Charitable remainder annuity trusts, or CRATS, are excellent estate planning vehicles and provide a litany of benefits to those who implement them, but as Devin Mills discussed in his recent article on the 2023 IRS Dirty Dozen list, the IRS considers CRATS as one of the legitimate tax strategies that are often abused by taxpayers.[1] In a recent decision[2], the United States Tax Court held against the petitioning taxpayers, who claimed that CRAT they established effectively eliminated the gain derived from the low-basis property contributed to it. The taxpayers in question were referred to a CPA, who proposed the supposed “CRAT strategy.” Soon after the CPA’s proposal, the taxpayers, with the aid of the CPA, formed the CRAT in 2015.
Background[3]
Under the trust instrument, the trustee was required to pay the beneficiaries an annuity amount over a five-year period equal to the greater of (1) ten percent of the initial net fair market value of all property transferred to the CRAT, or (2) payments received from one or more single premium immediate annuities (“SPIAs”) purchased by the trustee. The taxpayers were the beneficiaries of such payments, but the trust instrument also provided that neither the taxpayers nor their children shall have any right, interest, or incident of ownership in any SPIA transferred to or purchased by the trustee.
The taxpayers, a married couple, contributed real properties to the CRAT, reporting the total fair market value of the contributed properties as $1,808,000. On their Form 709, United States Gift Tax Return, the taxpayers reported the adjusted basis of the contributed properties as $95,517. A few months after the couple contributed the properties to the trust, the trustee sold the same properties for approximately $1,658,000.
Using the proceeds from the sale of the property, the trustee immediately purchased a SPIA for $1,537,822. The SPIA contract identified the CRAT as the owner of the annuity but listed the taxpayers as the annuitants. Under the contract, the taxpayers were entitled to receive five annual payments of $311,708. The taxpayers received such payment in 2016 and 2017, the years in question. The CRAT reported these payments on Form 5227 as distributions from the trust. On their jointly filed federal income tax returns for 2016 and 2017, the taxpayers reported only interest income from the distributions of $2,026, failing to report the remaining payment amount.
Upon examination, the IRS determined that the gain attributable to the sale of the contributed properties should have been properly reported as ordinary income to the CRAT, and consequently, the taxpayers should have reported the 2016 and 2017 annuity payments as ordinary income under IRS § 664(b). The IRS subsequently issued the taxpayers a notice of deficiency for 2016 and 2017, increasing their gross income for the years in question to reflect the annuity payments as ordinary income.
Charitable Remainder Annuity Trusts
CRATS are a commonly used estate planning tool, combining the charitable intentions of an individual with the need to provide an income stream to satisfy his or her financial needs. Such individual transfers property to the CRAT, an irrevocable trust, the terms of which provide for specified payments, at least annually, to the grantor or other noncharitable beneficiaries for life or another specified period of time up to twenty years.[4] Upon expiration of that time period, the property remaining in the trust, which cannot be less than ten percent of the initial fair market value of all contributed property[5], must be transferred to one or more charitable organizations or continue to be held in trust for the benefit of such organizations[6]
CRATs are particularly useful to individuals who own appreciated capital gain property. The grantor who contributes appreciated property to the CRAT recognizes no gain upon contribution.[7] Additionally, CRATS are exempt from income tax, so the CRAT may sell such appreciated property without paying tax on the sale.[8] Distributions from the CRAT, however, do not receive the same favorable tax treatment. Payments made by the CRAT to noncharitable beneficiaries are subject to tax at the individual level.[9]
When property is contributed to the CRAT, the basis of the property in the hands of the trust is generally the same as it would be in the hands of the grantor.[10] When the CRAT sells the contributed property, it realizes, but does not recognize, gain to the extent the sale price exceeds the adjusted basis.[11] While this gain is not taxable to the CRAT, it must be tracked, as it affects the treatment of distributions from the CRAT. The Code provides specific ordering rules that apply to the reporting of annuity payments distributed by a CRAT to its noncharitable beneficiaries[12], as follows:
- As ordinary income, to the extent of the CRAT’s current and previously undistributed ordinary income;
- As capital gain, to the extent of the CRAT’s current and previously undistributed capital gain;
- As other income, to the extent of the CRAT’s current and previously undistributed other income; and
- As a nontaxable distribution of trust principal.[13]
Applying the Law to the Case on Hand
In the present case, the taxpayers contributed appreciated real property to the CRAT. The taxpayers recognized no gain upon contribution, and the CRAT had the same basis in the property as the taxpayers. Shortly after contribution, the CRAT sold the property and used the proceeds to purchase the SPIAs. The taxpayers then received the annuities purchased by the CRAT.
While the CRAT was not subject to tax on the gain realized on the sale of the contributed property, the earned income was relevant to determining the character of the distributions made to the taxpayers, as the income of the CRAT is taxable to its noncharitable beneficiaries upon distribution. Here, the IRS determined the gain realized by the CRAT was ordinary income under the deprecation recapture rules of I.R.C. § 1245. The taxpayer did not dispute this determination by the IRS.
Unfortunately for the taxpayers, they did not have a viable argument to bring before the Court as to why they reported only interest income, and no other portion of the CRAT distributions made to them, on their federal income tax return. In the Court’s own words, “The gain disappearing act the [Taxpayers] attribute to the CRAT is worthy of a Penn and Teller magic show. But it finds no support in the Code, regulations, or case law.”
In short, the taxpayers argued the basis of the contributed property was equal to the fair market value at the time of contribution, and the CRAT trustee is not required to know the cost basis, nor is the trustee required to obtain such basis. Both contentions are blatantly contradicted by I.R.C. § 1015, which states the basis of the property shall be the same as it would be in the hands of the grantor.” As such, the Tax Court upheld the IRS’s notice of deficiency, as the gain realized by the CRAT was ordinary income under § 1245, and the ordering rules under § 664(b) mandated that the distributions made to the taxpayers be recognized as ordinary income.
Conclusion
A charitable remainder annuity trust is an excellent estate planning tool, particularly to those individuals who are philanthropically minded, hold appreciated property, and also wish to provide themselves with an income stream for the remainder of their lives. CRATs also provide the benefit of gain deferral, as any gains within the instrument will be recognized upon distribution from the trust, instead of the year of sale. CRATs do not, however, “disappear” all taxable gains, as the taxpayers argued before the Court. Familiarize yourself with CRATs, as well as other estate planning vehicles, but also be mindful of each’s limitations.
[1] Devin Mills, “2023 Dirty Dozen List” (April 19, 203), https://esapllc.com/irs-dirty-dozen-2023/.
[2] Gerhardt v. Commissioner of Internal Revenue, 160 T.C. No. 9, April 20, 2023.
[3] This case involved four married couples, all within the same family. The fact patterns of all four couples, other than monetary amounts, are substantially similar. For brevity’s sake, this article contemplates the fact pattern of only one of the couples.
[4] Richard Fox, Charitable Giving: Taxation, Planning, and Strategies.
[5] I.R.C. § 664(d)(1)(D)
[6] Fox, supra, 25.01.
[7] Buehner v. Commissioner, 65 T.C. 723, 740 (1976).
[8] I.R.C. § 664(c)(1).
[9] Fox, supra, 25.50.
[10] I.R.C. § 1015.
[11] I.R.C. § 1001.
[12] I.R.C. § 664(b).
[13] Id., (1)-(4).
