Form 5227 Reporting: Mastering Compliance With Charitable Split-Interest Trusts, NIIT Calculations, and More

FOR LIVE PROGRAM ONLY Form 5227 Reporting: Mastering Compliance With Charitable Split-Interest Trusts, NIIT Calculations, and More THURSDAY, AUGUST 18, 2016, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. You will have to write down only the final verification code on the attestation form, which will be emailed to registered attendees. To earn full credit, you must remain connected for the entire program. WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.

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Form 5227 Reporting Aug. 18, 2016 Charles J. McLucas, Jr., CPA, PFS, Founder and CEO Charitable Trust Administrators, San Clemente, Calif. cmclucas@ctai-ca.com Joylyn Ankeney, CPA AKT, Lake Oswego, Ore. jankeney@aktcpa.com

Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

Form 5227 Reporting: Mastering Compliance With Charitable Split-Interest Trusts, NIIT Calculations, and More Charles J. McLucas, Jr., President CPA/PFS/AEP Charitable Trust Administrators, Inc. Joylyn Ankeney, CPA Senior Manager AKT LLP 5

Split Interest Gift Types Charitable Gift Annuities Charitable Lead Trusts (CLT) Grantor Lead Trust Non-grantor Lead Trust Retained Life Estate Gifts Charitable Remainder Trusts (CRT) Charitable Remainder Unitrust (CRUT) Charitable Remainder Annuity Trust (CRAT) 6

Considerations for Split Interest Gift Planning Annuity or UniTrust Fixed payment amount Easy to zero out/ GST Kids or Grandkids Grantor/ Non Grantor Income Tax deduction? Totally out of estate Now or at Death Immediate benefits Estate Tax Wipeout Market Performance What are expected returns AFR What does the IRS say we will earn Asset Issues Taxes due? Liquid? 7

Charitable Gift Annuity A contract in which a donor transfers an asset to charity in exchange for a fixed income stream for life, not to exceed two lives. Donor receives an immediate charitable income tax deduction for the net present value of the calculated remainder interest. Upon termination of the contract (term or death), the charity receives the remainder of the value of the contract. Not a trust no annual filing requirement. 8

Charitable Lead Trust (CLT) A CLT is the opposite of a CRT: the income stream goes to charity for a term of years and at the end of the trust the remainder is returned to either the granter or a non-granter. There is no minimum payout requirement. There is no maximum limitation on the term. There may or may not be income tax, gift tax and/or estate tax consequences depending on the type of CLT. 9

Non-Grantor CLT Designed to pass income to a qualified exempt charity for a term of years and then distribute the remainder to family. Major advantage of the CLT is the ability to leverage the donor's gift exemption. Donors with larger estates can move major assets through to family with little or no gift or estate tax. One major contrast to the CRT is that CLT is a taxable trust. No income tax deduction. 10

Charitable Lead Trust: Non-Grantor Donor Gift of cash, securities, or real estate Charitable Lead Trust Annual payments to charity Family Remainder to Family Designated Charity 11

Grantor CLT A qualifying grantor CLT generally allows the donor to take the net present value of all charitable gifts over the life of the trust and deduct them in the year the trust is created. The donor/grantor will be subject to tax on all of the trust s income during the charitable term. 12

Charitable Lead Trust: Grantor Donor Gift of cash, securities, or real estate Current income tax deduction Remainder returned to donor Charitable Lead Trust Annual payments to charity Designated Charity 13

Charitable Lead Trust Tax Benefits Permits transfer of assets to heirs with significantly reduced estate or gift taxes. Can reduce income taxes. Flexible planning tool to zero out estate tax. Can create delayed inheritance/retirement benefit for heirs. 14

Retained Life Estate Gifts A retained life estate gift allows a person to become a donor by irrevocably transferring ownership of a home or farm to a charity while retaining lifetime use of the property. Life estate gifts create a current income tax deduction for individuals who want to make a testamentary gift of real property to charity. 15

Charitable Remainder Trust (CRT) A CRT is a tax-exempt trust that provides for a specified distribution, at least annually, to at least one non-charitable income recipient for a period specified in the trust instrument (not to exceed 20 years), with the remainder interest paid to at least one charitable beneficiary. CRT s are governed by IRC Section 664. 16

