[Federal Register Volume 64, Number 203 (Thursday, October 21, 1999)]
[Proposed Rules]
[Pages 56718-56720]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-27376]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-116125-99]
RIN 1545-AX62


Prevention of Abuse of Charitable Remainder Trusts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations that modify the 
application of the rules governing the character of certain 
distributions from a charitable remainder trust. These regulations are 
necessary to prevent taxpayers from using charitable remainder trusts 
to achieve inappropriate tax avoidance. The regulations affect 
charitable remainder trusts described in section 664 and certain 
beneficiaries of those trusts. This document also provides a notice of 
public hearing on these proposed regulations.

DATES: Written comments must be received by January 19, 2000. Requests 
to speak (with outlines of oral comments) at the public hearing 
scheduled for February 9, 2000, at 10 a.m. must be submitted by January 
19, 2000.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-116125-99), room 
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. In the alternative, submissions may be hand 
delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. 
to: CC:DOM:CORP:R (REG-116125-99), Courier's Desk, Internal Revenue 
Service, 1111 Constitution Avenue NW., Washington, DC. Alternatively, 
taxpayers may submit comments electronically via the Internet by 
selecting the ``Tax Regs'' option of the IRS Home Page, or by 
submitting comments directly to the IRS Internet site at: http://
www.irs.ustreas.gov/tax__regs/regslist.html. The public hearing will be 
held in room 2615, Internal Revenue Building, 1111 Constitution Avenue, 
NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Catherine 
Moore, (202) 622-3070; concerning submissions of comments, the hearing, 
and/or to be placed on the building access list to attend the hearing, 
Guy Traynor, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: This document proposes to amend sections 643 
and 664 of the Income Tax Regulations (26 CFR part 1) to provide 
additional rules regarding charitable remainder trusts.

Background

    Section 664, added to the Internal Revenue Code (Code) by section 
201(e) of the Tax Reform Act of 1969 (Public Law 91-172 (83 Stat. 487, 
562-64)), contains the rules for charitable remainder trusts. In 
general, a charitable remainder trust provides for a specified periodic 
distribution to one or more noncharitable beneficiaries for life or for 
a term of years, with an irrevocable remainder interest held for the 
benefit of charity. The amount distributed to the noncharitable 
beneficiaries may be either a sum certain, in the case of a charitable 
remainder annuity trust, or a fixed percentage of the net fair market 
value of the trust's assets valued annually, in the case of a 
charitable remainder unitrust. Section 664(b) provides rules for 
determining the character of amounts distributed by a charitable 
remainder trust in the hands of the beneficiary to whom the 
distribution is made. In general, a distribution is taxable to the 
beneficiary if it represents a distribution of ordinary income or 
capital gain of the trust. A distribution generally is not taxable to 
the beneficiary if it represents a distribution of tax-exempt income of 
the trust or of trust corpus. Section 664(c) provides that a charitable 
remainder trust is exempt from all taxes under subtitle A of the Code 
for any taxable year except a taxable year in which the trust has 
unrelated business taxable income under section 512.
    Section 643(a)(7), added to the Code by section 1906(b) of the 
Small Business Job Protection Act of 1996 (Public Law 104-188 (110 
Stat. 1755, 1915)), authorizes the Secretary of the Treasury to issue 
regulations that may be necessary or appropriate to carry out the 
purposes of the rules applicable to estates, trusts, and beneficiaries, 
including regulations to prevent the avoidance of those purposes.

