[Federal Register Volume 63, Number 237 (Thursday, December 10, 1998)]
[Rules and Regulations]
[Pages 68188-68194]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-32559]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1, 25, and 602

[TD 8791]
RIN 1545-AU25


Guidance Regarding Charitable Remainder Trusts and Special 
Valuation Rules for Transfers of Interests in Trusts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to 
charitable remainder trusts and to special valuation rules for 
transfers of interests in trusts. The final regulations provide 
additional guidance regarding charitable remainder trusts. The final 
regulations affect charitable remainder trusts and their beneficiaries.

DATES: Effective date: These regulations are effective December 10, 
1998.
    Applicability dates: For dates of applicability of these 
regulations, see the explanations under SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: Mary Beth Collins or Jeff Erickson, 
(202) 622-3080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

[[Page 68189]]

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under 
control number 1545-1536. Responses to this collection of information 
are required to allow taxpayers alternative means of valuing a 
charitable remainder trust's unmarketable assets.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number.
    The estimated annual burden per respondent varies from .25 to .75 
hours, depending on individual circumstances, with an estimated average 
of .5 hours.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, 
Washington, DC 20224, and to the Office of Management and Budget, Attn: 
Desk Officer for the Department of the Treasury, Office of Information 
and Regulatory Affairs, Washington, DC 20503.
    Books or records relating to this collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    On April 18, 1997, the IRS published in the Federal Register (62 FR 
19072) a notice of proposed rulemaking (REG-209823-96) regarding 
sections 664 and 2702. Comments responding to the proposed regulations 
were received, and a public hearing was held on November 18, 1997. 
After considering the comments received and the statements made at the 
public hearing, the proposed regulations are adopted as revised by this 
Treasury decision.

Explanation of Provisions

    This document amends 26 CFR parts 1 and 25 to provide additional 
rules under sections 664 and 2702. Section 664 contains the rules for 
charitable remainder trusts (CRTs). In general, a CRT provides for a 
specified periodic distribution to one or more beneficiaries (at least 
one of whom is a noncharitable beneficiary) for life or for a term of 
years with an irrevocable remainder interest held for the benefit of 
charity.
    There are two types of CRTs: a charitable remainder annuity trust 
(CRAT) and a charitable remainder unitrust (CRUT). A CRAT pays a sum 
certain at least annually to the beneficiaries (the annuity amount). A 
CRUT pays a unitrust amount at least annually to the beneficiaries. 
Generally, the unitrust amount is a fixed percentage of the net fair 
market value of the CRUT's assets valued annually (fixed percentage 
CRUT). The unitrust amount can instead be calculated under one of two 
income exception methods (income exception CRUT). Under the first 
method, the unitrust amount is the lesser of the fixed percentage 
amount or the trust's annual net income (net income method). Under the 
second method, the unitrust amount is determined under the net income 
method plus any amount of income that exceeds the current year's fixed 
percentage amount to make up for any shortfall in payments from prior 
years when the trust income was less than the fixed percentage amount 
(NIMCRUT method). The shortfall in payments from prior years is 
commonly referred to as the ``make-up amount.''
    The revisions to the proposed regulations are discussed below.

I. Flip Unitrusts

A. Triggering Events

    The proposed regulations provide specific rules for when a trust 
may convert from one of the income exception methods of computing the 
unitrust amount to the fixed percentage method (flip unitrust). The 
proposed rule was designed for taxpayers who ultimately wanted the 
unitrust amount to be computed on the fixed percentage method but 
funded the trust with unmarketable assets that generate little annual 
income. A number of commentators agreed with the policy underlying the 
proposed rule. Some commentators requested that we permit flip 
unitrusts for all income exception CRUTs regardless of the 
marketability of the trust assets. Other commentators suggested that 
the final regulations clarify whether the proposed rule was a safe 
harbor or the exclusive circumstance for which a flip unitrust would be 
permitted.
    In response, the final regulations expand the availability of the 
flip unitrust to certain other situations that the IRS and Treasury 
believe are consistent with the legislative history indicating that a 
trustee should not have discretion to change the method used to 
calculate the unitrust amount. H.R. Conf. Rep. No. 782, 91st Cong., 1st 
Sess. 296 (1969), 1969-3 C.B. 644, 655.
    The final regulations allow the governing instrument of a CRUT to 
provide that the CRUT will convert once from one of the income 
exception methods to the fixed percentage method for calculating the 
unitrust amount if the date or event triggering the conversion is 
outside the control of the trustees or any other persons. The final 
regulations include examples of permissible and impermissible 
triggering events. For example, permissible triggering events with 
respect to any individual include marriage, divorce, death, or birth of 
a child. Also, the sale of an unmarketable asset such as real estate is 
a permissible triggering event. Examples of impermissible triggering 
events include the sale of marketable assets and a request from the 
unitrust recipient or the unitrust recipient's financial advisor that 
the trust convert to the fixed percentage method.
    The final regulations also provide that the conversion to the fixed 
percentage method occurs at the beginning of the taxable year that 
immediately follows the taxable year in which the triggering date or 
event occurs. Any make-up amount described in section 664(d)(3)(B) is 
forfeited when the trust converts to the fixed percentage method.
    The proposed regulations define unmarketable assets as assets other 
than cash, cash equivalents, or marketable securities (within the 
meaning of section 731(c)). Commentators asked for clarification of the 
term unmarketable assets and recommended changing the scope of this 
class of assets. In response, the final regulations define unmarketable 
assets as assets other than cash, cash equivalents, or assets that can 
be readily sold or exchanged for cash or cash equivalents. For example, 
unmarketable assets include real property, closely-held stock, and 
unregistered securities for which there is no available exemption 
permitting public sale.
    Commentators requested that the final regulations permit 
conversions from the fixed percentage method to one of the income 
exception methods and conversions from a CRAT to a CRUT. The flip 
unitrust allowed in the final regulations is the only type of 
permissible conversion. Thus, a CRAT cannot convert to a CRUT without 
losing its status as a CRT. Similarly, a CRUT using the fixed 
percentage method cannot convert to an income exception method without 
losing its status as a CRT.

