On March 25, 2024, the IRS issued Prop. Reg. Section 1.6011-15[1], which designates certain transactions involving charitable remainder annuity trusts (“CRATs”) in tandem with single premium immediate annuity (“SPIA”) products as listed transactions[2]. Last year, I wrote an article in which the Tax Court decided against a taxpayer couple who undertook this exact transaction.[3] Now, it seems, the IRS is proactively attacking these transactions by designating them as a listed transaction, subjecting taxpayers who undertake such to significant fines and penalties for failure to disclose their undertaking.
CRATs, Generally
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, the value of which (calculated under Section 7520) 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 the 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]
The Proposed Listed Transaction
The Proposed Regulations identify a transaction as a listed transaction if it contains the following elements (or, if not, produces the same or substantially similar tax results as a transaction containing these elements)[14]:
- The grantor creates a trust purporting to qualify as a CRAT under Section 664;
- The grantor funds the trust with property having a fair market value in excess of its basis;
- The trustee sells the contributed property;
- The trustee uses some or all of the proceeds from the sale of the contributed property to purchase an annuity; and
- On a Federal income tax return, the beneficiary of the trust treats the amount payable from the trust as if it were, in whole or in part, an annuity payment subject to Section 72, instead of as carrying out to the beneficiary amounts in the ordinary and capital gain tiers of the trust in accordance with Section 664(b).
Generally in these transactions, a taxpayer (grantor) creates a trust purporting to qualify as a CRAT and transfers appreciated property, such as a closely held business, to the CRAT. The CRAT, in turn, sells the appreciated property and uses the proceeds to purchase a SPIA. On the taxpayer’s income tax return, he or she treats the annuity amount payable from the trust as if it were an annuity payment subjection to Section 72, which causes only the portion of each payment in excess of the taxpayer’s basis in the annuity contract to be included in gross income.
This treatment, whereby the taxpayer treats the balance of the annuity as untaxable return of investment, is in lieu of carrying out the received amount through the previously mentioned undistributed ordinary income and capital gains of the trust to the taxpayer and results in an extreme reduction in tax liability, especially when considering that the CRAT is not subject to tax on the sale of the appreciated property.[15] In short, the trust does not recognize income on the sale of the appreciated property, and the grantor of the trust is not recognizing income on distributions from the trust. This treatment is improper, as distributions to the taxpayer are taxable to the taxpayer in relation to the accumulated ordinary income and capital gains of the CRAT, respectively.
Furthermore, taxpayers, such as the petitioners in Gerhardt v. Commissioner, the subject of my previous article3 sometimes take the position that the transfer of the appreciated property to the CRAT gives those assets a step-up in basis to fair market value as if they were sold to the trust. As seen in Gerhardt, this is not the case. Under Section 1015, the property transferred to the trust retains its basis as it was in the hands of the taxpayer (although basis is increased, but not above fair market value, by any gift tax paid on the transfer).
Disclosure Requirements
By designating these transactions, as well as substantially similar transactions, as listed transactions, the Proposed Regulations, if finalized, will require taxpayers who have engaged in these transactions and those substantially similar to disclose such transactions to the IRS, past or future, unless the statute of limitations for all tax years in which the transactions were entered has lapsed, as further stipulated below.
Regulations Section 1.6011-4(d) and (e) provide that the disclosure statement Form 8886, Reportable Transaction Disclosure Statement, must be attached to the taxpayer’s Federal tax return for each taxable year for which a taxpayer participates in a reportable transaction, and a copy of the same must be sent to the Office of Tax Shelter Analysis (“OTSA”) at the same time such form is filed with the tax return. Additionally, Taxpayers who have participated in this transaction, or a transaction substantially similar, and filed their respective Federal tax returns in years preceding the finalization of the Proposed Regulations, but for whom the statute of limitations has not yet lapsed for assessment for such respective tax year(s), must file Form 8886 with OTSA disclosing such transaction within ninety (90) calendar days from the date the Proposed Regulations are finalized.[16]
Fines and Penalties for Failure to Comply with Proposed Regulations
Taxpayers who fail to disclose such transactions under Section 1.6011-4 are subject to penalties under Section 6707A. This disclosure must also include any gift tax consequences.[17] Section 6706A(b) provides that the amount of the penalty is seventy-five percent (75%) of the decrease in tax shown on the return as a result of the reportable transaction, or which would have resulted from such transaction if such transaction were respected for Federal tax purposes, subject to a minimum penalty amount of $5,000 in the case of a natural person and $10,000 in any other case and a maximum penalty amount of $100,000 in the case of a natural person and $200,000 in any other case.
As if the fines and penalties above are not enough, additional penalties may also apply. Section 6662A imposes a 20 percent (20%) accuracy-related penalty on any understatement[18] attributable to an adequately disclosed reportable transaction. Further, if the taxpayer is required, but does not adequately disclose participation in a reportable transaction in accordance with the regulations under Section 6011, the imposed penalty increases to thirty percent (30%) of any understatement.