Standard Charitable Remainder Trust Donor Gift of cash, securities, or real estate Income Tax Deduction Plus Annual Income Charitable Remainder Trust Remainder to charity Designated Charity 17

Tax Benefits of a CRT Donor avoids capital gains taxes on sale of assets contributed to the trust Donor receives an immediate charitable deduction The trust income that stays inside the trust is tax exempt Donor avoids estate taxes on any assets of the CRT that pass to charity 18

CRT s: Things to bear in mind Properties subject to an encumbrance: mortgage or a debt can cause the CRT to loose its exempt status, run afoul of self dealing rules or cause an adverse tax consequence Grantor Trust: trust will not qualify as a CRT if the donor is treated as the owner of the trust. i.e. trust caused to make payments on a debt that is deemed as a debt of the grantor Self Dealing: transactions that are deemed to benefit the donor or the donor s family. i.e. sale or exchange of the property by a disqualified person, use of the property by a disqualified person Prohibited Payments: Payments are limited to the named income beneficiaries per the specified payout (annuity versus unitrust) and to the named charity or charities 19

Funding a CRT with Appreciated Real Estate 20

Appreciated Real Estate Like the dramatic declines in the financial markets, the value of real estate in across the U.S. has fluctuated over the same time period. 21

Options for Real Estate Owners Keep the asset Exchange the asset Sell the asset Gift the asset Other options? 22

Reasons for Selling Real Estate Capitalize on the appreciation in value. Tired of property management: ready to receive passive income vs. active from your investment. Need more income from a low-income producing, yet highlyappreciated property. Exchanging/trading-up is no longer appealing; want to get out. Receive an offer they cannot refuse. Diversification 23

Obstacles to Selling Real Estate Capital Gain Taxes Federal 20% on long-term gains due to appreciation. Plus 3.8% 25% on gains due to straightline depreciation State 1% - 10% Personal Attachment Market Conditions 24

Charitable Gifting Strategies Case Studies 25

Income/Investment Properties George owns a property with an appraised fair market value of $1,000,000. He paid $140,000 for the property 25 years ago. After taking depreciation, his tax basis is $50,000. The property produces net annual income of $30,000 or 3%. He is in a 33% combined federal and state marginal income tax bracket and 23.9% capital gain bracket. He recently turned age 75 and would like to retire. He does not want to manage real estate and would like to sell the property. 26

Option #1 Charitable Remainder Unitrust Rather than a fixed income, let s assume George would like something that has the potential for an up-side in the income it generates. A Charitable Remainder Unitrust would be a more appropriate charitable life-income plan for him to consider. With this type of trust the income is based upon the value of the assets inside the trust. In years where the value of the principal grows, the person receives an increased income based upon that value. However, in years where the value of the trust principal declines, the income beneficiary is going to receive a lesser amount of income. (Options/solutions for this situation will be addressed in the next case study). Let s assume George establishes a 6% CRUT and that it will have an average annual net investment return of 8.5%. The projected results are as follows 27

Option #1 Charitable Remainder Unitrust By-pass capital gains of $950,000 saving $227,050. Receive income tax deduction of $422,840 saving $101,059. Tax-free exit from the property. 1st year income from trust is $60,000, an increase of $30,000 doubling his income. Assuming the trust s principal grows, the annual income will also increase. A significant charitable legacy will ensue after the death of its income beneficiary. Out of property management. Now receiving passive income vs. active income. Downside: potential for income to decrease in years when the trust s principal decreases. Gift of Asset Income for Life Tax Deductions Income Capital Gain Charitable Remainder Trust Remainder to Charity at death of donor. 28

Benefits Analysis Present Income $150,000 Year-old Male 75 Year-old Female 73 Child(ren) 3 Net Estate $12,000,000 Fair Market Value $1,000,000 Less Cost Basis $ 50,000 Taxable Capital Gain $ 950,000 Combined Tax Rate 33.80% Capital Gains Tax $ 321,100 Mortgage $ - Capital After Tax $ 678,900 8.50% Investment = $ 65,701 Annual Earnings $ 834,786 Lifetime Earnings Estate Tax Rate 40.00% Total Estate Tax $ 271,560 Net To Heirs $407,340 59.27% Loss To Taxes 29

