Step 4. Brown and the trustee each sell their respective interests to a
third party buyer.
Step 5. Brown uses his $200,000 of sales proceeds to pay off the loan
against his bungalow.
To summarize, Brown will incur a capital gain of $180,000 on the sale of his retained interest ($200,000 - $20,000 allocable basis). However, the gain can be partially offset by the charitable contribution deduction.
Caution: IRS has suggested that a transfer of an undivided fractional interest in property to a charitable remainder trust with a retained interest by the trustor (a disqualified person) may constitute a prohibited act of self-dealing.82 Until the Service reverses its stand on the self-dealing
issue surrounding gifts of fractional interests, this technique may not be advisable. See Chapter 7 - Self-Dealing Rules - for a detailed discussion.
c. Charity Purchases a Fractional Interest in Property Equal to Debt and Joins in Sale
In the previous example, the charitable remainderman might have participated as the lender. Such transactions are usually structured at arms length with an independent trustee. As an alternative, the trustor can avoid a potential self-dealing problem by having the charity purchase an undivided fractional interest in the property from the trustor in an amount equal to or greater than the indebtedness. The sale proceeds are used to retire the indebtedness, and then the free-and-clear remaining interest is transferred to the charitable remainder trust. The trustor and charity then join in the sale of their respective interests.
Because the seller is transferring his entire interest in the property, no self-dealing issue should be raised. Gain recognized on the taxable sale to the charity can be mitigated by the charitable contribution deduction generated upon transfer of the retained interest to the trust.
d. Trustor Holds Trustee Harmless for Debt Obligation
The issues of bargain sale, unrelated debt-financed income, and grantor trust implications all assume the trustor is relieved of the mortgage obligation. Several legal commentators have speculated that, if the trustor indemnifies the trustee against liability for the debt, there is no such relief of indebtedness.
However, because the lender would most likely not reduce its security by releasing any portion of the property transferred to the trust, the trustor would retain an undivided fractional interest in the property. When the property is ultimately sold, the trustor will have the proceeds necessary to retire the debt.
Comment: Again, the potential self-dealing problem may discourage use of this technique. The problem is, proceeds paid on the sale of the property owned by the trust will not relieve the trustor of the personal liability unless the trustor pays off the debt outside the trust.
e. Real Estate Investment Trust
In Ltr. Rul. 199952071, a limited liability company, which is treated as a partnership for federal tax purposes ("Company"), proposes to contribute appreciated real property encumbered by debt to a limited partnership ("Partnership") for units in the Partnership ("Units"). The general partner of the Partnership is a non-public real estate investment trust that is intended to qualify as a real estate investment trust under Section 856 of the Code ("REIT"). The Partnership uses an interim-closing- of-the-books allocation method with a semi-monthly convention for allocating partners' varying shares in partnership items. It is anticipated that when debt- encumbered property is contributed to the Partnership, the Partnership will almost immediately pay the debt, and close its books on the 15th day of each month. Pursuant to the Partnership's agreement, debt-encumbered property can only be contributed during the first half of each month and charitable donations of the interests in the Partnership can be made only during the second half of each month. The Partnership agreement provides that limited partners of the Partnership may not convert their Units to shares of common stock in the REIT for a period of two years from the date the limited partner acquires its Units. If the limited partner is a non-profit or charitable remainder trust and had received the Units for less than full consideration, the two-year period will be calculated from the date that the donor of the Units acquired the Units.
Company anticipates holding the Units for two years and then transferring them to a charitable remainder trust ("Trust"), which may in turn exchange the Units for common stock in the REIT to hold as an investment or for future sale. The Trust will pay a unitrust amount to Company for 20 years and the remainder to a charitable organization described in Sections 170(b)(1)(A), 170(c), 2055(a), and 2522(a) of the Code. The unitrust amount will initially be the lesser of trust income or six percent of the net fair market value of the Trust's assets. It will flip to a fixed percentage payout of six percent upon the sale or exchange of interests in the Partnership, or REIT stock, for marketable assets.
