Teaching an Old Dog New Tricks: CRTs and UBTI

By Ted R. Batson, Jr., MBA, CPA, CFP, Senior Vice President Professional Services, Renaissance, Indianapolis, IN, and Member, AICPA Tax Division’s Trust, Estate & Gift Tax Technical Resource Panel’s Trust Accounting Income Task Force

Dec. 20, 2006 marked a unique day in the taxation of charitable remainder trusts (CRTs)— President Bush signed into law the Tax Relief and Health Care Act of 2006 (TRAHCA ’06). Buried in that legislation is revised Sec. 664(c), which significantly alters the tax treatment of unrelated business taxable income (UBTI) received by a CRT in tax years ending after 2006.

Old Law

Since 1969, CRTs have been tax-exempt under Sec. 664. This exemption was permitted as long as the CRT did not receive UBTI, as defined in Sec. 512.1 For CRTs, UBTI typically arises from ownership of an interest in a passthrough operating entity (e.g., a partnership or limited liability company (LLC)) or from unrelated debt-financed income generated from property subject to acquisition indebtedness.2.

If a CRT lost its tax exemption due to the receipt of UBTI, it was taxed under subchapter J as though it were a nonexempt complex trust.3 Sec. 661(a) permits a complex trust to claim a deduction for income distributed to income beneficiaries under the terms of the trust agreement. Thus, if all of the trust’s income was distributed, no tax would be due. The danger has always been that a CRT would receive UBTI in a year when it realized substantial gains from the sale of an appreciated asset—gains in excess of its distribution deduction. In the typical worst-case scenario, this convergence of events would occur in the year in which a substantially appreciated asset that had been contributed to the CRT was sold. The realized gain would then be subject to tax, thereby nullifying one of the significant tax benefits of creating and funding a CRT.

Example 1: On March 1, 2006, S funded a CRT with $500,000 of appreciated securities, with a $75,000 basis. T, a trustee, liquidated the securities on March 3, 2006 for $510,000, realizing a $435,000 long-term capital gain. T then invested 85% of the proceeds in a diversified portfolio of securities and 15% in a real estate investment partnership. During the year, T received $15,000 of dividends, interest and partnership distributions—all of which were distributable to S under the trust terms. At the end of the year, the Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., received from the partnership disclosed that the CRT’s allocable share of partnership income was $2,500, all of which was UBTI.

As a result of receiving the UBTI from the partnership, S’s CRT lost its exemption for 2006. T can take a deduction for all of the income distributed to S during the year; however, the $435,000 gain from the sale of the appreciated securities contributed to the trust is now taxable.

This treatment was upheld by the Tax Court in Newhall,4 in which in-come received from three different publicly traded limited partnerships was determined to be UBTI. As a result, all of the trust’s income (no matter its source) was subject to tax. The Ninth Circuit affirmed the Tax Court’s conclusion, even though the tax liability created was over three times the trust’s UBTI.

New Law

Revised Sec. 664(c) has radically altered UBTI treatment in a CRT. The trust will now pay an excise tax of 100% of the UBTI, rather than lose exempt status. Depending on the facts and circumstances, this may significantly affect the outcome; instead of potentially exposing all of the trust’s taxable income to tax, it is now possible that only a portion will be taxed.

Example 2:: The facts are the same as in Example 1. Under revised Sec. 664(c), only the $2,500 UBTI will be subject to tax. The tax is $2,500 (100% of the UBTI); this is still much better than a capital gain tax of $65,250 ($435,000 × 0.15).

New Opportunities?

Previously, gifts of partnership and LLC interests to a CRT might have been rejected without significant analysis. The new UBTI rules create opportunities to consider gifts of such interests, especially when an interest will be sold soon after it is contributed.

Example 3: J is the sole owner of W, an LLC (currently valued at $725,000) that has elected to be taxed as a partnership. J transfers her interest in W to a CRT. As an operating manufacturing concern, W’s passthrough income is UBTI to J’s CRT. Under prior Sec. 664(c), J’s CRT would have lost exempt status from its inception; thus, it would have received no capital gain deferral benefits on a subsequent sale of its W interest.

Under revised Sec. 664(c), it is possible that gain from the sale of W units (or, perhaps, even gain from the sale of W’s assets, as described below) will be excluded from the excise tax. Assuming that a small amount of income is allocated to J’s CRT while it is W’s partner, the excise tax on such income may be smaller than the capital gain tax on the sale of W units.