B. Effective Date and Transitional Rules

    The rules for flip unitrusts are effective for CRUTs created on or 
after December 10, 1998. The proposed regulations allowed reformations 
in

[[Page 68190]]

limited circumstances. In response to comments, the final regulations 
expand the circumstances in which reformation is available. The final 
regulations allow income exception CRUTs to be reformed to add 
provisions allowing a conversion to the fixed percentage method 
provided the triggering event does not occur in a year prior to the 
year in which the court issues the order reforming the trust. Adding 
the conversion provisions will not cause the CRUT to fail to function 
exclusively as a CRT and will not be an act of self-dealing under 
section 4941 if the trustee initiates legal proceedings to reform the 
trust by June 8, 1999.

II. Time for Paying the Annuity Amount or the Unitrust Amount

    The proposed regulations provide that the payment of the annuity 
amount or the unitrust amount determined under the fixed percentage 
method must be made by the close of the taxable year in which it is 
due. The rules were proposed in response to abuses associated with the 
use of accelerated CRTs described in Notice 94-78 (1994-2 C.B. 555). 
After receiving a significant number of comments on the proposed rules, 
the IRS issued Notice 97-68 (1997-48 I.R.B. 11), which provided 
guidance on complying with the proposed rules for the 1997 taxable 
year.
    One commentator recommended applying the proposed rules only to 
trusts created after the date the final regulations are published. 
Another commentator suggested adopting the rules in Notice 97-68 for 
all trusts created after a certain date. Although recent legislative 
changes have reduced the potential tax benefits of accelerated CRTs, 
the IRS and Treasury continue to be concerned about the potential abuse 
of the post-year-end grace period to produce a tax-free return of 
appreciation in the assets contributed to a CRAT or a fixed percentage 
CRUT. Therefore, the final regulations adopt rules similar to those in 
Notice 97-68 with certain modifications. The rules are effective for 
taxable years ending after April 18, 1997.
    For CRATs and fixed percentage CRUTs, the annuity or unitrust 
amount may be paid within a reasonable time after the close of the year 
for which it is due if (a) the character of the annuity or unitrust 
amount in the recipient's hands is income under section 664(b)(1), (2), 
or (3); and/or (b) the trust distributes property (other than cash) 
that it owned as of the close of the taxable year to pay the annuity or 
unitrust amount and the trustee elects on Form 5227, ``Split-Interest 
Trust Information Return,'' to treat any income generated by the 
distribution as occurring on the last day of the taxable year for which 
the amount is due. In addition, for CRATs and fixed percentage CRUTs 
that were created before December 10, 1998, the annuity or unitrust 
amount may be paid within a reasonable time after the close of the 
taxable year for which it is due if the percentage used to calculate 
the annuity or unitrust amount is 15 percent or less.

