Thursday March 28, 2024

3.10.9 Income, Gift, Estate and Generation-Skipping Transfer Taxes

Income, Gift, Estate and Generation-Skipping Transfer Taxes

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

Gift Taxation:   If the donor is an 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, then the trust corpus will be included in his or her estate.

Tax Apportionment Provisions:   With a testamentary unitrust, most state tax apportionment statutes would reduce charitable remainder trusts in order to pay taxes in the same manner as other non-charitable transfers.

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 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.

The unitrust 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 unitrust 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 unitrust 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

A gift tax return may be required when there is a transfer of property without full consideration. A donor is allowed to make non-taxable present interest gifts to recipients of an amount equal to the annual gift exclusion amount. If the gift exceeds the annual exclusion amount, the donor is required to file an IRS Form 709 Gift Tax Return but may involve use of the donor's applicable exclusion amount. If the gift exceeds both the annual exclusion and the applicable exclusion, gift tax may be payable. Using the applicable exclusion to reduce gift tax will also affect the estate tax exclusion available at death.

If the donor is the sole income beneficiary of a one-life trust or the trust is a two-life trust with donor and donor's spouse as beneficiaries, there are no gift tax implications. If the donor is the income recipient and retains a testamentary power of revocation for a multiple life CRUT, there is no current gift. The power to revoke the income interest of a successor recipient must be testamentary and not inter-vivos. Reg. 1.664-3(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 set up a unitrust to benefit himself and his daughter, age 40, 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 65 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 $54,943. 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 $45,057 and $54,943 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 unitrust 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 3.10.9A Testamentary Power of Revocation

Jane Donor creates a charitable remainder unitrust 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, then 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, then the trust corpus will be included in his or her estate. Sec. 2036(a). With a one-life unitrust, there will then be a deduction for the full value of the trust. Sec. 2055. If the trust is funded for husband and wife and one spouse passes away, there then is a marital deduction. Sec. 2056(b)(8). Only if the successor income recipient is a child, nephew, niece or other family member, will there then be a taxable transfer. In this case, the taxable transfer will be the present value of the income interest of the non-charitable beneficiary 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 and appropriate mortality tables.

If the estate is subject to estate tax, it is a requirement that the estate tax 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 unitrust, most state tax apportionment statutes would reduce charitable remainder trusts in order to pay taxes in the same manner as other non-charitable transfers. This has the result of substantially increasing the total estate tax. If the charitable trust is not to bear a portion of the estate tax, then 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 trust makes payments to a grandchild, great-grandchild or other skip person, there will then 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 non-charitable 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 non-charitable 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 unitrust, 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 3.10.9B Non-Donor Is Sole Income Recipient

Donor transfers $100,000 to a charitable remainder trust that names his 35 year-old son as sole income recipient for his lifetime. The unitrust payout percentage is 5% and the AFR is 3.0%. If the one-life remainder value of $14,436 is subtracted from $100,000, the present value of the son's unitrust interest-and therefore the gift-is $85,564. 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 unitrust 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 3.10.9C Donor Is Primary Income Recipient Followed by Non-Donor

Donor, age 60, names himself as primary income recipient and Son, age 35, as successor income recipient of a $100,000 trust. The unitrust percentage is 5% and the AFR is 3.0%. The value of the son's successor income interest is calculated as follows:

PV of income interest based on joint lives            $87,194 (Two Life Calculation)

PV of income interest based on Donor's life          $61,733 (One Life Calculation)

PV of son's income interest (taxable gift)             $25,461

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 60, names himself and his Son, age 35, as joint and survivor income recipients of a $100,000 trust. The unitrust percentage is 5% and the AFR is 3.0%. 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            $43,597 (Two Life Calculation)

PV of income interest based on Donor's life            $30,867 (One Life Calculation)

Equals Gift 1 Amount (PV of Son's Future Interest) $12,730

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            $7,218 (One Life Calculation)

Equals Gift 2 Amount (PV Income to Son)            $42,782

Total Combined Taxable Gift is $55,512. 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.