Benefits Analysis Property Transferred Income Tax Deduction 1) 42.28% $ 422,840 2016 + 5 Years Charitable Trust $1,000,000 No Tax On Capital Gain 2) Projected Trust Cash Flow Unitrust 3) Percentage 6.00% $73.359 Average Per Year $ 1,320,454 Lifetime Income Wealth Replace Trust Annual Premiums $23,256 Insurance Policy Net To Heirs $ 1,000,000 Income Tax Gift Estate Tax Probate FREE! Charity $1,508,100 30

Benefits Analysis Without Unitrust Planning With Unitrust Planning Capital Gains Tax $ 321,100 $ 0 Estate Taxes $ 271,560 $ 0 Cost $ 592,600 Savings $592,600 Net To Heirs $ 407,340 $ 1,000,000 Charity $ 0 $ 1,508,100 Tax Deduction $ 0 $ 422,840 Trust Income $ 0 $ 1,320,454 Without Trust $ 834,786 $ 834,786 $ 485,668 Higher Lifetime Earnings 31

Option #2 Trust & Sale Zero-Tax CRT Let s assume George likes the idea of a charitable gift annuity or charitable remainder trust BUT wants to get cash out of the real estate as well. He could contribute an undivided interest into the CRT and retain an undivided interest. Together, George and the trustee would sell their respective interests prorating the selling costs, basis and capital gain proportionate to their interests. By gifting a sufficient interest to the CRT it will generate enough income tax savings (from the charitable deduction) to off-set the capital gain tax liability on the interest George personally keeps and sells. Assuming George contributed an undivided 65% interest in the property to a CRT here s how the numbers work out. 32

Option #2 Trust & Sale Zero-Tax CRT 1. Gift $496,103 Zero-Tax Charitable Remainder Trust $496,103 RESULTS Sale $503,893 Prorated Basis $ 25,195 Selling Costs $ Capital Gain $478,702 C.G. Tax @ 26% $ 71,805 Real Estate $1,000,000 Charitable Income Tax Deduction $205,158 Trust $496,103 Income Tax Ded. $205,158 Tax Savings @33% $ 71,805 Net of Capital Gain Tax Liability and Income Tax Savings is zero. Total cash to donor $503,897 2. Sell $503,897 for cash Capital Gains by-passed with CRT $496,702 saving $71,805 in taxes. Lifetime Income starting at $29,776 per year. Charitable Legacy 33

CRT: Donor Profile Not age specific but generally speaking: For a CRUT, younger donors For a CRAT, older donors Has highly appreciated property that may or may not be generating an income stream. Would like increased cash-flow/income from their assets. Generally Adverse to Capital Gains Taxes Has a desire to benefit charity and would like to benefit from their charitable gifting. Would like asset diversification and professional management. Would like more flexibility in the design of their gift. Would like to provide an income stream to their spouse and/or children. 34

Six Key Decisions in Establishing a Charitable Remainder Trust 35

Six Key Decisions in Establishing a CRT Trust Type of Trust: Type I Standard Payout Option: This type of Unitrust requires a distribution of a fixed percentage amount of at least 5% of the annual value from the trust s assets. This percentage is distributed regardless of the income earned. Accordingly, if the income earned for any year is less than the required distribution, principal will be distributed. Type II Net Income Payout Option: This option provides for the lesser of the Unitrust percentage amount (Type I above) or the trust s income to be distributed annually. IRS Section 643(b) defines the term income to whatever definition is provided within the governing instrument or applicable state laws. Unless defined in the document, or in state law, income does not include capital gain or corpus. 36

Type of Trust: Six Key Decisions in Establishing a Charitable Trust.continued Six Key Decisions in Establishing a CRT Type III Net Income with Make-up Option: This trust may be designed to pay income in excess of the full Unitrust amount. It can extend the aggregate amounts paid in prior years less the aggregate of the fixed amounts of prior years (by reason of the income only exception). In other words, this trust can make-up past deficiencies of prior years by paying out the actual income earned in the current year. (This is just like a TYPE II with the addition make-up option.) 37

