In the case of Gerhardt v. Commissioner,[1] the Tax Court found no support for a taxpayer’s claim that the charitable remainder annuity trust structure the taxpayers had entered into virtually eliminated any tax on the gain inherent in low-basis property contributed to a charitable remainder annuity trust (CRAT) which then sold the property and purchased an annuity product that paid the CRAT annuity amount to the taxpayers.

The Facts

All of the various structures involved in this case were similar. The one set up by Albert and Gladys Gerhardt is described in the opinion as follows, starting with how they learned about the transaction:

The Gerhardts apparently learned about using CRATs as a wealth-preservation strategy from John Eickhoff of Hoffman Associates, LLC, in 2015. Mr. Eickoff referred the Gerhardts to Aric Schreiner of Columbia CPA Group, LLC, for tax advice. In 2015, Mr. Schreiner presented the Gerhardts with a “CRAT strategy.” The record does not disclose the substance of Mr. Schreiner’s presentation, but soon after that presentation, the Gerhardts formed CRATs with Mr. Schreiner’s involvement.[2]

The Tax Court notes in a footnote that “both Mr. Eickoff and Mr. Schreiner also were involved in the formation of the CRATs in Furrer.”[3] Furrer v. Commissioner, T.C. Memo. 2022-100 involved taxpayers who used a very similar CRAT strategy to attempt to escape paying tax on income from the sale of crops they had grown and had resulted in an IRS victory at trial.

The Court describes the donation to the CRAT as follows:

Albert and Gladys contributed real estate to the Albert and Gladys CRAT on November 10, 2015. The Albert and Gladys CRAT filed Form 5227, Split-Interest Trust Information Return, for the 2015 tax year reporting the total fair market value of the contributed properties as $1,808,000. With Mr. Schreiner’s assistance, Gladys filed Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, with her and Albert’s 2015 income tax return, reporting total adjusted basis of $97,517 in the contributed properties. In December 2015 and March 2016, the trustee of the Albert and Gladys CRAT sold the properties for at least $1,658,000.[4]

This sale did not itself immediately trigger an income tax liability for any party, as the CRAT does not pay tax on such income. So up to this point, there’s nothing unusual happening. But the CRAT had an interesting provision as the Court noted:

…[T]he CRAT instrument required the trustee to pay to the beneficiaries for a five-year period an “Annuity Amount” “equal to the greater of: (1) ten percent of the initial net fair market value of all property transferred to [the CRAT] . . . or (2) the payments received . . . from one . . . or more Single Premium Immediate Annuities [(SPIAs)] purchased by the Trustee.” Stipulation of Facts Ex. 13-J, at 23.

The CRAT instrument listed Albert and Gladys Gerhardt as the beneficiaries of the Annuity Amount. But the CRAT instrument also provided that “[n]either the Recipients nor the Recipients' Children shall have any right title, interest, or incident of ownership in or to any [SPIA] transferred to or purchased by the Trustee.” Id. at 22. The CRAT instrument defined the term “Recipients” as those “entitled to receive the current annuity payment” and identified Albert and Gladys as the Recipients. Id. at 15.[5]

The CRAT, not surprisingly as this was key to the supposed tax “magic” of the transaction, acquired such an SPIA after selling the property:

Using the proceeds from the sales, the Albert and Gladys CRAT purchased a SPIA from Symetra Life Insurance Co. (Symetra) for $1,537,822 on March 7, 2016. The SPIA contract identified the Albert and Gladys CRAT as the “Owner” of the SPIA, but listed Albert as the annuitant and Gladys as the joint annuitant. Under the SPIA contract, Symetra was required to pay an annuity of $311,708 to Albert and Gladys beginning on April 6, 2016, and on each April 6 thereafter until five total payments were made.[6]

For 2016 and 2017 the couple received annuity payments of $311,708.[7] As will be discussed later when looking at the underlying law involving charitable remainder trusts, such payments would normally look to the “layers” of income previously recognized by the CRAT and treat the payments first as a distribution of income, beginning with the highest tax rate type of income and then moving in rate order to other types of income.

