Payment of Annuity with Appreciated Property by Grantor Charitable Lead Annuity Trust

By Frances Schafer, J.D., Washington, DC

Editor: Greg A. Fairbanks, J.D., LL.M.

Taxpayers often are interested in using excess assets to benefit their own philanthropic interests as well as those of their family members. Split-interest trusts, in which charitable and noncharitable beneficiaries have interests, can accomplish both purposes. Three types of split-interest trusts are sanctioned by the Internal Revenue Code, so the interest passing to the charitable organizations qualifies for the charitable deduction for income, gift, and/or estate tax purposes—charitable remainder trusts, pooled income funds, and charitable lead trusts. With charitable remainder trusts and pooled income funds, the noncharitable beneficiaries receive the lead interests and the charities receive the remainder interests. Charitable lead trusts (CLTs) are the reverse of these trusts because the charities receive the lead interests and the noncharitable beneficiaries receive the remainder interests.

In a CLT, an annuity or unitrust payment is made annually to charity for the term of the trust. At the end of the trust term, the assets in the trust pass to individuals designated by the grantor. The remainder beneficiaries are usually the grantor’s family members or trusts established for the benefit of family members.

Most frequently taxpayers who set up CLTs provide that the charity will receive an annuity rather than a unitrust amount. The amount of the annuity, which must be established in the governing instrument, is usually either a stated sum of money or based on a stated percentage of the fair market value of the trust assets as of the date they are transferred to the trust. As a result, the amount required to be paid does not fluctuate with the value of the trust corpus or the amount of income generated by the trust. In contrast, the unitrust amount is a fixed percentage of the fair market value of the trust assets determined annually, so the amount paid each year fluctuates with the value of the trust assets. By using an annuity amount, the grantor is able to know exactly what will be paid to charity, and any appreciation in the value of the assets in excess of the discount rate used to determine the present value of the charitable interest will inure solely to the benefit of the named noncharitable beneficiaries.

A charitable lead annuity trust (CLAT) may be established as an inter vivos trust during the grantor’s life or as a testamentary trust that is created upon the grantor’s death. A CLAT set up during the grantor’s life can be established as either a grantor trust (grantor CLAT) or a nongrantor trust (nongrantor CLAT). Whether the trust is a grantor or nongrantor trust affects whether the grantor is entitled to an income tax charitable deduction upon the creation of the trust, but for both types of trusts the grantor is entitled to a gift tax charitable deduction for the present value of the annuity interest payable to charity. A testamentary CLAT is obviously a nongrantor trust, and the grantor’s estate is entitled to an estate tax charitable deduction for the present value of the charitable lead interest.

The amount of the annuity can be set at a level so that the present value of the annuity payments equals the value of the property transferred to the trust. In this situation, the remainder interest passing to the grantor’s beneficiaries has an initial value of zero. For an inter vivos trust, the taxable gift for gift tax purposes is zero. If the property in the trust has a return greater than the discount rate used to value the charitable interest, any assets remaining in the trust pass to the grantor’s beneficiaries free of any transfer taxes. For example, the Sec. 7520 rate for December 2009 is 3.2%. If the assets in a trust using that rate to value the charitable interest have a total return greater than 3.2% per annum over the term of the trust, there will be assets in the trust upon termination. Those assets will pass to the grantor’s beneficiaries free of gift tax and, if structured properly, free of estate tax.

If the trust is a nongrantor CLAT, the grantor receives no charitable deduction for income tax purposes upon the creation of the trust. The trust is a taxable trust, but in computing its taxable income the trust is entitled to a charitable deduction under Sec. 642(c) for the amounts of gross income paid to charity as part of the annuity payment.

Frequently the grantor will transfer appreciated assets to the CLAT. The nongrantor CLAT’s basis in those assets is generally the same as the grantor’s basis (see Sec. 1015(a)). Some of the appreciated assets may be sold each year to fund the charitable annuity payments. In that case, the nongrantor CLAT will recognize gain on the sale of the appreciated assets but will be entitled to an income tax charitable deduction under Sec. 642(c) for the amount of the income, including capital gain, that is paid to charity.

