[Federal Register Volume 70, Number 50 (Wednesday, March 16, 2005)]
[Rules and Regulations]
[Pages 12793-12798]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-5110]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9190]
RIN 1545-AW35


Charitable Remainder Trusts; Application of Ordering Rule

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final regulations on the ordering rules 
of section 664(b) of the Internal Revenue Code for characterizing 
distributions from charitable remainder trusts (CRTs). The final 
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 final regulations provide guidance 
needed to comply with these changes and affect CRTs and their 
beneficiaries.

DATES: Effective Date: These regulations are effective March 16, 2005.
    Applicability Dates: For dates of applicability, see Sec.  1.664-
1(d)(1)(ix).

FOR FURTHER INFORMATION CONTACT: Theresa M. Melchiorre, (202) 622-7830 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to the Income Tax Regulations (26 
CFR part (1) under section 664(b) of the Internal Revenue Code. On 
November 20, 2003, the Treasury Department and the IRS published a 
notice of proposed rulemaking (REG-110896-98, 2003-2 C.B. 1226) in the 
Federal Register (68 FR 65419). The public hearing scheduled for March 
9, 2004, was cancelled because no requests to speak were received. 
Several written comments responding to the notice of proposed 
rulemaking were received. After consideration of the written comments, 
the proposed regulations are adopted as revised by this Treasury 
decision. The revisions and a summary of the comments are discussed 
below.
    The proposed regulations reflected changes made to income tax 
rates,

[[Page 12794]]

including the rates applicable to capital gains and certain dividends, 
by the Taxpayer Relief Act of 1997 (TRA), Public Law 105-34 (111 Stat. 
788), and the Jobs and Growth Tax Relief Reconciliation Act of 2003 
(JGTRRA), Public Law 108-27 (117 Stat. 752). These changes affect the 
ordering rules of section 664(b) for characterizing distributions from 
CRTs.
    Prior to the TRA, long-term capital gains were generally subject to 
the same Federal income tax rate. The TRA provided, however, that gain 
from certain types of long-term capital assets would be subject to 
different Federal income tax rates. Accordingly, after May 6, 1997, a 
CRT could have at least three classes of long-term capital gains and 
losses: a class for 28-percent gain (gains and losses from collectibles 
and section 1202 gains); a class for unrecaptured section 1250 gain 
(long-term gains not treated as ordinary income that would be treated 
as ordinary income if section 1250(b)(1) included all depreciation); 
and a class for all other long-term capital gain. In addition, the TRA 
provided that qualified 5-year gain (as defined in section 1(h)(9) 
prior to amendment by the JGTRRA) would be subject to reduced capital 
gains tax rates under certain circumstances for certain taxpayers. For 
taxpayers subject to a 10-percent capital gains tax rate, qualified 5-
year gain would be taxed at an 8-percent capital gains tax rate 
effective for taxable years beginning after December 31, 2000. For 
taxpayers subject to a 20-percent capital gains tax rate, qualified 5-
year gain would be taxed at an 18-percent capital gains tax rate 
provided the holding period for the property from which the gain was 
derived began after December 31, 2000. As a result, a CRT could also 
have a class for qualified 5-year gain.
    Prior to the JGTRRA, a CRT's ordinary income was generally subject 
to the same Federal income tax rate. The JGTRRA provided, however, that 
qualified dividend income as defined in section 1(h)(11) would be 
subject to the Federal income tax rate applicable to the class for all 
other long-term capital gain. As a result, after December 31, 2002, a 
CRT could have a qualified dividend income class that would be subject 
to a different Federal income tax rate than that applicable to the 
CRT's other types of ordinary income. In addition, the JGTRRA provided 
that qualified 5-year gain would cease to exist after May 5, 2003, but 
that it would return after December 31, 2008.
    In response to the changes made by the TRA and the technical 
corrections to the TRA made by the Internal Revenue Service 
Restructuring and Reform Act of 1998, Public Law 105-206 (112 Stat. 
685), the IRS issued guidance on the treatment of capital gains under 
section 664(b)(2) in Notice 98-20 (1998-1 C.B. 776), as modified by 
Notice 99-17 (1999-1 C.B. 871). The proposed regulations incorporated 
the guidance provided in Notice 98-20 and Notice 99-17. In addition, 
the proposed regulations provided additional guidance on the treatment 
of qualified dividend income under section 664(b)(1) and the treatment 
of a class of income that temporarily ceases to exist, like the 
qualified 5-year gain class.

