In Memorandum AM 2020-006[1] the IRS looked at a marketed charitable remainder annuity trust structure which claimed to allow a taxpayer to completely avoid paying tax on large capital gains. The IRS was not impressed with the marketing materials they reviewed, finding the program failed to accomplish the goal implied by the materials.

The Plan

The IRS describes the structure as follows:

Taxpayer creates and funds a trust which is purported to qualify as a CRAT. The trust is funded with interests in a closely-held business, with farmland, and/or with the crops produced by farmland. The trust resembles the model CRAT described in the appropriate revenue procedure (for an inter vivos CRAT for one measuring life, this would be Rev. Proc. 2003-53, 2003-2 C.B. 230, which is cited in the promotional materials), with the following significant modifications:

Article 5B provides that the trustee may provide for the annuity amount by purchasing one or more annuities (including without limitation one or more single premium immediate annuities (SPIAs)), with the total cost of such annuity or annuities to be less than 90% of the initial fair market value (FMV) of the trust property, which will guarantee to pay to the beneficiaries or beneficiaries’ children as applicable, the annual annuity amount during the five year annuity period.

Article 5F provides that in each taxable year of the trust, the trustee shall pay “to the beneficiary for during the [annuity period], during their lifetime for a period of five years,” an annuity amount equal to the greater of (1) 10% of the initial FMV of all property transferred to the trust; or (2) the payments received by the trustee from one or more SPIAs purchased by the trustee as provided in Article 5B, provided however, that such annuity payments cannot exceed 49% of the initial FMV of the trust property valued as described above. Upon the death of the last surviving initial beneficiary prior to the end of the annuity period, the annuity amount shall be paid in equal shares, per stirpes and not per capita to the grantor’s children for the remainder of the annuity period.

Article 5L provides that in lieu of the remainder distribution to the charitable organization, the trustee, upon the availability of adequate funding in cash, may pay to the charitable organization a cash sum equal to 10% of the initial FMV of the trust property plus $100. The trustee shall not make a distribution in kind to satisfy this cash distribution.[2]

The marketing materials provided a series of descriptions of the tax implications of various transactions that were part of the marketed program:

A single premium immediate annuity (SPIA) creates a stream of payments that are only partially taxable under the tax law, with each payment consisting of a portion that is a return of original investment and a portion that is income;[3]
A charitable remainder annuity trust (CRAT) does not pay capital gain taxes when it sells the appreciated property initially transferred to fund the CRAT;[4]
The CRAT’s basis in an annuity it purchases is based on the funds it invests into the SPIA, not the grantor’s basis in the donated asset;[5]
In Revenue Procedure 2020-53 the IRS allowed for an early distribution to charity from a CRAT;[6] and
CRATs are allowed to purchase SPIAs in lieu of purchasing other, more traditional investments.[7]

The memorandum does not take the position that any of those statements are incorrect. However, the promoter’s materials go on to state or imply the following tax results based on those items.

The beneficiary each year will pay tax only on the ordinary income portion of the annuity, with the portion allocated to investment in the contract becoming a wholly nontaxable distribution to the beneficiary;

The capital gain will never be taxable to the beneficiary in any amount; and
The structure qualifies as a CRAT, giving the taxpayer the immediate deduction benefit of a CRAT.

The memorandum does take the position that every one of those statements is false.

Arrangement is Not a Charitable Remainder Annuity Trust

The memorandum finds two key flaws cause this arrangement to fail to qualify for treatment as a charitable remainder annuity trust. If the arrangement is not a charitable remainder annuity trust, then there is not a tax exempt entity that would not initially pay tax on the gain on the sale of the capital asset and the grantor would not get a charitable contribution deduction for the partial interest gift.

The first objection is that the provision that calculates the payment as 10% of the original trust principal or the amount of the SPAI annual distribution (capped at 49% of the initial fair market value) means this does not qualify as a charitable remainder annuity trust as the payment stream is not the required sum certain annuity:

Excessive authorized payments/Payment not a sum certain: Article 5F of the trust agreement described above provides that in each taxable year of the trust, the trustee shall pay to the beneficiary “during their lifetime for a period of five years” an annuity amount equal to the greater of (1) 10% of the initial FMV of all property transferred to the trust or (2) the payments received by the trustee from one or more SPIAs purchased by the trustee. Even if the trust was being correctly administered, this provision allowing a payment to the income beneficiary in excess of the amount determined at the funding of the trust based on a percentage of the initial FMV of the trust assets causes the trust to fail to qualify under § 664(d)(1)(B) since such excess payments are not described in § 664(d)(1)(A). This determination is not dependent on whether any excess payments are ever actually made. Additionally, Article 5F does not satisfy the “sum certain” requirement of § 1.664-2(a)(1)(i), as the amount payable could change if the trust purchases an SPIA.[8]

While a charitable remainder unitrust is allowed to have a provision that provides for payment of the greater of the unitrust amount or trust income, such an income provision is not allowed in an annuity trust which must have a sum certain payout.