Explanation of Provisions

A. Tax-Avoidance Arrangements Using Charitable Remainder Trusts

    The IRS and the Treasury Department are aware of certain abusive 
transactions that attempt to use a section 664 charitable remainder 
trust to convert appreciated assets into cash while avoiding tax on the 
gain from the disposition of the assets. In these transactions, a 
taxpayer typically contributes highly appreciated assets to a 
charitable remainder trust having a relatively short term and 
relatively high payout rate. Rather than sell the assets to obtain cash 
to pay the annuity or unitrust amount to the beneficiary, the trustee 
borrows money, enters into a forward sale of the assets, or engages in 
some similar transaction. Because the borrowing, forward sale, or other 
similar transaction does not result in current income to the trust, the 
parties attempt to characterize the distribution of cash to the 
beneficiary as a tax-free return of corpus under section 664(b)(4). 
Distributions may continue to be funded in this manner for the duration 
of the trust term (which is usually short, so as to meet the 10-percent 
remainder requirement of section 664(d)(1)(D) or 664(d)(2)(D)). The 
appreciated assets may be sold and the transaction closed out (e.g., 
the loan is repaid) in the last year of the trust, or the trustee may 
distribute the appreciated assets, subject to a contractual obligation 
to complete the transaction (e.g., the forward sale contract), to the 
charitable beneficiary.
    A mechanical and literal application of rules and regulations that 
would yield a result inconsistent with the purposes of the charitable 
remainder trust provisions will not be respected. When section 664 was 
amended by the Revenue Reconciliation Act of 1997, Congress indicated 
that a scheme that, in effect, attempts to convert appreciated assets 
to a tax-free cash distribution to the non-charitable beneficiary is 
``abusive and is inconsistent with the purpose of the charitable 
remainder trust rules.'' S.

[[Page 56719]]

Rep. No. 33, 105th Cong., 1st Sess. 201 (1997). Although the particular 
scheme that was the focus of Congress's attention in 1997 involved an 
attempt to exploit the interplay of rules under section 664 governing 
the timing of income and the character of trust distributions, the 
attempted result of the scheme (commonly referred to as an 
``accelerated charitable remainder trust'') was the same as that 
claimed by the promoters of the transactions described above--that is, 
a literal application of rules governing trust distributions in an 
attempt to convert appreciated trust assets into tax-free cash in the 
hands of the non-charitable beneficiary. The latest schemes involving 
charitable remainder trusts are no less ``abusive'' or ``inconsistent 
with the purpose of the charitable remainder trust rules'' than were 
the accelerated charitable remainder trust schemes addressed by 
Congress in 1997.

B. The Proposed Regulations

    Section 643(a)(7) authorizes the Secretary to prescribe regulations 
to carry out the purposes of the provisions of the Code relating to the 
taxation of estates, trusts, and beneficiaries, including regulations 
to prevent avoidance of such purposes. The proposed regulations 
exercise this authority by modifying the treatment of certain 
distributions by charitable remainder trusts for purposes of section 
664(b) to prevent a result that, as discussed above, is inconsistent 
with the purposes of the charitable remainder trust rules.
    The proposed regulations provide that, to the extent that a 
distribution of the annuity or unitrust amount from a charitable 
remainder trust is not characterized in the hands of the recipient as 
income from the categories described in section 664(b)(1), (2), or (3) 
(determined without regard to the rules in these proposed regulations) 
and was made from an amount received by the trust that was neither a 
return of basis in any asset sold by the trust (determined without 
regard to the rules in these proposed regulations) nor attributable to 
a contribution of cash to the trust with respect to which a deduction 
was allowable under section 170, 2055, 2106, or 2522, the trust shall 
be treated as having sold, in the year for which the distribution is 
due, a pro rata portion of the trust assets. Any transaction that has 
the purpose or effect of circumventing this rule will be disregarded. 
For example, a return of basis in an asset sold by a charitable 
remainder trust does not include basis in an asset purchased by the 
charitable remainder trust from the proceeds of a borrowing secured by 
previously contributed assets.
    The proposed regulations include examples that illustrate the 
application of the above rule. The IRS and the Treasury Department 
request comments on whether there are situations where the application 
of this rule would be inappropriate.
    These proposed regulations adopt a pro-rata sale approach to 
determine the amount of gain on the distribution of funds acquired in 
advance of income recognition. The IRS and the Treasury Department also 
considered an approach that more directly related the distributed funds 
to the asset that is the subject of the borrowing or forward sale. 
Comments are requested on this alternative approach.

