Final regulations have been issued (TD 9729) to eliminate what some had claimed was a method that could allow the use of a charitable remainder trustto allow a donor to gain a charitable deduction, have the trust sell off the appreciated assets, acquire new high basis assets and then allow the grantor to sell off his retained interest (the right to future payments from the trust) while recognizing no or very little taxable gain.

The structure in question had been identified by the IRS as a “transaction of interest” in Notice 2008-99. A transaction of interest is one type of reportable transaction under Reg. §1.6011-4(b)(1), which requires taxpayers to disclose their participation in such transactions and material advisers must prepare and maintain lists of those individuals for whom the individual acted as a material adviser with regard to such transactions.

Under the transaction in question, a grantor would place an appreciated asset into a charitable remainder trust (CRT), claiming a deduction for the charitable contribution. The CRT would then sell the asset and no tax would be paid by the trust.

In a “normal” CRT transaction there is either an annuity interest or unitrust interest that is paid to someone other than the charity. That interest is paid for a term of years (or for life). When that interest ends the balance is transferred to a charity. The grantor may retain that annuity or unitrust interest or it may be given to another person. In either event, the grantor is given a charitable contribution deduction in the year the trust is funded for the discounted value of the contribution.

The unitrust or annuity interest is taxed under special rules. While the CRT does not pay tax on items of income received by the trust, it does keep track of such income, placing them into “layers” of undistributed income of differing classes. The annuity or unitrust interest paid each year is deemed to come out of these layers, generally receiving first the income layer that is taxed at the highest rate and moving in order to the lower rate layers.

The sale of the asset transferred into the trust would generate such a “layer” of capital gain income. Thus, even if the trust invested in assets that created no taxable income (say municipal bonds), the income beneficiary would still end up paying tax at least at capital gain rates. In a more normal case the CRT would generate interest and/or dividend income that would make the distribution taxable.

However in this case the income beneficiary and the charity would sell their respective interests. The taxpayers argued that under the special rule applicable to sales of entire term interests under IRC §1001(e)(3) the gain or loss on the disposition of their interest would be measured by looking inside the trust to their share of the underlying basis of the assets (those the trust had just purchased) creating a zero gain. That section is an exception to the general rule under IRC §1001(e)(1) that in the sale of a term interest acquired by gift or transfer in trust or from a decedent, the basis of the asset sold is reduced by any basis transferred to the decedent under the standard gift or estate transfer rules—that is, the entire amount received would be taxable. Thus, the argument went, since the entire interest was sold that provisions, not applying, allowed the use of the trust inside basis.

While the IRS does not concede this worked previously, the revisions to the regulations explicitly require that any such basis for a sale of the entire term interest of a taxable beneficiary must be reduced by

· The balance of undistributed ordinary income in the CRT at the time of the sale and

· The balance of undistributed capital gain income in the CRT at the time of the sale [Reg. §1.1014-5(c)(1)]

This special rule applies only in the case of interests in charitable remainder annuity trusts (CRATs) and charitable remainder unitrusts (CRUTs). [Reg. §1.1014-5(c)(2)]

The IRS provides two examples of the application of these regulations.

Example 7. (a) Grantor creates a charitable remainder unitrust (CRUT) on Date 1 in which Grantor retains a unitrust interest and irrevocably transfers the remainder interest to Charity. Grantor is an individual taxpayer subject to income tax. CRUT meets the requirements of section 664 and is exempt from income tax.

(b) Grantor's basis in the shares of X stock used to fund CRUT is $10x. On Date 2, CRUT sells the X stock for $100x. The $90x of gain is exempt from income tax under section 664(c)(1). On Date 3, CRUT uses the $100x proceeds from its sale of the X stock to purchase Y stock. On Date 4, CRUT sells the Y stock for $110x. The $10x of gain on the sale of the Y stock is exempt from income tax under section 664(c)(1). On Date 5, CRUT uses the $110x proceeds from its sale of Y stock to buy Z stock. On Date 5, CRUT's basis in its assets is $110x and CRUT's total undistributed net capital gains are $100x.

