'Tis the season to be filing. In this article, Pasadena, California CPA and CRT tax return software developer Temo Arjani and partner Matthew Rayer take us step by step through the preparation of Form 5227 and related schedules for a net income with makeup charitable remainder unitrust (NIMCRUT) and discuss some of the interesting twists that can happen along the way.

Introduction

The objective of this article is to walk you through the process of how Form 5227 (Split-Interest Trust Information Return) is prepared for a Net Income with Make-Up Charitable Remainder Trust (NIMCRUT). During the process, we will clarify and point out the applicable tax rules. Throughout the article, we will refer to the completed Form 5227, which you can access in PDF format. We suggest you take a moment now to download and print the Form 5227 so you can refer to it as you read.

Download: Sample 5227.pdf (2MB - 14 pages)

Here we go:

A trustee, creator and income recipient of a NIMCRUT calls you on March 8, 2006 to say that he wants you to prepare the tax returns (Form 5227 and Form 1041-A) for the NIMCRUT. The trust was funded on January 1, 2005 with an office building that was then sold on December 20, 2005. This article does not cover preparation of Form 1041-A since almost the entire information required on the form comes from Form 5227.

It is efficient to ask the trustee, at one time, all the additional information you need. The information you need and the trustee's response are reproduced below:

Process of Preparing Form 5227

A. The Opening Balance Sheet

The first thing one would do, apart from the routine items (name, address, type of CRT, etc. required on Page 1) is to prepare the opening balance sheet on Page 2 (Column (a) of Part IV). The balance sheet (Column (a) and (b)) should be prepared using tax basis (not fair market value) figures. When a donor transfers assets to a CRT, the CRT acquires the same basis as that of the donor. Accordingly, Line 33 (Column (a)) is completed by entering $400,000. After entering the total (Line 37), one completes Line 44 Trust Corpus, using the same number of $400,000, and the appropriate "total" Lines 46 and 47.

B. The Year's Transactions

There are three types of transactions in the illustration we have:

1. Interest income of $1,300 - this is entered on Line 1, Part I, Page 1.
   
   
2. Rental income - Schedule E Form 1040 (there is no Schedule E for Form 5227) should be completed next. After entering the routine information for Lines 1 and 2, the Rental income of $70,000 is entered on Line 3 and the real estate tax of $10,000 on Line 16. One calculates the depreciation to be $15,000 and that is entered on Line 20.  The net rental income of $45,000 from Line 26 is then entered on Line 4, Part I on Page 1.
   
   
3. Sale of Office Building
   
   (a) Form 4797 - Form 4797 is to be next completed.  Start with Part III on Page 2. An office building is a Section 1250 property. The gross sales price of the office building of $1,200,000 is entered on Line 20.  Line 21 will show the sum of the original cost of $600,000 and the selling expense of $100,000. Line 22 shows the total of the depreciation claimed by the donor ($200,000) and the depreciation claimed by the CRT on Schedule E Form 1040 ($15,000). Line 23, 24 and 26g are completed next.  Assume straight-line depreciation was used and Line 26g is zero. Finally, the gain of $715,000 is entered on Line 30 and 32. Next, proceed to Page 1, Part I of Form 4797 and enter on Line 6 (and carry it to Lines 7 and 9) the figure of $715,000.
   
   (b) Schedule D - Form 1041 - Line 7 of Schedule D, Form 1041 then reflects the gain of $715,000. This amount is finally entered on Line 17 of Page 1 of Form 5227 as "long-term capital gain." Even though the CRT held title to the office building for less than a year, the holding period of the donor is added to the holding period of the CRT to make this gain a long-term gain.
   
   (c) Unrecaptured Section 1250 Gain - Line 17c, on Page 1 of Form 5227, namely, "unrecaptured Section 1250 gain" needs some explanation. This line represents that portion of the total long-term capital gain, which is generally taxed, in the hands of the income recipient of the CRT at a higher rate, namely, 25% rather than the 15% rate enjoyed on all other long-term capital gains (other than on art, collectibles, and similar assets that are generally taxed at a rate of 28%).
   
   Question: "What portion of the total long-term capital gain" will be taxed at 25%?"
   
   Answer: The sum of depreciation deducted by both the CRT ($15,000) and the donor ($200,000), that is $215,000, but not to exceed the total long-term gain on the sale of the asset of $715,000.
   

C. The "Infamous" Four Tier System

We are now ready to address the "Worst-in-First Out" (WIFO) Four Tier System reflected on Part II of Page 1 of Form 5227.