III. Appraising Unmarketable Assets

    Under section 664(d)(2)(A), a CRUT must value its assets annually. 
The proposed regulations provide that, if a CRT holds unmarketable 
assets and the only trustee is the grantor, a noncharitable 
beneficiary, or a related or subordinate party to the grantor or the 
noncharitable beneficiary within the meaning of section 672(c) and the 
applicable regulations, the trustee must value those assets using a 
current qualified appraisal, as defined in Sec. 1.170A-13(c)(3), from a 
qualified appraiser, as defined in Sec. 1.170A-13(c)(5).
    The final regulations follow the proposed regulations and provide 
that the trust's unmarketable assets must be valued by an independent 
trustee, or by a qualified appraisal from a qualified appraiser. The 
proposed regulations define an independent trustee as a person who is 
not the grantor, a noncharitable beneficiary or a related or 
subordinate party to the grantor, or the noncharitable beneficiary 
within the meaning of section 672(c) and the applicable regulations. 
The final regulations add the grantor's spouse to the list of persons 
to whom an independent trustee cannot be related or subordinate. A co-
trustee who is an independent trustee may value the trust's 
unmarketable assets.
    Finally, in response to comments, the final regulations define 
unmarketable assets as assets other than cash, cash equivalents, or 
assets that can be readily sold or exchanged for cash or cash 
equivalents. For example, unmarketable assets include real property, 
closely-held stock, and unregistered securities for which there is no 
available exemption permitting public sale.
    The rules for valuing unmarketable assets are effective for trusts 
created on or after December 10, 1998.

IV. Application of Section 2702 to Certain CRUTs

    Under the proposed regulations, unitrust interests in an income 
exception CRUT that are retained by the donor or any applicable family 
member will be valued at zero when a noncharitable beneficiary of the 
trust is someone other than (1) the donor, (2) the donor's U.S. citizen 
spouse, or (3) both the donor and the donor's U.S. citizen spouse. 
Commentators stated that income exception CRUTs without a make-up 
provision should be exempt from section 2702. The IRS and Treasury 
believe that, in addition to the NIMCRUT method, the net income method 
can be used to circumvent the intent of section 2702. Therefore, the 
final regulations do not exempt from section 2702 CRUTs that use only 
the net income method.
    Commentators also stated that the proposed rule encompassed other 
transfers that section 2702 was not intended to include. A commentator 
noted that the proposed rule would value a transferor's interest at 
zero even though the transferor merely retained a secondary life 
estate. The final regulations clarify that section 2702 will not apply 
when there are only two consecutive noncharitable beneficial interests 
and the transferor holds the second of the two interests.
    Commentators also asked whether section 2702 may apply to flip 
unitrusts. The potential abuse associated with income exception CRUTs 
also exists with flip unitrusts. Therefore, under the final 
regulations, section 2702 applies to a flip unitrust if the CRUT does 
not fall within one of the exemptions.

V. Prohibition on Allocating Precontribution Gain to Trust Income 
and Make-up Amount as a Liability

    The proposed regulations clarify that the proceeds from the sale of 
an income exception CRUT's assets, at least to the extent of the fair 
market value of the assets when contributed to the trust, must be 
allocated to trust principal. Some commentators stated that the rule is 
inconsistent with the rule concerning income under section 643(b). 
Other commentators questioned whether the make-up amount under the 
NIMCRUT method should be treated as a liability when valuing the 
trust's assets.
    The final regulations maintain the prohibition on allocating 
precontribution gain to trust income for an income exception CRUT. 
However, the governing instrument, if permitted under applicable local 
law, may allow the allocation of post-contribution capital gains to 
trust income. Taxpayers do not have to treat the make-up amount as a 
liability when valuing the assets of a NIMCRUT.

VI. Example Illustrating Rule for Characterizing Distributions From 
CRUTs

    The proposed regulations contain an example of how the ordering 
rule under section 664(b) operates when the

[[Page 68191]]

unitrust amount is computed under an income exception method. No 
comments were received on this example. Thus, the final regulations 
adopt the example without any changes.

Effect on Other Documents

    Notice 97-68 (1997-48 I.R.B. 11) is obsolete as of December 10, 
1998.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
does not apply to these regulations, and because the regulation does 
not impose a collection of information on small entities, the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. 
Therefore, a Regulatory Flexibility Analysis is not required. Pursuant 
to section 7805(f), the notice of proposed rulemaking preceding these 
regulations was submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.
    Drafting Information. The principal authors of these regulations 
are Mary Beth Collins and Jeff Erickson, Office of the Assistant Chief 
Counsel (Passthroughs and Special Industries), IRS. However, other 
personnel from offices of the IRS and Treasury Department participated 
in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 25

    Gift taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, CFR parts 1, 25, and 602 are amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. In Sec. 1.664-1, paragraphs (a)(7) and (d)(1)(iii) are 
added and paragraph (f)(4) is added following the concluding text of 
paragraph (f)(3) to read as follows:


Sec. 1.664-1  Charitable remainder trusts.

