CLIENT ALERT

CSG Law Alert: “CRAT” Crackdown

The IRS has recently added certain charitable remainder annuity trust (“CRAT”) transactions to its growing “listed transactions.”¹ The IRS identifies arrangements or transactions that it views as an abuse of the U.S. tax system and requires taxpayers who engage in these transactions to report them or otherwise be subject to penalties.

One space in which corrupt promoters and tax practitioners have been operating includes charitable remainder annuity trusts, which, in addition to the label as a “listed transaction,” earned a spot on the IRS’ dirty dozen list. Often, these schemes are advertised as a way to reduce or eliminate taxes. Fortunately, not all CRATs are created equal.

What is a CRAT?

A CRAT is an estate planning tool that allows donors to contribute appreciated property to a trust for a term of years (not greater than 20) or for the lifetime of a beneficiary (the “payment term”). The structure of a CRAT allows the named beneficiary to receive distributions from the CRAT in the form of an annuity during the payment term. The remainder of the CRAT passes to charity at the end of the payment term. The payment to the annuitant beneficiary must be equal to at least 5% but not more that 50% of the net fair market value of trust’s assets as of their contribution date.²

For CRAT donors, two distinct advantages include the ability to take a charitable contribution deduction for the present value of the remainder interest that will pass to the charity and, many times, the donor does not recognize a capital gain on the transfer of appreciated property to the CRAT.

Are all CRATs created equal?

All CRATs are not created equal. Only CRATs with the following characteristics will be subject to the IRS’s proposed regulations:

• The grantor creates a trust purporting to qualify as a charitable remainder annuity trust under Section 664(d)(1);³
• The grantor funds the trust with property having a fair market value in excess of its basis (contributed property);
• 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
• On a Federal income tax return, the beneficiary of the trust treats the annuity amount payable from the trust as if it were, in whole or in part, an annuity payment subject to Section 72, instead of carrying out to the beneficiary amounts in the ordinary income and capital gain tiers of the trust in accordance with Section 664(b).

The IRS proposed regulations will require a taxpayer to file Form 8886 (Reportable Transaction Disclosure Statement) for any reportable transaction identified by the IRS. For taxpayers who participate in a CRAT transaction as described above will be required to disclose the transaction regardless of whether taxes are owed.

Why is the IRS cracking down on these types of CRATs?

The IRS has identified certain abuses taxpayers have taken with their CRATs, which has prompted the IRS to add these types of CRATs to the listed transaction list. So long as the CRAT has the attributes listed above, a taxpayer will have to report the CRAT or risk being subject to IRS penalties, which are often severe.

The main abuses of a CRAT concern the transfer and subsequent sale of a low-basis asset that has appreciated. These types of assets often include interests in a closely held business and assets used in a trade or business. Once transferred, the donor then sells the asset, which is used to purchase a single premium immediate annuity. The taxpayer then treats the annuity payment under Section 72 on their Federal income tax return, which essentially means the taxpayer avoids recognition of ordinary income and/or gain.⁴

The IRS deems this transaction an improper application of Sections 664 and 72. Instead, the correct application would result in annual ordinary income from the annuity payments and a one-time capital gain treatment at the time of the sale of the appreciated property to the CRAT.⁵

Cautionary Tales from Tax Court

Furrer v. Commissioner⁶ involved taxpayers who formed two CRATs after seeing an advertisement in an industry magazine. They then donated crops from their farming business to the CRATs. They sold the crops, giving ten percent to the charity and purchased a single premium immediate annuity from which it made distributions to the taxpayers.

On their gift tax returns, the taxpayers listed the basis of the crops as $0. On their Federal return, the taxpayers failed to include the distributions as income. Because they expensed the crops on their personal tax return, the profit from the sale of crops was deemed ordinary income.⁷ The Tax Court determined that being active farmers, the crops constituted inventory, and profits from the sale of inventory constituted ordinary income. Under the ordering rules in Section 664, all ordinary income must be distributed by a CRAT before anything else, therefore, all the distributions made to the taxpayers were deemed ordinary income.⁸

A second case, Gerhardt v. Commissioner,⁹ involved similar facts to Furrer. In Gerhardt, the Tax Court addressed the ordering rules, which require distributions from the CRAT to the beneficiaries be first treated and reported as ordinary income, then as capital gains, then as other income, then as a nontaxable distribution. However, in this case, the Tax Court imposed penalties under Section 6662(a) and 6662(b)(2). A taxpayer can defend themselves against these severe penalties if they can show reasonable cause for the underpayment, which includes reliance on a professional. The Tax Court applied a three-prong test in this case to determine whether the taxpayers’ reliance on their advisors was reasonable: (1) whether the advisor was a competent professional with appropriate proficiency to warrant reliance, (2) whether the taxpayer provided necessary and accurate information to the advisor, and (3) whether the taxpayer actually relied in good faith on the advisor’s judgment.¹⁰ Unfortunately, the taxpayers could not produce any information related to their advisor’s qualifications, their communications with him and the type of advice they received so the Tax Court upheld the penalty.¹¹

Conclusion

A CRAT could be an advantageous estate planning vehicle. However, because CRATs are already on the IRS’s radar as a listed transaction, charitably minded taxpayers should consult with a trusts and estates attorney who is experienced in this area. Your trusts and estates attorney can guide you through the creation of a CRAT that would best suit your needs and estate planning goals. Conferring with your attorney before creating and making contributions to a CRAT will also ensure that your plans properly fall within IRS guidelines to avoid negative tax consequences.

¹ Prop. Reg. § 1.6011-15.

² I.R.C. § 664(d)(1)(A).

³ All references to “section” are to a section of the Internal Revenue Code of 1986, as amended.

⁴ Prop. Reg. § 1.6011-15.

⁵ Id.

⁶ T.C. Memo 2022-100.

⁷ Id.

⁸ Id.

⁹ 160 T.C. No. 9 (April 20, 2023).

¹⁰ Id. at 17.

¹¹ Id.

Ann Clogan