C. Proposed Effective Date

    The regulations are proposed to apply to distributions made by 
charitable remainder trusts after October 18, 1999.
    However, to the extent that a charitable remainder trust financed a 
distribution to a beneficiary by borrowing funds or entering into a 
forward sale or other similar transaction prior to the effective date 
of these regulations, the IRS may apply an appropriate legal doctrine 
to recast the entire transaction, to characterize the distribution as 
gross income rather than corpus, or to challenge the qualification of 
the trust under section 664. In appropriate circumstances, the IRS may 
impose the tax on self-dealing transactions under section 4941. 
Additionally, the trust may be treated as having unrelated business 
taxable income under section 512 from the transaction. The IRS will 
also apply any applicable penalties to the participants in the 
transaction.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It is hereby 
certified that these regulations will not have a significant economic 
impact on a substantial number of small entities. This certification is 
based on the understanding of the IRS and Treasury Department that the 
number of charitable remainder trusts engaging in transactions affected 
by these regulations is not substantial, and none are small entities 
within the meaning of the Regulatory Flexibility Act (5 U.S.C. chapter 
6). Therefore, a Regulatory Flexibility Analysis under the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to 
section 7805(f) of the Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (preferably a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The IRS and the Treasury Department specifically request comments 
on the clarity of the proposed regulations and how they may be made 
easier to understand. All comments will be available for public 
inspection and copying.
    A public hearing has been scheduled for February 9, 2000, at 10 
a.m. in room 2615, Internal Revenue Building, 1111 Constitution Avenue 
NW., Washington, DC. Due to building security procedures, visitors must 
enter at the 10th Street entrance, located between Constitution and 
Pennsylvania Avenues, NW. In addition, all visitors must present photo 
identification to enter the building. Because of access restrictions, 
visitors will not be admitted beyond the immediate entrance area more 
than 15 minutes before the hearing starts. For information about having 
your name placed on the building access list to attend the hearing, see 
the FOR FURTHER INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons 
that wish to present oral comments at the hearing must submit timely 
written comments and an outline of the topics to be discussed and the 
time to be devoted to each topic (preferably a signed original and 
eight (8) copies) by January 19, 2000.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal authors of these regulations are Mary Beth Collins 
and Catherine Moore, Office of Chief Counsel (Passthroughs and Special 
Industries). However, other personnel from the IRS and Treasury 
Department participated in their development.

[[Page 56720]]

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry in numerical order to read in part as follows:

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

    Section 1.643(a)-8 also issued under 26 U.S.C. 643(a)(7). * * *

    Par. 2. Section 1.643(a)-8 is added to read as follows:


Sec. 1.643(a)-8  Certain distributions by charitable remainder trusts.

    (a) Purpose and scope. This section is intended to prevent the 
avoidance of the purposes of the charitable remainder trust rules and 
should be interpreted in a manner consistent with this purpose. This 
section applies to all charitable remainder trusts described in section 
664 and the beneficiaries of such trusts.
    (b) Deemed sale by trust. (1) For purposes of section 664(b), a 
charitable remainder trust shall be treated as having sold, in the year 
for which a distribution of an annuity or unitrust amount from the 
trust is due, a pro rata portion of the trust assets to the extent that 
the distribution of the annuity or unitrust amount--
    (i) Is not characterized in the hands of the recipient as income 
from the categories described in section 664(b)(1), (2), or (3), 
determined without regard to this paragraph (b); and
    (ii) Was made from an amount received by the trust that was not--
    (A) A return of basis in any asset sold by the trust, determined 
without regard to this paragraph (b); or
    (B) Attributable to cash contributed to the trust with respect to 
which a deduction was allowable under section 170, 2055, 2106, or 2522.
    (2) Any transaction that has the purpose or effect of circumventing 
the rules in this paragraph (b) shall be disregarded.
    (3) For purposes of paragraph (b)(1) of this section, ``trust 
assets'' do not include cash or assets purchased with the proceeds of a 
trust borrowing, forward sale, or similar transaction.
    (4) Proper adjustment shall be made to any gain or loss 
subsequently realized for gain or loss taken into account under 
paragraph (b)(1) of this section.
    (c) Examples. The following examples illustrate the rules of 
paragraph (b) of this section:

    Example 1. Deemed sale by trust. Donor contributes stock having 
a fair market value of $2 million to a charitable remainder unitrust 
with a unitrust amount of 50 percent of the net fair market value of 
the trust assets and a two-year term. The stock has a total basis of 
$400,000. In Year 1, the trust receives dividend income of $20,000. 
As of the valuation date, the trust's assets have a net fair market 
value of $2,020,000 ($2 million in stock, plus $20,000 in cash). To 
obtain additional cash to pay the unitrust amount to the 
noncharitable beneficiary, the trustee borrows $990,000 against the 
value of the stock. The trust then distributes $1,010,000 to the 
beneficiary before the end of Year 1. Under section 664(b)(1), 
$20,000 of the distribution is characterized in the hands of the 
beneficiary as dividend income. The rest of the distribution, 
$990,000, is attributable to an amount received by the trust that 
did not represent either a return of basis in any asset sold by the 
trust (determined without regard to paragraph (b) of this section) 
or a cash contribution to the trust with respect to which a 
charitable deduction was allowable. Under paragraph (b)(3) of this 
section, the stock is a trust asset because it was not purchased 
with the proceeds of the borrowing. Therefore, in Year 1, under 
paragraph (b)(1) of this section, the trust is treated as having 
sold $990,000 of stock and as having realized $792,000 of capital 
gain (the trust's basis in the shares deemed sold is $198,000). 
Thus, in the hands of the beneficiary, $792,000 of the distribution 
is characterized as capital gain under section 664(b)(2) and 
$198,000 is characterized as a tax-free return of corpus under 
section 664(b)(4).
    Example 2. Adjustment to trust's basis in assets deemed sold. 
The facts are the same as in Example 1. During Year 2, the trust 
sells the stock for $2,100,000. The trustee uses a portion of the 
proceeds of the sale to repay the outstanding loan, plus accrued 
interest. Under paragraph (b)(4) of this section, the trust's basis 
in the stock is $1,192,000 ($400,000 plus the $792,000 of gain 
recognized in Year 1). Therefore, the trust recognizes capital gain 
(as described in section 664(b)(2)) in Year 2 of $908,000.
    Example 3. Distribution of cash contributions. Upon the death of 
D, the proceeds of a life insurance policy on D's life are payable 
to T, a charitable remainder annuity trust. The terms of the trust 
provide that, for a period of three years commencing upon D's death, 
the trust shall pay an annuity amount equal to $x annually to A, the 
child of D. After the expiration of such three-year period, the 
remainder interest in the trust is to be transferred to charity Z. 
In Year 1, the trust receives payment of the life insurance proceeds 
and pays the appropriate pro rata portion of the $x annuity to A 
from the insurance proceeds. During Year 1, the trust has no income. 
Because the entire distribution is attributable to a cash 
contribution (the insurance proceeds) to the trust for which a 
charitable deduction was allowable under section 2055 with respect 
to the present value of the remainder interest passing to charity, 
the trust will not be treated as selling a pro rata portion of the 
trust assets under paragraph (b)(1) of this section. Thus, the 
distribution is characterized in A's hands as a tax-free return of 
corpus under section 664(b)(4).

    (d) Effective date. This section is applicable to distributions 
made by a charitable remainder trust after October 18, 1999.
    Par. 3. Section 1.664-1 is amended as follows:
    1. Paragraph (d)(1)(iii) is redesignated as paragraph (d)(1)(iv).
    2. New paragraph (d)(1)(iii) is added.
    The addition reads as follows:


Sec. 1.664-1  Charitable remainder trusts.

* * * * *
    (d) * * *
    (1) * * *
    (iii) Application of section 643(a)(7). For application of the 
anti-abuse rule of section 643(a)(7) to distributions from charitable 
remainder trusts, see Sec. 1.643(a)-8.
* * * * *
Charles O. Rossotti,
Commissioner of Internal Revenue.
[FR Doc. 99-27376 Filed 10-18-99; 11:16 am]
BILLING CODE 4830-01-P