    (a) * * *
    (7) Valuation of unmarketable assets--(i) In general. If 
unmarketable assets are transferred to or held by a trust, the trust 
will not be a trust with respect to which a deduction is available 
under section 170, 2055, 2106, or 2522, or will be treated as failing 
to function exclusively as a charitable remainder trust unless, 
whenever the trust is required to value such assets, the valuation is--
    (a) Performed exclusively by an independent trustee; or
    (b) Determined by a current qualified appraisal, as defined in 
Sec. 1.170A-13(c)(3), from a qualified appraiser, as defined in 
Sec. 1.170A-13(c)(5).
    (ii) Unmarketable assets. Unmarketable assets are assets that are 
not cash, cash equivalents, or other assets that can be readily sold or 
exchanged for cash or cash equivalents. For example, unmarketable 
assets include real property, closely-held stock, and an unregistered 
security for which there is no available exemption permitting public 
sale.
    (iii) Independent trustee. An independent trustee is a person who 
is not the grantor of the trust, a noncharitable beneficiary, or a 
related or subordinate party to the grantor, the grantor's spouse, or a 
noncharitable beneficiary (within the meaning of section 672(c) and the 
applicable regulations).
* * * * *
    (d) * * * (1) * * *
    (iii) Example. The following example illustrates the application of 
this paragraph (d)(1):

    Example. (i) X is a charitable remainder unitrust described in 
section 664(d)(2) and (3). The annual unitrust amount is the lesser 
of the amount of trust income, as defined in Sec. 1.664-
3(a)(1)(i)(b), or six percent of the net fair market value of the 
trust assets valued annually. The net fair market value of the trust 
assets on the valuation date in 1996 is $150,000. During 1996, X has 
$7,500 of income after allocating all expenses. All of X's income 
for 1996 is tax-exempt income. At the end of 1996, X's ordinary 
income for the current taxable year and undistributed ordinary 
income for prior years are both zero; X's capital gain for the 
current taxable year is zero and undistributed capital gain for 
prior years is $30,000; and X's tax-exempt income for the current 
year is $7,500 and undistributed tax-exempt income for prior years 
is $2,500.
    (ii) Because the trust income of $7,500 is less than the fixed 
percentage amount of $9,000, the unitrust amount for 1996 is $7,500. 
The character of that amount in the hands of the recipient of the 
unitrust amount is determined under section 664(b). Because the 
unitrust amount is less than X's undistributed capital gain income, 
the recipient of the unitrust amount treats the distribution of 
$7,500 as capital gain. At the beginning of 1997, X's undistributed 
capital gain for prior years is reduced to $22,500, and X's 
undistributed tax-exempt income is increased to $10,000.
* * * * *
    (f) * * *
    (4) Valuation of unmarketable assets. The rules contained in 
paragraph (a)(7) of this section are applicable for trusts created on 
or after December 10, 1998. A trust in existence as of December 10, 
1998 whose governing instrument requires that an independent trustee 
value the trust's unmarketable assets may be amended or reformed to 
permit a valuation method that satisfies the requirements of paragraph 
(a)(7) of this section for taxable years beginning on or after December 
10, 1998.
* * * * *
    Par. 3. In Sec. 1.664-2, paragraph (a)(1)(i) is revised to read as 
follows:


Sec. 1.664-2  Charitable remainder annuity trust.

    (a) * * *
    (1) * * * (i) Payment of sum certain at least annually. The 
governing instrument provides that the trust will pay a sum certain not 
less often than annually to a person or persons described in paragraph 
(a)(3) of this section for each taxable year of the period specified in 
paragraph (a)(5) of this section.
    (a) General rule applicable to all trusts. A trust will not be 
deemed to have engaged in an act of self-dealing (within the meaning of 
section 4941), to have unrelated debt-financed income (within the 
meaning of section 514), to have received an additional contribution 
(within the meaning of paragraph (b) of this section), or to have 
failed to function exclusively as a charitable remainder trust (within 
the meaning of Sec. 1.664-1(a)(4)) merely because the annuity amount is 
paid after the close of the taxable year if such payment is made within 
a reasonable time after the close of such taxable year and the entire 
annuity amount in the hands of the recipient is characterized only as 
income from the categories described in section 664(b)(1), (2), or (3), 
except to the extent it is characterized as corpus described in section 
664(b)(4) because--
    (1) The trust distributes property (other than cash) that it owned 
at the close of the taxable year to pay the annuity amount; and
    (2) The trustee elects to treat any income generated by the 
distribution as