Six Key Decisions in Establishing a CRT Type of Trust: Six Key Decisions in Establishing a Charitable Trust; continued The FLIP Unitrust: This option became available after 12/10/98. It provides the feature of beginning as a TYPE II or III trust, but then drops the income limitation feature, converting to a TYPE I, on the occurrence of a qualifying Triggering Event. The Triggering Event is a Specific date or single event whose occurrence is not in control of the trustee. This type of trust is typically used in real estate and other non-liquid assets. Charitable Annuity Trust: A charitable remainder annuity trust is a trust from which a sum certain (not less than 5% of the initial fair market value of all assets) is to be paid to one or more persons, not less often then annually. The annuity amount may be stated as a fixed percentage of the initial fair market value, or a fixed sum. This is a fixed percentage or amount that cannot be changed regardless of fluctuations in portfolio value. For this reason, additional contributions to annuity trusts are prohibited 38

Six Key Decisions in Establishing a CRT Term: Six Key Decisions in Establishing a Charitable Trust continued A Charitable Remainder Trust (CRT) can be established for one or more lives or a term of years (maximum of 20) or a combination of both. However, the term of the trust may not be established for a time period that would not provide an actuarially calculated 10% remainder interest for the charity. Percentage Payout to Income Beneficiary: The distribution % must be established at the inception of the trust. It cannot be changed! It must be at least 5% (see notes on NIMCRUT s in #1 above). It cannot exceed a % which combined with the age or term described above would give the charity less than 10% of the initial value of the trust at the trust s termination. (Note less is sometimes more over a long payout period when using a NIMCRUT type of CRT. 39

Six Key Decisions in Establishing a CRT Six Key Decisions in Establishing a Charitable Trust continued The Name of the Charity or Charities: Any 501c3 can be named as your charitable remainderman (beneficiary).this includes Private Foundations and Donor Advised Funds also known as Gift Giving Funds Definition of Income: Changes in the IRS regulations (2003) provide the definition of income in a CRT to include post-contribution capital gains. This change was made to allow the trustee of the trust to manage the investment portfolio. Under modern portfolio theory for total returns, the donor can be flexible in choosing how much capital gain to distribute annually. The trust document must include such language and provide for a special independent trustee to make these decisions. 40

Six Key Decisions in Establishing a CRT Trustee: Six Key Decisions in Establishing a Charitable Trust; continued The decision of who or what type of entity should be the trustee of a CRT is sometimes difficult. In many situations it may be advisable for the donor to be trustee, or at least have the authority to hire or fire the trustee. A bank or qualified trust company may also provide trustee services. Unless a donor has specialized knowledge of tax and investment duties, a donortrustee should retain the services of a third-party administration firm (such as CTAI). A trustee of a CRT has the fiduciary duty (stewardship responsibilities) to manage the trust in such a manner as to not favor either the income or the remainder beneficiary. This can be a more difficult task when the donor is both the trustee and income beneficiary. 41

Preparing Form 5227 42

Who must file Form 5227 Split-interest trusts Charitable Remainder Trusts Charitable Lead Trusts Pooled Income Funds Any other trust described in IRC 4947(a)(2) The form is an information return No tax due 43

Form 5227 is open to public inspection Information about trusts that filed Form 5227 has been included in the IRS Business Master File Commercial companies downloaded this list and created publicly searchable databases Search for your client s CRT, CLT, or PIF on Google! Consider not using the client s name in the name of the trust Note that the trustee s name and address are disclosable Portions of the return are not disclosable Trust agreement (including amendments), Schedule A, Schedules(s) K-1, attachments referencing contributor info 44

Other complementary forms Form 1041 for CLTs Grantor lead trusts file as any other grantor trust would and provide the grantor with a statement of items of income, deduction, and credit to include on the grantor s return Because nongrantor CLTs claim a section 642(c) deduction, charitable beneficiaries should not be issued a Schedule K-1 Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code Used to report self-dealing and other private foundation type excise taxes Used by CRTs to report unrelated business taxable income 45

Other complementary forms (continued) Form 709 Transfers to charitable trusts do not meet any of the exceptions to filing gift tax return section under 6019(3) State forms State filing requirements vary widely California requires the completion of Form 541-B, which duplicates much of Form 5227 Indiana requires that Form 5227 be attached to a blank state fiduciary return Pennsylvania and New Jersey require that CRTs pay tax on any undistributed income 46