Case Studies on Income, Gift, Estate and Generation-Skipping Transfer Taxes

Megan's CRUT - 'til Marriage Do Us Part:   Kali Billings, 85, is a retired writer. Besides being an accomplished publisher, she is an active philanthropist. Throughout her life, Kali frequently gave of her time and money to many charities. In fact, she plans on leaving the bulk of her $1,000,000 estate to three of her favorite charities. While her family is very important to her, she feels they are all very successful and financially well off. However, Kali is concerned about her adopted daughter, Megan. Megan is a single 30 year old teacher living in a small town. Her salary is quite modest (especially in comparison to her siblings) and the likelihood of any significant increase over time is unlikely. Kali wishes to support her while she is single and building her career but does not want to alienate her other children. Ideally, she wants to provide support for Megan until she marries or until Megan reaches an annual salary of $60,000, whichever comes first. Kali's goal is to help Megan until her financial position is more in line with her other siblings.

Death and Taxes - The Madison Era of Giving, Part 1 of 7:   Financial titan George Madison, Jr., has truly lived the American dream. A child of immigrant parents, he grew up during the Depression on the tough streets of New York. Thereafter, he served two arduous tours in World War II. While always grateful no matter where his place in life, George returned to the States determined to "make it big" and live the "good life." In particular, he wanted to lift many of the hardships his parents were enduring as poor immigrants. Consequently, George committed himself to the study of finance with an emphasis in investment banking. And the rest, as they say, is history.

Death and Taxes - The Madison Era of Giving, Part 2 of 7:   Still on an emotional high from his multi-million dollar gift toward the construction of a state-of-the-art library (see last week's Case Study), George Madison, Jr. has a new focus in his life - making a difference in children's lives. After making the gift to the school, George had a life-changing realization. George spent his entire life building up his business and accumulating his fortune and rarely gave of his time or money to others. Like many people, George's career and family were his number one priorities. Now nearing the latter part of his life, George feels a strong urgency to do things differently. Knowing the importance education played in his success, George strongly desires to set up gifts that would provide educational opportunities for underprivileged children. In addition, he would like to take full advantage of the tax benefits of making such a gift. While he is becoming more generous as of late, George has no interest in increasing his cash "donations" to Uncle Sam.

The Dirtiest CRT Ever Created, Part 1 of 2:   Sam Morello, 50, has been in the mining business for some 30 years. His company, Hard Hat Drillers, a sole proprietorship, owns and operates several mines in the northeast part of the country. The company's sole source of revenue is from its mining efforts. However, a national landscaping company has made Sam an offer to buy his entire surplus of dirt for $100,000. There has not yet been any contract or other formal agreement between the two parties. In total, Sam estimates that he has about 12,000 tons of dirt.

Private Letter Rulings

PLR 200204022 Disclaimer of CRUT Interests by Children Entitles Estate to Marital Deduction:   Husband and Wife created a four-life charitable remainder unitrust (CRUT). The CRUT was drafted to pay first income to Husband and Wife. After both passed away, the CRUT payout was to be made to Son and Daughter.

PLR 200229046 CRT Income Beneficiaries Responsible for Payment of Death Taxes:   Decedent created a NIMCRUT and a revocable living trust. The NIMCRUT was designed to pay income to Decedent and then to successor income beneficiaries after Decedent's death. On the death of the last income beneficiary, the NIMCRUT was to distribute the remaining trust assets to six charities.

PLR 200305023 Qualified Reformation Saves Improperly Drafted NIMCRUT:   During his lifetime, Dan Donor created a revocable living trust and will. At Dan's death, the revocable living trust and Dan's estate would be distributed to a net income plus makeup charitable remainder unitrust (NIMCRUT). The two-life NIMCRUT was drafted with a 5% payout. Upon termination of the trust, the NIMCRUT would distribute the remaining trust property equally to four charities.

PLR 200425027 Scrivener's Error Defense Saves Estate Tax Charitable Deduction:   Dominic Donor created Dominic's Trust to receive his retirement assets and the residue of his estate at his death. Dominic's Trust was designed to make distributions to Foundation, a Sec. 501(c)(3) organization, to fund Dominic's Memorial Fund at Foundation. Foundation will then distribute amounts from Dominic's Memorial Fund to other educational and charitable institutions. Dominic's attorney stated by affidavit that due to a drafting error, he failed to include the language necessary so that the assets transferred to Dominic's Trust would qualify for the federal estate tax charitable deduction. On this basis, state court granted a petition to reform Dominic's Trust to include the required language. The executor of Dominic's estate sought a ruling that an estate tax charitable deduction would be allowed for the value of assets transferred to the reformed trust.

