[Federal Register Volume 66, Number 4 (Friday, January 5, 2001)]
[Rules and Regulations]
[Pages 1034-1038]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-248]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8926]
RIN 1545-AX62


Prevention of Abuse of Charitable Remainder Trusts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document finalizes regulations that modify the 
application

[[Page 1035]]

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.

EFFECTIVE DATES: These regulations are effective January 5, 2001. For 
dates of applicability of these regulations, see Secs. 1.643(a)-8(d), 
1.664-2(a)(1)(i)(e), and 1.664-3(a)(1)(i)(l).

FOR FURTHER INFORMATION CONTACT: Catherine Moore (202) 622-3070.

SUPPLEMENTARY INFORMATION:

Background

    On October 18, 1999, proposed regulations (REG-116125-99) to amend 
Secs. 1.643(a)-8 and 1.664-1 of the Income Tax Regulations (26 CFR Part 
1) were published in the Federal Register (64 FR 56718). Several 
written comments were received in response to the notice of proposed 
rulemaking, and a public hearing was held on February 9, 2000. After 
considering all the comments, the proposed regulations under sections 
643 and 664 are adopted as revised by this Treasury decision. The 
comments received and the revisions made are discussed below.

Explanation of Provisions and Summary of Comments

I. General Background

    The proposed regulations were issued in response to 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 abusive transactions, 
a taxpayer typically contributes highly appreciated assets to a 
charitable remainder trust having a relatively short term and a 
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. The borrowing, forward sale, or other similar 
transaction does not result in current income to the trust; thus, the 
parties attempt to characterize the distribution of cash to the 
beneficiary as a tax-free return of corpus under section 664(b)(4). The 
proposed regulations provide that, in this situation, the trust shall 
be treated as having sold a pro rata portion of the trust assets.

II. Public Comments

    One commentator argued that the transactions targeted by the 
regulations are not abusive because they comply with the statutory 
changes made to section 664 by the Taxpayer Relief Act of 1997 (1997 
Act), Public Law 105-34, 111 Stat. 788 (1997). Those statutory changes 
require that the annual payout rate to noncharitable beneficiaries not 
exceed 50 percent of the value of the property contributed to the 
charitable remainder trust and that the actuarial value of the 
charity's remainder interest be not less than 10 percent of the value 
of such property. Although the charitable remainder trusts involved in 
transactions targeted by the proposed regulations are drafted to comply 
with these statutory changes, the transactions result in the same kind 
of abuse that Congress was concerned about in the 1997 Act. It does not 
follow that because Congress did not anticipate in 1997 this latest 
abuse that Congress intended to allow it.
    In the legislative history to the 1997 Act, Congress labeled the 
accelerated charitable remainder trusts it was targeting as ``abusive 
and * * * inconsistent with the purpose of the charitable remainder 
trust rules.'' S. Rep. No. 33, 105th Cong., 1st Sess. 201 (1997). 
Congress noted the efforts of the Treasury Department and the IRS to 
combat abuse in the area through issuing proposed regulations in 1997, 
stating:

    The Committee intends that the provision of the Committee bill 
does not limit or alter the validity of regulations proposed by the 
Treasury Department on April 18, 1997, or the Treasury Department's 
authority to address this or other abuses of the rules governing the 
taxation of charitable remainder trusts or their beneficiaries.

