Tuesday May 7, 2024

Rev. Rul. 90-103

GiftLaw Note: In Rev. Rul. 90-103, 1990-2 C.B. 159, the IRS addressed the issue of a pooled income fund that could potentially hold depreciable or depletable interests. In this ruling, the IRS stated that a pooled income fund governing instrument must include provisions for a depreciation or depletion reserve under generally accepted accounting principles (GAAP). If the pooled income fund agreement did not exclude the potential for depreciable or depletable assets, then the document "must provide for the creation of a depreciation reserve pursuant to GAAP." Therefore, if there are depletable assets such as oil and gas, the governing document must require the creation of a depletion reserve.

Rev. Rul. 90-103, 1990-2 C.B. 159

ISSUE

1. If the trustee of a trust that otherwise qualifies as a pooled income fund is not required by the governing instrument or state law to establish a depreciation reserve fund with respect to any depreciable property held by the trust, does the trust meet the requirements for a pooled income fund under section 642(c)(5)(A) of the Internal Revenue Code?

2. If the trustee of a trust that otherwise qualifies as a pooled income fund is required by the governing instrument to establish a depreciation reserve fund with respect to any depreciable property held by the trust, but additions to the reserve fund are not required to be determined in accordance with Generally Accepted Accounting Principles (GAAP), does the trust meet the requirements for a pooled income fund under section 642(c)(5)(A) of the Code?

FACTS

SITUATION 1. N, a public charity described in section 170(b)(1)(a)(ii) of the Code, established a trust, P, that is intended qualify as a pooled income fund under section 642(c)(5)(A). Neither the governing instrument of P nor applicable state law porhibits the trustee from accepting or investing in depreciable property. The governing instrument of P and applicable state law are silent as to whether the trustee must establish a depreciation reserve with respect to any depreciable property held by the trust.

SITUATION 2. The facts are the same as in Situation 1 except that the governing instrument of P requires the trustee to establish a depreciation reserve with respect to any depreciable property held by the trust. However, the governing instrument does not require that additions to the depreciation reserve be determined in accordance with GAAP. Rather, the provision requires that amounts be added to the reserve at the trustee's discretion, based on estimates of changes in the fair market value of the depreciable property. No amount need be added in any period if, to the best of the trustee's knowledge, there has been no decrease in the fair market value of the property.

LAW AND ANALYSIS

Section 642(c)(5)(A) of the Code defines a pooled income fund as a trust to which each donor transfers property, contributing an irrevocable remainder interest in such property to or for the use of an organization described in section 170(b)(1)(A) (other than in clauses (vii) or (viii)), and retaining an income interest for the life of one or more noncharitable beneficiaries (living at the time of such transfer).

Section 1.642(c)-5(a)(2) of the Income Tax Regulations provides that a pooled income fund, and its beneficiaries, are taxable under the provisions of part I, subchapter J, chapter 1 of the Code. Section 642(e) of the Code provides that an estate or trust shall be allowed a deduction for depreciation only to the extent not allowable to beneficiaries under section 167(h). The regulations under sections 170, 2055, and 2522 of the Code provide that a deduction is allowed for a contribution to or for the use of a charity of a remainder interest in property transferred to a pooled income fund. The amount of the deduction is the present value of the remainder interest in the property transferred to the pooled income fund. Computed under the provisions of section 1.642(c)-6.

Section 1.642(c)-6(d)(2) of the regulations provides that the value of the remainder interest in property is determined by multiplying the factor given in the present value tables set forth in section 1.642(c)-6(d)(3) by the fair market value of the contributed property on the valuation date.

Section 1.642(c)-6(b)(1) of the regulations explains that the tables set forth in section 1.642(c)-6(d)(3) are based on actuarial projections of the life expectancy of the noncharitable beneficiaries.

Section 1.642(c)-6(b)(2) of the regulations provides that the yearly rate of return to be used in determining the applicable discount rate is equal to the highest yearly rate of return of the pooled income fund for the three taxable years immediately preceding the year of contribution.

The amount of the charitable deduction for a contribution to charity of a remainder interest in property transferred to a pooled income fund must be calculated from the present value tables set forth in section 1.642(c)-6(d)(3) of the regulations, and be based on two factors: a discount rate, based on the fund's recent performance, and the term of the income interest or the life expectancy of the income beneficiary. Although the present value tables do not factor in economic depreciation due to exhaustion, wear and tear, and obsolescence of property transferred to or acquired by the trust, the regulations assume that there will be a reasonable relationship between the value of the property upon which the charitable deduction is based in the year of the contribution and the value of the property that is to be received by the charitable remainderman in a later year. See, e.g., H.R. Rep. No. 413, 91st Cong., 1st Sess., pt. 1, at 58 (1969), 1969-3 C.B. 200, at 237.

The only way to assure such a reasonable relationship is to establish a reserve to protect the value of the remainder interest. A depreciation reserve is designed "to protect the principal of the trust against loss due to the gradual shrinkage in value of the [depreciable property] . . . caused by obsolescence, wear and tear, and depreciation in value, which may occur even if ordinary repairs were constantly being made. . . ." G. Bogert, Trusts & Trustees, Sec. 600 (Rev. 2d ed. 1980). In the absence of a reserve for depreciation, there is no certainty that the charity will receive anything of value on the termination of the noncharitable interests. The allowance of a deduction in respect of a contribution to a pooled income fund implies the need for a depreciation reserve to preserve the value of the fund's assets. Similarly, the method of valuing the deduction provided by section 1.642(c)-6 of the regulations assumes that the value of the properties will be preserved.