PLR 200441024 Donor "Cashes Out" Her Term-of-Years CRUT:   Terri Taxpayer created a charitable remainder unitrust (CRUT) for her benefit. The CRUT had a term of 20 years and a high 10% payout. After 20 years, all of the CRUT assets would be distributed to Charity. Terri, however, wanted to terminate her CRUT prior to the lapse of 20 years. Moreover, she wanted to "cash out" or accelerate her remaining CRUT income payments at the time of termination.

TAM 200840008 Property Distributed to Trust Doesn't Qualify Estate for Charitable Deduction:   D's will directed the funding of a testamentary trust with the residue of D's estate. The trustees were to divide half of the trust's net income between A and B for their lives and to distribute the remainder at the trustees' discretion. The will provided that after A and B passed away, the trustees could distribute the remaining trust assets to a charity or charities of their choice.

PLR 200901023 Transfer to Charitable Trust Qualifies for Gift and Estate Tax Deductions:   T created Trust to "manage, conserve and distribute" her deceased husband's artwork. The trustee of Trust would make the artwork available for display in public and private institutions in the United States and Country A.

PLR 200905027 Extension Granted to Take Deduction:   Trust was created as a revocable living trust. Upon Trustor's death, Trust became irrevocable. The terms of Trust required it to make a series of distributions to Foundation following the death of Trustor.

PLR 200906008 Trust Qualifies for Charitable Deduction:   Trust is an irrevocable trust with A as the primary beneficiary. The provisions of Trust provide A with a lifetime limited power of appointment to order the distribution of all or any portion of the trust assets to one or more charitable organizations.

PLR 201225004 Trust Distributions Qualify for Charitable Deduction:   A and B are the primary beneficiaries of an irrevocable trust. A holds a lifetime limited power of appointment allowing A to make distributions from income and/or principal to any qualified charitable organization.

PLR 201320009 IRS Rules on Proposed Conversion of Trusts:   When Son died, Son's three children became the sole beneficiaries of Trust 1 and Trust 3 ("the Trusts"). The Trusts are governed by the laws of State. A State statute allows the trustee to convert a trust to a unitrust for the purposes of defining trust income as long as five factors are met.
PLR 201321012 Couple Entitled to Gift Tax Charitable Deductions:   Husband and Wife ("the Trustors") created two charitable remainder unitrusts ("the Trusts"). Payments from the Trusts were made to Trustors for life with the remainder to be distributed to Charity.

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.

PLR 9244013 QDOT and Unitrust:   Taxpayer desired to create a charitable remainder unitrust (CRUT) for himself and his spouse. However, his spouse was not a U.S. citizen and therefore did not qualify for the Sec. 2056(b)(8) marital deduction. Taxpayer planned to fund the CRUT with separate property and retain a testamentary right of revocation. The CRUT included the required provisions for a qualified domestic trust (QDOT) under Sec. 2056A(a).

PLR 9425004 Self Dealing Exception for Compensation of Disqualified Person:   In PLR 9425004 a family corporation was created to provided trust management and financial services to various family members. The stock in the corporation is owned by two grandchildren and the corporation serves a number of family members. The Service noted that an exception to the self dealing rules under Sec. 4941(d)(2)(E) enables the payment of compensation to disqualified persons for "services which are reasonable and necessary to carrying out the exempt purpose" so long as the compensation is not excessive. In effect, there is a reasonable or incidental exception to the self dealing rules that allows payment to qualified persons for providing services to a charitable trust. These services must be customary or necessary for the functioning of the trust and the compensation must be fair and appropriate.

PLR 9442017 Capital Gain Discretion:   In PLR 9442017, several powers were approved for inclusion in the trust. First, so long as the trustee has no discretion to allocate income among recipients, under Reg. 1.664-3(a)3(ii) there is no problem with the retention of a right to appoint a successor trustee, including one of the trust grantors.

PLR 9547004 No Partnership Unitrusts Allowed:   Charitable remainder trusts are subject to the regulatory power of the Service. In a very controversial decision, the Service stated that a family of eight individuals would not be permitted to create a charitable remainder trust. Charitable trusts are not created for a business purpose. The joining together of eight members to create a trust would be in essence a partnership and a partnership is a business entity. Thus, the Service refused to recognize the trust as qualifying under Sec. 664 of the Code.


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