[[Page 68192]]

occurring on the last day of the taxable year in which the annuity 
amount is due.
    (b) Special rule for trusts created before December 10, 1998. In 
addition to the circumstances described in paragraph (a)(1)(i)(a) of 
this section, a trust created before December 10, 1998 will not be 
deemed to have engaged in an act of self-dealing (within the meaning of 
section 4941), to have unrelated debt-financed income (within the 
meaning of section 514), to have received an additional contribution 
(within the meaning of paragraph (b) of this section), or to have 
failed to function exclusively as a charitable remainder trust (within 
the meaning of Sec. 1.664-1(a)(4)) merely because the annuity amount is 
paid after the close of the taxable year if such payment is made within 
a reasonable time after the close of such taxable year and the sum 
certain to be paid each year as the annuity amount is 15 percent or 
less of the initial net fair market value of the property irrevocably 
passing in trust as determined for federal tax purposes.
    (c) Reasonable time. For this paragraph (a)(1)(i), a reasonable 
time will not ordinarily extend beyond the date by which the trustee is 
required to file Form 5227, ``Split-Interest Trust Information 
Return,'' (including extensions) for the taxable year.
    (d) Example. The following example illustrates the rules in 
paragraph (a)(1)(i)(a) of this section:

    Example. X is a charitable remainder annuity trust described in 
section 664(d)(1) that was created after December 10, 1998. The 
prorated annuity amount payable from X for Year 1 is $100. The 
trustee does not pay the annuity amount to the recipient by the 
close of Year 1. At the end of Year 1, X has only $95 in the 
ordinary income category under section 664(b)(1) and no income in 
the capital gain or tax-exempt income categories under section 
664(b)(2) or (3), respectively. By April 15 of Year 2, in addition 
to $95 in cash, the trustee distributes to the recipient of the 
annuity a capital asset with a $5 fair market value and a $2 
adjusted basis to pay the $100 annuity amount due for Year 1. The 
trust owned the asset at the end of Year 1. Under Sec. 1.664-
1(d)(5), the distribution is treated as a sale by X, resulting in X 
recognizing a $3 capital gain. The trustee elects to treat the 
capital gain as occurring on the last day of Year 1. Under 
Sec. 1.664-1(d)(1), the character of the annuity amount for Year 1 
in the recipient's hands is $95 of ordinary income, $3 of capital 
gain income, and $2 of trust corpus. For Year 1, X satisfied 
paragraph (a)(1)(i)(a) of this section.

    (e) Effective date. This paragraph (a)(1)(i) is applicable for 
taxable years ending after April 18, 1997.
* * * * *
    Par. 4. Section 1.664-3 is amended as follows:
    1. Paragraphs (a)(1)(i)(a), (a)(1)(i)(b)(1), and (a)(1)(i)(b)(2) 
are revised.
    2. Paragraphs (a)(1)(i)(b)(3), (a)(1)(i)(b)(4), (a)(1)(i)(b)(5), 
and (a)(1)(i)(c) through (a)(1)(i)(l) are added.
    3. The third sentence of paragraph (a)(1)(iv) is revised.
    The added and revised provisions read as follows:


Sec. 1.664-3  Charitable remainder unitrust.

    (a) * * *
    (1) * * * (i) * * * (a) General rule. The governing instrument 
provides that the trust will pay not less often than annually a fixed 
percentage of the net fair market value of the trust assets determined 
annually to a person or persons described in paragraph (a)(3) of this 
section for each taxable year of the period specified in paragraph 
(a)(5) of this section. This paragraph (a)(1)(i)(a) is applicable for 
taxable years ending after April 18, 1997.
    (b) * * *
    (1) The amount of trust income for a taxable year to the extent 
that such amount is not more than the amount required to be distributed 
under paragraph (a)(1)(i)(a) of this section.
    (2) An amount of trust income for a taxable year that is in excess 
of the amount required to be distributed under paragraph (a)(1)(i)(a) 
of this section for such year to the extent that (by reason of 
paragraph (a)(1)(i)(b)(1) of this section) the aggregate of the amounts 
paid in prior years was less than the aggregate of such required 
amounts.
    (3) For this paragraph (a)(1)(i)(b), trust income means income as 
defined under section 643(b) and the applicable regulations.
    (4) For this paragraph (a)(1)(i)(b), proceeds from the sale or 
exchange of any assets contributed to the trust by the donor must be 
allocated to principal and not to trust income at least to the extent 
of the fair market value of those assets on the date of contribution.
    (5) The rules in paragraphs (a)(1)(i)(b)(1), (2), and (3) of this 
section are applicable for taxable years ending after April 18, 1997, 
and the rule in paragraph (a)(1)(i)(b)(4) is applicable for sales or 
exchanges that occur after April 18, 1997.
    (c) Combination of methods. Instead of the amount described in 
paragraph (a)(1)(i)(a) or (b) of this section, the governing instrument 
may provide that the trust will pay not less often than annually the 
amount described in paragraph (a)(1)(i)(b) of this section for an 
initial period and then pay the amount described in paragraph 
(a)(1)(i)(a) of this section (calculated using the same fixed 
percentage) for the remaining years of the trust only if the governing 
instrument provides that--
    (1) The change from the method prescribed in paragraph (a)(1)(i)(b) 
to the method prescribed in paragraph (a)(1)(i)(a) is triggered on a 
specific date or by a single event whose occurrence is not 
discretionary with, or within the control of, the trustees or any other 
persons;
    (2) The change from the method prescribed in paragraph (a)(1)(i)(b) 
of this section to the method prescribed in paragraph (a)(1)(i)(a) of 
this section occurs at the beginning of the taxable year that 
immediately follows the taxable year during which the date or event 
specified under paragraph (a)(1)(i)(c)(1) of this section occurs; and
    (3) Following the trust's conversion to the method described in 
paragraph (a)(1)(i)(a) of this section, the trust will pay at least 
annually to the permissible recipients the amount described only in 
paragraph (a)(1)(i)(a) of this section and not any amount described in 
paragraph (a)(1)(i)(b) of this section.
    (d) Triggering event. For purposes of paragraph (a)(1)(i)(c)(1) of 
this section, a triggering event based on the sale of unmarketable 
assets as defined in Sec. 1.664-1(a)(7)(ii), or the marriage, divorce, 
death, or birth of a child with respect to any individual will not be 
considered discretionary with, or within the control of, the trustees 
or any other persons.
    (e) Examples. The following examples illustrate the rules in 
paragraph (a)(1)(i)(c) of this section. For each example, assume that 
the governing instrument of charitable remainder unitrust Y provides 
that Y will initially pay not less often than annually the amount 
described in paragraph (a)(1)(i)(b) of this section and then pay the 
amount described in paragraph (a)(1)(i)(a) of this section (calculated 
using the same fixed percentage) for the remaining years of the trust 
and that the requirements of paragraphs (a)(1)(i)(c)(2) and (3) of this 
section are satisfied. The examples are as follows:

    Example 1. Y is funded with the donor's former personal 
residence. The governing instrument of Y provides for the change in 
method for computing the annual unitrust amount as of the first day 
of the year following the year in which the trust sells the 
residence. Y provides for a combination of methods that satisfies 
paragraph (a)(1)(i)(c) of this section.
    Example 2. Y is funded with cash and an unregistered security 
for which there is no available exemption permitting public sale 
under the Securities and Exchange Commission rules. The governing 
instrument of Y provides that the change in method for computing the 
annual unitrust amount is triggered on the earlier of the date when 
the

[[Page 68193]]

stock is sold or at the time the restrictions on its public sale 
lapse or are otherwise lifted. Y provides for a combination of 
methods that satisfies paragraph (a)(1)(i)(c) of this section.
    Example 3. Y is funded with cash and with a security that may be 
publicly traded under the Securities and Exchange Commission rules. 
The governing instrument of Y provides that the change in method for 
computing the annual unitrust amount is triggered when the stock is 
sold. Y does not provide for a combination of methods that satisfies 
the requirements of paragraph (a)(1)(i)(c) of this section because 
the sale of the publicly-traded stock is within the discretion of 
the trustee.
    Example 4. S establishes Y for her granddaughter, G, when G is 
10 years old. The governing instrument of Y provides for the change 
in method for computing the annual unitrust amount as of the first 
day of the year following the year in which G turns 18 years old. Y 
provides for a combination of methods that satisfies paragraph 
(a)(1)(i)(c) of this section.
    Example 5. The governing instrument of Y provides for the change 
in method for computing the annual unitrust amount as of the first 
day of the year following the year in which the donor is married. Y 
provides for a combination of methods that satisfies paragraph 
(a)(1)(i)(c) of this section.
    Example 6. The governing instrument of Y provides that if the 
donor divorces, the change in method for computing the annual 
unitrust amount will occur as of the first day of the year following 
the year of the divorce. Y provides for a combination of methods 
that satisfies paragraph (a)(1)(i)(c) of this section.
    Example 7. The governing instrument of Y provides for the change 
in method for computing the annual unitrust amount as of the first 
day of the year following the year in which the noncharitable 
beneficiary's first child is born. Y provides for a combination of 
methods that satisfies paragraph (a)(1)(i)(c) of this section.
    Example 8. The governing instrument of Y provides for the change 
in method for computing the annual unitrust amount as of the first 
day of the year following the year in which the noncharitable 
beneficiary's father dies. Y provides for a combination of methods 
that satisfies paragraph (a)(1)(i)(c) of this section.
    Example 9. The governing instrument of Y provides for the change 
in method for computing the annual unitrust amount as of the first 
day of the year following the year in which the noncharitable 
beneficiary's financial advisor determines that the beneficiary 
should begin receiving payments under the second prescribed payment 
method. Because the change in methods for paying the unitrust amount 
is triggered by an event that is within a person's control, Y does 
not provide for a combination of methods that satisfies paragraph 
(a)(1)(i)(c) of this section.
    Example 10. The governing instrument of Y provides for the 
change in method for computing the annual unitrust amount as of the 
first day of the year following the year in which the noncharitable 
beneficiary submits a request to the trustee that the trust convert 
to the second prescribed payment method. Because the change in 
methods for paying the unitrust amount is triggered by an event that 
is within a person's control, Y does not provide for a combination 
of methods that satisfies paragraph (a)(1)(i)(c) of this section.