The Four Tiers are:

1. Ordinary Income
   
   
2. Capital Gains
   
   
3. Nontaxable Income
   
   
4. Corpus

Any distribution first comes out of the Ordinary Income tier then out of Capital Gains tier, then out of the Nontaxable Income tier and finally out of Corpus. Each tier, for this purpose, includes both the current and accumulated amounts from previous years.

The WIFO theory is also invoked within each tier. For example, if in tier one (the Ordinary Income tier) there is rental and interest income of $20,000 (which, in the hands of the income recipient can be taxed at as high a rate as 35%) and also qualified dividends of $25,000 (that cannot be taxed at a rate higher than 15%), a distribution of, say, $35,000 is first treated as coming out of the 35%-type income to the full extent of $20,000 and the balance of $15,000 treated as coming out of the qualified dividends.

Similarly, in the second tier of capital gains the distributions exhaust the following sub-tiers in the order indicated below:

1. Short-Term Capital Gain
   
   
2. 28% Long-Term Capital Gain
   
   
3. 25% Long-Term Capital Gain
   
   
4. 15% Long-Term Capital Gain

D. Planning Opportunities

The above WIFO rules can be used for more efficient tax planning. For example, if an existing CRUT has large amounts of accumulated interest income (taxed in the hands of the income recipient at, say, a 35% rate) in tier one and the donor/income recipient intends to contribute additional amounts to the CRUT to generate qualified dividend income (taxed in the hands of the income recipient at a rate not exceeding 15%), the donor/income recipient should consider setting up a new CRUT. This would ensure the low rate to apply to the income recipient on the additional CRUT contribution.

Similarly a CRT should consider investing in growth securities so the income recipient does not receive any tier one 35%-type income.

E. Required Distribution for 2005

Before one decides which tier a distribution comes from, one has to ascertain the amount of the required distribution. Because the CRT is a NIMCRUT, the required distribution is the lesser of the trust's payout rate of 8% of $1,000,000 (i.e., $80,000) or trust accounting income ($146,300), as explained below:

• Trust Accounting Income
  
  Trust accounting income is defined in Section 643(b) of the Internal Revenue Code and is sometimes referred to as net income or fiduciary income or accounting income. One first looks at the CRT instrument to see if it contains any definition of trust accounting income. If it does not, one looks at the Principal and Income Act of the State.
  
  
  1. Depreciation Reserve
     
     A trust instrument can explicitly state whether a depreciation charge should reduce trust accounting income or not. Absent such an explicit statement the 1997 Revised Uniform Principal and Income Act would make such a depreciation charge discretionary, subject to the trustee's duty of impartiality.
     
     In a trust, which is not a Charitable Remainder Trust, the trustee's duty of impartiality may require in most cases for depreciation to reduce trust accounting income. In a CRT context (but not in the case of a Charitable Remainder Annuity Trust or a standard Charitable Remainder Unitrust, since in both these types of CRTs trust accounting income is not of any relevance) some commentators believe that a charge for depreciation should not be made. Others believe that a charge would be appropriate especially when a trustee intends to hold the property for a considerable period.
     
     In the case study the trustee has determined, based on the guidelines stated above, that a charge of $15,000 should be made for depreciation.
     
     
  2. Capital Gains
     
     In the case study we are using, the attorney in consultation with the trustee included capital gains as part of trust accounting income in the trust instrument. For this purpose only, capital gain is measured by any increase in value from the date the asset was contributed to the CRT ($1,000,000) to the ultimate net sale price ($1,100,000) or $100,000. This is referred to as post-contribution gains. The total trust accounting income is $100,000 of capital gains plus $1,300 of interest plus $45,000 of net rental income (i.e., $146,300).
     
     The sophistication of the attorney drafting the trust instrument to include capital gains as part of trust accounting income proved very helpful to the income recipient. The recipient, absent this provision, would have been entitled to only a $46,300 of distribution instead of the $80,000.
     
     
  3. Form 5227, Page 2
     
     Back to Form 5227 and Page 2, Part IV. One completes Column (c) with the fair market value on January 1, 2005 (the valuation date mentioned in the trust instrument) of $1,000,000 in Line 33. Next, one completes Part V-B on Page 2 and 3 of Form 5227. Line 49a shows the fixed unitrust percentage, namely, 8%. Multiplying it by the value of assets on the valuation date (Line 37 column (c)) gives us $80,000 on Line 49b.
     
     The trust accounting income of $146,300 is entered on Line 50a and the lower of the fixed percentage amount ($80,000) or the trust accounting income ($146,300) is entered on Line 50b.
     
     Line 51a would have included the so-called "deficiency" that is the excess of the fixed percentage amount over the trust accounting income in prior years. Our case study, being for the first year of existence of the CRT, has no deficiency from a prior year. Accordingly, Line 52 indicates the amount required to be distributed for 2005 is $80,000.
     
