[Federal Register Volume 68, Number 224 (Thursday, November 20, 2003)]
[Proposed Rules]
[Pages 65419-65422]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-29042]



[[Page 65419]]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-110896-98]
RIN 1545-AW35


Charitable Remainder Trusts; Application of Ordering Rule

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 on the ordering 
rules of section 664(b) of the Internal Revenue Code for characterizing 
distributions from charitable remainder trusts. The proposed 
regulations reflect changes made to income tax rates, including the 
rates applicable to capital gains and certain dividends, by the 
Taxpayer Relief Act of 1997, the Internal Revenue Service Restructuring 
and Reform Act of 1998, and the Jobs and Growth Tax Relief 
Reconciliation Act of 2003. The proposed regulations affect charitable 
remainder trusts and their beneficiaries. This document also provides 
notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received Tuesday, 
February 17, 2004. Outlines of topics to be discussed at the public 
hearing scheduled for Tuesday, March 9, 2004, must be received by 
Tuesday, February 17, 2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-110896-98), room 
5203, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-
110896-98), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit 
comments electronically directly to the IRS Internet site at 
www.irs.gov/regs. The public hearing will be held in the auditorium, 
Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, 
DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Theresa M. Melchiorre, (202) 622-7830; concerning submissions of 
comments, the hearing, and/or to be placed on the building access list 
to attend the hearing, Robin Jones, (202) 622-7180 (not toll-free 
numbers).

SUPPLEMENTARY INFORMATION: 

Background

    Section 664 contains the rules for charitable remainder annuity 
trusts and charitable remainder unitrusts. In general, a charitable 
remainder trust provides for a specified periodic distribution (CRT 
distribution) to one or more beneficiaries (at least one of which is a 
noncharitable beneficiary) for life or for a term of years, with an 
irrevocable remainder interest held for the benefit of charity.
    Section 664(b) provides ordering rules for determining the 
character of CRT distributions in the hands of the recipient of those 
distributions. A CRT distribution is treated: First, as ordinary income 
to the extent of the trust's gross income other than gains from the 
sale of capital assets (``ordinary income'') for the trust's taxable 
year and its undistributed ordinary income for prior years; second, as 
capital gain to the extent of the trust's capital gain for the trust's 
taxable year and its undistributed capital gain for prior years; third, 
as other income (that is, tax-exempt income) to the extent of the 
trust's other income for the trust's taxable year and its undistributed 
other income for prior years; and, finally, as a distribution of trust 
corpus. The general principle of section 664(b) is that income subject 
to the highest Federal income tax rate is deemed distributed prior to 
income subject to a lower (or no) Federal income tax rate. The existing 
regulations under ``1.664-1(d)(1)(i)(b)(1) follow this general 
principle by providing that short-term capital gain is deemed 
distributed prior to any long-term capital gain.
    Beginning with the Taxpayer Relief Act of 1997 (TRA), Public Law 
105-34 (111 Stat. 788), different types of long-term capital gains are 
subject to different Federal income tax rates. The different classes of 
long-term capital gains and losses properly taken into account by a 
charitable remainder trust after May 6, 1997, may, for example, consist 
of 28-percent rate gain as defined in section 1(h)(4), unrecaptured 
section 1250 gain as defined in section 1(h)(6), and all other long-
term capital gains and losses. For taxable years beginning after 
December 31, 2002, the Jobs and Growth Tax Relief Reconciliation Act of 
2003 (JGTRRA), Public Law 108-27 (117 Stat. 752), provides that 
qualified dividend income as defined in section 1(h)(11) is taxed at 
the rates applicable to all other long-term capital gains. Because 
dividends represent one type of ordinary income, different types of 
ordinary income are subject to different Federal income tax rates as a 
result of JGTRRA.
    Notice 98-20 (1998-1 C.B. 776), as modified by Notice 99-17 (1999-1 
C.B. 871), provides guidance on the treatment of capital gains under 
section 664(b)(2) following the changes made by the TRA and the 
technical corrections made by the Internal Revenue Service 
Restructuring and Reform Act of 1998, Public Law 105-206 (112 Stat. 
685). The proposed regulations incorporate this guidance as well as 
provide additional guidance regarding the treatment of qualified 
dividend income under section 664(b)(1).