    (f) Effective date--(1) General rule. Paragraphs (a)(1)(i)(c), (d), 
and (e) of this section are applicable for charitable remainder trusts 
created on or after December 10, 1998.
    (2) General rule regarding reformations of combination of method 
unitrusts. If a trust is created on or after December 10, 1998 and 
contains a provision allowing a change in calculating the unitrust 
amount that does not comply with the provisions of paragraph 
(a)(1)(i)(c) of this section, the trust will qualify as a charitable 
remainder unitrust only if it is amended or reformed to use the initial 
method for computing the unitrust amount throughout the term of the 
trust, or is reformed in accordance with paragraph (a)(1)(i)(f)(3) of 
this section. If a trust was created before December 10, 1998 and 
contains a provision allowing a change in calculating the unitrust 
amount that does not comply with the provisions of paragraph 
(a)(1)(i)(c) of this section, the trust may be reformed to use the 
initial method for computing the unitrust amount throughout the term of 
the trust without causing the trust to fail to function exclusively as 
a charitable remainder unitrust under Sec. 1.664-1(a)(4), or may be 
reformed in accordance with paragraph (a)(1)(i)(f)(3) of this section. 
Except as provided in paragraph (a)(1)(i)(f)(3) of this section, a 
qualified charitable remainder unitrust will not continue to qualify as 
a charitable remainder unitrust if it is amended or reformed to add a 
provision allowing a change in the method for calculating the unitrust 
amount.
    (3) Special rule for reformations of trusts that begin by June 8, 
1999. Notwithstanding paragraph (a)(1)(i)(f)(2) of this section, if a 
trust either provides for payment of the unitrust amount under a 
combination of methods that is not permitted under paragraph 
(a)(1)(i)(c) of this section, or provides for payment of the unitrust 
amount under only the method prescribed in paragraph (a)(1)(i)(b) of 
this section, then the trust may be reformed to allow for a combination 
of methods permitted under paragraph (a)(1)(i)(c) of this section 
without causing the trust to fail to function exclusively as a 
charitable remainder unitrust under Sec. 1.664-1(a)(4) or to engage in 
an act of self-dealing under section 4941 if the trustee begins legal 
proceedings to reform by June 8, 1999. The triggering event under the 
reformed governing instrument may not occur in a year prior to the year 
in which the court issues the order reforming the trust, except for 
situations in which the governing instrument prior to reformation 
already provided for payment of the unitrust amount under a combination 
of methods that is not permitted under paragraph (a)(1)(i)(c) of this 
section and the triggering event occurred prior to the reformation.
    (g) Payment under general rule for fixed percentage trusts. When 
the unitrust amount is computed under paragraph (a)(1)(i)(a) of this 
section, a trust will not be deemed to have engaged in an act of self-
dealing (within the meaning of section 4941), to have unrelated debt-
financed income (within the meaning of section 514), to have received 
an additional contribution (within the meaning of paragraph (b) of this 
section), or to have failed to function exclusively as a charitable 
remainder trust (within the meaning of Sec. 1.664-1(a)(4)) merely 
because the unitrust amount is paid after the close of the taxable year 
if such payment is made within a reasonable time after the close of 
such taxable year and the entire unitrust amount in the hands of the 
recipient is characterized only as income from the categories described 
in section 664(b)(1), (2), or (3), except to the extent it is 
characterized as corpus described in section 664(b)(4) because--
    (1) The trust distributes property (other than cash) that it owned 
at the close of the taxable year to pay the unitrust amount; and
    (2) The trustee elects to treat any income generated by the 
distribution as occurring on the last day of the taxable year for which 
the unitrust amount is due.
    (h) Special rule for fixed percentage trusts created before 
December 10, 1998. When the unitrust amount is computed under paragraph 
(a)(1)(i)(a) of this section, a trust created before December 10, 1998 
will not be deemed to have engaged in an act of self-dealing (within 
the meaning of section 4941), to have unrelated debt-financed income 
(within the meaning of section 514), to have received an additional 
contribution (within the meaning of paragraph (b) of this section), or 
to have failed to function exclusively as a charitable remainder trust 
(within the meaning of Sec. 1.664-1(a)(4)) merely because the unitrust 
amount is paid after the close of the taxable year if such payment is 
made within a reasonable time after the close of such taxable year and 
the fixed percentage to be paid each year as the unitrust amount is 15 
percent or less of the net fair market value of the trust assets as 
determined under paragraph (a)(1)(iv) of this section.