(c) Later, when the fair market value of CRUT's assets is $150x and CRUT has no undistributed net ordinary income, Grantor and Charity sell all of their interests in CRUT to a third person. Grantor receives $100x for the retained unitrust interest, and Charity receives $50x for its interest. Because the entire interest in CRUT is transferred to the third person, section 1001(e)(3) prevents section 1001(e)(1) from applying to the transaction. Therefore, Grantor's gain on the sale of the retained unitrust interest in CRUT is determined under section 1001(a), which provides that Grantor's gain on the sale of that interest is the excess of the amount realized, $100x, over Grantor's adjusted basis in the interest.

(d) Grantor's adjusted basis in the unitrust interest in CRUT is that portion of CRUT's adjusted uniform basis that is assignable to Grantor's interest under Sec. 1.1014-5, which is Grantor's actuarial share of the adjusted uniform basis. In this case, CRUT's adjusted uniform basis in its sole asset, the Z stock, is $110x. However, paragraph (c) of this section applies to the transaction. Therefore, Grantor's actuarial share of CRUT's adjusted uniform basis (determined by applying the factors set forth in the tables contained in Sec. 20.2031-7 of this chapter) is reduced by an amount determined by applying the same factors to the sum of CRUT's $0 of undistributed net ordinary income and its $100x of undistributed net capital gains.

(e) In determining Charity's share of the adjusted uniform basis, Charity applies the factors set forth in the tables contained in Sec. 20.2031-7 of this chapter to the full $110x of basis.

Example 8. (a) Grantor creates a charitable remainder annuity trust (CRAT) on Date 1 in which Grantor retains an annuity interest and irrevocably transfers the remainder interest to Charity. Grantor is an individual taxpayer subject to income tax. CRAT meets the requirements of section 664 and is exempt from income tax.

(b) Grantor funds CRAT with shares of X stock having a basis of $50x. On Date 2, CRAT sells the X stock for $150x. The $100x of gain is exempt from income tax under section 664(c)(1). On Date 3, CRAT distributes $10x to Grantor, and uses the remaining $140x of net proceeds from its sale of the X stock to purchase Y stock. Grantor treats the $10x distribution as capital gain, so that CRAT's remaining undistributed net capital gains amount described in section 664(b)(2) and Sec. 1.664-1(d) is $90x.

(c) On Date 4, when the fair market value of CRAT's assets, which consist entirely of the Y stock, is still $140x, Grantor and Charity sell all of their interests in CRAT to a third person. Grantor receives $126x for the retained annuity interest, and Charity receives $14x for its remainder interest. Because the entire interest in CRAT is transferred to the third person, section 1001(e)(3) prevents section 1001(e)(1) from applying to the transaction. Therefore, Grantor's gain on the sale of the retained annuity interest in CRAT is determined under section 1001(a), which provides that Grantor's gain on the sale of that interest is the excess of the amount realized, $126x, over Grantor's adjusted basis in that interest.

(d) Grantor's adjusted basis in the annuity interest in CRAT is that portion of CRAT's adjusted uniform basis that is assignable to Grantor's interest under Sec. 1.1014-5, which is Grantor's actuarial share of the adjusted uniform basis. In this case, CRAT's adjusted uniform basis in its sole asset, the Y stock, is $140x. However, paragraph (c) of this section applies to the transaction. Therefore, Grantor's actuarial share of CRAT's adjusted uniform basis (determined by applying the factors set forth in the tables contained in Sec. 20.2031-7 of this chapter) is reduced by an amount determined by applying the same factors to the sum of CRAT's $0 of undistributed net ordinary income and its $90x of undistributed net capital gains.

(e) In determining Charity's share of the adjusted uniform basis, Charity applies the factors set forth in the tables contained in Sec. 20.2031-7 of this chapter to determine its actuarial share of the full $140x of basis.

The regulation applies to apply to sales and other dispositions of interests in tax-exempt trusts occurring on or after January 16, 2014, except for sales or dispositions occurring pursuant to a binding commitment entered into before January 16, 2014. [Reg. §1.1014-5(c)(4)]

As well, these transactions cease to be transactions of interest if entered into after January 16, 2014.