Filing Deadlines All split-interest trusts are calendar year taxpayers by statute The form is due on April 15 An automatic 6-month extension is available starting with the 2016 tax year. Form 1041 is extended to September 30 (with 2016 tax year) Form 4720 requires a separate extension 47

Failure to File or Filing Late The penalty is $20 for each day the form is late up to a maximum of $10,000 If the trust s gross income is greater than $250,000, this penalty increases to $100 per day up to a maximum of $50,000 Note that in the year of the sale of a large appreciated asset, this gross income threshold may easily be met For 2015 and beyond penalties are indexed for inflation The penalty is an obligation of the trust, not the trustee Exception: Knowingly failing to file the return results in the additional imposition of the penalty on the person who knowingly failed to file and they are personally liable for this additional penalty 48

The Trust Instrument Attach a copy of the trust instrument to the return in the first year Include a declaration signed under penalty of perjury that the copy is a true and complete copy Attach a copy of any amendments to the trust instrument to the return covering the year in which the amendment is made 49

Common preparation errors Most preparation errors result from failing to read the trust agreement Don t prepare a return without the trust agreement Preparing Form 1041 but not preparing Form 5227 Note that CRTs should never file a Form 1041 Not properly identifying the trust type Confusing a CRAT and CRUT Not recognizing NICRUT, NIMCRUT, or Flip-CRUT provisions Not identifying a CLT as grantor vs nongrantor CLT 50

Recognizing trust types/formats One means of recognizing a trust type is where the trust agreement cites a Rev. Proc. as the type of trust it is trying to create. CRAT Payment of Annuity Amount. In each taxable year of the trust during the annuity period, the Trustee shall pay to [permissible recipient] (hereinafter the Recipient ) an annuity amount equal to [a number no less than 5 and no more than 50] percent of the initial net fair market value of all property transferred to the trust, valued as of the above date (that is, the date of the transfer). 51

Recognizing trust types/formats CRUT Payment of Unitrust Amount. In each taxable year of the trust during the unitrust period, the Trustee shall pay to [permissible recipient] (hereinafter the Recipient ) a unitrust amount equal to [a number no less than 5 and no more than 50] percent of the net fair market value of the assets of the trust valued as of the first day of each taxable year of the trust (hereinafter the valuation date ). NICRUT Payment of Unitrust Amount. In each taxable year of the trust during the unitrust period, the Trustee shall pay to [permissible recipient] (hereinafter the Recipient ) a unitrust amount equal to the lesser of (a) a fixed percentage amount equal to [a number no less than 5 and no more than 50] percent of the net fair market value of the assets of the trust valued as of the valuation date (hereinafter the fixed percentage amount described in (a) of paragraph 2 ) or (b) the trust income for the taxable year as defined in 643(b) of the Code and the applicable regulations. 52

Recognizing trust types/formats NIMCRUT Payment of Unitrust Amount. In each taxable year of the trust during the unitrust period, the Trustee shall pay to [permissible recipient] (hereinafter "the Recipient") a unitrust amount equal to the lesser of (a) a fixed percentage amount equal to [a number no less than 5 and no more than 50] percent of the net fair market value of the assets of the trust valued as of the valuation date (hereinafter "the fixed percentage amount described in (a) of paragraph 2") or (b) the trust income for the taxable year as defined in 643(b) of the Code and the applicable regulations. The unitrust amount for a taxable year shall also include any amount of trust income for the year that is in excess of [the fixed percentage amount determined under (a) of this paragraph for the year], but only to the extent that the aggregate of the amounts paid to the Recipient in prior years was less than the aggregate of the amounts determined for all prior years under (a) of this paragraph and (a) of paragraph 5. 53

Recognizing trust types/formats Flip-CRUT Conversion to fixed percentage method of determining unitrust amount. Notwithstanding paragraph 2(i), upon the occurrence of [permissible triggering event as described in 1.664-3(a)(1)(i)(c) and (d) of the Income Tax Regulations] (hereinafter "the triggering event") and effective as of the first day of the taxable year that immediately follows the triggering event (hereinafter "the effective date of the triggering event"), the Trustee shall pay to the Recipient in each remaining taxable year of the trust during the unitrust period a unitrust amount equal to [same percentage used in (a) of paragraph 2(i)] percent of the net fair market value of the trust assets as of the valuation date. Beginning on the effective date of the triggering event, the Trustee shall no longer pay the amount equal to the lesser of (a) or (b) in paragraph 2(i). 54