As the trust had realized a gain of over $1,500,000, you would expect the entire distribution to be subject to some sort of tax. But that wasn’t the position the taxpayers took. Rather, the CRAT reported these distributions as taxable only to the extent of the taxable income shown on annuity Forms 1099R ($4,052 each year), with the remainder treated as a nontaxable return of corpus.[8]

The Forms 5227 filed by the CRAT also showed only trust principal or corpus on its balance sheet for each year, with no undistributed income of any sort.[9]

The Law

IRC §664 governs the taxation of charitable remainder trusts, of which a CRAT is one type. The Tax Court describes the basic concept as follows:

A CRAT is a type of a charitable remainder trust. I.R.C. §664. “[A] staple among estate planners,” a charitable remainder trust is often a vehicle used by “individuals with substantial appreciated capital gain property, a charitable intent, and a need for a stream of income during their lifetimes.” Richard Fox, Charitable Giving: Taxation, Planning, and Strategies ¶ 25.01 (2023), Westlaw WGL-CHARGIV (footnotes omitted). “The basic concept of a [CRAT] involves a [grantor’s] transfer of property to an irrevocable trust, the terms of which provide for the payment of a specified amount, at least annually, to the grantor or other designated noncharitable beneficiaries for life or another predetermined period of time up to twenty years.” Id. (footnotes omitted); see also I.R.C. §664(d). What remains in the trust after the expiration of that period (which cannot be less than “10 percent of the initial net fair market value of all property placed in the trust,” I.R.C. §664(d)(1)(D)) “must be transferred to one or more qualified charitable organizations or continue to be held in the trust for the benefit of such organizations.” Fox, supra, ¶ 25.01. In short, unlike an immediate gift to charity, a contribution to a CRAT “blends the philanthropic intentions of a donor with his or her financial needs or the financial needs of others.” Id.[10]

As well, the Court describes how the transaction is generally taxed:

As a rule, the grantor recognizes no gain when transferring appreciated property to a CRAT. See Buehner v. Commissioner, 65 T.C. 723, 740 (1976) (“A gift of appreciated property [to a CRAT] does not result in income to the donor. . . .” (quoting Humacid Co. v. Commissioner, 42 T.C. 894, 913 (1964))); see also Furrer, T.C. Memo. 2022-100, at *8-9 (discussing treatment of CRATs). Moreover, because CRATs are exempt from income tax, a CRAT can sell appreciated property without itself paying tax on the sale. See I.R.C. §664(c)(1); Treas. Reg. § 1.664-1(a)(1)(i); Fox, supra, ¶ 25.01.

But that does not mean that the grantor or other noncharitable CRAT beneficiaries do not have to pay tax with respect to distributions from the CRAT. “Although a [CRAT] is itself exempt from income tax and, therefore, pays no tax on any of its taxable income, the annuity . . . payments made to the noncharitable beneficiaries carry out taxable income that is subject to tax at the beneficiary level.” Fox, supra, ¶ 25.50 (footnote omitted); see also Alpha I, L.P. v. United States, 682 F.3d 1009, 1015 (Fed. Cir. 2012) (stating the rule and citing section 664(b) and (c)(1)). This is so because when property is transferred to a CRAT, the basis of the property in the CRAT's hands generally is the same as it would be in the hands of the grantor. See I.R.C. §1015(a) and (b); Treas. Reg. §§ 1.1015-1(a)(1), 1.1015-2(a)(1). And when the CRAT sells the property, it realizes gain to the extent the amount realized from the sale exceeds its adjusted basis. I.R.C. §1001; see also Treas. Reg. § 1.664-1(d)(1)(i) (discussing the assignment of income to categories at the CRAT level). Although not taxable to the CRAT, that gain must be tracked and affects the treatment of distributions from the CRAT.30 See, e.g., Treas. Reg. § 1.664-1(d)(1)(viii) (providing examples illustrating the rules).[11]

The Court then describes the ordering rules that determine the tax treatment to the beneficiaries of distributions from the CRAT:

Congress has established specific ordering rules that govern the characterization and reporting of annuity amounts distributed by a CRAT to its income beneficiaries. See I.R.C. §664(b). Under this regime, distributions from a CRAT to income beneficiaries are deemed to have the following character and to be distributed in the following order:

(1) as ordinary income, to the extent of the CRAT's current and previously undistributed ordinary income;

(2) as capital gain, to the extent of the CRAT's current and previously undistributed capital gain;

(3) as other income, to the extent of the CRAT's current and previously undistributed other income; and

(4) as a nontaxable distribution of trust corpus.

