Converting Ordinary Income Into Capital Gains Using The Early Termination Of Private Trusts And Charitable Remainder Trusts

Transcription

1 Converting Ordinary Income Into Capital Gains Using The Early Termination Of Private Trusts And Charitable Remainder Trusts by Jerome M. Hesch Berger Singerman, LLP. Miami, Florida Director Notre Dame Tax & Estate Planning Institute South Bend, Indiana Adjunct Professor of Law Graduate Program in Estate Planning University of Miami School of Law Coral Gables, Florida Florida International University Law School Miami, Florida Vanderbilt University School of Law Nashville, Tennessee On-Line LL.M. Program in Taxation Boston University School of Law Boston, Massachusetts and Matt Brown Brown & Streza, LLP Irvine, California Austin, Texas 62 nd Annual Taxation Conference The University of Texas School of Law December 4, 2014

2 Jerome M. Hesch is Of Counsel to Berger Singerman LLP in its Miami, Florida office and is Special Tax Counsel to Oshins & Associates in Las Vegas, Nevada and Jeffrey Verdon & Associates in Newport Beach, California. He is the Director of the Notre Dame Tax and Estate Planning Institute, on the Tax Management Advisory Board, a Fellow of ACTEC and the ACTC, has published numerous articles, Tax Management Portfolios, and co-authored a law school casebook on Federal Income Taxation, now in its fourth edition. He has presented papers for the University of Miami Heckerling Institute on Estate Planning, the University Of Southern California Tax Institute, the Southern Federal Tax Conference, the AICPA and the New York University Institute On Federal Taxation, among others. He participated in several bar association projects, including the Drafting Committee for the Florida Revised Uniform Partnership Act and preparing the ABA s comments on the IRS s proposed private annuity regulations. He was elected to the NAEPC Estate Planning Hall of Fame. He received his BA and MBA from the University of Michigan and a JD from the University of Buffalo Law School. He was with the Office of Chief Counsel, Internal Revenue Service, in Washington, D.C. from 1970 to 1975, and was a full-time law professor from 1975 to 1994, teaching at the University of Miami School of Law and the Albany Law School, Union University. He is currently an adjunct professor of law, teaching courses at the Florida International University Law School, the Graduate Program in Estate Planning at the University of Miami, the Vanderbilt University School of Law and the On-line LL.M. program at Boston University School of Law. Having grown up in Buffalo, NY, he remains a Buffalo Bills fan. Matt Brown is a partner with the Orange County, California law firm of Brown & Streza LLP, where he counsels business owners and philanthropists on income tax and estate tax issues that arise in the areas of business planning and charitable planning. Matt is board certified in estate planning law by the California Bar, was recently elected as a Fellow to ACTEC and is an adjunct professor of law at the University of California, Irvine School of Law. Matt was named in Orange County Register Metro s annual 40 Under 40 issue in 2011, and has been named a Southern California Super Lawyers-Rising Star by Los Angeles magazine. Matt is a frequent speaker and author on advanced estate planning, tax, and philanthropy topics. He received a BA in Finance from the University of California at Davis and his JD degree, cum laude, from the Southern Methodist University Dedman School of Law where he was a member of the law review.

3 Table of Contents Introduction... 1 Allocation and Amortization of Basis: In General... 2 Wasting Assets and Non-Wasting Assets Coupon Stripping: Separating the Right to Income from an Income-Producing Debt Obligation... 4 Allocating Basis Between Income and Remainder Beneficiaries in a Private Trust... 5 Basis Allocation to Sales of Term Interests... 6 Basis Allocation Assuming the Trust Continues... 8 Basis Allocation to Sales of Term Interests Before Basis Allocation to Sales of Term Interests After Basis Allocation to Termination of Private Trusts... 9 Basis Allocation Upon Trust Merger... 9 Basis Allocation of Purchased and Resold Term Interest Ascertaining Whether to Sell a Life Estate Allocating Basis Between Income and Remainder Beneficiaries in a Charitable Remainder Trust Term Interests Taxation of CRT Distributions to Term Interest Holder Basis Allocation Upon Termination of Charitable Remainder Trusts No-Rule Position Is a Term Interest a Capital Asset? Drafting Considerations Impaired Life Expectancy Valuation Issues Transaction of Interest: Notice CRT Exit Strategy Alternatives Partial Acceleration of Remainder Interest Full Acceleration of Remainder Interest CRT Termination Divide Assets Among Beneficiaries Sell Term Interest to Third Party Simultaneous Sale of Term and Remainder Interest to Third Party Gift Term Interest to New CRT Convert CRT to Charitable Gift Annuity Notice Conclusion... 20