If instead of selling the appreciated assets the nongrantor CLAT transfers them in kind to the charity in satisfaction of the charity’s right to the annual annuity payment, a similar tax result occurs. Rev. Rul. 83-75 provides that a distribution by a nongrantor CLAT of appreciated securities in satisfaction of the trust’s obligation to pay a fixed annuity to charity is a sale or exchange of the securities that results in taxable gain to the trust.

Some different income tax rules apply to a CLAT that is structured so that the grantor is treated as the owner of the entire trust under subpart E, part I of subchapter J, chapter 1, subtitle A (Secs. 671–679). The grantor of a grantor CLAT is entitled to an income tax charitable deduction for the present value of the charitable interest under Sec. 170(f)(2)(B). But because the trust is a grantor trust, the grantor must include the trust’s income in his or her income during the charitable term. If the grantor CLAT sells appreciated assets to fund the annuity payment, the grantor would include in his or her income the gain resulting from the sale of these assets as well as any other trust income. Some have questioned whether a different result would be available if, instead of selling the securities, they were transferred in kind to the charitable organization in satisfaction of the annuity payment.

The IRS purports to answer that question in Letter Ruling 200920031. In that ruling, the taxpayer asked the IRS to conclude that the satisfaction of the annuity payment by a transfer to charity of appreciated marketable securities does not trigger gain or loss to the grantor or the trust under the rationale of Rev. Rul. 55-410. That revenue ruling provides that the satisfaction of a mere pledge to charity with property that has either appreciated or depreciated does not give rise to a taxable gain or a deductible loss. Under the rationale of Rev. Rul. 55-410, a mere charitable pledge does not give rise to a charitable deduction until the pledge is satisfied, so it would be inconsistent with this treatment to require taxation that ordinarily applies when appreciated or depreciated property is used to satisfy a debt.

In the letter ruling, the IRS reasoned that Rev. Rul. 55-410 is not applicable because upon the creation of the trust the charity has a claim against the CLAT’s assets that is satisfied by the transfer of appreciated securities and because there are no income tax consequences on the creation of a pledge agreement as there are upon the creation of a grantor CLAT. The IRS therefore concluded that the grantor recognizes gain when appreciated securities are transferred from a grantor CLAT to charity to make the annuity payment. The IRS cited as authority for its conclusion Kenan, 114 F.2d 717 (2d Cir. 1940), and Rev. Rul. 83-75, both involving taxable trusts that were not grantor trusts, and Rev. Proc. 2007-45, which is the only citation involving a grantor trust.

Rev. Proc. 2007-45 contains sample trust documents that meet the requirements for an inter vivos CLAT. In the annotations addressing nongrantor CLATs, the statement is made that if the trustee distributes appreciated property in satisfaction of the required annuity payment, the trust will realize capital gain on the assets distributed to satisfy part or all of the annuity payment. Rev. Rul. 83-75 is cited as authority for that statement (see Section 5.02(2) of Rev. Proc. 2007-45). In the annotations addressing grantor CLATs, a similar statement is made to the effect that the donor will realize capital gain on the assets distributed to satisfy the annuity payment. There is no citation to authority for this statement (see Section 8.02(2) of Rev. Proc. 2007-45).

Revenue procedures do not interpret how the Code applies to a particular factual situation. That is the role of revenue rulings, which set forth the IRS’s interpretation of the Code to particular factual situations. Rather, revenue procedures set forth procedures that affect the rights or duties of taxpayers under the Code (see Regs. Sec. 601.601(d)(2) (i) for the distinction between revenue rulings and revenue procedures). Normally an IRS legal position is not stated in a revenue procedure without an authoritative citation. The fact that Rev. Proc. 2007-45 states that the donor of a grantor CLAT will be taxable on the gain on appreciated assets transferred to charity does not give that position the weight of one published in a revenue ruling. In the letter ruling, the IRS is trying to bootstrap its answer by using the statement in a revenue procedure, for which there is no cited authority.