Additional Considerations

Despite the simplicity of revised Sec. 664(c), there are a number of additional considerations.

Principal and income allocations: Under most state principal and income statutes, reported UBTI is includible in trust accounting income if it is actually received in the form of cash. A trustee should examine the trust agreement and the applicable state principal and income act, to determine whether the excise tax should be paid from income or principal.

Reported UBTI exceeds cash distributed: It is not uncommon for a passthrough entity to report on a partner’s Schedule K-1 an amount of UBTI that exceeds the funds distributed; in such case, the CRT trustee would need to pay the excise tax from other sources. If the interest in the passthrough entity is the trust’s sole asset, the trustee must sell a portion of the interest or borrow the funds to pay the excise tax.

Four-tier allocations: An amount reported as UBTI is includible in its respective income tier within the unique four-tier accounting structure of CRTs—despite the fact that this amount is required to be paid out as excise tax. The UBTI will be carried out to the CRT income beneficiary, to be taxed at that beneficiary’s marginal income tax rate—which may be the highest current marginal rate, 35%. Thus, the UBTI is taxed twice—at both the trust and beneficiary levels—at a rate that exceeds 100%.

Fiduciary duty: Given the foregoing discussion, a trustee must consider carefully whether investing in a way that gives rise to UBTI violates his or her fiduciary duty to invest prudently. The trustee should also consider whether accepting a contribution of an asset that will inherently generate an obligation to pay the UBTI excise tax is prudent (e.g., accepting a gift of a partnership interest).

Passthrough entities and asset sales: When a passthrough entity sells its assets, the resulting gain or loss on the sale passes through to the entity’s partners for inclusion in their gross income. As a result, the contribution of an interest in a passthrough entity to a CRT will generally shelter the gain from the sale of the entity’s assets in much the same way as if the CRT had owned the assets outright.

However, there is a very important exception. When a passthrough entity’s assets are subject to Sec. 514 acquisition indebtedness, the sheltering effect of a CRT in the case of an asset sale is nullified. A portion of the gain on the sale of an asset subject to acquisition indebtedness is includible in the amount characterized as unrelated debt-financed income (UDFI), which is a form of UBTI. This taint persists in a diminishing fashion for 12 months after the acquisition indebtedness is removed.

Example 4:  P contributes a 50% interest in R Co., a partnership, to his CRT, with a $1.5 million fair market value (FMV). R’s assets include a building valued at $900,000 with a $150,000 adjusted basis that is subject to a $300,000 mortgage. A buyer has expressed an interest in purchasing R’s assets at FMV. On a sale of the building in an asset sale, one-third of the $750,000 gain (the ratio of the debt to FMV ($300,000/$900,000)) will be UDFI. The $250,000 UDFI will be subject to the 100% excise tax.

In TAM 9651001,5 the Service examined whether a CRT’s sale of a partnership interest, rather than the partnership’s assets, would produce a different result. The IRS concluded that it was more appropriate to consider a partnership as an aggregate of its partners, thereby effectively imputing the acquisition indebtedness to the partnership interest. It reached this conclusion despite the fact that, under the TAM’s facts, no debt was incurred to acquire the partnership interest.


If the assets of a passthrough entity are subject to a lien, a partner who seeks to contribute his or her interest to a CRT must not be personally liable for such debt. Transfer of the liability may be a prohibited act of self-dealing, cause the CRT to be treated as a grantor trust, and/or cause the subsequent sale of the underlying assets or passthrough entity interest to be subject to bargain-sale treatment.


The tax treatment of UBTI received by a CRT has changed significantly. Based on the facts and circumstances, application of the new 100% excise tax may operate to the benefit of some trusts and to the detriment of others. Trustees and their advisers must fully consider the costs arising from accepting a contribution of a UBTI-producing asset. In addition, it is not likely that the purchase of a UBTI-producing investment, which will subject the trust to the new excise tax and the beneficiary to income taxation on the same dollars, can be considered a prudent investment.


1 See Sec. 664(c) as it existed prior to amendment by TRAHCA ’06 Section 424(a).

2 See Sec. 514.

3 See Regs. Sec. 1.664-1(c).

4 Newhall Unitrust, 105 F3d 482 (9th Cir. 1997), aff’g 104 TC 236 (1995).

5 IRS Letter Ruling (TAM) 9651001 (12/20/96).

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