The IRS held that, (i) the Company is a permissible grantor of the Trust; (ii) the Trust will qualify as a charitable remainder unitrust; (iii) the Trust will receive no debt-financed property transferred to it by Company; therefore, the satisfaction of the debt by the Partnership or its general partner during a semi-monthly period for allocating partners' varying shares, in partnership items in which the Trust does not hold any Units, will prevent the Trust from holding the Units subject to acquisition indebtedness under Section 514 of the Code; (iv) the conversion of Units to shares of common stock in the REIT will not result in unrelated business taxable income to the Trust; (v) the Trust will not recognize unrelated business taxable income from activities of the Partnership; (vi) ownership of shares of common stock in the REIT resulting in payment out of the earnings and profits of the REIT which constitute dividends within the meaning of Section 316 of the Code will not result in unrelated
business taxable income to the Trust by virtue of Section 512(b)(1) of the Code; and (vii) the sale of the common stock of the REIT by the Trust will not result in unrelated business taxable income by the Trust by virtue of Section 512(b)(5) of the Code.
The IRS deferred ruling on whether the transfer of Units to the Trust by the Company, and the subsequent exchange of the Units for common stock of the REIT, should be recharacterized for federal income tax purposes as the conversion of the Units into REIT stock by the Company followed by the subsequent
contribution of the REIT stock to the Trust by the Company, based on all facts and circumstances surrounding the transfer (citing Palmer and Blake).83
I. Intangible Assets
Certain intangible personal property such as copyrights, royalty interests, patents, oil and gas interests, installment obligations, life insurance contracts, and partnership interests are often considered for transfer to charitable remainder trusts.
1. Copyrights
A copyright owned by an individual whose personal efforts created the copyrighted work (or given to the individual by the work’s creator) is considered ordinary income property.84 Therefore, any charitable deduction must be based on the cost basis in the
work.
Further, a transfer of a copyright without the underlying tangible asset (e.g., an original artwork) constitutes a gift of other than the donor’s entire interest in property and, therefore, is not deductible.85 However, an income tax deduction for gift of a copyright
where the tangible asset had little intrinsic value (i.e., a book with a large circulation) has been allowed.86
2. Royalty Interests
A royalty is defined in part as “amounts received for the privilege of using patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and other like property.”87
The transfer of a royalty interest to a charitable remainder trust without the underlying property would, most likely, be considered an assignment of income. In such case, the trustor would remain liable for paying the tax on such income.88
If the royalty interest is transferred along with the property, the property might qualify as a capital asset (subject to related use rules). The royalty interest will, however, be
83 This concept and ruling were sponsored by Thornburg Foundation Realty, Santa Fe, NM. 84 IRC §1221(3)
85 Reg. §1.170A-7(b)(1) 86 Ltr. Rul. 7944030 87 GCM 38083
considered ordinary income property for which a deduction is limited to the lesser of fair market value and its adjusted cost basis.
Finally, IRC §512(b)(2) provides that one of the modifications to be taken into account in determining unrelated business taxable income is “all royalties (including overriding royalties and net profits income) whether measured by production or by gross or taxable income from the property, and all deductions directly connected with all such income.” These items are excluded in determining UBTI; however, Reg. §1.512(b)-1 cautions that all the facts and circumstances of each case must be examined to determine whether a particular item of income falls within any of the modifications provided in IRC §512(b).
a. Royalties from Working Mineral Interests
A working or operating interest is defined as an interest in oil and gas in place that is burdened with the cost of development and operation of the property.
