The Intersection of Charitable Remainder Trusts and Estate Tax, Part I

Gross estate inclusion, basis step-up, IRD deduction, and effects on income beneficiaries

Table of Contents (skip to Intro)

1. Intro

2. IRC Section 2036 Inclusion

3. IRD Analysis

4. Basis Step-Up Analysis

5. Effect on Income Tiers – Prospective or Retrospective? 

6. Conclusion and Executive Summary

I would like to acknowledge the inspiration and contributions of Jack Rabuck of West Coast Financial in putting together this article.

This is the first of a three-part series. While I have provided a lot of my analysis for all readers, the ultimate conclusions are behind the paywall for monthly and annual subscribers.

Intro

While I will discuss the basics of charitable remainder unitrusts and charitable remainder trusts in separate articles, this three-part series of articles focuses on an issue that does not seem to have been covered in great detail.  To that end, some conclusions may be speculative, but I hope to shed some light on an issue that often flies under the radar. 

To set the stage, let’s assume you have a charitable remainder trust with successive income interests.  In other words, perhaps a grantor establishes a charitable remainder trust under which they retain an annuity or income interest until death whether alone or as a joint income interest with one or more individuals.  Then, at the grantor’s death, a successive income interest for at least one non-charitable beneficiary is created or continued.  It is only at the end of that successive income beneficiary’s (or beneficiaries’) interest in the trust that the remainder will be paid to charity.  For ease of reading, I will refer to just one income beneficiary with an interest continuing after the grantor’s death for purposes of this article.

In this situation, we encounter some interesting issues.  Any interest in a charitable remainder trust held by a grantor at death, usually as an income interest and/or as a right to change charitable remainder beneficiaries, will invoke IRC Section 2036.  This will cause inclusion of some or all of the assets of the charitable remainder trust in the grantor’s gross estate.  If the remainder is paid to the charitable beneficiaries as a result of the grantor’s death, any gross estate inclusion will usually be offset in full by the estate tax charitable deduction under IRC Section 2055 – resulting in no incremental increase in estate tax from 2036 inclusion. 

But, if a successive income interest is created or continues (as would be the case for a joint interest) at the grantor’s death for a noncharitable income beneficiary, we could have a mismatch between (1) the amount of trust assets included in the gross estate, and (2) the estate tax charitable deduction available to offset this gross estate inclusion.  If the grantor’s surviving spouse is the next successive income beneficiary, the marital deduction may apply to some or all of this mismatch under IRC Section 2056(b)(8).  In the absence of a spousal beneficiary, however, it is possible that this mismatch could use some of the grantor’s applicable credit against estate tax or, if the credit is used up, generate estate tax. 

This gross estate inclusion also raises questions about the ability of income beneficiaries to reduce the deferred income tax that would have been paid by the grantor on annuity or unitrust distributions, whether through a step-up in basis due to gross estate inclusion or a 691(c) deduction for estate tax attributable to income in respect of a decedent.  

This mini-series of articles is all about addressing these outcomes, valuations, and calculations.  In this first installment, we will focus on the ability of income beneficiaries to use a basis step-up or 691(c) deduction. 

IRC Section 2036 Inclusion

At the grantor’s death, the amount included in the gross estate is determined under IRC Section 2036.  In many cases, all assets of the charitable remainder trust will be included in the grantor’s gross estate based on their fair market value at the grantor’s date of death (or the alternate valuation date if available and elected under IRC Section 2032).  But, depending on the 7520 rate applicable at the time of the grantor’s death (or, if selected, the 7520 rate for one of the two months preceding the grantor’s death), the regulations under Treas. Reg. 20.2036-1(c)(2) may cause less than the full value of the trust assets to be included in the gross estate.  The math behind this calculation will be discussed in the next article in this series.