Explanation of Provisions

    The proposed regulations provided that trusts must maintain 
separate classes within a category of income when two classes are only 
temporarily subject to the same tax rate (for example, if the current 
tax rate applicable to one class sunsets in a future year). In the 
preamble to the proposed regulations, comments were requested on the 
degree of administrative burden and potential tax benefit or detriment 
of this requirement. Only one comment was received in response to this 
request. The commentator pointed out that maintaining a class during a 
temporary period of suspension could be favorable to taxpayers in one 
situation and unfavorable in another. For example, maintaining the 
qualified 5-year gain class during a temporary period of suspension 
would be advantageous because when the class is again in existence, 
gain distributed from the class probably would be taxed at a rate lower 
than the rates applicable to other classes of long-term capital gain. 
On the other hand, if the 28-percent long-term capital gain class is 
taxed at 15 percent during a temporary period, gain distributed from 
that class after the expiration of that temporary period is likely to 
be taxed at a rate higher than the rates applicable to other classes of 
long-term capital gain.
    The IRS and Treasury Department continue to believe that it is 
appropriate for CRTs to maintain separate classes for income only 
temporarily taxed at the same rate, and no comment received indicated 
that this requirement would be unduly burdensome. Therefore, this 
requirement remains unchanged in the final regulations.
    The proposed regulations provided that, to be eligible for 
inclusion 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. Several commentators suggested that the 
final regulations should provide that undistributed dividends received 
by a CRT prior to January 1, 2003, that would otherwise meet the 
definition of qualified dividends under section 1(h)(11), be treated as 
qualified dividends.
    Subsequent to the issuance of the proposed regulations, a technical 
correction was made to the JGTRRA by the Working Families Tax Relief 
Act of 2004, Public Law 108-311 (118 Stat. 1166), to provide that 
dividends received by a trust on or before December 31, 2002, shall not 
be treated as qualified dividend income as defined in section 1(h)(11). 
Accordingly, this suggestion has not been adopted in the final 
regulations.
    The proposed regulations provided that, in netting capital gains 
and losses, a net short-term capital loss is first netted against the 
net long-term capital gain in each class before the long-term capital 
gains and losses in each class are netted against each other. One 
commentator suggested that this netting rule be revised to provide that 
the gains and losses of the long-term capital gain classes be netted 
prior to netting short-term capital loss against any class of long-term 
capital gain.
    The IRS and Treasury Department believe that the netting rules for 
CRTs should be consistent with the netting rules applicable generally 
to other noncorporate taxpayers. Accordingly, the final regulations 
adopt this suggested change.
    The proposed regulations provided that items of income 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 CRT. One commentator suggested that the assignment 
of items of income to different classes in the year the items are 
required to be taken into account by the CRT should be based on the 
Federal income tax rate that is likely to apply to that item in the 
hands of the recipient (for example, depending on the recipient's 
marginal income tax rate bracket) in the year in which the item is 
distributed.
    The final regulations do not adopt this change. It is not feasible 
in many instances for trustees to determine the tax bracket of 
beneficiaries. The IRS and Treasury Department believe that the 
assignment of an item to a particular class should be based upon the 
tax rate applicable to each class when the item is received by the CRT, 
and not the various tax rates applicable to the classes at the time of 
a distribution to the beneficiary.