The arrangement also violates the CRAT requirements in the view of the memorandum by the method it uses to implement a prepayment of the charitable contribution:

Prepayment: Article 5L provides that in lieu of the remainder distribution to the charitable organization, the trustee may pay to the charitable organization a cash sum equal to 10% of the initial FMV of the trust property plus $100. This provision and the description of the structure in the promotional materials indicate that after a payment of 10% of the initial FMV of the trust assets to charity, the charity has no further rights under the trust and will not receive the remainder at the end of the trust term. Under § 664(d)(1)(C), the payment of the remainder to charity is a mandatory definitional requirement for a CRAT. A trust which does not require such payment is disqualified without regard to any actual distributions which it may make to charity during or at the end of its term. Section 664(d)(1)(D) provides that the value of the remainder calculated at the creation of the trust must be at least 10% of FMV; it neither states nor implies that a current payment of that amount to charity vitiates the requirement to also pay the remainder at the end of the term. The cited publications, such as Rev. Proc. 2003-53 and PLR 200124010, do not support the promoters' contentions, as the provisions described therein clearly authorize payments to charity in addition to, not in lieu of, the payment of the remainder, such additional payments being consistent with § 664(d)(1)(B) and explicitly authorized by § 1.664-2(a)(4).[9]

Clearly, the promoter’s idea in most cases would be to immediately give the 10% plus $100 to the charity, and then have a trust that had no additional obligation to pay the charity, allowing the entire proceeds of the annuity to go to the beneficiary. But, as the memorandum notes, that structure would appear to invalidate the CRAT.

Annuity Distributions and the §644 Layers

The IRS memorandum, noting that the above failures would remove the arrangement’s tax benefits, goes on to note that even if, for the sake of argument, you assume the trust does qualify as a CRAT, the claimed tax treatment misapplies the rules of §72 for taxation of annuities and §644 for taxation of charitable remainder trust distributions to beneficiaries.

The memorandum begins by citing the proper tax treatment of such a CRT that sells an asset, purchases a SPIA, and then makes distributions while receiving payments from the SPIA:

Amounts received under an immediate annuity that meets certain requirements and is described under § 72(u)(3)(E), which the annuities purchased as part of this structure appear to be, are taxed under the general rules of §§ 72(a)(1) and 72(b)(1). That is, each payment under the annuity will consist of an ordinary income portion and an excluded portion representing return of investment, until such time as the entire investment has been recovered. See, generally, § 1.72-1. A CRT is exempt from ordinary income taxation itself, but its distributions to the annuity or unitrust recipients, as the case may be, are taxable to the extent that those distributions are treated as coming from the potentially taxable tiers in § 664(b): current and accumulated ordinary income and current and accumulated capital gain. Note that the promoters’ paraphrase of § 664(b) quoted above omits the “accumulated” element of each of these tiers.

Applying the rules of § 664 and § 72 together to the standard facts described in the promoters’ materials, in which the appreciated asset is contributed to the CRAT, sold shortly thereafter, and the proceeds used to purchase the SPIA, would result in annual ordinary income being added to the § 664(b)(1) tier each year from the annuity, and a large one-time amount being added to the § 664(b)(2) tier from the sale of the asset (assuming the asset is of a kind to produce capital gain). Assuming no other activity, the annual annuity distributions would take out current and any accumulated ordinary income from the annuity and then accumulated capital gain from the sale, only reaching non-taxable corpus to the extent these two accounts have been exhausted.[10]

The IRS notes the misleading implications created by the promoter’s materials regarding Notice 2008-99 and PLR 9237030 in a footnote, stating:

The promoters’ citation to Notice 2008-99 is simply misleading in that they quote it for the correct statement that a CRT is exempt from ordinary income taxation and has a cost basis in purchased assets, without noting that the gain on assets sold will be added to the § 664 tiers and thus preserved for taxation to the income beneficiaries as distributions are made. Similarly, they draw a false implication from the accurate summary of the § 72 rules regarding immediate annuities in PLR 9237030, that those rules somehow override the § 664 tier structure in cases where a CRT holds such an annuity.[11]

That is, the promotional materials left out significant details (like the tier structure), thus inviting the reader to “fill in” conclusions that are erroneous without a memorandum ever actually making the statements in question. So technically, there’s no actual falsehood in the statements—but that doesn’t mean the materials are not misleading.

Specifically, the memorandum goes on to say:

Instead, the promoters are treating the capital gains as being trapped in the CRAT, with the income beneficiaries only taxed on the ordinary annuity income each year as if they were themselves the owners of the SPIA, rather than it being an asset of the CRAT funding their annuity payments from the trust. To reach this result, they are misinterpreting the cited TAM and PLRs. In those documents discussing a CRT holding an annuity contract, it is clear that the annuity income is included in the income of the trust, thus entering the § 664(b) tiers, not bypassing the trust and appearing directly on the income beneficiaries’ returns. Put differently, the annuity is a funding mechanism for the CRT’s required payments to the income beneficiaries, not an income stream of the beneficiaries in lieu of such payments.[12]