Explanation of Provisions

    The proposed regulations will amend Sec.  1.664-1(d)(1) to revise 
the rules for characterizing a CRT distribution to take into account 
differences in the Federal income tax rates applicable to items of 
income that are assigned to the same category under section 664(b). The 
trust's income is assigned, in the year it is required to be taken into 
account by the trust, to one of three categories: the ordinary income 
category, the capital gains category, or the other income category. 
Further, within the ordinary income and capital gains categories, items 
are also assigned to different classes based on the Federal income tax 
rate applicable to each type of income in the category. In accordance 
with section 664(b), a CRT distribution is treated as being made from 
the categories in the following order: ordinary income, capital gain, 
other income, and trust corpus. Within the ordinary income and capital 
gains categories, income is treated as distributed from the classes of 
income in that category beginning with the class subject to the highest 
Federal income tax rate and ending with the class subject to the lowest 
Federal income tax rate. The proposed regulations also provide rules 
for netting different classes of capital gains and losses based on the 
guidance in Notice 97-59 (1997-2 C.B. 309).

Proposed Effective Date

    The provisions in these regulations that were set forth in Notice 
98-20 (1998-1 C.B. 776) and Notice 99-17 (1999-1 C.B. 871) are proposed 
to apply for taxable years ending on or after December 31, 1998, and 
taxpayers may rely on the provisions for taxable years beginning on or 
after January 1, 1998. The other provisions of these regulations are 
proposed to apply for taxable years ending after [DATE OF PUBLICATION 
OF THIS DOCUMENT IN THE Federal Register].

[[Page 65420]]

Special Analyses

    It has been determined that this proposed regulation is not a 
significant regulatory action as defined in Executive Order 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 
these regulations do not impose on small entities a collection of 
information requirement, 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) of the Internal Revenue 
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 (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and Treasury Department specifically request comments on 
the clarity of the proposed regulations and how they may be made easier 
to understand. In addition, comments are requested on the 
administrative difficulty and potential tax benefit or detriment of 
maintaining separate classes within a category when two classes are 
only temporarily subject to the same rate (for example, if the current 
rate applicable to one class sunsets in a future year). All comments 
will be available for public inspection and copying.
    A public hearing has been scheduled for Tuesday, March 9, 2004 in 
the auditorium, Internal Revenue Building, 1111 Constitution Avenue, 
NW., Washington, DC. Due to building security procedures, visitors must 
use the main building entrance on Constitution Avenue. 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 30 minutes before the hearing 
starts. For more information about having your name placed on the 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 who 
wish to present oral comments at the hearing must submit written 
(signed original and eight (8) copies) or electronic comments and an 
outline of the topics to be discussed and the time to be devoted to 
each topic by Tuesday, February 17, 2004. 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 author of these regulations is Theresa M. Melchiorre, 
Office of Chief Counsel, IRS. Other personnel from the IRS and Treasury 
Department participated in their development.

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 for part 1 continues to read in part as 
follows:

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

    Par. 2. Section 1.664-1 is amended as follows:
    1. Paragraph (d)(1) is revised.
    2. Paragraph (d)(2) is amended by:
    a. Removing the language ``or to corpus (determined under 
subparagraph (1)(i) of this paragraph)'' in the first sentence and 
adding ``(determined under paragraph (d)(1)(i)(a) of this section) or 
to corpus'' in its place.
    b. Removing the language ``subparagraph (1)(i)(c) of this 
paragraph'' from the fifth sentence and adding ``paragraph 
(d)(1)(i)(a)(3) of this section'' in its place.
    c. Removing the language ``or corpus in the categories described in 
subparagraph (1) of this paragraph'' from the last sentence and adding 
``described in paragraph (d)(1)(i)(a) of this section or to corpus'' in 
its place.
    3. Paragraph (e)(1) is amended by removing the language ``paragraph 
(d)(1)'' from the first sentence and adding ``paragraph (d)(1)(i)(a)'' 
in its place.
    The revision reads as follows:


Sec.  1.664-1  Charitable remainder trusts.