S. Rep. No. 33 at 201. Thus, Congress has neither prohibited nor 
discouraged further regulatory activity in the charitable remainder 
trust area. To the contrary, based on the legislative history to the 
1997 Act, Congress intended the Treasury Department to continue to take 
all necessary action to prevent abuses in this area.
    Several commentators questioned the authority to issue the 
regulations under section 643(a)(7). Two commentators maintained that 
the proposed regulations overstep the bounds of administrative 
rulemaking in that section 643(a)(7) was enacted along with the foreign 
trust provisions of the Small Business Job Protection Act of 1996 (SBJP 
Act), Public Law 104-88, 110 Stat. 1755 (1996), and therefore applies 
only to foreign trusts. One commentator, citing the introductory clause 
of section 664(a), ``[n]otwithstanding any other provision of this 
subchapter,'' argued that the Treasury Department and the IRS are 
prohibited from applying section 643(a)(7) to charitable remainder 
trusts. Some commentators maintained that section 643(a)(7) does not 
authorize the promulgation of regulations imposing a deemed sale where 
no actual sale has occurred. These commentators implied that regulatory 
authority under section 643(a)(7) should be limited to the concept of 
distributable net income (DNI). The Treasury Department and the IRS 
disagree with these views.
    Although the SBJP Act included dramatic changes in the foreign 
trust area, the trust anti-abuse rule was not limited to foreign trusts 
and in fact contains no reference to foreign trusts. Furthermore, the 
Treasury Department and the IRS believe that Congress put the anti-
abuse rule in section 643 because that section contains the rules 
applicable to all of Part 1 of Subchapter J of the Internal Revenue 
Code. Section 643(a)(7) gives the Secretary of the Treasury the 
authority to ``prescribe such regulations as may be necessary or 
appropriate to carry out the purposes of this part, including 
regulations to prevent avoidance of such purposes'' (emphasis added). 
``Part'' in this context refers to Part 1 of Subchapter J and 
encompasses sections 641 through 685, including section 664 governing 
charitable remainder trusts. The legislative history to the SBJP Act 
clarifies that the anti-abuse rule is not limited to foreign trusts or 
the DNI rules. The House Conference Report states:

[The rule] authorizes the Secretary of the Treasury to issue 
regulations, on or after the date of enactment, 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.

H.R. Conf. Rep. No. 737, 104th Cong., 2d Sess. 335 (1996).
    In addition, the plain language of section 664(a) does not prohibit 
the promulgation of regulations that apply section 643(a)(7) to abusive 
charitable remainder trust transactions. Section 664(a) states in full:

    Notwithstanding any other provision of this subchapter, the 
provisions of this section shall, in accordance with regulations 
prescribed by the Secretary, apply in the case of a charitable 
remainder annuity trust and a charitable remainder unitrust.

This language provides that the provisions of section 664 apply in the 
case of a charitable remainder annuity trust and charitable remainder 
unitrust. The Treasury Department and the IRS,