… Promoters cite two of these rulings for the indisputable proposition that a CRT may purchase an annuity, but then do not explain that the trust will be the owner of the annuity contract and the income therefrom. Moreover, none of these rulings address the taxation of any distributions from the CRAT to the individual beneficiaries. Thus, none of cited authorities in the promotional materials support taxing the payments under the annuity contract solely under § 72 without running them through the § 664(b) tier system. Rather, the taxable portions of the annuity payments are income to the trust, which would mechanically fall into the first tier as ordinary income, with distributions from the trust first coming from ordinary income before dipping into the other tiers, including capital gain, until the entire distribution is accounted for.[13]

The IRS then posits two potential alternative treatments for imposing tax on a taxpayer who is taking an incorrect reporting position based on the implications of the promotional materials. First, the annuities could be treated as distributed to the beneficiaries by the CRAT upon purchase:

The first alternative is to treat the CRAT as actually having distributed the entire annuity contract to the individual beneficiaries. CRTs may make in-kind distributions to satisfy their income distribution requirements, but the value of the policy would far exceed the beneficiaries’ required annuity payment for the year and thus would violate the prohibition of § 1.664-2(a)(4) that no amount other than the annuity amount may be paid to or for the use of any person other than charity. This and any subsequent failure to make annuity payments would be operational failures disqualifying the CRAT retroactively under the rule of Atkinson v. Commissioner, 115 T.C. 26 (2000), aff’d 309 F.3d 1290 (11th Cir. 2002).[14]

The IRS notes that some of the structures attempt to block this result by having the CRAT listed as the owner of the annuity, with the beneficiaries listed as the annuitants receiving the benefits. But the memorandum finds this just changes the problems that the CRAT faces:

To the extent that the trusts argue that their record ownership of the annuity contracts prevents the Service from asserting that the CRATs made in-kind distributions of the annuity contracts to the income beneficiaries, we note that it could create a new set of hazards for them. If the trusts have retained a right to change the recipient of the annuity, then the CRTs will be disqualified for not meeting the requirements of §§ 1.664-2(a)(3)(i) and (ii). Under § 1.664-2(a)(3)(i), individual beneficiaries must be living at the time of trust creation, but the trust’s retained power to substitute annuitants would allow it to direct the annuity payments to beneficiaries who were born after the creation of the trust. Under § 1.664- 2(a)(3)(ii), no person can retain a power which would cause the trust to be a grantor trust; the retained power to change the annuity recipient would generally create a grantor trust as a power to control “beneficial enjoyment” of the trust under § 674(a) and none of the exceptions provided in §§ 674(b), (c), and (d) appear to apply. Additionally, distributions of trust assets to individuals other than those named in the trust instrument would be another Atkinson operational failure.[15]

Alternatively, the IRS could argue to treat it as if it was a valid CRAT and tax the distributions under those rules:

The second alternative is simply to treat the payments under the annuity contract as if they had been correctly routed through the CRAT, taking out the tiers. Assuming that in any given case, the contributed assets are highly appreciated and are sold shortly after contribution, this would result in the distributions consisting of a thin layer of ordinary income with the balance being current or (in years after the year of sale) accumulated capital gain. We understand that some examinations have conceded the validity of the CRAT under § 664, in which cases this alternative would become the primary argument. Even if the CRATs are valid, this does not validate the attempt to trap the capital gains at the entity level.[16]

Memorandum’s Recommendation to Agents

The IRS memorandum concludes with the following recommendation to agents when they encounter one of these structures:

In all cases using this structure, the validity of the CRAT should be challenged both on the basis of disqualifying terms in the instrument and subsequent operational failures, with the result under both theories being (1) the disallowance of any charitable deductions claimed for the value of the remainder and (2) the treatment of the trust as a taxable entity from its creation, causing the sale of any appreciated donated assets to be currently taxable to the trust (or its beneficiaries, if the gain is included in DNI) in the year of sale. In appropriate cases, an assignment of income argument should be made to tax the gain of the sale of assets by the trust to the grantors or to assert SECA tax liability against the trust grantors. A whipsaw argument should also be included that if the trust is a qualified CRAT, the beneficiaries have reported incorrectly by only including the § 72 ordinary income on the annuity contract and not current or accumulated capital gain on the sale of the assets as part of their § 664(b) distribution.[17]

[1] Memorandum AM 2020-006, June 26, 2020, https://www.irs.gov/pub/lanoa/am-2020-006.pdf (retrieved July 2, 2020)

[2] Memorandum AM 2020-006, pp. 2-3

[3] Memorandum AM 2020-006, p. 3

[4] Memorandum AM 2020-006, pp. 2-3

[5] Memorandum AM 2020-006, p. 3

[6] Memorandum AM 2020-006, p. 5

[7] Memorandum AM 2020-006, pp. 5-7

[8] Memorandum AM 2020-006, p. 11

[9] Memorandum AM 2020-006, pp. 11-12

[10] Memorandum AM 2020-006, pp. 12-13

[11] Memorandum AM 2020-006, p. 12

[12] Memorandum AM 2020-006, p. 13

[13] Memorandum AM 2020-006, p. 14

[14] Memorandum AM 2020-006, p. 14

[15] Memorandum AM 2020-006, p. 15

[16] Memorandum AM 2020-006, p. 15

[17] Memorandum AM 2020-006, p. 17