The Tax Relief and Health Care Act of 2006, signed into law on December 20, 2006, includes a provision that will be welcome news to most trustees of charitable remainder trusts. Beginning in 2007, charitable remainder trusts that have unrelated business taxable income will no longer lose their tax-exempt status for the year; rather, an excise tax will be imposed in the amount of unrelated business taxable income itself. While this will be welcome news to most trustees, the new law also creates a trap that is potentially more confiscatory.
Background
Since their inception in 1969, charitable remainder trusts have been subject to a heavy-handed rule that reminds us of comedian Steve Martin's line about promoting the "death penalty for parking tickets."
As background, charitable remainder trusts ("CRTs") are generally exempt from all income taxes. This feature makes CRTs ideal for use by persons who desire to convert highly appreciated, low yielding property into an income stream free from immediate capital gains tax exposure.
However, there's a catch. A charitable remainder trust is exempt from income taxes unless it has any unrelated business taxable income ("UBTI") within the meaning of IRC §512.
The purpose of denying tax-exempt status to a charitable remainder trust that has UBTI is to eliminate the unfair competitive advantage the trust might otherwise enjoy over its non-exempt commercial rivals. For tax years prior to 2007, in any year in which a charitable remainder trust reports even one dollar of UBTI, the trust loses its tax-exempt status for that year and is subject to tax as a complex trust.
UBTI Defined
Unrelated business taxable income is defined as "the gross income derived by an exempt organization from any unrelated trade or business regularly carried on by it, less the deductions directly connected with the carrying out of such trade or business, both computed with certain modifications."1 Included in the permitted modifications is a specific deduction of $1,000.2 However, it should be mentioned that IRS has stated informally that the $1,000 does not apply in determining if a trust has UBTI or not.
The term "trade or business" carries the same meaning as it does under IRC §162. Therefore, it is defined generally as income generated from the sale of goods or services. Presumably, any trade or business carried on by a charitable remainder trust is unrelated to its tax-exempt purpose. For this reason, passthrough entities such as sole proprietorships and partnerships are usually unsuitable for transfer to charitable remainder trust.
Another common source of UBTI is debt-financed income from property held to produce income (e.g., rental real estate, tangible personal property, and corporate stock), and with respect to which there is an acquisition indebtedness at any time during the taxable year.3
Distinguishing UBI from UBTI
It is important to distinguish between unrelated business income ("UBI") and UBTI. Under pre-2007 law, only the presence of UBTI causes a charitable remainder trust to lose its tax-exemption. Therefore, a charitable remainder trust can have some UBI and, as long as such income is offset by deductions and/or the specific deduction, still retain its tax-exempt status. In each subsequent year, if the trust has no UBTI, it regains its tax-exempt status.
Why UBTI Was Kryptonite to CRTs
The actual effect of UBTI on a charitable remainder trust can range from benign to catastrophic. For example, a trust that has income in an amount less than distributions to income recipients will pay no tax because such distributions are deductible to the trust.
A charitable remainder trust assumes the trustor's adjusted cost basis and holding period in the transferred property based on the carryover basis provisions of the Code. Therefore, when the trustee sells the property, the trust realizes the same amount of gain as the trustor would have realized if he or she had sold the property. It is only the trust's tax-exempt status that protects it from paying tax.
Here's an example, again under pre-2007 law. A 5% charitable remainder unitrust is created on December 31, 2005 with $1,000,000 of investment real estate having $50,000 adjusted cost basis. The trustee sells the property in 2006 and reinvests the proceeds in a balanced portfolio that produces $75,000 of income and realized gains during 2006. Included in this amount is a $10,000 from a publicly traded master limited partnership. Unfortunately, it is later determined the income from the partnership was debt-financed and, therefore, included within the definition of unrelated business income under Reg. §1.514(b)-1(a). The trust will therefore lose its exemption and be taxable as a complex trust for 2006.
The trust will be able to deduct the $50,000 unitrust amount distributed to trust's income recipient(s) under IRC §661(a), the specific deduction of $1,000, a personal exemption of $100 under §642(b)(2)(A), and other allowable deductions (e.g., fiduciary, legal, and tax preparation fees. See IRS Form 1041). So most of the post-sale income is taxed to the beneficiary, leaving less than $23,000 of income and gains to be taxed to the trust.