* * * * *
    (d) Treatment of annual distributions to recipients--(1) Character 
of distributions--(i) Assignment of income to categories and classes. 
(a) A trust's income, including income includible in gross income and 
other income, is assigned to one of three categories in the year in 
which it is required to be taken into account by the trust. These 
categories are--
    (1) Gross income, other than gains and amounts treated as gains 
from the sale or other disposition of capital assets (referred to as 
the ordinary income category);
    (2) Gains and amounts treated as gains from the sale or other 
disposition of capital assets (referred to as the capital gains 
category); and
    (3) Other income (including income excluded under part III, 
subchapter B, chapter 1, subtitle A of the Internal Revenue Code).
    (b) Items within the ordinary income and capital gains categories 
are assigned to different classes based on the Federal income tax rate 
applicable to each type of income in that category in the year the 
items are required to be taken into account by the trust. For example, 
the ordinary income category may include a class of qualified dividend 
income as defined in section 1(h)(11) and a class of all other ordinary 
income. In addition, the capital gains category may include separate 
classes for short-term capital gains and losses, for 28-percent rate 
gain as defined in section 1(h)(4), for unrecaptured section 1250 gain 
as defined in section 1(h)(6), and for all other long-term capital 
gains and losses. After items are assigned to a class, the tax rates 
may change so that items in two or more classes would be taxed at the 
same rate if distributed during a particular year. If the changes to 
the tax rates are permanent, the undistributed items in those classes 
are combined into one class. If, however, the changes to the tax rates 
are only temporary (for example, the new rate for one class will sunset 
in a future year), the classes are kept separate.
    (ii) Order of distributions. (a) The categories and classes of 
income (determined under paragraph (d)(1)(i) of this section) are used 
to determine the character of an annuity or unitrust distribution from 
the trust in the hands of the recipient irrespective of whether the 
trust is exempt from taxation under section 664(c) for the year of the 
distribution. The determination of the character of amounts distributed 
shall be made as of the end of the taxable year of the trust. The 
recipient is taxed on the distribution based on the tax rates 
applicable in the year of the distribution to the classes of income 
that are deemed distributed from the trust. The character of the 
distribution in the hands of the annuity or unitrust recipient is 
determined by treating the distribution

[[Page 65421]]