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however, do not view this language as providing that no other 
provisions of subchapter J can apply in the case of abusive charitable 
remainder trust transactions. Applying these regulations to abusive 
charitable remainder trust transactions does not conflict with or 
override the provisions of section 664. Accordingly, the Treasury 
Department and the IRS believe that the plain language of section 
664(a) does not prohibit promulgation of these regulations.
    After considering the comments questioning the authority to 
promulgate and finalize the proposed regulations, the Treasury 
Department and the IRS have concluded that the regulations are an 
appropriate exercise of their regulatory authority and are authorized 
by the regulatory authority granted to them under section 643(a)(7) and 
664(a).
    Another commentator, while supporting the proposed regulations in 
general, suggested that the regulations contain a more precise 
definition of the targeted abuse. In response to this comment, the 
stated purpose in Sec. 1.643(a)-8(a) has been modified to include a 
specific reference to the rules regarding the characterization of 
distributions from charitable remainder trusts in the hands of the 
recipients.
    That same commentator requested clarification of whether a deemed 
sale by a charitable remainder trust under Sec. 1.643(a)-8(b) would 
generate unrelated business taxable income (UBTI) within the meaning of 
section 512. Section 664(c) provides that whether a charitable 
remainder trust has UBTI for any taxable year, and thus is subject to 
tax for that year, is determined under the normal rules of sections 
512, 513, and 514. The proposed regulations do not affect this general 
rule. However, an example in the final regulations clarifies that, to 
the extent that a borrowing by a charitable remainder trust is 
recharacterized as a deemed sale by the trust under Sec. 1.643(a)-8(b), 
the borrowing is not ``acquisition indebtedness'' within the meaning of 
section 514(c).
    Another commentator suggested eliminating the provisions in 
Secs. 1.664-2(a)(1)(i)(a) and 1.664-3(a)(1)(i)(g) of the regulations 
requiring that the annuity amount or the fixed percentage unitrust 
amount generally be paid by the end of the year for which it is due. 
That commentator contended that the payment rule is no longer necessary 
in light of the proposed regulations.
    The Treasury Department and the IRS believe that the proposed 
regulations serve a function different from the payment rule. The 
proposed regulations seek to eliminate tax-free distributions from 
charitable remainder trusts due to manipulation of the character of 
distributions from those trusts. The payment rule, on the other hand, 
eliminates tax-free distributions from charitable remainder trusts due 
to manipulation of the timing of the distributions. A particular 
distribution could run afoul of either of these rules, or both rules.
    In response to this comment, and to further clarify the different 
functions of the two rules, some minor changes have been made to the 
proposed regulation to eliminate references to timing and to clarify 
the application of the deemed sale rule. In addition, in order to make 
it less likely that a non-abusive trust would violate the payment rule, 
two new exceptions have been added to Secs. 1.664-2(a)(1)(i)(a) and 
1.664-3(a)(1)(i)(g). These new exceptions provide that a distribution 
of cash made within a reasonable period of time after the close of the 
year may be characterized as corpus under section 664(b)(4) to the 
extent it was attributable to (i) a contribution of cash to the trust 
with respect to which a deduction was allowable under section 170, 
2055, 2106, or 2522, or (ii) a return of basis in any asset contributed 
to the trust with respect to which a deduction was allowable under 
section 170, 2055, 2106, or 2522, and sold by the trust during the year 
for which the annuity or unitrust amount was due.
    One commentator asserted that the proposed regulations should not 
apply to charitable remainder trusts established prior to the date the 
proposed regulations were published in the Federal Register. This 
commentator compared the effective date of the proposed regulations to 
the effective date of the 1997 Act's trust provisions. Each of the 
changes made by the 1997 Act applies to transfers made to trusts after 
the date specified in the 1997 Act, while the regulations apply to 
distributions made by trusts after October 18, 1999.
    The Treasury Department and the IRS do not believe this assertion 
has merit. These effective dates are not comparable because the 1997 
Act and these regulations apply to different aspects of charitable 
remainder trusts. The 1997 Act changed the requirements a trust must 
meet to qualify as a charitable remainder trust. Whether a trust 
qualifies as a charitable remainder trust is determined at the time 
property is transferred to the trust. As a result, it was appropriate 
to set the effective dates for the 1997 Act with respect to the time 
that transfers were made to a trust. The regulations, on the other 
hand, change the character of a distribution from a charitable 
remainder trust. The character of a distribution from a charitable 
remainder trust is not determined until after the distribution is made. 
Accordingly, the regulations can be applied, without being retroactive, 
to distributions made after the date the proposed regulations were 
filed with the Federal Register. Section 7805(b)(1). Furthermore, the 
Treasury Department and the IRS would have had the authority under 
section 7805(b)(3) to write regulations that take effect retroactively 
to prevent abuse. The abuse targeted by these regulations is well 
documented in Notice 94-78 (1994-2 C.B. 555), the legislative history 
to the 1997 Act, the changes to the charitable remainder trust 
regulations that were finalized in 1998 (TD 8791, 1999-5 I.R.B. 7), and 
Notice 2000-15 (2000-12 I.R.B. 826).
    Finally, the preamble to the proposed regulations requested 
comments on two specific issues: (1) Whether there are situations where 
the application of the proposed regulation would be inappropriate, and 
(2) whether an approach that more directly related the distributed 
funds to the asset that is the subject of the borrowing or forward sale 
would be more appropriate. No comments were received on either of these 
issues.