Where an individual owns subsurface minerals in place and grants the right to develop those minerals to an operator in exchange for a lease bonus and a percentage of all minerals found, such income is generally considered a non-operating interest. Income from a non-operating interest is characterized as royalty income provided the owner does not participate in exploration, completion, or operating costs.89
If the owner of the non-operating interest transfers a royalty, overriding royalty interest, or net profits interest to a charitable remainder trust, such interests are considered interests in real property and are treated, for income tax deduction purposes, as long-term capital gain property (provided such interests are held for at least one year), unless the interest is used by the trustor in a trade or business. In the latter case, the property is characterized under IRC §1231 and is subject to the reduction rules applicable to ordinary income property.90 Recapture of intangible drilling costs
is not applicable to non-operating interests and, therefore, has no effect on the charitable deduction.91
b. Carved Out Production Payments
An operator may seek outside financial resources for exploration, development, and operating expenses by carving out a portion of the production payments to an investor.92 Such amounts are considered as a mortgage on the property.93 Thus, if a
charitable remainder trust is given an interest in carved out production payments, such payments will most likely be characterized as debt-financed income.94
89 IRC §614 90 Rev. Rul. 73-428, 1973-2 C.B. 303 91 IRC §1254 92 Reg. §1.636-3(a) 93 IRC §636(a) 94 IRC §514
c. Overriding Royalties or Net Profits Interest Contributed by an Operator
The transfer of an overriding royalty interest or net profits interest by the owner of an operating interest under an oil and gas lease to charity is not entitled to charitable contribution deduction under IRC §170(a).
Reason: The contributed interest is less than the taxpayer’s entire interest within the meaning of IRC §170(f)(3) and is not an undivided portion of the taxpayer’s entire interest.95
3. Patents
A transfer of all substantial rights to a patent is considered a transfer of a capital asset. Therefore, if the patent is held by the trustor for more than one year prior to transfer, the trustor’s charitable income tax deduction will be based on fair market value. In order for the transfer to avoid violating the partial interest rules, the trustor must transfer “all substantial rights to the patent” (or an undivided fractional interest in the same) as described in Reg. §1.1235-2(b).
Income generated by a patent should be characterized as royalty income and thereby excepted from characterization as unrelated business income.96
4. Installment Obligations
The transfer of an installment obligation (such as a note secured by a deed of trust or mortgage carried by the seller of real property) to a charitable remainder trust is considered a taxable disposition resulting in acceleration of all gain to the trustor. The charitable deduction is based on fair market value.97
Even though the transfer of an installment obligation to a charitable remainder trust is considered a taxable disposition under IRC §453B, the creation by the trustee of a note within the trust causes no adverse tax consequences. Further, the trust will not have debt-financed income because it is serving as lender rather than borrower.
There are several concerns regarding a trustee carrying paper. The first is security. If the buyer defaults, is the trustee prepared to foreclose and can the trust and income recipients withstand the loss of income? The second concern is valuation. Will the note be discounted and will such discount affect the annual unitrust amount? Another concern is that, in the event of a foreclosure, a lender/trustee may face CERCLA liability, may have to service a prior lien or may receive UBTI from the property.
95 Rev. Rul. 88-37, 1988-1 C.B. 97 96 GCM 38083
5. Life Insurance Contracts
The sale of a cash value life insurance contract results in the seller realizing ordinary income to the extent the sales price exceeds the owner’s basis in the contract.98
Therefore, when an insurance contract is transferred to a charitable remainder trust, the trustor’s deduction is based on the lesser of fair market value and adjusted cost basis under the reduction rules applicable to ordinary income property. The trustor’s basis in the contract is equal to the aggregate premiums paid, less dividends paid and outstanding policy loans. For non-modified endowment contracts, partial withdrawals from cash value are considered made on a first-in-first-out (FIFO) basis. Therefore, partial
withdrawals are considered made first from basis. For modified endowment contracts (and deferred annuity contracts), withdrawals are considered made on a last-in-first-out basis (LIFO). Therefore, a reduction in basis does not occur until all gain in the contract has first been withdrawn.
Caution: The transfer of an insurance contract with outstanding policy loans may cause the trust to have “debt-financed income” under IRC §514(c)(1)(A).