This invokes another issue that is unclear when it comes to charitable remainder trusts.  Normally, under IRC Section 1014(b)(9), any assets included in the gross estate receive an adjustment to tax basis to reflect the value finally determined for estate tax.  Put differently, this can provide a step-up in basis for appreciated assets.  Given that non-cash assets contributed by a grantor to a charitable remainder trust are usually appreciated assets (for reasons to be discussed in a separate series of articles), this would usually lead to the conclusion that the assets within the charitable remainder trust would get a step-up in basis at the grantor’s death to the extent of gross estate inclusion. 

But, IRC Section 1014(c) denies this basis step-up (or step-down) to assets that are treated as income in respect of a decedent (IRD) under IRC Section 691.

Currently, the Code and Treasury Regulations lack express guidance as to whether the successive income interests under a charitable remainder trust are treated as income in respect of a decedent or, alternatively, are eligible for a step-up in income tax basis within the charitable remainder trust itself.  Treas. Reg. 1.664-1(d)(4)(iii) notes that the distribution, or prorated portion thereof, payable to the grantor’s estate for the year of death is treated as IRD under 691. But, no other provisions of the Code or Regulations expressly provide that any distribution to be received by a successor income beneficiary would be treated as IRD.

If the continuing income interest in a charitable remainder trust is treated as IRD, then any income or gain accrued or realized prior to the grantor’s death under IRC Section 664(b) (but included in the gross estate) could be taxed to the next successive income beneficiary upon receipt as an annuity or unitrust distribution. This would include any gain previously turned into trust “principal” during the grantor’s life.  Any estate tax generated by the inclusion of the charitable remainder trust assets in the grantor’s gross estate could, however, be eligible for the deduction for estate tax on IRD granted under IRC Section 691(c) after reduction for the estate tax charitable deduction under IRC Section 2055. 

On the other hand, a step-up in basis for appreciated charitable remainder trust assets could reduce some of the potential or throwback gain otherwise accounted for within the charitable remainder trust.  As a result, some realized or potential gain could be converted to principal, meaning it would not be subject to income tax upon distribution to the next successive income beneficiary as an annuity or unitrust distribution.

In this vein, we must also consider whether the step-up in basis due to gross estate inclusion under IRC Section 2036 would apply to the assets of the charitable remainder trust itself or, instead, would apply to the actual interest in the charitable remainder trust.  This could have special application under the uniform basis rules of IRC Section 1014 if, for example, the next successive income beneficiary of the charitable remainder trust elects to sell or dispose of their interest in a transaction that invokes the rules of Treas. Reg. 1.1014-5(c).  (The disposition of such an interest will be a subject for another series of articles.)

Having set this (very broad) stage, let’s dive in. 

IRD Analysis

When it comes to income tax, charitable remainder trusts are tax-exempt under IRC Section 664(c)(1).  However, for any unrelated business taxable income received by the charitable remainder trust, IRC Sections 664(c)(2) and 512 impose an excise tax equal to the amount of such income.  Due to this UBIT potential, gross income and deductions are still tracked at the trust level – an important outcome that, as we will see below, has relevance to this discussion. 

This tax-exempt nature applies only to the trust itself.  Because income is distributed to the grantor or successive income beneficiaries, any income received by the charitable remainder trust is tax-deferred with respect to income beneficiaries.  IRC Section 664(b), supplemented by Treas. Reg. 1.664-1(d), sets forth somewhat-complicated rules about the tiering of the various forms of income received and distributable by a charitable remainder trust.  These rules generally provide that any annuity or unitrust distribution consists first of current-year income, broken into first-tier ordinary income and second-tier gains, then prior years’ accumulated income by tier, before being treated as a tax-free distribution of principal to the income beneficiary.  Further, distributions of assets in-kind trigger a realization event at the trust level, increasing the amount of current and accumulated second-tier income.  This income is tracked on IRS Form 5227, filed annually for the charitable remainder trust. 