[[Page 12795]]

    The proposed regulations provided that the determination of the tax 
character of amounts distributed by a CRT shall be made as of the end 
of the taxable year of the CRT. One commentator recommended that the 
language in the proposed regulations be reworded to make it clear that 
this rule applies to all distributions made by the CRT to recipients 
throughout the calendar year. In response to the comment, the second 
sentence in Sec.  1.664-1(d)(1)(ii)(a) is revised in the final 
regulations to read, ``[t]he determination of the character of amounts 
distributed or deemed distributed at any time during the taxable year 
of the trust shall be made as of the end of that taxable year.''
    The proposed regulations provided that the annuity or unitrust 
recipient is taxed on the distribution from the CRT based on the tax 
rates applicable in the year of the distribution to the classes of 
income that are deemed distributed from the trust. One commentator 
suggested that the language in the proposed regulations be reworded to 
make it clear that the tax rates applicable to a distribution or deemed 
distribution from a CRT to a recipient are the tax rates applicable to 
the classes of income from which the distribution is derived in the 
year of distribution, and not the tax rates applicable to the income in 
the year it is received by the CRT. This suggestion has been adopted. 
In the final regulations, the third sentence in Sec.  1.664-
1(d)(1)(ii)(a) is revised to read as follows:

    The tax rate or rates to be used in computing the recipient's 
tax on the distribution shall be the tax rates that are applicable, 
in the year in which the distribution is required to be made, to the 
classes of income deemed to make up that distribution, and not the 
tax rates that are applicable to those classes of income in the year 
the income is received by the trust.

    One commentator suggested that a cross-reference to Sec.  1.664-
1(d)(4) should be made following the above sentence. This suggestion 
has not been adopted because the IRS and Treasury Department do not 
believe that a cross reference is needed. Section 1.664-1(d)(1)(ii)(a) 
confirms that a class of income will be taxed to the beneficiary at the 
tax rate applicable to that class in the year the distribution is made. 
Section 1.664-1(d)(4) identifies the year of the distribution.
    One commentator proposed that the final regulations specifically 
address the treatment of municipal bond income and the effect of the 
alternative minimum tax (AMT) provisions and section 469 on CRT income. 
The final regulations do not address these issues, because the IRS and 
Treasury Department believe they are beyond the scope of these 
regulations. These regulations are intended to address only the income 
tax rates applicable to classes of income and the order in which those 
classes of income are to be applied to determine the character of a 
distribution in the hands of a recipient. The issues raised by the 
commentator are more appropriately addressed in separate guidance.
    One commentator requested clarification of whether the ordering 
rules in the proposed regulations apply to a CRT that has lost its tax-
exempt status under section 664(c) in the year income is distributed. 
Section 1.664-1(d)(1)(ii) of the proposed regulations provides that the 
categories and classes of income determined under Sec.  1.664-
1(d)(1)(i) 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 final regulations retain 
this provision.
    One commentator recommended that the IRS provide a detailed 
worksheet that would include all of the possible classes of income a 
CRT could have so that the trustees can track a CRT's income from year 
to year. Because the types of income that each CRT may have can vary 
widely, the IRS and Treasury Department have determined that such a 
worksheet is not administratively feasible at this time.
    One commentator recommended that a provision similar to Sec.  
1.664-1(d)(4)(ii) be added to the final regulations to permit the 
trustee to make corrections when the trustee has made incorrect 
distributions as a result of mistakes in fiduciary accounting 
practices, suggesting that such a provision would allow the CRT to 
receive the benefit of any correction in the year during which the 
correction is made. The IRS and Treasury Department believe that the 
proper method to remedy such errors is the filing of amended returns, 
rather than a current year adjustment and, therefore, such a provision 
is not included in the final regulations.
    One commentator requested that examples addressing the following 
situations be provided in the final regulations:
    Situation 1. The end result of a short-term capital loss and a 
combination of long-term capital gains and losses that net to a long-
term capital loss;
    Situation 2. The end result when a class of income has a net-loss 
amount that is carried forward without affecting the tax character of 
distributions;
    Situation 3. The applicability of the passive loss rules under 
section 469 to the ordering rules of section 664(b);
    Situation 4. The applicability of the alternative minimum tax (AMT) 
provisions under section 55 to the ordering rules under section 664(b); 
and
    Situation 5. The treatment of the distribution of qualified 5-year 
gain between January 1, 2004, and December 31, 2008.
    In response to this request, Examples 4 and 5 have been added to 
the final regulations. Example 4 addresses situations 1 and 2. Example 
5 addresses situation 5. Examples will not be added to address 
situations 3 and 4 because they involve issues beyond the scope of 
these final regulations.

