Prevention of Abuse of
Charitable Remainder Trusts

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8926] RIN 1545-AX62

TITLE: Prevention of Abuse of Charitable Remainder Trusts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document finalizes regulations that modify the
application of the rules governing the character of certain
distributions from a charitable remainder trust. These regulations
are necessary to prevent taxpayers from using charitable remainder
trusts to achieve inappropriate tax avoidance. The regulations
affect charitable remainder trusts described in section 664 and
certain beneficiaries of those trusts.

EFFECTIVE DATES: These regulations are effective January 5, 2001.
For dates of applicability of these regulations, see
§§1.643(a)-8(d), 1.664-2(a)(1)(i)(e), and 1.664- 3(a)(1)
(i)(l).

FOR FURTHER INFORMATION CONTACT: Catherine Moore (202) 622-3070.

SUPPLEMENTARY INFORMATION:

Background

On October 18, 1999, proposed regulations (REG-116125-99) to amend
§§1.643(a)-8 and 1.664-1 of the Income Tax Regulations (26
CFR Part 1) were. published in the Federal Register (64 FR 56718) .
Several written comments were received in response to the notice of
proposed rulemaking, and a public hearing was held on February 9,
2000. After considering all the comments, the proposed regulations
under sections 643 and 664 are adopted as revised by this Treasury
decision. The comments received and the revisions made are discussed
below. Explanation of Provisions and Summary of Comments

I. General Background

The proposed regulations were issued in response to certain abusive
transactions that attempt to use a section 664 charitable remainder
trust to convert appreciated assets into cash while avoiding tax on
the gain from the disposition of the assets. In these abusive
transactions, a taxpayer typically contributes highly appreciated
assets to a charitable remainder trust having a relatively short
term and a relatively high payout rate. Rather than sell the assets
to obtain cash to pay the annuity or unitrust amount to the
beneficiary, the trustee borrows money, enters into a forward sale
of the assets, or engages in some similar transaction. The
borrowing, forward sale, or other similar transaction does not
result in current income to the trust; thus, the parties attempt to
characterize the distribution of cash to the beneficiary as a tax-
free return of corpus under section 664(b)(4). The proposed
regulations provide that, in this situation, the trust shall be
treated as having sold a pro rata portion of the trust assets.

II. Public Comments.

One commentator argued that the transactions targeted by the
regulations are not abusive because they comply with the statutory
changes made to section 664 by the Taxpayer Relief Act of 1997 (1997
Act), Public Law 105-34, 111 Stat. 788 (1997). Those statutory
changes require that the annual payout rate to noncharitable
beneficiaries not exceed 50 percent of the value of the property
contributed to the charitable remainder trust and that the actuarial
value of the charity's remainder interest be not less than 10
percent of the value of such property. Although the charitable
remainder trusts involved in transactions targeted by the proposed
regulations are drafted to comply with these statutory changes, the
transactions result in the same kind of abuse that Congress was
concerned about in the 1997 Act. It does not follow that because
Congress did not anticipate in 1997 this latest abuse that Congress
intended to allow it.

In the legislative history to the 1997 Act, Congress labeled the
accelerated charitable remainder trusts it was targeting as "abusive
and . . . inconsistent with the purpose of the charitable remainder
trust rules." S. Rep. No. 33, 105th Cong., 1st Sess. 201 (1997).
Congress noted the efforts of the Treasury Department and the IRS to
combat abuse in the area through issuing proposed regulations in
1997, stating: The Committee intends that the provision of the
Committee bill does not limit or alter the validity of regulations
proposed by the Treasury Department on April 18, 1997, or the
Treasury Department's authority to address this or other abuses of
the rules governing the taxation of charitable remainder trusts or
their beneficiaries.

S. Rep. No. 33 at 201. Thus, Congress has neither prohibited nor
discouraged further. regulatory activity in the charitable remainder
trust area. To the contrary, based on the legislative history to the
1997 Act, Congress intended the Treasury Department to continue to
take all necessary action to prevent abuses in this area.