While complicated, this setup is designed to prevent a grantor (and any other income beneficiaries) from avoiding income tax by leveraging the tax exemption of the charitable remainder trust.  Importantly, this also avoids double-dipping by creating a potential “recapture” of any charitable income tax deduction claimed by the grantor for the present value (at the time of trust funding) of cash and appreciated assets transferred to the charitable remainder under IRC Section 170.  There would never be full recapture, however, as the charitable remainder beneficiary or beneficiaries must receive at least 10% of the initial contribution (by value) to the trust.

However, the character of income in the hands of the income beneficiary is determined from an accounting perspective at the level of the charitable remainder trust.  Thus, the trust can be thought of as having various “buckets” of income that are sequentially drained in a specific order by tier of income before dipping into principal.  These buckets also take into account income that is subject to the net investment income tax under IRC Section 1411 – preserving the potential for the 3.8% NIIT tax for income received by a noncharitable beneficiary. 

While the specifics of these buckets is beyond the scope of this article, there are some asset-specific private letter rulings addressing this issue from the perspective of a charitable remainder trust funded at a grantor’s death (instead of an inter vivos charitable remainder trust).  Two in particular, PLRs 199901023 and 9634019, reached a similar conclusion that payments from a qualified retirement plan (which would usually be income in respect of a decedent to an individual beneficiary) to a charitable remainder trust would be income in respect of a decedent to the trust itself.  Accordingly, as the recipient of the income in respect of a decedent, the trust itself could be entitled to the IRC Section 691(c) deduction for estate taxes attributable to the qualified plan assets paid to the trust, after reduction for any estate tax charitable deduction. 

But, this deduction could not be directly used by the beneficiaries.  Instead, it would be a deduction against the gross income of the charitable remainder trust on Form 5227 for each year in which IRD is received.  The deduction would, in turn, usually reduce the first-tier (ordinary) income of the charitable remainder trust for each qualified plan distribution until the deduction is exhausted.  As noted above, this makes sense when we consider that a charitable remainder trust could be subject to UBIT – thus necessitating the need to track gross income and deductions at the trust level. 

At first glance, these rulings seem to have little utility to a lifetime (instead of a testamentary) charitable remainder trust.  But, while not binding authority, they do stand for an important proposition - that income in respect of a decedent is always determined at the trust level for a charitable remainder trust.  Therefore, income distributions from a charitable remainder trust to an income beneficiary can never be IRD.   While splitting hairs, the IRD is accounted for at the trust level, and simply becomes first-tier ordinary income to be accounted for on Form 5227 (which will be the subject of another series of articles).  Could this open up room for a basis step-up? 

This also potentially means that, due to UBIT potential, any basis step-up due to IRC Section 2036 inclusion is tracked at the trust level.  As a result, before considering the uniform basis rules applicable to lifetime disposition of an income beneficiary’s interest in a charitable remainder trust under Treas. Reg. 1014-5(c), the step-up in basis is first determined at the trust level and is not automatically treated as a step-up in basis of a noncharitable beneficiary’s income interest itself. 

In the next article, we will discuss the risk of estate tax being paid out of the principal or income of the charitable remainder trust itself.  For the time being, however, it is important to note that the 691(c) deduction available to the trust does not require the trust itself to actually pay all or a portion of the estate tax.  Apportionment of estate tax does not drive the deduction itself.  Of course, it can also create a matching issue where a beneficiary whose share is reduced by estate tax may not actually benefit from a 691(c) deduction if they do not themselves receive a directly proportionate share of IRD.  In this situation, unless there are literally no other assets available for payment of estate tax, the other beneficiaries of an estate may pay a disproportionate share of estate tax on behalf of the charitable remainder trust without getting any direct benefit from the 691(c) deduction (since this deduction can only be claimed by the trust itself). 

