Wednesday April 24, 2024

3.1.10 Income, Gift, Estate and GSTT

Income, Gift, Estate and GSTT

Income Taxation:   The donor to a charitable remainder annuity trust will receive an income tax deduction equal to the present value of the remainder interest.

Gift Taxation:   If the donor is the income beneficiary of a one-life trust or the donor retains a testamentary power of revocation with a multiple-life trust, there is no current gift.

Testamentary Power of Revocation:   When a donor sets up a trust to benefit a non-donor, the donor often retains a testamentary power of revocation over the non-donor beneficiary's income interest.

Estate Taxes:   If the donor retains income, the trust corpus will be included in his or her estate.

Tax Apportionment Provisions:   With a testamentary annuity trust, most state tax apportionment statutes would reduce charitable remainder trusts in order to pay taxes in the same manner that other noncharitable transfers would be reduced.

Generation-Skipping Transfer Tax:   Generation-skipping transfer tax is levied on direct skips, taxable distributions and taxable terminations.

Calculating Taxable Transfers:   A charitable remainder trust consists of a gift of a remainder interest and the retention of an income interest.

Taxable Transfer Scenarios:   The following are several common taxable transfer scenarios and the resulting taxable gift calculations.

Income Taxation
The donor to a charitable remainder annuity trust will receive an income tax deduction equal to the present value of the remainder interest. It is calculated using the applicable federal rate for the current month or one of the prior two months, as permitted under Sec. 7520.

The annuity payouts will be taxed to the recipient under the four-tier taxation structure. Sec. 664(c). Payments will be first ordinary income, then capital gain, then tax exempt or other income and finally return of principal.

A charitable remainder annuity trust is irrevocably dedicated to charity, and therefore is normally exempt from income tax. However, if the trust has acquisition indebtedness or engages in business that is regularly carried on, the trust will recognize unrelated business income. Sec. 512. Sec. 514. See also Newhall v. Commissioner.

With assets from an active trade or business in the charitable remainder trust, there will be tax on the UBI. The trust will be subject to 100% excise tax on the unrelated business income. Sec. 664(c)(2)(A). Since a charitable trust with unrelated business taxable income does not lose exempt status, an active business asset may still be transferred to the trust and sold fairly quickly. If the asset is sold quickly, a donor may receive the capital gains bypass benefit with a modest cost for the 100% excise tax on trust unrelated business income.

Gift Taxation

If the donor is the income beneficiary of a one-life trust or the donor retains a testamentary power of revocation with a multiple-life trust, there is no current gift. The power to revoke the income interest of a successor recipient must be testamentary and not inter vivos. Reg. 1.664-2(a)(4).

Testamentary Power of Revocation

When a donor sets up a trust to benefit a non-donor, the donor often retains a testamentary power of revocation over the non-donor beneficiary's income interest. This power can be exercised only by the donor's will. If the donor does not retain a testamentary power of revocation, then the gift to the non-donor beneficiary is complete and there is potentially a current taxable gift. On the other hand, if the donor retains a testamentary power of revocation, then the gift to the non-donor beneficiary is considered incomplete. Because the gift is incomplete, there is no current taxable gift. Taxable gifts will be made when distributions from the trust exceeding the annual exclusion are made to the non-donor beneficiary. However, retaining the testamentary power of revocation may also have estate tax consequences for the donor. The estate tax consequences of a donor exercising or not exercising the right of revocation are explained below.

1. Donor has retained a right of revocation over a non-donor's income interest and does not exercise that power at donor's death. Under Sec. 2038(a), the present value of the income interest over which the donor has retained a right of revocation will be included in the donor's gross estate for estate tax purposes. For example, assume a donor sets up an annuity trust to benefit himself and his daughter, age 65, as successor income recipient. Donor retains a testamentary power of revocation over the daughter's income interest. At the time of the donor's death, the daughter is age 70 and the current trust value is $100,000. Based on the daughter's age and a current rate of the month of 3.0%, the daughter's income interest is $55,054. Because the donor has retained a right of revocation over this interest, the $100,000 trust is included in his taxable estate. There is a Sec. 2055(e) charitable deduction for $44,946 and $55,054 is a taxable transfer in the donor's gross estate.