Several commentators questioned the authority to issue the
regulations under section 643(a)(7). Two commentators maintained
that the proposed regulations overstep the bounds of administrative
rulemaking in that section 643(a)(7) was enacted along with the
foreign trust provisions of the Small Business Job Protection Act of
1996 (SBJP Act), Public Law 104-88, 110 Stat. 1755 (1996), and
therefore applies only to foreign trusts. One commentator, citing
the introductory clause of section 664(a), "[n]otwithstanding any
other provision of this subchapter," argued that the Treasury
Department and the IRS are prohibited from applying section 643(a)
(7) to charitable remainder trusts. Some commentators maintained
that section 643(a)(7) does not authorize the promulgation of
regulations imposing a deemed sale where no actual sale has
occurred. These commentators implied that regulatory authority under
section 643(a)(7) should be limited to the concept of distributable
net income (DNI). The Treasury Department and the IRS disagree with
these views.

Although the SBJP Act included dramatic changes in the foreign trust
area, the trust anti-abuse rule was not limited to foreign trusts
and in fact contains no reference to foreign trusts. Furthermore,
the Treasury Department and the IRS believe that Congress put the
anti-abuse rule in section 643 because that section contains the
rules applicable to all of Part 1 of Subchapter J of the Internal
Revenue Code. Section 643(a)(7) gives the Secretary of the Treasury
the authority to "prescribe such.5 regulations as may be necessary
or appropriate to carry out the purposes of this part, including
regulations to prevent avoidance of such purposes" (emphasis added).
"Part" in this context refers to Part 1 of Subchapter J and
encompasses sections 641 through 685, including section 664
governing charitable remainder trusts. The legislative history to
the SBJP Act clarifies that the anti-abuse rule is not limited to
foreign trusts or the DNI rules. The House Conference Report states:

[The rule] authorizes the Secretary of the Treasury to issue
regulations, on or after the date of enactment, that may be
necessary or appropriate to carry out the purposes of the rules
applicable to estates, trusts, and beneficiaries, including
regulations to prevent the avoidance of those purposes.

H.R. Conf. Rep. No. 737, 104th Cong., 2d Sess. 335 (1996). In
addition, the plain language of section 664(a) does not prohibit the
promulgation of regulations that apply section 643(a)(7) to abusive
charitable remainder trust transactions. Section 664(a) states in
full:

Notwithstanding any other provision of this subchapter, the
provisions of this section shall, in accordance with regulations
prescribed by the Secretary, apply in the case of a charitable
remainder annuity trust and a charitable remainder unitrust.

This language provides that the provisions of section 664 apply in
the case of a charitable remainder annuity trust and charitable
remainder unitrust. The Treasury Department and the IRS, however, do
not view this language as providing that no other provisions of
subchapter J can apply in the case of abusive charitable remainder
trust transactions. Applying these regulations to abusive charitable
remainder trust transactions does not conflict with or override the
provisions of section 664. Accordingly, the Treasury Department and
the IRS believe that the plain language of section 664(a) does not
prohibit promulgation of these regulations.

After considering the comments questioning the authority to
promulgate and finalize the proposed regulations, the Treasury
Department and the IRS have concluded that the regulations are an
appropriate exercise of their regulatory authority and are
authorized by the regulatory authority granted to them under section
643(a)(7) and 664(a). Another commentator, while supporting the
proposed regulations in general, suggested that the regulations
contain a more precise definition of the targeted abuse. In response
to this comment, the stated purpose in §1.643(a)-8(a) has been
modified to include a specific reference to the rules regarding the
characterization of distributions from charitable remainder trusts
in the hands of the recipients.

That same commentator requested clarification of whether a deemed
sale by a charitable remainder trust under §1.643(a)-8(b) would
generate unrelated business taxable income (UBTI) within the meaning
of section 512. Section 664(c) provides that whether a charitable
remainder trust has UBTI for any taxable year, and thus is subject
to tax for that year, is determined under the normal rules of
sections 512, 513, and 514. The proposed regulations do not affect
this general rule. However, an example in the final regulations
clarifies that, to the extent that a borrowing by a charitable
remainder trust is recharacterized as a deemed sale by the trust
under §1.643(a)-8(b), the borrowing is not "acquisition
indebtedness" within the meaning of section 514(c).