as being made from each category in the following order:
    (1) First, from ordinary income to the extent of the sum of the 
trust's ordinary income for the taxable year and its undistributed 
ordinary income for prior years.
    (2) Second, from capital gain to the extent of the trust's capital 
gains determined under paragraph (d)(1)(iv) of this section.
    (3) Third, from other income to the extent of the sum of the 
trust's other income for the taxable year and its undistributed other 
income for prior years.
    (4) Finally, from trust corpus (with corpus defined for this 
purpose as the net fair market value of the trust assets less the total 
undistributed income (but not loss) in paragraphs (d)(1)(i)(a)(1) 
through (3) of this section)).
    (b) If the trust has different classes of income in the ordinary 
income category, the distribution from that category is treated as 
being made from each class, in turn, until exhaustion of the class, 
beginning with the class subject to the highest Federal income tax rate 
and ending with the class subject to the lowest Federal income tax 
rate. If the trust has different classes of net gain in the capital 
gains category, the distribution from that category is treated as being 
made first from the short-term capital gain class and then from each 
class of long-term capital gain, in turn, until exhaustion of the 
class, beginning with the class subject to the highest Federal income 
tax rate and ending with the class subject to the lowest rate. If two 
or more classes within the same category are subject to the same 
current tax rate, but at least one of those classes will be subject to 
a different tax rate in a future year (for example, if the current rate 
sunsets), the order of that class in relation to other classes in the 
category with the same current tax rate is determined based on the 
future rate or rates applicable to those classes. Within each category, 
if there is more than one type of income in a class, amounts treated as 
distributed from that class are to be treated as consisting of the same 
proportion of each type of income as the total of the current and 
undistributed income of that type bears to the total of the current and 
undistributed income of all types of income included in that class. For 
example, if rental income and interest income are subject to the same 
current and future Federal income tax rate and therefore are in the 
same class, a distribution from that class will be treated as 
consisting of a proportional amount of rental income and interest 
income.
    (iii) Treatment of losses--(a) Ordinary income category. An 
ordinary loss for the current year is first used to reduce 
undistributed ordinary income for prior years that is assigned to the 
same class as the loss. Any excess loss is then used to reduce the 
current and undistributed ordinary income from other classes, in turn, 
beginning with the class subject to the highest Federal income tax rate 
and ending with the class subject to the lowest Federal income tax 
rate. If any of the loss exists after all the current and undistributed 
ordinary income from all classes has been offset, the excess is carried 
forward indefinitely to reduce ordinary income for future years. For 
purposes of this section, the amount of current income and prior years' 
undistributed income shall be computed without regard to the deduction 
for net operating losses provided by sections 172 or 642(d).
    (b) Other income category. A loss in the other income category for 
the current year is used to reduce undistributed income in this 
category for prior years and any excess is carried forward indefinitely 
to reduce other income for future years.
    (iv) Netting of capital gains and losses. Capital gains of the 
trust are determined on a cumulative net basis under the rules of this 
paragraph (d)(1) without regard to the provisions of section 1212. For 
each taxable year, current and undistributed gains and losses within 
each class are netted to determine the net gain or loss for that class, 
and the classes of capital gains and losses are then netted against 
each other in the following order. A net loss from the class of short-
term capital gain and loss offsets the net gain from each class of 
long-term capital gain and loss, in turn, until exhaustion of the 
class, beginning with the class subject to the highest Federal income 
tax rate and ending with the class subject to the lowest Federal income 
tax rate. A net loss from a class of long-term capital gain and loss 
(beginning with the class subject to the highest Federal income tax 
rate and ending with the class subject to the lowest rate) is used to 
offset net gain from each other class of long-term capital gain and 
loss, in turn, until exhaustion of the class, beginning with the class 
subject to the highest Federal income tax rate and ending with the 
class subject to the lowest rate. A net loss from all the classes of 
long-term capital gain and loss (beginning with the class subject to 
the highest Federal income tax rate and ending with the class subject 
to the lowest rate) offsets any net gain from the class of short-term 
capital gain and loss.
    (v) Carry forward of net capital gain or loss. If, at the end of a 
taxable year, a trust has, after the application of paragraph 
(d)(1)(iv), any net loss or any net gain that is not treated as 
distributed under paragraph (d)(1)(ii)(a)(2) of this section, the net 
gain or loss is carried over to succeeding taxable years and retains 
its character in succeeding taxable years as gain or loss from its 
particular class.
    (vi) Special transitional rules. To be eligible to be included in 
the class of qualified dividend income, dividends must meet the 
definition of section 1(h)(11) and must be received by the trust after 
December 31, 2002. Long-term capital gain or loss properly taken into 
account by the trust before January 1, 1997, is included in the class 
of all other long-term capital gains and losses. Long-term capital gain 
or loss properly taken into account by the trust on or after January 1, 
1997, and before May 7, 1997, if not treated as distributed in 1997, is 
included in the class of all other long-term capital gains and losses. 
Long-term capital gain or loss (other than 28-percent rate gain as 
defined in section 1(h)(4), unrecaptured section 1250 gain as defined 
in section 1(h)(6), and qualified 5-year gain as defined in section 
1(h)(9) prior to its amendment by the Jobs and Growth Tax Relief 
Reconciliation Act of 2003, Public Law 108-27 (117 Stat. 752)), 
properly taken into account by the trust on or after January 1, 2003, 
and before May 6, 2003, if not treated as distributed during 2003, is 
included in the class of all other long-term capital gains and losses. 
Qualified 5-year gain properly taken into account by the trust after 
December 31, 2000, and before May 6, 2003, if not treated as 
distributed by the trust in 2003 or a prior year, must be maintained in 
a separate class within the capital gains category.
    (vii) 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.
    (viii) Examples. The following examples illustrate the rules in 
this paragraph (d)(1):

    Example 1. (i) X, a charitable remainder annuity trust described 
in section 664(d)(1), is created on January 1, 2003. The annual 
annuity amount is $100. X's income for the 2003 tax year is as 
follows:


Interest income.................................................     $80
Qualified dividend income.......................................      50
Capital gains and losses........................................       0
Tax-exempt income...............................................       0
 


    (ii) In 2003, the year this income is received by the trust, 
qualified dividend income is subject to a different rate of

[[Page 65422]]

Federal income tax than interest income and is, therefore, a separate 
class of income in the ordinary income category. The annuity amount is 
deemed to be distributed from the classes within the ordinary income 
category, beginning with the class subject to the highest Federal 
income tax rate and ending with the class subject to the lowest rate. 
Because during 2003 qualified dividend income is taxed at a lower rate 
than interest income, the interest income is deemed distributed prior 
to the qualified dividend income. Therefore, in the hands of the 
recipient, the 2003 annuity amount has the following characteristics:


Interest income.................................................     $80
Qualified dividend income.......................................      20
 


    (iii) The remaining $30 of qualified dividend income that is not 
treated as distributed to the recipient in 2003 is carried forward to 
2004 as undistributed qualified dividend income.
    Example 2. (i) The facts are the same as in Example 1, and at 
the end of 2004, X has the following classes of income:


Interest income class...........................................      $5
Qualified dividend income class.................................      40
    ($10 from 2004 and $30 carried forward from 2003)
Net short-term capital gain class...............................      15
Net long-term capital loss in 28-percent rate class.............   (325)
Net long-term capital gain in unrecaptured section 1250 gain         175
 class..........................................................
Net long-term capital gain in all other long-term capital gain       350
 class..........................................................
 


