Thursday, April 25, 2024
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GiftLaw Note: The taxpayers requested guidance on the federal income tax consequences of establishing a charitable remainder unitrust and contributing qualified replacement property (QRP) to the charitable trust. The donors sold shares of their closely held corporation stock to an employee stock ownership program (ESOP). The proceeds from the stock sale were reinvested in QRP as provided under Sec. 1042 of the Code. A portion of the QRP was transferred to the charitable trust. The Service ruled that no gain would be realized on the transfer of the QRP to the charitable trust. Accordingly, contributing of the QRP to the charitable trust would not cause a recapture of the gain deferred on the sale to the ESOP.
This responds to the letter, dated January 10, 1997, submitted on your behalf by your authorized representative regarding the federal income tax consequences of the establishment of a trust and the contribution to the trust of "qualified replacement property" (QRP), as defined in section 1042(c)(4) of the Internal Revenue Code of 1986 (Code).

Taxpayers A and B (collectively, the "Taxpayers") are husband and wife, respectively. Taxpayer A is an officer and director of the Corporation. The Taxpayers owned W shares of the Corporation's common stock out of the X shares of common stock outstanding. The Taxpayers' basis in the common stock of the Corporation was approximately $X.

On or about October 3, 1993, the Corporation duly established the ESOP, an employee stock ownership plan described in section 4975(e)(7) of the Code. The ESOP received a favorable determination letter from the District Director of the X Key District in September 1994.

On or about November 22, 1993, the Taxpayers sold Y shares of their common stock of the Corporation to the ESOP for $Y. Subsequently, on or about November 15, 1994, the Taxpayers sold an additional Z shares of their common stock of the Corporation to the ESOP for $Z. However, simultaneous with each sale of Corporation common stock, another shareholder of the Corporation sold an equal number of his shares of stock of the Corporation to the ESOP. As a result of each sale, the Taxpayers realized a gain because the amount of proceeds they received exceeded the adjusted basis of their stock. Accordingly, the Taxpayers represent that they have reinvested the proceeds from sale in QRP, as defined in section 1042(c)(4), within the "replacement period" of section 1042(c)(3) of the Code. Furthermore, the Taxpayers represent that they properly elected to defer the gain from each sale under Section 1042(a) of the Code.

The Taxpayers now intend to establish a charitable remainder unitrust (the "Trust"), reserving for themselves a unitrust interest and naming an organization described in sections 170(c) and 501(c)(3) of the Code as the recipient of the remainder interest. The Taxpayers propose to contribute a portion of the QRP to the Trust. The Taxpayers represent that the Trust will substantially follow the form of the model trust set forth in section 6 of Rev. Proc. 90-31, 1990-1 C.B. 539 (i.e., Sample Inter Vivos Charitable Remainder Unitrust: Two Lives, Concurrent and Consecutive Interests). The trustee of the Trust will neither be under any obligation, express or implied, to sell the QRP, nor can the trustee be legally bound to sell the QRP. In addition, the Trust will be valid under local law.

You have requested a ruling that the contribution of QRP to the charitable remainder unitrust will not cause a recapture of gain under section 1042(e) of the Code.

Under section 1042(a) of the Code, a taxpayer or executor may elect in certain cases not to recognize long-term capital gain on the sale of "qualified securities" to an ESOP (as defined in section 4975(e)(7)) or eligible worker owned cooperative if the taxpayer purchases "qualified replacement property" (as defined in section 1042(c)(4)) within the replacement period of section 1042(c)(3) and the requirements of section 1042(b) and Section 1.1042-1T of the Temporary Income Tax Regulations are satisfied.

Section 1.1042-1T of the Temporary Income Tax Regulations provides that sales of qualified securities by two or more taxpayers may be treated as a single sale if such sales are made as part of a single, integrated transaction under a prearranged agreement between the taxpayers. See Q&A-2(b).

Section 1042(d) of the Code provides that a taxpayer's basis in QRP purchased during the qualified replacement period will be reduced by the amount of gain not recognized by reason of the application of section 1042(a). If more than one item of QRP is purchased, the basis of each item of QRP shall be reduced by an amount determined by multiplying the total gain not recognized by reason of the application of section 1042(a) by a fraction: the numerator of which is the cost of such item of QRP, and the denominator of which is the total cost of all items of such property.