     

F. Parts II & III

We now go back to Part III of Page 1 of Form 5227 showing the Current Distribution Schedule, and following the WIFO approach enter $46,300 in Column (a) and $33,700 in Column (c). Therefore, Part II, Line 23 will show the undistributed amounts at the end of the tax year in column (c) to be $681,300 ($715,000 less $33,700).

G. The Year-End Balance Sheet (Part IV, COLUMN (b))

The final set of figures the tax return requires completing is the end of year balance sheet (Column (b), Page 2, Part IV). This part of the return often takes the most time since, by definition, the Balance Sheet has to balance (i.e., debits equal credits) and most trustees do not have formal books of accounts recording all debits and credits.

In our case study, we have a temporary cash investment of $1,161,300 on Line 26 ($1,100,000 from sale of real estate, $60,000 of net rental income (before depreciation) and $1,300 of interest income). There are no other assets.

Do we have any liabilities? Yes, the amount required to be distributed to the income recipient for 2005, namely, $80,000 has not been distributed. It should appear on Line 42 column (b).

Line 44 Trust Corpus has not changed from the beginning of the year and, therefore, should stand at $400,000. Line 45a and 45b should come from Page 1, Line 23 columns (a) and (c) respectively. These amounts are $0 and $681,300 respectively.

Suspended Passive Activity Loss

The donor/income recipient had $10,000 of suspended passive activity losses (PAL) related to the contributed real estate. There are two general PAL rules that must be considered in the context of the real estate contribution to the CRT. If property with suspended PALs is gifted, such losses are added to the donee's basis in the property (Sec. 469(j)(6)). Alternatively, in the context of a fully taxable disposition such losses would become fully deductible against gain, if any, from the disposition with any excess losses deductible against other income of the taxpayer (Sec. 469(g)(1)).

What happens to these losses in a CRT context where it is in part a gift and in part a "sale" with deferred gain recognition? While there is no direct guidance on this point, it would seem that both rules would apply to different portions of the PAL. Upon the initial contribution of the real estate, a portion of the PALs would be allocable to the charitable gift, namely, 20% ($200,000 charitable deduction as a percentage of the total value of the property of $1,000,000) or $2,000. This would increase the basis of the property in the CRT by $2,000. This in turn would increase the depreciation deduction at the CRT level and also reduce the gain at the CRT level at disposition. (For sake of simplicity, we did not factor this additional basis in the tax return preparation process) The remaining PALs (not attributable to the gift) of $8,000 remain with the individual taxpayer and would be used only if the individual receives distributions (from ordinary income or capital gains), which are associated with the property contributed to the CRT.

In the case study, the net rental income of $45,000, which is being distributed from tier one, should enable Mr. Jacobs to utilize the remaining PAL of $8,000. What if there was no tier one income from the rental property (but only $1,300 of interest income) and the distribution from tier two was $78,700? It would appear that the amount of $78,700 would enable the remaining PALs of $8,000 to be used in 2005. It should further be noted that the excess passive income from the CRT may offset other PALs that may exist from other properties/activities of the income recipient.

What if in the basic case study the PALS were $1,000,000, the PAL added to the basis of asset on the CRT was, therefore, $200,000 (20% as before) and the gain on the sale was $515,000 ($1,200,000 sale price less selling expense of $100,000 less basis, including the $200,000 of PAL added to basis, but after depreciation of $585,000)? While there is no direct authority, a supportable position exists to utilize the PAL of $800,000 that remains with Mr. Jacobs as follows:

The remaining PAL loss of $702,650 ($800,000 minus $97,350) would be used in the same manner when future distributions are made from the CRT from the gain on the property.

Gift tax issues aside, what if the donor names his sibling as the income recipient when the CRT is formed and funded? In such a case, it appears that the entire PAL merely adds to the basis of the property in the hands of the CRT. This has limited benefit since the reduction in tier two capital gain is of no benefit until that tier is completely exhausted - an occurrence that is rare. Therefore, in the planning process one should avoid transferring property carrying PAL to a CRT whose income recipient is not the donor.

The ability to utilize the suspended PALs of the taxpayer against the related capital gain income of the CRT should influence trustees to minimize first tier income (other than from the property) in order that passive capital gain distributions are maximized that would be tax free to the extent PALs are available to shelter this income. The complexity in dealing with PALs in the CRT context is such that the taxpayers should seek proper tax advice.

Final Words

We were asked to keep it to 2,500 words or less and we've exceeded that limit (slightly). Suffice it to say, these are but a few of the issues that accompany the preparation of fiduciary returns for charitable remainder trusts.