If the policy is considered paid-up, the fair market value is based on the single premium amount it would cost for a comparable policy having an equal death benefit for an individual the same age as the insured.99 If the cash surrender value of the contributed
policy exceeds the policy’s replacement cost, the trustor could arguably use the interpolated terminal reserve.100
If the policy requires additional premiums, the fair market value is the policy’s
interpolated terminal reserve on the date of transfer, adjusted for the proportionate value of premiums paid that cover the period of time extending beyond the date of the gift.101
a. Life Insurance Contract as a Trust Investment
In 1979, the Service approved the funding of a charitable remainder unitrust with life insurance. In that ruling, a husband transferred a life insurance policy on his life to a unitrust that named his wife as the sole life income recipient. The husband then made premium payments directly to the insurance company. The trust was deemed a qualified trust to which contributions were deductible (provided the recipient trust could not be changed at the option of the insured). Further, each additional
premium payment was considered an additional contribution to the trust for which the husband was allowed a deduction equal to the present value of the remainder interest.102
In Letter Ruling 8745013, an individual proposed to transfer appreciated non- income producing real property to a charitable remainder unitrust. The trustee intended to sell the property and use the proceeds to buy life insurance on the lives of the income recipients.
98 Comm. v. Phillips (4 Cir; 1960), 275 F.2nd 33,5 AFTR 2d 855 99 Reg. §25.2512-6(a), Example 3
100 Rev. Rul. 78-137, 1978-1 C.B. 280
101 Reg. §25.2512-6(a); Rev. Rul. 59-195, 1959-1 C.B. 18 102 Ltr. Rul. 7928014
Ruled: If the trustee borrows from an insurance policy and invests proceeds to create income, acquisition indebtedness under IRC §514(c)(1)(A) will exist. The transaction will not violate Reg. §§1.664-1(a)(3) and 1.664-3(a)(4) under specified conditions. A life insurance contract is not considered a jeopardizing investment under IRC§4944 under specified conditions.
In Letter Ruling 199915045, a grantor proposed to create a charitable remainder unitrust with a bank being the trustee (“Trust”). Under the governing instrument of the Trust, the trustee is to pay quarterly installments to the grantor’s stepdaughter, who is the sole income beneficiary of the Trust. The grantor intends to purchase an insurance policy on her spouse’s life, fund the policy with enough cash so that no additional premiums are expected to be due, and then assign ownership of the policy to the Trust. Upon the death of the stepdaughter, the trustee will distribute all of the then principal and income of the Trust to charities that qualify as organizations described in sections 170(b)(1)(a), 170(c), 2055(a), and 2522(a) of the Code. Taking note that the insurance policy is irrevocably payable for a charitable purpose, the Service held that neither the existence nor exercise of the trustee’s power to pay the annual premiums on the insurance policy will disqualify the Trust as a charitable remainder trust. Additionally, the Service held that (i) the grantor will be entitled to an income tax charitable contribution deduction for the present fair market value of the remainder interest in the insurance policy, (ii) the grantor will be allowed a gift tax charitable deduction under 2522(a) of the Code for the present value of the remainder interest in the Trust, and (iii) the Trust will not be included in the gross estate of either the grantor or his wife because neither retained any interest in or power over any of the property transferred to the Trust and that under the terms of the Trust neither will possess any interest or power with respect to the Trust corpus. Query: Could the donors have contributed appreciated securities, with the proceeds of the sale of the securities used to fund the premium payments, with the same tax consequences?
b. Insurable Interest Concerns
In 1991, the IRS ruled that a gift of a newly issued life insurance policy to charity and gifts of future premium payments were not deductible for income tax and gift tax purposes.
Reason: Under local law (New York), the charity did not have an insurable interest. Therefore, the executor of the estate could maintain an action to recover the death benefit. Since the possibility of the charity’s rights in the policy being divested was not so remote as to be negligible, the transfer would be considered a nonqualified gift of a partial interest.103
New York and many other states subsequently amended the definition of insurable