Since you have not requested a ruling concerning whether the taxpayer has satisfied the requirements of section 1042 of the Code, we express no opinion on this issue. In addition, for purposes of this ruling request we will assume that the property purchased by the Taxpayers is qualified replacement property as defined in section 1042(c)(4) and that section 1042(e) applies to such property.

Section 1042(e)(1) of the Code provides that "if a taxpayer disposes of any qualified replacement property, then, notwithstanding any other provision of this title, gain (if any) shall be recognized to the extent of the gain which was not recognized under subsection (a) by reason of the acquisition by such taxpayer of such qualified replacement property."

The legislative history of section 1042(e) indicates that it was added as part of the Tax Reform Act of 1986 to coordinate the requirement that deferred gain be recognized on the disposition of any QRP with other nonrecognition provisions of the Code. "Effective for dispositions made after the date of enactment, the Act overrides all other provisions permitting nonrecognition and requires that gain realized upon the disposition of qualified replacement property be recognized at that time." S. Rep. 99-313, 99th Cong., 2nd Sess., 1032 (1986), 1986-3 C.B., v. 3, 1032. Thus, gain realized from the disposition of any QRP by a taxpayer who made an election under section 1042 must be recognized at the time of the disposition regardless of any other nonrecognition provisions of the Code that may otherwise have applied. However, limited exceptions to this rule are provided in section 1042(e)(3).

Section 1042(e)(3) provides that the recapture rules of section 1042(e)(1) shall not apply to any transfer of qualified replacement property that occurs: (1) in any reorganization (within the meaning of section 368) unless the person making the election under section 1042(a)(1) owns stock representing control of the acquiring or acquired corporation and such property is substituted basis property in the hands of the transferee; (2) by reason of the death of the person making the election; (3) by gift; or (4) in any transaction to which section 1042(a) applies. Neither the statute nor the Temporary Income Tax Regulations define the term "gift" for purposes of section 1042(e)(3).

Section 664 of the Code provides rules for the creation and operation of charitable remainder unitrusts. Section 664(d)(2) defines a charitable remainder unitrust as a trust: (1) from which a fixed percentage (which is not less than 5 percent) of the net fair market value of its assets, valued annually, is to be paid, not less often than annually, to one or more persons (at least one of which is not an organization described in section 170(c) and, in the case of individuals, only to an individual who is living at the time of the creation of the trust) for a term of years (not in excess of 20 years) or for the life or lives of such individual or individuals; (2) from which no amount other than the payments described above may be paid to or for the use of any person other than an organization described in section 170(c); and (3) from which, following the termination of the payments described above, the remainder interest in the trust is to be transferred to, or for the use of, an organization described in section 170(c) or retained by the trust for such a use.

Rev. Proc. 90-31, supra, provides that if a taxpayer makes a transfer to a trust that substantially follows one of the sample forms of trust contained in the revenue procedure, the Service will recognize the trust as meeting all of the requirements of a charitable remainder unitrust, provided that the trust operates in a manner consistent with the terms of the instrument creating the trust and provided that the trust is valid under applicable local law.

In the present case, the transfer of the QRP to the charitable remainder unitrust constitutes a disposition of such property within the meaning of section 1042(e) of the Code. However, under the facts of the present case, no gain is realized by the Taxpayers on the transfer of QRP to the charitable remainder unitrust. Therefore, provided that the Trust satisfies the requirements of section 664 and accompanying Treasury regulations and that the Trust substantially follows the form of the model trust set forth in section 6 of Rev. Proc. 90-31, supra, we conclude that the contribution of the QRP to the charitable remainder unitrust will not cause a recapture of the gain deferred by the Taxpayers under section 1042(a) by operation of the provisions of section 1042(e).

No opinion is expressed concerning the federal tax consequences of the transactions described above under any other provisions of the Code.

This ruling is directed only to the taxpayers who requested it. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.

Sincerely,
____
James L. Brokaw
Chief, Branch 5
Associate Chief Counsel
(Employee Benefits and Exempt Organizations)

Related Topics On ESOP/QRP Funds Unitrust

4.6.7  ESOPs and Qualified Replacement Property:    A business owner who has held stock for three or more years may sell the stock to an employee stock ownership plan (ESOP) and acquire qualified replacement property (QRP). The ESOP must hold 30% or more of the stock after the sale. The QRP may include public stocks and bonds in an operating corporation. Sec. 1042(c)(4).



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