Recognizing trust types/formats CLAT Payment of Annuity Amount. In each taxable year of the trust during the annuity period, the Trustee shall pay to [designated charitable recipient] an annuity amount equal to [number representing the annual annuity percentage to be paid to the designated charitable recipient] percent of the initial net fair market value of all property transferred to the trust, valued as of the date of the transfer. CLUT Payment of Unitrust Amount. For each taxable year of the trust during the unitrust period, the Trustee shall pay to [designated charitable recipient] a unitrust amount equal to [number representing the annual unitrust percentage to be paid to the designated charitable recipient] percent of the net fair market value of the assets of the trust, valued as of the first day of each taxable year of the trust (hereinafter the valuation date ). 55

Recognizing trust types/formats Grantor Trust Look for a reference to the remainder reverting back to the donor/grantor The CLT Rev. Proc. make reference to the power to substitute assets Retained Powers and Interests. During the Donor's life, [individual other than the donor, the trustee, or a disqualified person as defined in 4946(a)(1)] shall have the right, exercisable only in a nonfiduciary capacity and without the consent or approval of any person acting in a fiduciary capacity, to acquire any property held in the trust by substituting other property of equivalent value. 56

Common preparation errors (continued) Improperly computing the amount to which the beneficiary is entitled CRAT vs. CRUT CRUT vs. NICRUT, NIMCRUT, of Flip-CRUT Self-dealing concern Caution: Older NICRUTs or NIMCRUTs may have been amended between December 1998 and June 30, 2000 Failing to identify net-income affecting provisions Net income is trust accounting income as determined under state trust law State law permits a trust to override state law One common overriding provision is the inclusion of realized capital gains in trust income 57

Common preparation errors (continued) Failing to identify that the triggering event has occurred A date certain or sale of an unmarketable asset is determinable without reference to external events Other triggers (death, birth, marriage, divorce) require referring to event external to the administration of the trust Failing to identify the end of a beneficiary s right to income or end of the trust term Beneficiary interests are not always for life A trust for a term of years can be on autopilot and the trustee may forget which year is the last year of the trust term 58

Common preparation errors (continued) Failing to properly maintain the makeup amount Most common problem is that it is ignored altogether Tracked on lines 67a through 69 on the Form 5227 Failure to report a Flip-CRUT triggering event Note that in the year following the triggering event, you must report information on the triggering event at Part V-B, Line 64 of Form 5227. Include in the disclosure the nature of the event, the date, and the payment method previously used (NICRUT or NIMCRUT) 59

Common preparation errors (continued) Column (c) on the Balance Sheet in Part IV Must be completed by all forms of CRUT May be completed by CLUTs Presents the fair market value of the assets as determined under the terms of the trust agreement for the purpose of computing the unitrust amount 60

Four-tier accounting This is an income accumulation and distribution scheme Income is accumulated into four buckets (called tiers or categories) representing (broadly) four tax characters: Tier 1: Ordinary income (income taxed at ordinary rates) Tier 2: Capital gain (income taxed at capital gain rates) Tier 3: Other income (nontaxable income) Tier 4: Corpus or Principal 61

Four-tier accounting (continued) Within the tiers maintain: Classes based on highest potentially applicable tax rate Pre-2013 dollars are maintained in classes that do not include the net investment income tax (Excluded) Post-2012 dollars are maintained in classes that include the net investment income tax Income types within each class (e.g., U.S. Gov t interest, corporate bond interest, nonqualified dividends, qualified dividends) 62

Four-tier accounting (continued) Characterizing distributions Distributions are characterized by reducing each category in turn starting with Tier 1 and progressing to Tier 4. Within a Tier, each tax rate class is reduced in turn, beginning with the highest tax rate class and progressing to the lowest tax rate class. Within a tax rate class, types of income are reduced on a pro rata basis. 63