I.R.C. §664(b)(1)‒(4); Fox, supra, ¶ 25.50.[12]

The Decision

The Court finds that, applying the above rules, all payments received (even though run through a separate annuity contract) were income to the taxpayers:

The CRATs realized gains on the sales of the contributed properties. See I.R.C. §1001(a). Although the CRATs did not have to pay tax on those gains because of section 664(c), under section 664(b), the income they earned was relevant for determining the character of the distributions the Gerhardts received. See Treas. Reg. § 1.664-1(d)(1)(ii)(a); see also Alpha I, L.P., 682 F.3d at 1015 (“[T]he income of a CRUT is taxable to its income beneficiaries upon distribution.”); Fox, supra, ¶ 25.50.34

As we have already discussed, the character of CRAT distributions to noncharitable beneficiaries follows the character of the income to the CRAT. See I.R.C. §664(b). The distributions are characterized in the following order: (1) ordinary income, (2) capital gains, (3) other income, and (4) trust corpus. Id. Here, the Commissioner determined that the income the CRATs earned was ordinary income because the properties the CRATs sold were subject to the rules of section 1245 — a point not disputed by the Gerhardts.[13]

But the taxpayers claim that this is not how this transaction should be governed, instead finding that only the interest portion of the annuity should be subject to tax:

The Gerhardts resist the straightforward analysis set out above. In their telling, the Code does a lot more than exempt the CRATs from paying tax on built-in gains realized when contributed property is sold. According to the Gerhardts, the Code also relieves them from paying tax on the distributions that were made possible by the CRATs’ realization of the built-in gains. As they put it, “all taxable gains (on the sale of the asset[s contributed to the CRATs]) disappear and the full amount of the proceeds [is] converted to principal to be invested by the CRAT.” Pet’rs’ Opening Br. 6-7 (emphasis added). In the Gerhardts’ view, “[i]t becomes obvious that Congress intended [this treatment] to promote charitable giving while offering large tax benefits as incentives.” Id. at 7.[14]

However, the Tax Court finds that the one big flaw in that view is that it has no support that the Court can find:

The gain disappearing act the Gerhardts attribute to the CRATs is worthy of a Penn and Teller magic show. But it finds no support in the Code, regulations, or caselaw.[15]

The Court looks first at the claim that the CRAT’s basis in the property becomes its fair market value, so there would be no gain upon the sale—a conclusion the Court rejects:

As best we can tell, the Gerhardts maintain that the bases of assets donated to a CRAT are equal to their fair market values. See Pet’rs’ Reply to Resp’t’s Opening Br. 10-11 (“Utilizing CRATs, the assets are donated to a CRAT and book at the fair market value of the asset at that time. The donor’s basis is a moot point as the controlling fair market value is the price at the time the asset is donated to the CRAT.”); id. at 13 (“The trustee of the CRAT has no way to know the cost basis of any asset donated to it, nor is it required to obtain such information since that is not required by the Internal Revenue Code.”). Section 1015 flatly contradicts their position. Section 1015(a) governs transfers by gift, and section 1015(b) governs transfers in trust (other than transfers in trust by gift). Under either provision, the basis in the property “shall be the same as it would be in the hands of the donor” under section 1015(a) or “in the hands of the grantor” under section 1015(b).37 And the Gerhardts’ claim that section 1015 does not govern transfers to CRATs because it does not specifically mention them is meritless. Nothing in the text of the provision excludes CRATs from its scope.[16]

Nor do the tax rules applicable to annuities under IRC §72 create the claimed benefit:

The Gerhardts also seek shelter in the rules governing the taxation of annuities in section 72. But, if one respects the form of the transactions the Gerhardts chose, the Gerhardts did not buy any annuities from Symetra. The CRATs did so and directed how payments under the annuities were to be made. Thus, any amounts paid by Symetra as directed by the CRATs constitute amounts distributed by the CRATs for purposes of section 664(b). Contrary to the Gerhardts’ view, nothing in section 72 overrides their obligation to comply with the rules of section 664(b) with respect to those amounts.[17]

So the taxpayers had not found a magic method to escape tax on all forms of gains by using a charitable remainder annuity trust and a separate annuity contract.

[1] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/annuity-distributions-from-crats-taxable-as-ordinary-income/7gkh0 (retrieved April 21, 2023)

[2] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[3] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[4] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[5] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[6] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[7] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[8] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[9] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[10] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[11] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[12] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[13] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[14] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[15] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[16] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023

[17] Gerhardt v. Commissioner, 160 TC No. 9, April 20, 2023