a charitable remainder unitrust shall not be subject to tax, for the tax year, unless the trust has unrelated business taxable income within the meaning of section 512.
[35] Section 1.664-1(c) of the regulations provides that if a charitable remainder trust has any unrelated business taxable income within the meaning of section 512, then the trust for that year is subject to all the taxes imposed by subtitle A of the Code.
[36] Section 512(a)(1) of the Code defines the term "unrelated business taxable income" as the gross income derived by any organization from any unrelated trade or business (as defined in section 513(a)) regularly carried on by it, less allowable deductions directly connected with the carrying on of such trade or business computed with the modifications provided in section 512(b).
[37] Section 512(b)(1) of the Code provides that there shall be excluded from the definition of unrelated business taxable income all dividends paid to an exempt organization except to the extent acquisition of the dividend producing stock is debt-financed.
[38] Section 512(b)(3) of the Code provides that income derived from activities which are unrelated to an organization's tax exempt purposes under the definition of section 513(a) shall nevertheless be excluded from unrelated business taxable income if such amounts constitute rents from real property and rents from personal property leased with such real property, if the rents attributable to such personal property are only an incidental amount of the total rents received under the lease, provided the leased property is not debt- financed or leased to an entity controlled by the lessor exempt organization.
[39] Section 512(b)(5) of the Code provides that there shall be excluded from unrelated business taxable income all gains from the sale, exchange, or other disposition of property, other than property which would properly be includable in inventory if on hand at the close of a tax year, or property held primarily for sale to customers in the ordinary course of trade or business.
[40] Section 512(c)(1) of the Code requires that an organization shall include, in computing its unrelated business taxable income, its share of the gross income of the partnership of which it is a member derived from a trade or business regularly carried on by it and its share of the partnership deductions directly connected with such gross income.
[41] Section 513(a) of the Code defines the terra "unrelated trade or business" as any trade or business of an organization subject to the tax on unrelated business income the conduct of which is not substantially related (aside from the need of the organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its exempt function, subject to certain exceptions.
[42] Section 513(b)(1) of the Code defines the term "unrelated trade or business" for a trust exempt from tax under section 501(a) as any trade or business regularly carried on by the trust or by a partnership of which the trust is a member.
[43] Rev. Rul. 79-222, 1979-2 C.B. 236, provides that the investment of an exempt employees' trust as a limited partner in a partnership carrying on an unrelated trade or business may result in unrelated business taxable income within the meaning of section 512 of the Code. The limited partners did not participate in the management of the partnership and their liability was limited to the amount of their contributions. The ruling indicates that section 512(c) makes no distinction between general and limited partners in setting forth special rules applicable to members of partnerships in computing their unrelated business taxable income. The ruling cites S. Rep. No. 1402, 85th Cong., 2d. Sess. 2 (1958), 1958-1 C.B. 656, at 657 which states that, under existing law, income from a partnership interest held by a charitable organization -- whether the partnership interest is that of a general partner or that of a limited partner -- is unrelated business income except to the extent that the income received by the partnership is specifically excluded as dividends, interest, royalties, and the like.
[44] In Service Bolt and Nut Co. Profit Sharing Trust v. Commissioner, 78 T.C. 812 (1982), aff'd 724 F.2d 519 (6th Cir. 1983), the court held that an exempt trust which is a limited partner may receive unrelated business taxable income (within the meaning of section 512) through a limited partnership upon which the trust is taxable under section 511. Because the wholesale fastener partnerships in which the trust was a member engaged in the type of activity which falls within the section 513(a) definition of unrelated trade or business, the trust was liable for tax imposed by section 511.
[45] Under section 513(b)(1) of the Code, a trust computing its unrelated business income under section 512 must consider any trade or business regularly carried on by the trust or by a partnership of which the trust is a member to be an unrelated trade or business. However, under the provisions of section 512(b)(3), income received from the rental of real property is not subject to the tax on unrelated trade or business income. Trust 1 will receive income from the proposed ownership of general partnership interests in GP. GP will receive income exclusively from rents and investments in public liquid markets. As such, the trust cannot be deemed to be receiving income from the trade or business of real estate, and therefore, would not be subject to the tax on unrelated business income. Even if GP was deemed to be engaged in a trade or business, section 512(b) specifically excludes from unrelated business income dividends, interest, royalties, and the like.
[46] Trust 2, as a shareholder in Corp, will receive income from dividends, or income from the sale of stock, both of which are specifically excluded from unrelated business taxable income by, respectively, section 512(b)(1) and section 512(b)(5) of the Code. Trust 2 will not be subject to unrelated business income tax from its ownership of the stock of Corp.