Another commentator suggested eliminating the provisions in
§§1.664-2(a)(1)(i)(a) and 1.664-3(a)(1)(i)(g) of the
regulations requiring that the annuity amount or the fixed
percentage unitrust amount generally be paid by the end of the year
for which it is due. That commentator contended that the payment
rule is no longer necessary in light of the proposed regulations.

The Treasury Department and the IRS believe that the proposed
regulations serve a function different from the payment rule. The
proposed regulations seek to eliminate tax-free distributions from
charitable remainder trusts due to manipulation of the character of
distributions from those trusts. The payment rule, on the other
hand, eliminates tax-free distributions from charitable remainder
trusts due to manipulation of the timing of the distributions. A
particular distribution could run afoul of either of these rules, or
both rules.

In response to this comment, and to further clarify the different
functions of the two rules, some minor changes have been made to the
proposed regulation to eliminate references to timing and to clarify
the application of the deemed sale rule. In addition, in order to
make it less likely that a non-abusive trust would violate the
payment rule, two new exceptions have been added to
§§1.664-2(a)(1)(i)(a) and 1.664-3(a)(1)(i)(g). These new
exceptions provide that a distribution of cash made within a
reasonable period of time after the close of the year may be
characterized as corpus under section 664(b)(4) to the extent it was
attributable to (i) a contribution of cash to the trust with respect
to which a deduction was allowable under section 170, 2055, 2106, or
2522, or (ii) a return of basis in any asset contributed to the
trust with respect to which a deduction was allowable under section
170, 2055, 2106, or 2522, and sold by the trust during the year for
which the annuity or unitrust amount was due.

One commentator asserted that the proposed regulations should not
apply to charitable remainder trusts established prior to the date
the proposed regulations were published in the Federal Register.
This commentator compared the effective date of the proposed
regulations to the effective date of the 1997 Act's trust
provisions. Each of the changes made by the 1997 Act applies to
transfers made to trusts after the date specified in the 1997 Act,
while the regulations apply to distributions made by trusts after
October 18, 1999.

The Treasury Department and the IRS do not believe this assertion
has merit. These effective dates are not comparable because the 1997
Act and these regulations apply to different aspects of charitable
remainder trusts. The 1997 Act changed the requirements a trust must
meet to qualify as a charitable remainder trust. Whether a trust
qualifies as a charitable remainder trust is determined at the time
property is transferred to the trust. As a result, it was
appropriate to set the effective dates for the 1997 Act with respect
to the time that transfers were made to a trust. The regulations, on
the other hand, change the character of a distribution from a
charitable remainder trust. The character of a distribution from a
charitable remainder trust is not determined until after the
distribution is made. Accordingly, the regulations can be applied,
without being retroactive, to distributions made after the date the
proposed regulations were filed with the Federal Register. Section
7805(b)(1). Furthermore, the Treasury Department and the IRS would
have had the authority under section 7805(b)(3) to write regulations
that take effect retroactively to prevent abuse. The abuse targeted
by. these regulations is well documented in Notice 94-78 (1994-2
C.B. 555), the legislative history to the 1997 Act, the changes to
the charitable remainder trust regulations that were finalized in
1998 (TD 8791, 1999-5 I.R.B. 7), and Notice 2000-15 (2000-12 I.R.B.
826). Finally, the preamble to the proposed regulations requested
comments on two specific issues: (1) whether there are situations
where the application of the proposed regulation would be
inappropriate, and (2) whether an approach that more directly
related the distributed funds to the asset that is the subject of
the borrowing or forward sale would be more appropriate. No comments
were received on either of these issues.

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It is hereby
certified that these regulations will not have a significant
economic impact on a substantial number of small entities. This
certification is based on the understanding of the Treasury
Department and the IRS that the number of charitable remainder
trusts engaging in transactions affected by these regulations is not
substantial, and none are small entities within the meaning of the
Regulatory Flexibility Act (5 U.S.C. chapter 6). Therefore, a
Regulatory Flexibility Analysis under the Regulatory Flexibility Act
(5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of
the Code, the preceding notice of proposed rulemaking was submitted
to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its. impact on small business.