Accordingly, in Situation 1, because neither the governing instrument of P nor state law requires the trustee to establish a depreciation reserve with respect to any depreciable property held by the trust, P does not satisfy the requirements for a pooled income fund under section 642(c)(5)(A).

In Situation 2, the governing instrument of P provides for a depreciation reserve. However, additions to the depreciation reserve are not required to be determined in accordance with GAAP. As explained above, the purpose of establishing a depreciation reserve for a pooled income fund is the preservation of the value of the property which will pass to the charitable remainderman. This can be accomplished only by a method that systematically allocates the cost of a capital asset to the years in which the asset is expected to produce income. Depreciation based on GAAP is described as follows:

Generally accepted accounting principles require that [the cost of depreciation] be spread over the expected useful life of [an asset] in such a way as to allocate it as equitably as possible to the periods during which services are obtained from the use of the asset. This procedure is known as depreciation accounting, a system of accounting that aims to distribute the cost or other basic value of tangible capital assets . . . over the estimated useful life of the unit . . . in a systematic and rational manner. It is a process of allocation, not of valuation. Financial Accounting Standards Board, Accounting Standards, Current Text, General Standards, Vol. I, Section D40.101 (1988).

It is thus, appropriate for a pooled income fund to use a GAAP standard in calculating depreciation, since a GAAP method ensures that the cost of the asset will be allocated systematically over its useful life.

In Situation 2, under the governing instrument, additions to the reserve fund are determined at the trustee's discretion based on changes in the fair market value of the property. In the case of a pooled income fund, as in the case of a for-profit entity, it is the value of the property at the time of acquisition that must be preserved. Future increases in the fair market value of the property, due to inflation or market appreciation, are not relevant. A depreciation method that allows a trustee to charge depreciation at its discretion, or to take into account changes in the estimated market value of the property from time to time in determining the amount to be added to the depreciation reserve, does not ensure that the depreciable property will be turned over to charity undiminished by depreciation sustained.

Therefore, to ensure that the value of the remainder interest is preserved for the charitable remainderman, the governing instrument of a pooled income fund must provide for the creation of a depreciation reserve pursuant to GAAP, if the trustee either has the authority to accept or invest in, or is not specifically prohibited from accepting or investing in, depreciable property. Accordingly, in SITUATION 2, P does not qualify as a pooled income fund, even though its governing instrument provides for the establishment of a depreciation reserve, because additions to the reserve are not required to be determined in accordance with GAAP.

HOLDINGS

1. If the trustee of a trust that otherwise qualifies as a pooled income fund is not required by the governing instrument or state law to establish a depreciation reserve fund with respect to any depreciable property held by the trust, the trust does not meet the requirements for a pooled income fund under section 642(c)(5)(A) of the Code.

2. If the trustee of a trust that otherwise qualifies as a pooled income fund is required by the governing instrument to establish a depreciation reserve fund with respect to any depreciable property held by the trust, but the depreciation to be added to such reserve is not required to be determined in accordance with GAAP, the trust does not meet the requirements for a pooled income fund under section 642(c)(5)(A) of the Code.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 82-38, 1982-1 C.B. 96, amplified by Rev. Rul. 85-57, 1985-1 C.B. 182, serves as a guide for developing governing instruments for pooled income funds. It provides sample provisions that may be used to satisfy the requirements of section 642(c)(5) of the Code. This revenue ruling amplifies Rev. Rul. 82-38 to provide guidance to trustees so that provision can be made in the governing instrument for establishing a depreciation or depletion reserve in the event the trustee is not prohibited from accepting or investing in depreciable or depletable property. Section 3 of Rev. Rul. 82-38 is amplified by adding the following paragraphs:

06 In a case where the trustee of a pooled income fund is not prohibited by state law from accepting or investing in depreciable or depletable property, the governing instrument must provide either that the trustee shall establish a depreciation or depletion reserve in accordance with Generally Accepted Accounting Principles (GAAP) or that the trustee shall not accept or invest in any depreciable or depletable assets.

The following sample provisions will satisfy the requirements described in this section 3.06:

(1) If the trustee is permitted to accept or invest in depreciable or depletable assets:

If the trustee accepts or invests in depreciable or depletable property, it shall establish a depreciation or depletion reserve in accordance with Generally Accepted Accounting Principles (GAAP).

(2) If the trustee is prohibited from accepting or investing in depreciable or depletable assets:

The trustee shall not accept or invest in any depreciable or depletable assets.

EFFECTIVE DATE

This revenue ruling is effective with respect to all pooled income funds created after February 15, 1991, and all existing pooled income funds that accept additional donations after that date. Pooled income funds that were created before that date and that do not meet the requirements set forth herein must be amended to include a provision similar to either of the two sample provisions furnished by this revenue ruling prior to accepting any additional donations.

DRAFTING INFORMATION

The principal author of this revenue ruling is John McQuillan of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact John McQuillan on (202) 535-9546 (not a toll-free call).