Conspicuously absent from the discussion in the letter ruling is any mention of Rev. Rul. 85-13, which holds that the grantor of a grantor trust is treated as the owner of the assets in the trust. Historically, the grantor trust rules became part of the Code in an effort to penalize taxpayers who placed assets in a trust intended to be a separate taxable entity but retained sufficient control over those assets that the Congress believed the grantor should continue to be taxed on the income generated by those assets. Taxpayers, however, in many situations have turned the tables on the IRS and used the grantor trust provisions to their advantage, as opposed to the intended detriment of those provisions.

The IRS’s position that the grantor trust rules require the grantor to be treated as the owner of the assets in the trust is set forth in Rev. Rul. 85-13, a relatively recent pronouncement in light of the age of the statutory grantor trust provisions. Once again this pronouncement was to stop a perceived loophole. In Rothstein, 735 F.2d 704 (2d Cir. 1984), the Second Circuit upheld the concept that the grantor and the grantor trust have separate identities for transactional purposes. In that case the grantor sold to a third party assets that he had purchased from his wholly owned grantor trust. The taxpayer was successful in arguing that he had a loss on the sale resulting from the cost basis that he acquired when he purchased the assets from the trust. The IRS had argued that there could be no sale transaction between a grantor and his grantor trust and that the grantor must therefore use his original basis in the assets, resulting in a substantial gain on their sale.

After that loss the IRS published Rev. Rul. 85-13 to announce its disagreement with the court’s decision and to set forth the rule that the grantor is treated as the owner of the assets in the grantor trust. This theory has spawned myriad situations in which taxpayers have used this theory to their advantage, including the use of intentionally defective grantor trusts to sell appreciated assets to grantor trusts without recognizing any gain. As noted by Martin D. Ginsburg, “every stick crafted to beat on the head of a taxpayer will metamorphose sooner or later into a large green snake and bite the commissioner on the hind part” (Ginsburg, “Making Tax Law Through the Judicial Process,” 70 A.B.A.J. 74, 76 (March 1984)).

The issue arising with the grantor CLATs may well be another situation in which Rev. Rul. 85-13 creates a tax result that the IRS may not have intended. Under Rev. Rul. 85-13, the grantor of a grantor CLAT is treated as the owner of the assets in the CLAT. Thus, the transfer of some of those assets to charity should be treated as a transfer made directly from the grantor to the charity. An individual does not recognize gain when the individual transfers appreciated property directly to charity unless there is a bargain sale element to the transfer. As long as the grantor is treated as owning the assets in the grantor CLAT, the grantor for federal income tax purposes has merely promised to transfer them, or assets that they are converted into, at points of time in the future. This is an identical situation to Rev. Rul. 55-410, except for the fact that by statute the donor has received an accelerated charitable deduction.

If the IRS wishes to advance the position set forth in the letter ruling, it should do so in published guidance such as a revenue ruling, which would at least establish the IRS’s position. Such guidance would have to address the application of Rev. Rul. 85-13 and explain why the grantor is not treated as transferring the assets directly from the grantor to charity in satisfaction of a pledge. It should be pointed out that while revenue rulings are not binding on taxpayers or the courts, the IRS is bound to follow its revenue rulings in Tax Court proceedings, and indeed the Tax Court on several occasions has treated revenue rulings as concessions by the IRS where they are relevant to the facts before the court (see Rauenhorst, 119 T.C. 157 (2002)). Currently Rev. Ruls. 85-13 and 55-410 appear to stand for the proposition that the grantor of a grantor CLAT is treated as transferring the assets directly to charity, and as a result no gain or loss is triggered upon the transfer.


EditorNotes

Greg Fairbanks is a tax manager with Grant Thornton LLP in Washington, DC.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or greg.fairbanks@gt.com

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