Special Analyses

    It has been determined that this Treasury decision 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 Treasury Department and the IRS 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, the preceding notice of 
proposed rulemaking 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 Catherine Moore, Office of Chief Counsel (Passthroughs and Special 
Industries). However, other personnel

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from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is 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 
regarding the characterizations of distributions from those trusts in 
the hands of the recipients 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 
in which a distribution of an annuity or unitrust amount is made from 
the trust, a pro rata portion of the trust assets to the extent that 
the distribution of the annuity or unitrust amount would (but for the 
application of this paragraph (b)) be characterized in the hands of the 
recipient as being from the category described in section 664(b)(4) and 
exceeds the amount of the previously undistributed
    (i) Cash contributed to the trust (with respect to which a 
deduction was allowable under section 170, 2055, 2106, or 2522); plus
    (ii) Basis in any contributed property (with respect to which a 
deduction was allowable under section 170, 2055, 2106, or 2522) that 
was sold by the trust.
    (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 adjusted 
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 cash contributed to the trust or a return 
of basis in any contributed asset sold by the trust during Year 1. 
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). No part of the $990,000 loan is 
treated as acquisition indebtedness under section 514(c) because the 
entire loan has been recharacterized as a deemed sale.
    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 
adjusted 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.
* * * * *

    Par. 4. Sec. 1.664-2 is amended as follows:
    1. Paragraphs (a)(1)(i)(a)(1) and (a)(1)(i)(a)(2) are revised.
    2. Paragraph (a)(1)(i)(a)(3) is added.
    3. Paragraph (a)(1)(i)(e) is amended by adding a sentence at the 
end.
    The revision and additions read as follows:


Sec. 1.664-2  Charitable remainder annuity trust.

    (a) * * *
    (1) * * * (i) * * *
    (a) * * *
    (1) The trust pays the annuity amount by distributing property 
(other than cash) that it owned at the close of the taxable year to pay 
the annuity amount, and the trustee elects to treat any income 
generated by the distribution as occurring on the last day of the 
taxable year in which the annuity amount is due;
    (2) The trust pays the annuity amount by distributing cash that was 
contributed to the trust (with respect to which a deduction was 
allowable under section 170, 2055, 2106, or 2522); or
    (3) The trust pays the annuity amount by distributing cash received 
as a return of basis in any asset that was contributed to the trust 
(with respect to which a deduction was allowable under section 170, 
2055, 2106, or 2522), and

[[Page 1038]]

that is sold by the trust during the year for which the annuity amount 
is due.
* * * * *
    (e) * * * However, paragraphs (a)(1)(i)(a)(2) and (3) of this 
section apply only to distributions made on or after January 5, 2001.
* * * * *

    Par. 5. Sec. 1.664-3 is amended as follows:
    1. Paragraphs (a)(1)(i)(g)(1) and (a)(1)(i)(g)(2) are revised.
    2. Paragraph (a)(1)(i)(g)(3) is added.
    3. Paragraph (a)(1)(i)(l) is amended by adding a sentence at the 
end.
    The revision and additions read as follows.
* * * * *
    (g) * * *
    (1) The trust pays the unitrust amount by distributing property 
(other than cash) that it owned at the close of the taxable year, and 
the trustee elects to treat any income generated by the distribution as 
occurring on the last day of the taxable year in which the unitrust 
amount is due;
    (2) The trust pays the unitrust amount by distributing cash that 
was contributed to the trust (with respect to which a deduction was 
allowable under section 170, 2055, 2106, or 2522); or
    (3) The trust pays the unitrust amount by distributing cash 
received as a return of basis in any asset that was contributed to the 
trust (with respect to which a deduction was allowable under section 
170, 2055, 2106, or 2522), and that is sold by the trust during the 
year for which the unitrust amount is due.
* * * * *
    (l) * * * Paragraphs (a)(1)(i)(g)(2) and (3) apply only to 
distributions made on or after January 5, 2001.
* * * * *

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: December 13, 2000.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 01-248 Filed 1-4-01; 8:45 am]
BILLING CODE 4830-01-U