Four-tier accounting (continued) Applying Deductions Deductible items generally fall in four categories: Direct expenses which are deducted against the income to which they relate Indirect expenses (1) which are chargeable to a tier, but are not identified to a specific type of income within the tier These items are allocated pro rata among the items within the tier, ignoring any negative balances No type of income may become negative as a result of this allocation Indirect expenses (2) which are related to any income items (e.g., trustee fees) which may be charged any any manner the trustee chooses Nondeductible expenses which must be charged to Tier 4 64

Four-tier accounting (continued) Allocating losses Ordinary losses Deduct current ordinary losses against any prior year undistributed income from the same or like source Next deduct any remaining ordinary loss against the highest tax rate income in the ordinary income tier, then the next highest tax rate income, and so on Any remaining loss is carried forward indefinitely 65

Four-tier accounting (continued) Allocating losses (continued) Capital losses Within the short-term and long-term subtiers, capital losses are netted against the highest tax rate class, and then the next highest tax rate class, and so on Excess long-term capital losses (regardless of tax rate class) are then used to reduce any short-term gain Excess short-term capital losses are used to reduce any longterm gain, starting with the highest tax rate long-term gain Any remaining capital loss is carried forward indefinitely and retains its duration and tax rate class character 66

Net Investment Income Tax CRT s are not subject to the Net Investment Income Tax Beneficiaries are subject to the tax to the extent their distributions include NII amounts Undistributed amounts from prior to 2013 are not included in NII CLT s are not exempt from the tax But amounts of income distributed to charitable and noncharitable beneficiaries carry out NII and reduce the trust s taxable amount 67

Net Investment Income Tax (continued) Two methods are allowed for CRTs to capture Net Investment Income Tax information Section 664 Method: This method integrates with the category and class system to create tax rate classes that are the sum of the income tax rate and the 3.8% net investment income tax rate Then as each tax rate class is drawn from, net investment income taxable amounts flow out to the beneficiary 68

Section 664 Method Illustrated 69

Net Investment Income Tax (continued) Simplified Method: Cumulative totals of net investment income and non-net investment income buckets are maintained Each year the amount of the distribution that is net investment income is determined by First looking to the cumulative, undistributed net investment income If the distribution is larger than the cumulative, undistributed net investment income, then look to the cumulative, undistributed non-net investment income For trusts created prior to 2013, the Simplified Method had to be adopted on the 2013 return. The Simplified Method can be elected on an amended return so long as the year to be amended and all intervening years for both the CRT and the beneficiaries are open For trusts created after 2012, the Simplified Method must be elected the first year the trust is required to file Form 5227 70 70

Schedule K-1 reporting Net investment income All items of income are grouped together for Schedule K-1 reporting. E.g., included and excluded interest is all included on Schedule K-1 line 1 An adjustment amount is added on line 14 using code H for the excluded from net investment income amount 71

Unrelated Business Taxable Income (UBTI) Just $1 of UBTI triggers a tax The tax on UBTI is 100% of the UBTI amount Old rule (pre TRHCA 2006): CRT was fully taxable in any year there was even $1 of UBTI Report the tax using IRS Form 4720 Use Form 990-T as an attachment to provide relevant details Common sources of UBTI Publicly Traded Partnerships (see Box 20, Code V) Unrelated debt financed income Trading on margin Mortgaged Property Remember the $1,000 specific deduction in arriving at taxable UBTI 72

Self-Dealing and Other Chapter 42 Excise Taxes Split-Interest trusts are prohibited from Engaging in self-dealing IRC 4941 Purchase from, sale to, loan to/from, lease to/from, use of income or assets of trust by a disqualified person (see IRC 4946) Possessing excess business holdings IRC 4943 See exception for CRTs IRC 4947(b)(3)(B) See exception for certain CLTs IRC 4947(b)(3)(A) Purchasing jeopardizing investments IRC 4944 See exception for CRTs IRC 4947(b)(3)(B) See exception for certain CLTs IRC 4947(b)(3)(A) Making taxable expenditures IRC 4945 73

Self-Dealing and Other Chapter 42 Excise Taxes (continued) Compliance (or lack of compliance) with these prohibited activities is self-reported in Part VI-B Exercise care in completing this portion of the return the trustee signs the return under penalty of perjury 74

Questions? 75