Drafting Information

The principal authors of these regulations are Mary Beth Collins and
Catherine Moore, Office of Chief Counsel (Passthroughs and Special
Industries). However, other personnel from the IRS and Treasury
Department participated in their development. List of Subjects in 26
CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regu ations Accordingly, 26 CFR part 1
is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding
an entry in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.643(a)-8 also issued under 26 U.S.C. 643(a)(7). * * *

Par. 2. Section 1.643(a)-8 is added to read as follows:

§1.643(a)-8 Certain distributions by charitable remainder
trusts.

(a) Purpose and scope. This section is intended to prevent the
avoidance of the purposes of the charitable remainder trust rules
regarding the characterizations of distributions from those trusts
in the hands of the recipients and should be interpreted in a manner
consistent with this purpose. This section applies to all charitable
remainder trusts described in section 664 and the beneficiaries of
such trusts.

(b) Deemed sale by trust. (1) For purposes of section 664(b), a
charitable remainder trust shall be treated as having sold, in the
year in which a distribution of an annuity or unitrust amount is
made from the trust, a pro rata portion of the trust assets to the
extent that the distribution of the annuity or unitrust amount would
(but for the application of this subparagraph (b)) be characterized
in the hands of the recipient as being from the category described
in section 664(b)(4) and exceeds the amount of the previously
undistributed

(i) cash contributed to the trust (with respect to which a deduction
was allowable under section 170, 2055, 2106, or 2522), plus

(ii) basis in any contributed property (with respect to which a
deduction was allowable under section 170, 2055, 2106, or 2522) that
was sold by the trust.

(2) Any transaction that has the purpose or effect of circumventing
the rules in this paragraph (b) shall be disregarded.

(3) For purposes of paragraph (b)(1) of this section, "trust assets"
do not include cash or assets purchased with the proceeds of a trust
borrowing, forward sale, or similar transaction.

(4) Proper adjustment shall be made to any gain or loss subsequently
realized for gain or loss taken into account under paragraph (b)(1)
of this section.

(c) Examples. The following examples illustrate the rules of
paragraph (b) of this section:

Example 1. Deemed sale by trust. Donor contributes stock having a
fair market value of $2 million to a charitable remainder unitrust
with a unitrust amount of 50 percent of the net fair market value of
the trust assets and a two-year term. The stock has a total adjusted
basis of $400,000. In Year 1, the trust receives dividend income of
$20,000. As of the valuation date, the trust's assets have a net
fair market value of $2,020,000 ($2 million in stock, plus $20,000
in cash). To obtain additional cash to pay the unitrust amount to
the noncharitable beneficiary, the trustee borrows $990,000 against
the value of the stock. The trust then distributes $1,010,000 to the
beneficiary before the end of Year 1. Under section 664(b)(1),
$20,000 of the distribution is characterized in the hands of the
beneficiary as dividend income. The rest of the distribution,
$990,000, is attributable to an amount received by the trust that
did not represent either cash contributed to the trust or a return
of basis in any contributed asset sold by the trust during Year 1.
Under paragraph (b)(3) of this section, the stock is a trust asset
because it was not purchased with the proceeds of the borrowing.

Therefore......in Year 1, under paragraph (b)(1) of this section,
the trust is treated as having sold $990,000 of stock and as having
realized $792,000 of capital gain (the trust's basis in the shares
deemed sold is $198,000). Thus, in the hands of the beneficiary,
$792,000 of the distribution is characterized as capital gain under
section 664(b)(2) and $198,000 is characterized as a tax-free return
of corpus under section 664(b)(4). No part of the $990,000 loan is
treated as acquisition indebtedness under section 514(c) because the
entire loan has been recharacterized as a deemed sale.

Example 2. Adjustment to trust's basis in assets deemed sold. The
facts are the same as in Example 1. During Year 2, the trust sells
the stock for $2,100,000. The trustee uses a portion of the proceeds
of the sale to repay the outstanding loan, plus accrued interest.
Under paragraph (b)(4) of this section, the trust's adjusted basis
in the stock is $1,192,000 ($400,000 plus the $792,000 of gain
recognized in Year 1). Therefore, the trust recognizes capital gain
(as described in section 664(b)(2)) in Year 2 of $908,000.

