On March 22, 2024, the Treasury Department published a proposed regulation relating to certain transactions involving Charitable Remainder Annuity Trusts ("CRATs") investing in single premium immediate annuities ("SPIAs"). The rule would designate transactions seeking to exclude from income SPIA payments from a CRAT under Section 72(b)(2) of the Internal Revenue Code (the "Code"). Any transactions meeting the specific description in the proposed regulation, or any substantially similar transactions, must be reported to the Internal Revenue Service on a Form 8886, Reportable Transaction Disclosure Statement to avoid the penalties in Section 6707A of the Code.
What is a CRAT?
A CRAT, defined in Section 664(d)(1) of the Code, provides a fixed stream of annual income, ranging from five and fifty percent of the original fair market value of the trust, to one or more noncharitable beneficiaries with the remainder payable to one or more charities at the termination of the trust. The term of the irrevocable trust may be up to twenty years or for the life of the noncharitable beneficiary. Upon termination of the trust, the corpus must transfer to a charitable organization described in Section 170(c) of the Code and must have a fair market value of at least ten percent of the original fair market value of the trust assets. Under Section 664(b), distributions from a CRAT to the noncharitable beneficiaries take the character of the income realized by the trust, whether that be ordinary income, capital gain, or other income. Any distributions beyond the income recognized by the trust shall be treated as trust corpus.
Specifics of the Listed Transaction
The Treasury Department has identified a transaction by which taxpayers contribute appreciated property to a CRAT, sell the appreciated property, and use the proceeds to acquire a SPIA. The taxpayer treats the annuity payment from the trust as if it were an annuity payment subject to Section 72 of the Code rather than a payment to be treated under the Section 664(b) classification of income. Accordingly, the payments will be treated predominantly as tax-free returns of capital from the annuity rather than as ordinary or capital gain income.
Errors of Law Identified by Treasury
The proposed regulation critiques the application of Section 72 rather than Section 664(b) to the stream of annuity payments and questions whether the trust would qualify as a CRAT under Section 664(d)(1) in the first place. Treasury makes clear that Section 664(b) should control the classification of distributions from the trust because the taxpayer erroneously treats the income as if he or she owns the annuity "rather than the SPIA being an asset owned by the CRAT." Applying Section 644(b) to the stream of payments results in the payments being applied first to the ordinary income portion recognized by the trust, and then to the one-time capital gain recognized on the sale of the initial asset.
The proposed regulation also makes clear that many such transactions also fail to meet the CRAT requirements of Section 664(d)(1). Specifically, many trust documents contain provisions either authorizing a current payment in lieu of the payment of the remainder interest described in Section 664(d)(1)(C) or authorizing the payment of an annuity amount in excess of the amount described in Section 664(d)(1)(A), both of which violate mandatory requirements of a valid CRAT.
Test for Transactions Described in the Regulation
To qualify as a transaction described in the proposed regulation, five requirements must be satisfied:
- The grantor creates a trust purporting to be a CRAT under Section 664;
- The grantor contributes appreciated property to the trust;
- The trustee sells the contributed property;
- The trustee uses some or all of the proceeds from the sale of the contributed property to purchase an annuity; and
- The beneficiary of the trust treats the amount payable from the trust as if it were subject to Section 72 rather than Section 664(b).
Impact on the Parties to the Transaction
Participants to a transaction described in the proposed regulation must disclose that fact on a Form 8886. In addition to the disallowance of tax benefits, failure to make the required disclosure will extend the period of limitations under Section 6501(c)(10), incur enhanced accuracy-related penalties under Section 6662A, and incur failure to report penalties under Section 6707A. Material advisors providing aid, assistance or advise with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out the transaction described in the proposed regulation, must also disclose participation in the transaction and maintain lists of clients advised to engage in such transactions. Failure to comply with the requirements for material advisors will result in additional penalties. Finally, the charitable remainderman will not be deemed to be a participant merely due to its status as the remainderman, but Treasury specifically requested comments regarding what fees a charitable remainderman receives, "either directly or indirectly, for providing such material aid, assistance or advice." Accordingly, charitable organizations serving as a remainderman to a CRAT should consider whether their participation could amount to that of a material advisor.
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