Basis Step-Up Analysis

Given the PLRs cited above and the guidance of income tiers under IRC Section 664(b), the character of income is primarily accounted for at the level of the charitable remainder trust.  In this vein, IRD is also determined at the trust level, with the 691(c) deduction also being accounted for solely at the trust level.  So, while IRD does not benefit the income beneficiaries directly, it does reduce the amount of first-tier ordinary income to later be accounted for at the trust level (which would otherwise be taxed to income beneficiaries upon distribution).  And, as noted above, this means income distributions from the charitable remainder trust would not be IRD but instead would be superseded by the accounting and income characterization rules of IRC Section 664(b).

Which brings us to the question of basis.  It is clear that assets transferred by a grantor during life to a charitable remainder trust get a carryover basis in accordance with IRC Section 1015.  (Assets transferred at death to a testamentary charitable remainder trust, other than IRD, would instead have a basis determined under IRC Section 1014.)  And, if we follow the trend that IRD can be accounted for and benefit the charitable remainder trust itself (along with UBIT potential at the trust level), it stands to reason that a basis step-up due to gross estate inclusion at the grantor’s death should also primarily benefit the trust itself as noted above. 

The bigger question is whether the step-up in basis can actually benefit the successor income beneficiary? 

Logically, we can look at a parallel situation – the sale of an appreciated asset by the charitable remainder trust, followed by a repurchase of assets.  In such a situation, the assets newly purchased by the trust using the proceeds of the sale of old assets would get a “stepped-up” cost basis equal to their net purchase price under IRC Section 1016.  The tax-exempt nature of the charitable remainder trust means that any gain would not be recognized or taxed unless it is UBTI under IRC Section 512.  (The trickle-down effect of UBIT on the accounting under IRC Section 664(b) is a subject for a later series of articles.) 

In this situation, the charitable remainder trust would have a new basis.  But, the gain realized on the sale of the relinquished assets does not go away.  Instead, it is separately tracked at the trust level as second-tier income under IRC Section 664(b).  The outcome is that income beneficiaries do not get to use this cost basis step-up.  If we use this as our standard, it would seem to indicate that a basis step-up under IRC Section 1014 likewise could not be used by income beneficiaries.  But, we must also consider that the basis used to determine realized gain is driven at the trust level under either IRC Sections 1014 or 1015. 

Also, keep in mind that the IRC Section 691(c) deduction for estate tax attributable to IRD is designed to keep the same income or realized gain from being subject to both income tax and estate tax.  As we saw above, income beneficiaries can indirectly benefit from the 691(c) deduction due to the reduction to first-tier ordinary income at the level of the charitable remainder trust.  Given this outcome, it would stand to reason that income beneficiaries should also be able to indirectly benefit from a step-up in basis at the level of the charitable remainder trust – at least to the extent of estate tax liability. 

There is a problem, however, if we try to conflate estate tax liability with reduction of a beneficiary’s income tax potential.  The basis step-up under IRC Section 1014 is decoupled from actual estate tax liability.  If we were examining this under the framework of IRC Section 1015, this analogy would hold true – that the actual basis step-up, and perhaps the indirect benefit to income beneficiaries of the charitable remainder trust, would correlate to gift and GST tax actually paid.  In other words, use of gift tax annual exclusion or applicable credit does not generate a step-up in basis.  That is not the case, however, under IRC Section 1014, as the basis step-up is provided to all assets regardless of whether applicable credit is first used to offset estate tax on those assets. 

In the next article, we will discuss the calculation of IRC Section 2036 inclusion and the IRC Section 2055 deduction.  One thing we will learn is that the IRC Section 2055 deduction is determined under Treas. Reg. 1.664-4, which operates as if a new charitable remainder trust is being funded at that time for the successive income beneficiaries and charitable remainder beneficiaries.  Remember above when I mentioned that the basis of non-IRD assets transferred to a testamentary charitable remainder trust would be determined under IRC Section 1014?  Could it be that this rule is coupled with the valuation guidelines under Treas. Reg. 1.664-4, to determine basis as if the ongoing charitable remainder trust was treated as a newly-created trust at the time of the grantor’s death?