2. Donor has retained a right of revocation over a non-donor's income interest and has exercised that power at donor's death. Donor funds a two-life charitable remainder annuity trust with payouts to her for one life and names her niece as successor income recipient. The niece later inherits $10,000,000 from her grandfather. Donor elects to revoke by will the successor income interest of the niece. At the death of donor, the trust is distributed to charity. Because the donor has revoked the non-donor's income interest, there is no estate tax consequence. While the trust is included in donor's estate, there is a full Sec. 2055(e) charitable deduction

Example 3.1.10A Testamentary Power of Revocation

Jane Donor creates a charitable remainder annuity trust with a 5% payment to herself for life. After she passes away, the annuity will be paid to her daughter for life. Jane retains the right by will to revoke the income interest of the daughter. If she exercises this testamentary power of revocation, the daughter would not receive income and the trust would pass to charity when Jane dies. Since there is a "string" on the income interest of the daughter, it is a contingent interest and there is no current gift. However, when Jane Donor passes away, the value of the income interest for her daughter will be in her taxable estate.

Estate Taxes

If the donor retains income, the trust corpus will be included in his or her estate. Sec. 2036(a). With a one-life annuity trust, there will then be a deduction for the full value of the trust. Sec. 2055. If the trust is funded for a married couple and one spouse passes away, there is a marital deduction. Sec. 2056(b)(8). Only if the successor income recipient is a child, nephew, niece, friend or other person, will there be a taxable transfer. In this case, the taxable transfer will be the present value of the income interest of the noncharitable beneficiary(ies) as of the date of the trust grantor's death. The value of this taxable transfer will be calculated using the Sec. 7520 applicable federal rate at the time of death and appropriate mortality tables.

If the estate is subject to estate tax, the estate tax must not be payable from an existing charitable remainder trust. Rev. Rul. 82-128. The estate tax will normally be paid from the residuary of the estate.

Tax Apportionment Provisions

With a testamentary annuity trust, most state tax apportionment statutes would reduce charitable remainder trusts in order to pay taxes in the same manner that other noncharitable transfers would be reduced. This would have the result of substantially increasing the total estate tax. If the charitable trust is not to bear a portion of the estate tax, it may be necessary to draft a specific tax apportionment provision in the will or living trust that allows the trust not to be reduced to pay estate tax.

Generation-Skipping Transfer Tax

Generation-skipping transfer tax is levied on direct skips, taxable distributions and taxable terminations. If the charitable remainder annuity trust makes payments to a grandchild, great-grandchild or other skip person, there will be taxable distributions.

The preferred course of action is to allocate a sufficient portion of the generation-skipping transfer tax exemption to the trust to produce a zero inclusion ratio. The amount of the exemption allocated will equal the value of the taxable transfer. Sec. 2632, Sec. 2613.

So long as the allocated exemption equals the calculated present value of the transfer to the noncharitable beneficiary, there will be no generation-skipping transfer tax. It should be noted that if there are benefits payable to both children and grandchildren, the entire noncharitable interest may need to be covered by allocated GSTT exemption.

Calculating Taxable Transfers

A charitable remainder trust consists of a gift of a remainder interest and the retention of an income interest. The present value of that remainder interest qualifies for the unlimited gift and estate tax charitable deduction. If the transferee is someone other than the donor, the donor's spouse or charity, then there will be gift or estate tax on the value of the retained income interest.

Quite often, a donor who sets up a trust to benefit a non-donor will retain a testamentary power of revocation over the non-donor's income interest. The right of revocation renders the gift incomplete with respect to the non-donor. As a result, there is no taxable transfer when the trust is first created. In that rare instance where a donor does not retain the right of revocation it will be necessary to determine the value of the taxable gift.

It is important to note that a donor is allowed to make non-taxable present interest gifts to recipients of an amount equal to the annual gift tax exclusion amount. Therefore, if the annual exclusion requirements are met for a gift to another person, then that income interest gift will only be taxable to the extent it exceeds the annual exclusion amount.

Taxable Transfer Scenarios

 The following are several common taxable transfer scenarios and the resulting taxable gift calculations. Each scenario assumes that the donor has not retained a testamentary power of revocation over the recipient's income interest unless specified otherwise. Trust arrangements more complicated than those detailed below may require an actuary to perform the taxable gift calculations.