However, here's the kicker. The entire $950,000 capital gain from the sale of the contributed real estate also will be included in the trust's taxable income thereby subjecting the trust to additional capital gains tax, depreciation recapture, and alternative minimum tax. Ouch! And not even Superman could help. Clearly reform was needed.
Welcome Relief
Fortunately, Congress remembered one of the good ideas from previous charitable giving tax incentive bills. Both the Charitable Giving Act of 2005 (H.R. 3908) and the CARE Act of 2005 (S. 1780) included provisions to reform the UBTI rules applicable to CRTs. Patience is a virtue.
Effective for tax years beginning after December 31, 2006, Section 424 of the Tax Relief and Health Care Act of 2006 matches prior proposals. Under the new law, the presence of UBTI will not cause a CRT to lose its tax-exempt status; rather, a 100% excise tax will be imposed on the amount of the UBTI itself.
Continuing with the previous example, the total tax paid by the trust under the new law would be about $9,000.
IRC §664 is amended as follows:
(c) Taxation of Trusts. --
(1) INCOME TAX. -- A charitable remainder annuity trust and a charitable remainder unitrust shall, for any taxable year, not be subject to any tax imposed by this subtitle.
(2) EXCISE TAX. --
(A) IN GENERAL. -- In the case of a charitable remainder annuity trust or a charitable remainder unitrust which has unrelated business taxable income (within the meaning of section 512, determined as if part III of subchapter F applied to such trust) for a taxable year, there is hereby imposed on such trust or unitrust an excise tax equal to the amount of such unrelated business taxable income.
(B) CERTAIN RULES TO APPLY. -- The tax imposed by subparagraph (A) shall be treated as imposed by chapter 42 for purposes of this title other than subchapter E of chapter 42.
(C) TAX COURT PROCEEDINGS. -- For purposes of this paragraph, the references in section 6212(c)(1) to section 4940 shall be deemed to include references to this paragraph.
(b) Effective Date. -- The amendment made by this section shall apply to taxable years beginning after December 31, 2006.
Blessing or Booby Trap?
While the new rules are a vast improvement for most fact patterns, the new law also creates a land mine that is potentially more lethal to a CRT than under the old rules.
Continuing with our previous example, suppose the $1,000,000 of investment real estate transferred to the trust becomes subject to an acquisition indebtedness (as defined in IRC §514(c)(1)) incurred for the purpose of acquiring or improving the property. For example, an unknowledgeable trustee takes out an equity line of credit to construct a new carport or clubhouse in the belief it will make the property more marketable, and then sells the property with the debt still in place. Reg. §1.514(b)-1(a) provides gains from the sale of debt-financed property on which there was an acquisition indebtedness outstanding with respect to the property at any time during the 12-month period preceding the date of disposition (even if such period straddles the taxable year) are taxable as unrelated debt-financed income. In this example, under the new rules, a substantial portion of the gain from the sale of the property would be subject to the 100% excise tax,4 leaving a depleted trust--and likely an angry and confused donor.
Although this might seem like an isolated fact pattern, given the number of donors and laypersons who serve as self-trustees or special independent trustees, this is a legitimate concern.
As we see, although the new law is intended to mitigate the effects of UBTI on CRTs, it is not without some perhaps unintentional teeth. Because all UBTI will be confiscated under the new rules, UBI producing assets should still be treated with extreme caution if not avoided altogether.
Tha author wishes to thank to Laura H. Peebles, Lynda S. Moerschbaecher, Vaughn W. Henry, and Stephan R. Leimberg for their assistance in this article.
Comments
Article Regarding New UBTI Rules for CRTs
CRT and UBTI-New Rules
Unscrambling the Egg
One possible option would be for the trustee to sell an undivided fractional interest in the property in an amount sufficient to retire the debt and then wait 12 months and one day to sell the remainder. However, depending on the amount of debt and basis of the property, this might be impractical because the gain allocated to the fractional sale would be subject to the excise tax leaving only the basis attributable to fractional sale to retire the debt. The gain on the second sale should be exempt. While this may work in the theory, finding a buyer on the other end of the transaction might be challenging (perhaps the remainderman could help?).
Laura Peebles reminds us that much of the law surrounding UBI remains gray and suggests that trustees facing this issue should seek a tax expert specializing in UBI issues (e.g., someone in exempt orgs who deals with hospitals and universities that confront UBI issues on a regular basis). There might be room for additional planning that is fact specific.
UBI Excise Tax Disqualfies Trust?