IRS Targets Charitable Remainder Annuity Trusts (CRATs) As Listed Transactions

On March 25, 2024, the IRS issued proposed regulations (REG-108761-22) which, if finalized, would identify certain CRATs as listed transactions. For those unaware of the listed transaction rules, such a designation would mean that taxpayers and material advisors who participated in these CRATs would have to comply with lengthy disclosure statements or risk significant civil penalties and extended statute of limitations periods. This article briefly discusses CRATs and the proposed regulations.

What is a CRAT?

CRATs are a form of charitable remainder trust. Generally, these trusts provide annual payments to one or more private beneficiaries for life or a term of years with any remaining portion held in trust and payable to a tax-exempt entity. CRATs must meet strict requirements under section 664 of the Code.

There are significant tax benefits to using a CRAT. First, the grantor is entitled to a charitable contribution deduction for the present value of the remainder interest that later passes to the tax-exempt entity. Second, in most instances, the grantor does not have to recognize capital gains for contributions of appreciated property to the CRAT.

In addition to the two tax benefits above, CRATs themselves are usually tax-exempt entities. However, distributions from the CRAT to private beneficiaries are subject to taxation under special rules set forth in section 664(b). Section 664(b) generally requires the beneficiary to recognize a distribution as ordinary income, capital gain, or exempt, depending on the nature of the distribution.

The Proposed Regulations

In the proposed regulations, Treasury and the IRS indicate that they are aware of taxpayers abusing the tax benefits of CRATs. More specifically, the government states in the regulations that it is aware of taxpayers attempting to use CRATs and single premium immediate annuities (SPIAs) to permanently avoid recognition of ordinary income and capital gains. The proposed regulations provide the following details of the transaction:

In these transactions, a grantor creates a trust purporting to qualify as a CRAT under section 664. Generally, the grantor funds the trust with property having a FMV in excess of its basis (appreciated property) such as interests in a closely-held business, and/or assets used or produced in a trade or business. The trust then sells the appreciated property and uses some or all of the proceeds from the sale of the contributed property to purchase an annuity. On a Federal income tax return, the beneficiary of the trust treats the annuity amount payable from the trust as if it were, in whole or in part, an annuity payment subject to section 72, instead of carrying out to the beneficiary amounts in the ordinary and capital gain tiers of the trust in accordance with section 664(b).

The IRS squarely rejects any claimed tax benefits from the above transactions. Rather, the IRS contends that "proper application" of the governing statutes "results in annual ordinary income from the annuity payments from the SPIA being added to the section 664(b)(1) (ordinary income) tier of the CRAT's income each year" with a "one-time amount" added to the capital-gain tier of section 664(b)(2) at the time there is a sale of property by the CRAT. The proposed regulations disagree with any contention that the CRAT receives a step up in basis for the grantor's transfer of appreciated property to the CRAT. Rather, the IRS contends that the transfer should be characterized as a gift and therefore subject to the transferred-basis rules of section 1015.

The Listed Transaction

The following transactions (or substantially similar transactions) would be characterized as listed transactions if the proposed regulations are finalized:

1. The grantor creates a trust purporting to qualify as a CRAT under section 664.
2. The grantor funds the CRAT with appreciated property.
3. The trustee sells the contributed property.
4. The trustee uses some or all of the proceeds from the sale of the property to purchase an annuity.
5. On a federal tax return, the trust beneficiary treats the amounts payable from the trust as if it were, in whole or in part, an annuity payment subject to section 72, instead of as carrying out the beneficiary's amounts as ordinary income and capital gain under section 664(b).

What About Charitable Remainders?

Significantly, the proposed regulations exempt charitable remainders from the listed transaction rules and a special excise tax that could apply under section 4965.

Conclusion

More recently, the IRS has continuously used its authority under section 6011 to identify and require disclosure of transactions it views as abusive. If the proposed regulations are finalized, taxpayers and material advisors will need to disclose their participation in certain CRATs or potentially face significant civil penalties and extended statute of limitations periods. Because the listed-transaction disclosure rules generally apply to prior tax periods, taxpayers and material advisors may have to make disclosures even if they did not participate in the transactions in the year the proposed regulations are finalized. These taxpayers and material advisors should carefully watch the progress of the proposed regulations and should consider consulting with a tax professional to determine whether any proactive steps should be taken prior to the finalization of the regulation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.