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 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. Pursuant to section 7805(f) of the Internal 
Revenue Code, the notice of proposed rulemaking preceding this 
regulation 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 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.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority for part 1 continues to read in part as 
follows:

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

0
Par. 2. Section 1.664-1 is amended as follows:
0
1. Paragraph (d)(1) is revised.
0
2. Paragraph (d)(2) is amended by:
0
a. Removing the language ``or to corpus (determined under subparagraph 
(1)(i) of

[[Page 12796]]

this paragraph)'' in the first sentence and adding ``(determined under 
paragraph (d)(1)(i)(a) of this section) or to corpus'' in its place.
0
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.
0
c. Removing the language ``or to 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.

0
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 at 
the trust level. (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, 
for a trust with a taxable year ending December 31, 2004, 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, 
and the capital gains category may include separate classes for short-
term and long-term capital gains and losses, such as a short-term 
capital gain class, a 28-percent long-term capital gain class (gains 
and losses from collectibles and section 1202 gains), an unrecaptured 
section 1250 long-term capital gain class (long-term gains not treated 
as ordinary income that would be treated as ordinary income if section 
1250(b)(1) included all depreciation), a qualified 5-year long-term 
capital gain class as defined in section 1(h)(9) prior to amendment by 
the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), 
Public Law 108-27 (117 Stat. 752), and an all other long-term capital 
gain class. 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 to the recipient 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 
or deemed distributed at any time during the taxable year of the trust 
shall be made as of the end of that taxable year. The tax rate or rates 
to be used in computing the recipient's tax on the distribution shall 
be the tax rates that are applicable, in the year in which the 
distribution is required to be made, to the classes of income deemed to 
make up that distribution, and not the tax rates that are applicable to 
those classes of income in the year the income is received by the 
trust. The character of the distribution in the hands of the annuity or 
unitrust recipient is determined by treating the distribution 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 at the trust level--(a) Ordinary income 
category. A net 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 and retains its class assignment. For purposes of this 
section, the amount of current income and prior years' undistributed 
income shall be computed

[[Page 12797]]

without regard to the deduction for net operating losses provided by 
section 172 or 642(d).
    (b) Other income category. A net 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 at the trust level. 
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. First, 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. Second, either--
    (a) 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) is used 
to offset any net gain from the class of short-term capital gain and 
loss; or
    (b) A net loss from the class of short-term capital gain and loss 
is used to offset any 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.
    (v) Carry forward of net capital gain or loss by the trust. If, at 
the end of a taxable year, a trust has, after the application of 
paragraph (d)(1)(iv) of this section, 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 gain (gains and 
losses from collectibles and section 1202 gains), unrecaptured section 
1250 gain (long-term gains not treated as ordinary income that would be 
treated as ordinary income if section 1250(b)(1) included all 
depreciation), and qualified 5-year gain as defined in section 1(h)(9) 
prior to amendment by JGTRRA), properly taken into account by the trust 
before January 1, 2003, and distributed during 2003 is treated as if it 
were properly taken into account by the trust after May 5, 2003. Long-
term capital gain or loss (other than 28-percent gain, unrecaptured 
section 1250 gain, and qualified 5-year gain), 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 gain. 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 until distributed. Qualified 5-year gain 
properly taken into account by the trust before January 1, 2003, and 
deemed distributed during 2003 is subject to the same current tax rate 
as deemed distributions from the class of all other long-term capital 
gain realized by the trust after May 5, 2003. Qualified 5-year gain 
properly taken into account by the trust on or after January 1, 2003, 
and before May 6, 2003, if treated as distributed by the trust in 2003, 
is subject to the tax rate in effect prior to the amendment of section 
1(h)(9) by JGTRRA.
    (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 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 ($10 from 2004 and $30 carried        40
 forward from 2003).............................................
Net short-term capital gain class...............................      15
Net long-term capital loss in 28-percent 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 gain 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 gain class 
reduces the $175 net gain in the unrecaptured section 1250 gain 
class to $0. The remaining $150 loss from the 28-percent gain 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