Example 3. Distribution of cash contributions. Upon the death of D,
the proceeds of a life insurance policy on D's life are payable to
T, a charitable remainder annuity trust. The terms of the trust
provide that, for a period of three years commencing upon D's death,
the trust shall pay an annuity amount equal to $x annually to A, the
child of D. After the expiration of such three-year period, the
remainder interest in the trust is to be transferred to charity Z.
In Year 1, the trust receives payment of the life insurance proceeds
and pays the appropriate pro rata portion of the $x annuity to A
from the insurance proceeds. During Year 1, the trust has no income.
Because the entire distribution is attributable to a cash
contribution (the insurance proceeds) to the trust for which a
charitable deduction was allowable under section 2055 with respect
to the present value of the remainder interest passing to charity,
the trust will not be treated as selling a pro rata portion of the
trust assets under paragraph (b)(1) of this section. Thus, the
distribution is characterized in A's hands as a tax-free return of
corpus under section 664(b)(4).

(d) Effective date. This section is applicable to distributions made
by a charitable remainder trust after October 18, 1999. Par. 3.
Section 1.664-1 is amended as follows:

1. Paragraph (d)(1)(iii) is redesignated as paragraph (d)(1)(iv).

2. New paragraph (d)(1)(iii) is added.

The addition reads as follows:

§1.664-1 Charitable remainder trusts.

* * * * *

(d) * * *

(1) * * *

(iii) Application of section 643(a)(7). For application of the anti-
abuse rule of section 643(a)(7) to distributions from charitable
remainder trusts, see §1.643(a)-8.

* * * * *

Par. 4. §1.664-2 is amended as follows:

1. Paragraphs (a)(1)(i)(a)(1) and (a)(1)(i)(a)(2) are revised.

2. Paragraph (a)(1)(i)(a)(3) is added.

3. Paragraph (a)(1)(i)(e) is amended by adding a sentence at the
end. The revision and additions read as follows. §1.664-2
Charitable remainder annuity trust.

(a) * * *

(1) * * * (i) * * *

(a) * * *

(1) The trust pays the annuity amount by distributing property
(other than cash) that it owned at the close of the taxable year to
pay the annuity amount, and the trustee. elects to treat any income
generated by the distribution as occurring on the last day of the
taxable year in which the annuity amount is due;

(2) The trust pays the annuity amount by distributing cash that was
contributed to the trust (with respect to which a deduction was
allowable under section 170, 2055, 2106, or 2522); or

(3) The trust pays the annuity amount by distributing cash received
as a return of basis in any asset that was contributed to the trust
(with respect to which a deduction was allowable under section 170,
2055, 2106, or 2522), and that is sold by the trust during the year
for which the annuity amount is due.

* * * * *

(e) * * * Paragraphs (a)(1)(i)(a)(2) and (3) of this section apply
only to distributions made on or after January 5, 2001.

* * * * *

Par. 5. §1.664-3 is amended as follows:

1. Paragraphs (a)(1)(i)(g)(1) and (a)(1)(i)(g)(2) are revised.

2. Paragraph (a)(1)(i)(g)(3) is added.

3. Paragraph (a)(1)(i)(l) is amended by adding a sentence at the
end. The revision and additions read as follows.

* * * * *

(g) * * *

(1) The trust pays the unitrust amount by distributing property
(other than cash) that it owned at the close of the taxable year,
and the trustee elects to treat any income. generated by the
distribution as occurring on the last day of the taxable year in
which the unitrust amount is due;

(2) The trust pays the unitrust amount by distributing cash that was
contributed to the trust (with respect to which a deduction was
allowable under section 170, 2055, 2106, or 2522); or

(3) The trust pays the unitrust amount by distributing cash received
as a return of basis in any asset that was contributed to the trust
(with respect to which a deduction was allowable under section 170,
2055, 2106, or 2522), and that is sold by the trust during the year
for which the unitrust amount is due.

* * * * *

(l) * * * Paragraphs (a)(1)(i)(g)(2) and (3) of this section apply
only to distributions made on or after January 5, 2001.

* * * * *

Commissioner of Internal Revenue

Approved:

Secretary of the Treasury

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