Extended Statute of Limitations
Taxpayers who are required, but fail, to disclose participation in a listed transaction are subject to an extended statute of limitations.[19] The time of assessment of any tax with respect to the transaction will not expire before the date that is one year after the earlier of the date the taxpayer discloses the transaction or the date a material advisor discloses the participation pursuant to a written request under Section 6112(b)(1)(A). In essence, for transactions entered into prior to finalization of the Proposed Regulations for which the statute of limitations has not yet lapsed, such statute of limitations will be tolled until the taxpayer, or such taxpayer’s material advisor, adequately discloses the transactions pursuant to the foregoing.
Reporting Requirements for Material Advisors
Material advisors with respect to the SPIA and CRAT arrangements, or substantially similar transactions, are also subject to reporting requirements. A material advisor is any person who provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction, and directly or indirectly derives gross income in excess of the threshold amount as defined in Section 301.6111-3(b)(3) for the material aid, assistance, or advice.[20] Material advisors must disclose transactions on Form 8918, Material Advisor Disclosure Statement,[21] and such disclosure statement for a reportable transaction must be filed with OTSA by the last day of the month that follows the end of the calendar quarter in which the advisor becomes a material advisor with respect to a reportable transaction or in which the circumstances necessitating an amended disclosure statement occur.[22] A material advisor who fails to file a timely disclosure, or files an incomplete or false disclosure statement, is subject to a penalty.[23] For listed transactions, the penalty is the greater of $200,000 or fifty percent (50%) of the gross income derived by the material advisor with respect to aid, assistance, or advice which is provided with respect to the listed transaction before the date the return is filed.[24]
Furthermore, a material advisor with respect to any reportable transaction must maintain a list identifying each person to whom the advisor was a material advisor with respect to such transaction and containing such other information as the Secretary may by regulations require.[25] A material advisor may be subject to a penalty[26] for failing to maintain a list under Section 6112(a) and failing to make the list available upon written request to the Secretary in accordance with Section 6112(b) within twenty (20) business days after the date of such request. The penalty, under Section 6708(a), for failing to provide such list is $10,000 per day for each day of the failure to provide such list after the twentieth (20th) day. Here, material advisors are given some reprieve, as no penalty will be imposed with respect to the failure on any day if such failure is due to reasonable cause. Additionally, while not discussed in this article, many states have similar reporting requirements and penalties associated with noncompliance.
Conclusion
As stated in my previous article3, 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, avoid all taxable gains, and taxpayers should be weary of any promoter or advisor who claims such, especially when considering the IRS’s scrutiny of such transactions, evidenced by the Proposed Regulations. Given the substantial risks involved with undertaking these transactions, taxpayers should consult with a trusted tax professional before undertaking any transaction or structure that seems too good to be true. The Proposed Regulations require taxpayers to disclose participation in a transaction the IRS and Tax Court view unfavorably and will presumably attack, so while CRATs are a legitimate and extremely viable estate planning tool, taxpayers should be weary of those who overemphasize their utility.
[1] https://public-inspection.federalregister.gov/2024-06156.pdf?utm_campaign=pi%20subscription%20mailing%20list&utm_medium=email&utm_source=federalregister.gov
[2] See here previous articles concerning listed transactions: https://www.esapllc.com/goodbye-notice-2017-10/; https://www.esapllc.com/2017-10-demise-litigation-review-2022/; https://www.esapllc.com/monetized-installment-sales-proposed-regulations-2023/
[3] https://esapllc.com/crat-gerhardt-2023/
[4] Richard Fox, Charitable Giving: Taxation, Planning, and Strategies.
[5] I.R.C. § 664(d)(1)(D). Note, however, that there are certain exceptions to this rule, such as the contributed property may not be inventory property. See Furrer v. Comm’r, T.C. Memo 2022-100.
[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).
[14] Treas. Reg. § 1.6011-4(b)(2) defines a listed transaction as a transaction that is the same or substantially similar to one of the types of transactions that the IRS has determined to be a tax avoidance transaction. Reg. § 1.6011-4(c)(4) states that a transaction is “substantially similar” if it is expected to obtain the same of similar types of tax consequences and is either factually similar or based on the same or similar tax strategy.
[15] I.R.C. § 664(c)(1).
[16] Treas. Reg. § 1.6011-4(e)(2)(i).
[17] Treas. Reg. § 25.6011-4.
[18] As defined in I.R.C. § 6662A(b)(1).
[19] I.R.C. § 6501(c)(10).
[20] Treas. Reg. § 301.6111-3(b)(1).
[21] Treas. Reg. § 301.6111-3(d) and (e).
[22] Treas. Reg. § 301.6111-3(e).
[23] I.R.C. § 6707(a).
[24] I.R.C. § 6707(b)(2).
[25] I.R.C. § 6112(a); §301-6112-1(e).
[26] I.R.C. § 6708.
