Controlling Capital Gains Deferral With a ‘Spigot’ Net Income Charitable Remainder Unitrust

Charitable remainder unitrusts (CRUTs) are commonly used to combine charitable giving objectives with financial and estate planning goals such as retirement planning, deferring capital gain income on the sale of highly appreciated assets, and diversifying an investment portfolio. Deferring capital gain is generally a positive feature of a CRUT. However, the potential for higher capital gains tax rates could make deferral unattractive. Combining a “net income” CRUT with a “make-up” provision and a wholly owned limited liability company provides the donor with flexibility and control for deferring income.

CRUT Overview

Tax code Section 664(d)(2) defines a CRUT as an irrevocable trust that generates an income stream for the donor or other beneficiaries, by paying out a fixed percentage of the value of the CRUT’s assets each year to the beneficiary (unitrust amount), with the remainder of the donated assets going to the donor’s charity at the end of the trust term. Section 664(d)(2)(A) provides that a CRUT can be established for the life or lives of the income beneficiaries, or a term of years, not to exceed 20.

The donor to a CRUT receives an income tax deduction in the year the CRUT is funded (unless the CRUT is funded with tangible personal property in which case the deduction is taken in the year the CRUT sells the property) based on the actuarial value of the charity’s remainder interest, determined using the trust term (for a term of years CRUT) or IRS prescribed actuarial tables (for a CRUT that pays income for the life or lives of the income beneficiaries).

For the donor to obtain the tax deduction and other tax benefits of a CRUT, Section 664(d)(2)(D) requires that the actuarial value of the charity’s remainder interest be at least 10% of the fair market value of the CRUT’s assets on the date of the initial contribution. If the CRUT is funded with appreciated property other than publicly traded securities, the remainder beneficiary should be a public charity or private operating foundation. Otherwise, Section 170(e)(1)(B)(ii) provides that the donor’s charitable contribution deduction will be based on the adjusted basis of the property contributed to the CRUT, rather than its fair market value.

Two common variations on the CRUT are a “net income” provision and a “make-up” provision. Pursuant to Section 664(d)(3)(A), a “net income” CRUT pays the income beneficiary an annual payment equal to the lesser of (1) the unitrust amount (i.e., the fixed percentage of trust assets), or (2) the amount of the trust income. Section 664(d)(3)(B) permits a “net income” CRUT to utilize a “make up” provision, which provides that for any year in which the income of the trust is less than the standard unitrust payment, the shortfall is made up in future years if the trust income exceeds the standard unitrust payment in such years. A CRUT with a “net-income” limitation and a “make-up” provision is often referred to as a NIMCRUT.

Deferring Income

The “net income” provision defers the payment of income to the beneficiary, since the NIMCRUT is never required to pay to the beneficiary more than the trust income. Trust income is defined by reference to state principal and income acts, which generally limit trust income to interest and dividends. Furthermore, under these laws, trust income is a cash concept—a trust will not have trust accounting income if it does not have a cash receipt. Trust income is thus a more limited concept than gross income under the tax code, which under Section 61(a)(3), includes “all gains or undeniable accessions to wealth, clearly realized, over which a taxpayer has complete dominion.”

For purposes of determining trust accounting income, Treasury Regulation 1.664 3(a)(1)(i)(b)(3) provides that pre-contribution appreciation in the CRUT assets is not considered income. Thus, for example, if a donor contributes property with a basis of $10,000 and fair market value of $100,000 to a NIMCRUT, the $90,000 of pre-contribution appreciation cannot be allocated to trust accounting income and distributed to the income beneficiary if the property is sold. Even if the trustee of the NIMCRUT has a power to adjustment between income and principal, Treas. Reg. 1.664 3(a)(1)(i)(b)(3) requires that the pre contribution appreciation be allocated to trust principal, for the benefit of the charitable remainder beneficiary.

‘Spigot’ Variation of a NIMCRUT

The “spigot” variation of the NIMCRUT allows the income beneficiary to defer receipt of trust income by forming a single-member limited liability company (SMLLC) to hold the NIMCRUT assets. For federal tax purposes, the SMLLC is disregarded unless it makes an election to be taxed as a corporation. Because the SMLLC is disregarded for federal tax purposes, all income received by the SMLLC is taxed to the NIMCRUT, which is tax-exempt except to the extent that it has unrelated business income.

However, while the SMLLC is disregarded for federal tax purposes, it is treated as a separate entity for trust accounting purposes under state law. For trust accounting purposes, the CRUT will have income only when a distribution is received from the SMLLC. Therefore, unless the SMLLC makes distributions to the NIMCRUT, the NIMCRUT will not have trust accounting income and will not be required to make income payments to the beneficiary.

The income beneficiary of the NIMCRUT can be appointed as the manager of the SMLLC. As the manager of the SMLLC, the income beneficiary can control the timing of distributions from the SMLLC, thus allowing for the deferral of income and the strategic recognition of such income in tax years where there are off-setting losses to mitigate its effect.