1. Donor is sole income recipient. If the donor sets up a CRT to pay income to himself for life with remainder to charity, he has made a gift to charity. The present value of the remainder gift to charity qualifies for the gift tax charitable deduction. The donor's retention of the income interest results in no further gift tax consequences.

2. Donor is co-income recipient with spouse. If the donor sets up a CRT to pay income to himself and his spouse for their lives or for a term of years, then the gift to the spouse will qualify for the Sec. 2523(g) unlimited gift tax marital deduction. The donor will also receive a charitable gift tax deduction for the gift to charity.

Note: If there is another non-charitable beneficiary apart from spouse, then the gift to the spouse will not qualify for the unlimited marital deduction. The gift to the spouse and the other non-charitable beneficiary will need to then be calculated.

3. A non-donor is sole income recipient. If the donor sets up a CRT to pay income to a non-donor (not his/her spouse) for life with remainder to charity, the donor has made a gift to charity and to the non-donor. The present value of the gift to charity qualifies for the gift tax charitable deduction. The gift to the non-donor is a taxable gift. The taxable gift is calculated as the present value of the income interest. For a charitable remainder trust, the taxable gift (present value of the income interest) is equal to the full amount transferred minus the present value of the remainder interest.

Example 3.1.10B Non-Donor Is Sole Income Recipient

Donor transfers $100,000 to a charitable remainder annuity trust that names his 65 year-old son as sole income recipient for his lifetime. The payout percentage is 5% and the AFR is 3.0%. If the one-life remainder value of $35,000 is subtracted from $100,000, the present value of the son's income interest-and therefore the gift-is $65,000. Because this is a vested income stream, the Donor reduces the gift by one annual exclusion amount and the balance is a taxable gift. Reg. 25.2503-3(b). When he files IRS Form 709 to report the gift, Donor allocates gift basic applicable exclusion equal to the taxable gift.

4. A non-donor is primary income recipient followed by Donor. If the non-donor is the primary income recipient for life followed by the donor, the taxable gift is the same as if the non-donor were the sole income recipient. The value of the taxable gift is equal to the present value of the income interest based on the non-donor's life. The calculation uses a one-life annuity trust for the non-donor to determine the life interest. If the non-donor holds a vested income stream, Donor also reduces the gift value by one annual exclusion amount.

5. Donor is primary income recipient followed by the non-donor. If the donor is the primary income recipient followed by the non-donor as successor income recipient, then the taxable gift is equal to the present value of the non-donor's survivor income interest. The survivor income interest is equal to the difference between the present value of the income interest based on the donor's and non-donor's joint lives and the present value of the income interest based solely on the donor's life. With a future interest gift, there is no annual exclusion for a present vested income stream. The full value of the future income stream is offset by allocation from the gift basic applicable exclusion.

Example 3.1.10C Donor Is Primary Income Recipient Followed by Non-Donor

Donor, age 85, names himself as primary income recipient and Son, age 60, as successor income recipient of a $100,000 trust. The payout percentage is 5% and the AFR is 4.0%. The value of the son's successor income interest is calculated as follows:

PV of income interest based on joint lives            $69,503 (Two Life Calculation)

PV of income interest based on Donor's life            $25,980 (One Life Calculation)

PV of son's income interest (taxable gift)            $43,523

6. Donor and Non-donor are joint and survivor life income recipients. If the income interest is to be paid to the donor and a non-donor in equal shares for their joint lives with the decedent's portion payable to the survivor, the donor has made two gifts. First, the donor has made a gift to the non-donor of the present value of the non-donor's right to receive a survivor income interest from one-half of the trust. Second, the donor has made a gift of the present value of the income interest for the income recipients' joint lives from the remaining one-half of the trust.

Example 3.10.9D Donor and Non-Donor are Joint and Survivor Life Income Recipients

Donor, age 85, names himself and his Son, age 60, as joint and survivor income recipients of a $100,000 trust. The payout percentage is 5% and the AFR is 4.0%. When either Donor or Son passes away, the survivor will receive the entire income interest for his lifetime. The value of the taxable gift to Son is calculated as follows:

Gift 1 Calculation (Using One-Half of Trust Value or $50,000)

-Donor and then Son

PV of income interest based on joint lives            $34,752 (Two Life Calculation)

PV of income interest based on Donor's life            $12,990 (One Life Calculation)

Equals Gift 1 Amount (PV of Son's Future Interest)            $21,762

Gift 2 Calculation (Using One-Half of Trust Value or $50,000)-Son and then Donor

Calculation Uses Method from Example 3.10.9B

One-Half of Trust Value                                              $50,000

PV of remainder interest based on Son's life            $15,967 (One Life Calculation)

Equals Gift 2 Amount (PV Income to Son)            $34,033

Total Combined Taxable Gift is $55,795. With the vested income stream in one-half the trust income, one annual exclusion is permitted. The balance is offset by allocation from the applicable gift exclusion amount.