4 Introduction A charitable remainder trust ( CRT ) is a widely-used charitable planning technique that provides the settlor with significant income tax benefits and a source of future payments, followed by the distribution of trust assets to one or more charities at the end of the trust term. The CRT generates an immediate income tax charitable deduction (equal to the present value of the future interest passing to the charitable remainder beneficiary) that can offset ordinary income. 1 And the CRT can be used to eliminate the income tax on the gain realized from the sale of appreciated assets. The CRT creates a financial benefit because the person who transfers assets to the CRT receives (or can gift to one or more others) an annuity or unitrust payment for life or for a fixed term not to exceed 20 years. Sometimes the person entitled to the future annuity or unitrust payments the term interest holder desires to accelerate these payments. Reasons for desiring an acceleration range from an immediate need for more cash to a concern that income tax rates will increase in the future. In response to this phenomenon, several companies now specialize in purchasing charitable remainder trust annuity streams for cash. In addition, there are individuals who would like to accelerate the charitable distribution instead of delaying it until the end of the CRT term. And there are times when both the term interest holder and the charitable remainder beneficiary decide it is best to terminate the trust. Because of concerns about self-dealing and the income tax treatment of an early termination, several taxpayers obtained private letter rulings from the Internal Revenue Service regarding early CRT terminations. 2 In these private letter rulings, the facts stated that the holder of the annuity interest first sold the annuity interest to the CRT and that immediately thereafter, as a separate step, the trust distributed its remaining assets to the charitable remainder beneficiary. Since the term interest holder is separately selling the annuity interest, the gain on that sale needs to be determined. Based on prior case law and a published Revenue Ruling, the Service held that the gain is a capital gain. 3 In calculating the amount of the capital gain, the Service disallowed the use of the term interest holder s basis by concluding that the term interest holders were, in substance, selling their interests to the remainder beneficiaries, thereby triggering 1001(e)(1). 4 In effect, the entire amount received from the sale of the term interest must be reported as a capital gain, and the entire basis in the CRT s assets is allocated to the charitable remainder beneficiary, which does not need this extra allocation of basis because the charitable remainder beneficiary is tax-exempt. The focus of this paper is to examine how basis is allocated when there is a sale or other disposition of an income interest in a CRT. Before we examine how basis should be allocated with respect to CRTs, we will first examine how basis is allocated when there is a separation of 1 The charitable itemized deduction is not a tax preference item under the alternative minimum tax. 2 See, PLR , PLR , PLR , PLR , PLR , PLR , PLR , PLR , and PLR McAllister v. Commissioner, 157 F.2d 235 (2d Cir. 1946), and Rev. Rul , C.B See PLRs cited at Note 2, supra. 1

5 the income interest from the principal for debt obligations 5 and then examine the treatment where the same issues occur among private trusts. Because we conclude that the Service is taking a position that is inconsistent with the basis allocation treatment in analogous situations, we question whether the Service correctly applied 1001(e)(1) to situations in which a CRT was terminated by all beneficiaries. We believe that the complete termination of a CRT provides a ratable share of basis to the holder of the income interest. We believe this is true for two reasons. First, we believe that basic principles that apply to private trust terminations should apply to CRT terminations allocating basis ratably among income and remainder beneficiaries. Second, we believe a CRT termination triggers the exception to 1001(e)(1) found in 1001(e)(3). To support our position, we have analyzed how basis is allocated among debt obligations, private trusts, and the legislative history of 1001(e). The reader should note that this is a discussion of tax principles, not tax policy. The Service wins the policy argument inasmuch as, taken to the extreme, our theories would allow the income beneficiary of a CRT to accelerate the beneficiary s income interest at no tax cost. This would allow individuals using a CRT to reduce the amount of income that the individual would otherwise report if the CRT continued until its scheduled termination. The Service clearly understands this risk, as evidenced by the text of its many rulings on the matter, a notice identifying a related structure as a transaction of interest 6 and recent proposed regulations 7 along the same lines as the notice. But in its effort to enforce sound tax policy, the Service has taken an unprincipled approach. The intent of this paper is not to identify new, too-good-to-be-true, tax planning opportunities but, instead, to insist that the Service acknowledge its unprincipled approach and request the assistance of Congress in addressing the underlying policy issues. Allocation and Amortization of Basis: In General Wasting Assets and Non-Wasting Assets. Basis is a fundamental income tax concept that measures a taxpayer s investment in an asset and the starting point is typically the asset s initial cost. 8 A taxpayer can adjust the property s basis under certain circumstances, as set forth in the Code. 9 It is the adjusted basis that is ultimately used to determine the taxpayer s gain or loss upon a subsequent sale or exchange of the property. 10 Basis allocation can significantly affect the amount of gain or loss a taxpayer realizes upon a subsequent taxable disposition of the property. We will start by examining the recovery of basis between wasting assets and non-wasting assets, such as how basis is allocated for bonds. Annuities 5 This is so-called coupon stripping, which is, fundamentally, the separation of the fruit from the tree. 6 Notice (October 31, 2008). 7 REG (January 16, 2014); Basis in interests in tax-exempt trusts. 8 IRC IRC IRC 1001(a) and