In Technical Advice Memorandum 9825001, the IRS concluded that the mere ability to defer recognition of income to which the income beneficiary is entitled did not in itself constitute self-dealing under tax code Section 4941. The IRS analyzed a NIMCRUT’s purchase of variable annuities to hold and reinvest funds until the beneficiary desired a distribution from the NIMCRUT. Specifically, the IRS addressed whether the CRUT trustee’s ability to control the timing of trust income resulted in the use of the CRUT’s assets for the benefit of the income beneficiary, a “disqualified person” under the self-dealing rules.

The IRS stated that for an act of self-dealing to occur, two elements must be present. First, the disqualified person and income beneficiary must control investment decisions. Thus, such person must be serving as trustee or the facts of the case must establish that such person is acting in concert with the trustee as to these investment decisions. Second, control over the investments and distributions to the CRUT must serve the personal advantage and benefit of the income beneficiary beyond merely the receipt of the income provided by the trust instrument. The IRS noted that because the income beneficiary (a disqualified person) is entitled to receive the CRUT income interest, “it is difficult to argue that the disqualified person receives an inappropriate benefit by deferring the income interest, particularly where such deferral is permitted under section 664 of the Code.”

The IRS thus concluded that deferral of the income interest using a variable annuity did not constitute an act of self-dealing. The IRS subsequently stated in a 1999 continuing professional education manual that “[a]s a practical matter, the vast majority of income deferral NIMCRUTs adhering to ordinary fiduciary standards under state law will not run afoul of this problem” (i.e., self-dealing). Therefore, insofar as the NIMCRUT is administered in accordance with state principal and income laws, the deferral of income should not trigger an act of self dealing.

Converting an Existing CRUT to a ‘Spigot’ NIMCRUT

An existing NIMCRUT could be converted to a spigot NIMCRUT simply by transferring the CRUT assets to an LLC in exchange for a 100% interest in the LLC. For CRUTs that do not have the “net income” and “make-up” provisions, the transfer of the income interest in the CRUT to a newly formed spigot NIMCRUT may present a planning opportunity. Because a CRUT is an irrevocable trust, substantive terms of the trust, such as the identity of the income beneficiaries, the payout rate, or other features typically cannot be changed. Thus, to “roll” the old CRUT into a new spigot NIMCRUT, the taxpayer forms a new spigot NIMCRUT and contributes the income interest from the old CRUT to the new spigot NIMCRUT.

The donor receives an income interest in the new spigot NIMCRUT and a charitable deduction equal to the present value of the remainder interest in the new spigot NIMCRUT, provided that the remainder beneficiary of the new spigot NIMCRUT is a public charity or private operating foundation. If the remainder beneficiary of the new spigot NIMCRUT is a private non-operating foundation, the donor’s deduction will be limited to the donor’s basis in the income interest, which is disregarded under Section 1001(e), thus effectively eliminating any charitable deduction for the donor. The income interest in the old CRUT could be monetized through a sale to a third-party buyer or held by the new spigot NIMCRUT.

Effect of Green Book Proposals on Charitable Remainder Trusts

The Treasury Department released its explanation of the tax proposals included in President Joe Biden’s fiscal year 2022 budget submission on May 28, 2021, often referred to as the “Green Book.” The Green Book details two important proposals that would affect charitable remainder trusts (CRTs). First, the proposal would treat the transfer of appreciated property to a split-interest trust, such as a CRT, as a realization event, with an exclusion for the value of the charitable interest. Thus, for example, if a taxpayer transferred appreciated property to a CRT with a 10% remainder interest, 90% of the appreciation would be recognized on the transfer. This proposal would be effective for tax years beginning after Dec. 31, 2021. Second, the proposal would tax long-term capital gains of taxpayers with adjusted gross income of more than $1 million at 37% (plus the 3.8% net investment income tax under Section 1411). This proposal would be effective for gains recognized after the date of the announcement of the proposal, which is generally assumed to be April 28, 2021. The proposed retroactive effective date would prevent taxpayers from selling appreciated property before the end of 2021 to take advantage of current rates.

However, the transfer of such property to a CRT before the end of 2021 would not be a realization event subject to tax. Use of the spigot NIMCRUT could allow the income beneficiary to defer distribution of capital gains to years when the income beneficiary is not subject to the increased tax rate for long-term capital gains. Of course, the proposals detailed in the Green Book are a long way from becoming law. If, however, Congress enacts these proposals, a spigot NIMCRUT would provide a key planning opportunity in 2021.

Conclusion

A spigot NIMCRUT allows a taxpayer to sell appreciated property on a tax-free basis and control the timing of capital gain distributions from the NIMCRUT. The ability to control the timing of capital gain distributions could be particularly valuable if capital gains tax rates increase, as proposed by the Biden administration. Existing NIMCRUTs that do not contain a “spigot” feature may wish to convert by forming a SMLLC and transferring the CRUT assets to the SMLLC. Other CRUTs might consider converting to a spigot NIMCRUT by rolling over the income interest in the old CRUT to a new CRUT in 2021. In contrast, transferring assets to a new CRT in 2022 could trigger a realization event if the Green Book proposals are enacted.

This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.

Author Information

Jeff Gonya is a partner, and Chris Moran and Allison Church are associates, in the Baltimore office of Venable LLP.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.