[[Page 12798]]

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.......................................      20
Net loss in short-term capital gain class.......................    (50)
Net long-term capital gain in 28-percent gain 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) There are no long-term capital losses to net against the 
long-term capital gains. Thus, the 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 short-term loss reduces the $10 net gain in the 28-percent gain 
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. Therefore, 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.
    Example 4. (i) The facts are the same as in Examples 1, 2 and 3, 
and at the end of 2006, X has the following classes of income:

Interest income class...........................................    $ 95
Qualified dividend income class.................................      10
Net loss in short-term capital gain class.......................    (20)
Net long-term capital loss in 28-percent gain class.............   (350)
Net long-term capital gain in unrecaptured section 1250 gain          20
 class (carried forward from 2005)..............................
Net long-term capital gain in all other long-term capital gain       160
 class (carried forward from 2005)..............................
 

    (ii) A net long-term capital loss in one class is used to offset 
the net capital gains in the other 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 $350 net loss in the 28-
percent gain class reduces the $20 net gain in the unrecaptured 
section 1250 gain class to $0. The remaining $330 net loss reduces 
the $160 net gain in the all other long-term capital gain class to 
$0. As in Examples 1, 2 and 3, during 2006, qualified dividend 
income is taxed at a lower rate than interest income. 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 2006 annuity amount 
has the following characteristics:

Interest income.................................................    $ 95
Qualified dividend income.......................................       5
 

    (iii) The remaining $5 of qualified dividend income that is not 
treated as distributed to the recipient in 2006 is carried forward 
to 2007 as qualified dividend income. The $20 net loss in the short-
term capital gain class and the $170 net loss in the 28-percent gain 
class are carried forward to 2007 as net losses in their respective 
classes.
    Example 5. (i) X, a charitable remainder annuity trust described 
in section 664(d)(1), is created on January 1, 2002. The annual 
annuity amount is $100. Except for qualified 5-year gain of $200 
realized before May 6, 2003, but not distributed, X has no other 
gains or losses carried over from former years. X's income for the 
2007 tax year is as follows:

Interest income class...........................................    $ 10
Net gain in short-term capital gain class.......................       5
Net long-term capital gain in 28-percent gain class.............       5
Net long-term capital gain in unrecaptured section 1250 gain          10
 class..........................................................
Net long-term capital gain in all other long-term capital gain        10
 class..........................................................
 

    (ii) 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 2007, gains distributed to a recipient from both 
the qualified 5-year gain class and the all other long-term capital 
gains class are taxed at a 15/5 percent tax rate. Since after 
December 31, 2008, gains distributed from the qualified 5-year gain 
class will be taxed at a lower rate than gains distributed from the 
other classes of long-term capital gain and loss, distributions from 
the qualified 5-year gain class are made after distributions from 
the other classes of long-term capital gain and loss. In the hands 
of the recipient, the 2007 annuity amount has the following 
characteristics:

Interest income.................................................     $10
Short-term capital gain.........................................       5
28-percent gain.................................................       5
Unrecaptured section 1250 gain..................................      10
All other long-term capital gain................................      10
Qualified 5-year gain (taxed as all other long-term capital           60
 gain)..........................................................
 

    (iii) The remaining $140 of qualified 5-year gain that is not 
treated as distributed to the recipient in 2007 is carried forward 
to 2008 as qualified 5-year gain.

    (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 gain (gains and losses from collectibles and 
section 1202 gains); second, unrecaptured section 1250 gain (long-term 
gains not treated as ordinary income that would be treated as ordinary 
income if section 1250(b)(1) included all depreciation); 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 this paragraph (d)(1) are applicable for 
taxable years ending after November 20, 2003.
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: March 10, 2005.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury.
[FR Doc. 05-5110 Filed 3-15-05; 8:45 am]
BILLING CODE 4830-01-P