The Treasury recently issued final regulations that modify the rules for determining the basis of an income interest in a charitable remainder trust in order to curtail a perceived abuse of the general rules. To understand the perceived abuse, and the mechanics of these regulations, it is helpful to understand the context in which the issue arises.
Internal Revenue Code section 1001(e) provides that in determining gain or loss from the sale of an income interest in a CRT, the tax basis of that interest is disregarded. In other words, the general rule is that the income interest in a CRT has a zero basis. Thus, for example, the entire amount received by an income beneficiary upon termination of a CRT is treated as taxable gain, since the termination is treated as a sale of the income interest to the remainder beneficiary.
Subsection 1001(e)(3) provides an exception and the general rule will not apply if the sale is part of a transaction in which all interests in the CRT are transferred. So if a donor funded a CRT with zero-basis stock that is sold by the CRT for 100, and a purchaser buys her income interest in the CRT for 80, the entire 80 would be gain. On the other hand, if the income beneficiary and remainder beneficiary join together and sell all income interests in the CRT to someone for 100, the general rule of section 1001(e) doesn’t apply. Instead, the uniform basis rule would first look at the basis of assets in the trust following the sale of the stock – i.e. cash of 100 which, of course, has a basis of 100, and to allocate that basis actuarially between the income and remainder interests in the CRT. So if the normal CRT actuarial calculation determines that the remainder is 20% and the income interest is 80%, then the uniform basis of 100 allocated to the income interest would be 80, and a sale of that interest for 80 would yield no taxable gain.
This was one of those cases in which the special rules for CRTs collide with the general tax rules for trusts, to produce unintended results. In any case, the IRS was not pleased with this result and in 2008 issued a notice that said in this situation the donor’s basis in her income interest would be reduce to zero upon termination of the CRT. This reaction by the government, while effective to curtail these transactions, was criticized by the advisory community as a blunt instrument approach that unfairly impacted non-abusive transactions as well as those the IRS was targeting.
As a result of this commentary, the government adopted a more refined approach in the proposed regulations issued last year that were recently made final. Under the new regulations, if sale of an income interest in a CRT is within section 1001(e)(3) because all beneficial interests in the trust are being transferred in a single transaction, the actuarial share of the uniform basis of trust assets will be reduced by a corresponding share of the undistributed ordinary income and capital gain of the trust. So if in our example the trust had made no distributions at the time of the sale of the interests in the trust, the uniform basis of cash of 100 would be reduced by the amount of undistributed gain of 100, to zero, and the donor selling her income interest for 80 would have 80 of taxable gain.
Note that these new rules only affect a transaction in which all CRT beneficiaries – income and remainder beneficiaries – dispose of their interests in the trust in a single transaction, and do not affect the more typical scenario for termination of a CRT in which the income and remainder beneficiaries each get their share of trust assets.
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