Private Letter Rulings

PLR 200431005 Donor Requests Extension to Allocate GSTT Exemption to CRAT:   Diana Donor created a charitable remainder annuity trust (CRAT) for the benefit of Charity and Bobby Beneficiary. Bobby was the only noncharitable beneficiary. Because Bobby was more than 37½ years younger than Diana, he was deemed a skipped person for generation-skipping transfer tax (GSTT) purposes.

PLR 201648007 Charitable Remainder Trust Division Approved:   A established Trust for himself and his wife, B. Trust is a charitable remainder unitrust ("CRUT") as described in Sec. 664(d)(2). A and B subsequently commenced divorce proceedings and have executed a written settlement agreement.

PLR 7928014 Insurance in a Unitrust:   Taxpayer desired to fund a two-life unitrust with an insurance policy and deduct the remainder value of insurance premium payments. The Service permitted the use of an insurance policy as a unitrust investment. Since the taxpayer retained no rights except the right to change charity, the payments were deductible.

PLR 8405005 Municipal Bonds in Charitable Trust:   Under the four-tier structure of IRC Sec. 664, payments are first ordinary income, then capital gain, then other or tax free and then return of principal. In this ruling, the taxpayer desired tax-free income and planned to obtain that by funding the trust with municipal bonds. Since the trust would have no ordinary income and recognize no capital gains, the distributions would be third-tier tax-free income. While the Service did not expressly approve the plan to distribute tax-free income, it stated that this would be a qualified trust, even though it invests in tax-free bonds. Trustees should also note that state prudent investor laws can impact this investment strategy.

PLR 9009047 Commercial Annuity in a Unitrust:   In PLR 9009047, the Service approved a net income with makeup unitrust that invests the principal or corpus in a commercial annuity. Since under Sec. 72(u)(1), the trust is not a natural person, the ordinary income is received and accrued each year. However, while the ordinary income is received by the trust, it is not unrelated business taxable income and thus has no adverse effect on the trust. Under the ruling, the account value is used to set the net fair market value each calendar year.

PLR 9015049 Debt Not Permitted on Assets for Unitrust:   In PLR 9015049, the Service set forth a specific requirement concerning any asset encumbered by debt. Previously, it was thought permissible to transfer an asset into a charitable remainder trust so long as the debt was at least five years old and the owner had held title for at least five years. However, in PLR 9015049, the Service took the position that if there is any personal liability on the debt, under Sec. 677(a), the payment of debt with potential personal liability causes the unitrust to become a grantor trust. Since the regulations in Sec. 664 preclude a unitrust from being a grantor trust, the trust is disqualified under the rationale of the Service.

Related Topics on Income, Gift, Estate and GSTT

3.1.1  Annuity Trust Duration and Recipients:    A charitable remainder annuity trust (CRAT) usually pays a fixed annuity for a life, lives or a term of up to 20 years, but other combinations are possible. Reg. 1.664-2(a)(1)(i). In most circumstances, the annuity is paid to the donor for one life, or to donor and spouse for two lives. Alternatively, the annuity may be paid for a term of 20 years.

3.10.9  Income, Gift, Estate and Generation-Skipping Transfer Taxes:    The donor to a charitable remainder unitrust will receive an income tax deduction equal to the present value of the remainder interest. It is calculated using the applicable federal rate for the current month or one of the prior two months, as permitted under Sec. 7520.

Trombetta:    In Estate of Helen A. Trombetta et al. v. Commissioner; T.C. Memo. 2013-234; No. 23892-10 (20 Oct 2013), the tax court held that the taxable estate included the fair market value of assets held in an annuity trust and in a residence trust. It also determined that a transfer to charity did not qualify for a charitable estate tax deduction.

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