[[Page 68194]]

    (i) Example. The following example illustrates the rules in 
paragraph (a)(1)(i)(g) of this section:

    Example. X is a charitable remainder unitrust that calculates 
the unitrust amount under paragraph (a)(1)(i)(a) of this section. X 
was created after December 10, 1998. The prorated unitrust amount 
payable from X for Year 1 is $100. The trustee does not pay the 
unitrust amount to the recipient by the end of the Year 1. At the 
end of Year 1, X has only $95 in the ordinary income category under 
section 664(b)(1) and no income in the capital gain or tax-exempt 
income categories under section 664(b) (2) or (3), respectively. By 
April 15 of Year 2, in addition to $95 in cash, the trustee 
distributes to the unitrust recipient a capital asset with a $5 fair 
market value and a $2 adjusted basis to pay the $100 unitrust amount 
due for Year 1. The trust owned the asset at the end of Year 1. 
Under Sec. 1.664-1(d)(5), the distribution is treated as a sale by 
X, resulting in X recognizing a $3 capital gain. The trustee elects 
to treat the capital gain as occurring on the last day of Year 1. 
Under Sec. 1.664-1(d)(1), the character of the unitrust amount for 
Year 1 in the recipient's hands is $95 of ordinary income, $3 of 
capital gain income, and $2 of trust corpus. For Year 1, X satisfied 
paragraph (a)(1)(i)(g) of this section.

    (j) Payment under income exception. When the unitrust amount is 
computed under paragraph (a)(1)(i)(b) of this section, a trust will not 
be deemed to have engaged in an act of self-dealing (within the meaning 
of section 4941), to have unrelated debt-financed income (within the 
meaning of section 514), to have received an additional contribution 
(within the meaning of paragraph (b) of this section), or to have 
failed to function exclusively as a charitable remainder trust (within 
the meaning of Sec. 1.664-1(a)(4)) merely because payment of the 
unitrust amount is made after the close of the taxable year if such 
payment is made within a reasonable time after the close of such 
taxable year.
    (k) Reasonable time. For paragraphs (a)(1)(i) (g), (h), and (j) of 
this section, a reasonable time will not ordinarily extend beyond the 
date by which the trustee is required to file Form 5227, ``Split-
Interest Trust Information Return,'' (including extensions) for the 
taxable year.
    (l) Effective date. Paragraphs (a)(1)(i) (g), (h), (i), (j), and 
(k) of this section are applicable for taxable years ending after April 
18, 1997.
* * * * *
    (iv) * * * If the governing instrument does not specify the 
valuation date or dates, the trustee must select such date or dates and 
indicate the selection on the first return on Form 5227, ``Split-
Interest Trust Information Return,'' that the trust must file. * * *
* * * * *

PART 25--GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954

    Par. 5. The authority citation for part 25 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805. * * *

    Par. 6. In Sec. 25.2702-1, paragraph (c)(3) is revised to read as 
follows:


Sec. 25.2702-1  Special valuation rules in the case of transfers of 
interests in trust.

* * * * *
    (c) * * *
    (3) Charitable remainder trust. (i) For transfers made on or after 
May 19, 1997, a transfer to a pooled income fund described in section 
642(c)(5); a transfer to a charitable remainder annuity trust described 
in section 664(d)(1); a transfer to a charitable remainder unitrust 
described in section 664(d)(2) if under the terms of the governing 
instrument the unitrust amount can be computed only under section 
664(d)(2)(A); and a transfer to a charitable remainder unitrust if 
under the terms of the governing instrument the unitrust amount can be 
computed under section 664(d)(2) and (3) and either there are only two 
consecutive noncharitable beneficial interests and the transferor holds 
the second of the two interests, or the only permissible recipients of 
the unitrust amount are the transferor, the transferor's U.S. citizen 
spouse, or both the transferor and the transferor's U.S. citizen 
spouse.
    (ii) For transfers made before May 19, 1997, a transfer in trust if 
the remainder interest in the trust qualifies for a deduction under 
section 2522.
* * * * *

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 7. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 8. In Sec. 602.101, paragraph (c) is amended by adding a new 
entry in numerical order to the table to read as follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (c) * * *

------------------------------------------------------------------------
CFR part or section where identified
            and described                   Current OMB control No.
------------------------------------------------------------------------
 
                  *        *        *        *        *
1.664-1(a)(7).......................  1545-1536
 
                  *        *        *        *        *
------------------------------------------------------------------------

    Approved: December 1, 1998.
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
Donald C. Lubick,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 98-32559 Filed 12-9-98; 8:45 am]
BILLING CODE 4830-01-P