    (ii) In 2004, gain in the unrecaptured section 1250 gain class is 
subject to a 25-percent Federal income tax rate, and gain in the all 
other long-term capital gain class is subject to a lower rate. The net 
long-term capital loss in the 28-percent rate class is used to offset 
the net capital gains in the other classes of long-term capital gain 
and loss, beginning with the class subject to the highest Federal 
income tax rate and ending with the class subject to the lowest rate. 
The $325 net loss in the 28-percent rate class reduces the $175 net 
gain in the unrecaptured section 1250 gain class to $0. The remaining 
$150 loss from the 28-percent rate class reduces the $350 gain in the 
all other long-term capital gain class to $200. As in Example 1, 
qualified dividend income is taxed at a lower rate than interest income 
during 2004. The annuity amount is deemed to be distributed from all 
the classes in the ordinary income category and then from the classes 
in the capital gains category, beginning with the class subject to the 
highest Federal income tax rate and ending with the class subject to 
the lowest rate. In the hands of the recipient, the 2004 annuity amount 
has the following characteristics:


Interest income.................................................      $5
Qualified dividend income.......................................      40
Net short-term capital gain.....................................      15
Net long-term capital gain in all other long-term capital gain        40
 class..........................................................
 


    (iii) The remaining $160 gain in the all other long-term capital 
gain class that is not treated as distributed to the recipient in 2004 
is carried forward to 2005 as gain in that same class.
    Example 3. (i) The facts are the same as in Examples 1 and 2, 
and at the end of 2005, X has the following classes of income:


Interest income class...........................................      $5
Qualified dividend income class.................................      20
Net short-term capital loss class...............................    (50)
Net long-term capital gain in 28-percent rate class.............      10
Net long-term capital gain in unrecaptured section 1250 gain         135
 class..........................................................
Net long-term capital gain in all other long-term capital gain       160
 class (carried forward from 2004)..............................
 


    (ii) Net short-term capital loss is used to offset the net capital 
gains in the classes of long-term capital gain and loss, in turn, until 
exhaustion of the class, beginning with the class subject to the 
highest Federal income tax rate and ending with the class subject to 
the lowest rate. The $50 net loss reduces the $10 net gain in the 28-
percent rate class to $0. The remaining $40 net loss reduces the $135 
net gain in the unrecaptured section 1250 gain class to $95. As in 
Examples 1 and 2, during 2005, qualified dividend income is taxed at a 
lower rate than interest income; gain in the unrecaptured section 1250 
gain class is taxed at 25-percent; and gain in the all other long-term 
capital gain class is taxed at a rate lower than 25-percent. The 
annuity amount is deemed to be distributed from all the classes in the 
ordinary income category and then from the classes in the capital gains 
category, beginning with the class subject to the highest Federal 
income tax rate and ending with the class subject to the lowest rate. 
In the hands of the recipient, the 2005 annuity amount has the 
following characteristics:


Interest income.................................................      $5
Qualified dividend income.......................................      20
Unrecaptured section 1250 gain..................................      75
 


    (iii) The remaining $20 gain in the unrecaptured section 1250 gain 
class and the $160 gain in the all other long-term capital gain class 
that are not treated as distributed to the recipient in 2005 are 
carried forward to 2006 as gains in their respective classes.

    (ix) Effective dates. The rules in this paragraph (d)(1) that 
require long-term capital gains to be distributed in the following 
order: first, 28-percent rate gain as defined in section 1(h)(4); 
second, unrecaptured section 1250 gain as described in section 1(h)(6); 
and then, all other long-term capital gains are applicable for taxable 
years ending on or after December 31, 1998. The rules in this paragraph 
(d)(1) that provide for the netting of capital gains and losses are 
applicable for taxable years ending on or after December 31, 1998. The 
rule in the second sentence of paragraph (d)(1)(vi) of this section is 
applicable for taxable years ending on or after December 31, 1998. The 
rule in the third sentence of paragraph (d)(1)(vi) of this section is 
applicable for distributions made in taxable years ending on or after 
December 31, 1998. All other provisions of paragraph (d)(1) are 
applicable for taxable years ending after November 20, 2003.
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 03-29042 Filed 11-19-03; 8:45 am]
BILLING CODE 4830-01-P