[47] Section 512(b)(4) of the Code provides that in the case of debt-financed property (as defined in section 514) there shall be included, as an item of gross income derived from unrelated trade or business, the amount ascertained under section 514(a)(1).
[48] Section 514(b) of the Code provides in pertinent part that the term "debt-financed property" means any property which is held to produce income and with respect to which there is an acquisition indebtedness at any time during the tax year.
[49] "Acquisition indebtedness" is defined (in part) in section 514(c) of the Code to mean, with respect to debt-financed property, the unpaid amount of:
(A) the indebtedness incurred by the organization in acquiring or improving such property; and
(B) the indebtedness incurred before the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement.
[50] Section 1.514(c)-1(a)(2) of the regulations contains some examples illustrating the concept of acquisition indebtedness. Example (1) describes an exempt organization that pledges some of its investment securities with a bank for a loan and uses the proceeds to purchase an office building which it leases to the public for purposes other than those described in section 514(b)(1)(A) through (D) (purposes related to exempt function, and certain other exceptions). The amount of the outstanding principal indebtedness on the loan constitutes acquisition indebtedness incurred prior to the acquisition which would not have been incurred but for such acquisition.
[51] Alternatively, the trusts may derive unrelated business income because of debt financed income under section 514 of the Code. In the case of Trust 1, which is a general partner, the trust may be subject to unrelated business income tax if the partnership invests in property which is debt-financed. If so, income from the trust will constitute income derived from or attributable to property which is financed by indebtedness.
RULING REQUEST 5
[52] Section 170(a) of the Code allows as a deduction for income tax purposes any charitable contribution (as defined in section 170(c)), payment of which is made within the tax year.
[53] Section 170(f)(2)(A) of the Code provides that, in the case of property transferred in trust, no charitable deduction is allowed for the value of the contribution of a remainder interest unless the trust is a charitable remainder annuity trust or a charitable remainder unitrust (described in section 664), or a pooled income fund (described in section 642(c)(5)).
[54] We have determined that the trusts will qualify as charitable remainder unitrusts under section 664 of the Code. Therefore, section 170(f)(2)(A) will not disallow a deduction under section 170. The amount of any charitable deduction for the remainder interest will be determined under section 170 and the applicable regulations.
RULINGS
[55] Based solely on the facts as presented in this ruling request, and viewed in light of the applicable law and regulations, we rule as follows.
1. The trusts will qualify as charitable remainder unitrusts for federal income tax purposes for any tax year in which they continue to meet the definition of, and function exclusively as, charitable remainder unitrusts, provided that the trusts are valid trusts under local law. For that year, the trusts will be exempt from the taxes imposed by subtitle A of the Code, unless they have any unrelated business taxable income as defined in section 512 and the applicable regulations.
2. In the proposed transaction described, the trusts may be general partners and corporate shareholders without creating any acts of self-dealing within the meaning of section 4941 of the Code. This ruling is limited only to the initial funding of the trusts and does not apply to any other transactions that might occur between disqualified persons and the trusts.
3. Ownership of general partnership interests and corporate stock will not expose either trust to tax under section 4943 of the Code as an excess business holding.
4. The character of the unitrust payments in the hands of the recipients will be determined under section 664(b) and the regulations thereunder, whether or not the trusts are exempt from federal income taxation. Income generated by Trust 1 will not constitute unrelated business income to the trust within the meaning of section 511 of the Code, unless the partnership invests in property which is debt-financed.
5. Because the trusts will qualify as charitable remainder unitrusts under section 664 of the Code, section 170(f)(2)(A) will not disallow a deduction under section 170. The amount of any charitable deduction for the remainder interests will be determined under section 170 and the applicable regulations.
[56] No opinion is expressed or implied as to any other trust provisions or as to the federal tax consequences of the formation and operation of the trusts under any other provisions of the Code. Specifically, no opinion is expressed or implied regarding the applicability of section 4941 to any trust transactions beyond initial trust funding.
[57] A copy of this letter should be attached to each trust's federal tax return for the tax year the trust is formed. Copies of this letter are enclosed for that purpose.
[58] This ruling directed only to the taxpayer who requested it. According to section 6110(j)(3) of the Code, this ruling may not be cited or used as precedent.
Sincerely,
FRANCES D. SCHAFER
Senior Technician Reviewer, Branch 4
Office of Assistant Chief Counsel
(Passthroughs and Special Industries)
enclosures (3)
copies of this letter (2)
copy for section 6110 purposes