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George F. Bearup, J.D. Senior Legal Trust Advisor

December 20, 2022

Charitable Annuity Trusts Fail

Take-Away: The tax consequences with regard to transfers to charitable remainder trusts are very tricky and detailed. If those rules are not carefully followed by the donor, the penalty can be very high income taxes, interest and penalties.

Background: Income tax deductions are a matter of legislative grace. Practically speaking, that means that a donor must comply with all of the legislative restrictions in order to be able to claim a charitable income tax deduction, either directly to the charity or through a charitable remainder trust. A charitable income tax deduction may be allowable for a transfer of assets to a charitable remainder annuity trust (CRAT), corresponding to the value of the charitable remainder interest, but that charitable contribution deduction is permitted ‘only if verified under regulations prescribed by the Secretary of Treasury.’ [IRC 170(f)(2)(A).]

CRAT: A CRAT is a type of charitable remainder trust that provides for annual distributions to the grantor or other noncharitable lifetime beneficiaries in the form of a fixed annuity payment, with a an irrevocable remainder interest in the CRAT to one or more qualified charities. [Regulation 1.664-1(a).] A CRAT is exempt from income taxation; consequently, appreciated property can be sold by the CRAT tax-free. [IRC 664(c)(1).] While the CRAT enjoys a tax-exempt status, the income earned by the CRAT is taxable to its income/annuity beneficiaries on distribution.

CRAT Reporting Rules: CRATs are subject to strict reporting requirements to ensure compliance with the Tax Code’s ‘ordering rules,’ which are generally with respect to distributions to the non-charitable beneficiary: (i) first, as ordinary income; (ii) next, as capital gain; (iii) next, as other income to the extent of the CRAT’s current and previously undistributed other income, e.g. tax exempt income; and finally (iv) as a nontaxable distribution of trust corpus. A CRAT must file an annual informational return [Form 5227] which reflects its income, deductions, accumulations and distributions for the year. It must also issue to each income beneficiary annually a Schedule K-1, Beneficiary’s Share of Income, Deductions, Credits, etc., that properly describes the tax character of all distributions. [IRC 6034(a).] And, the CRAT must maintain a record of the basis of all property contributed to the CRAT.

Charitable Gift Substantiation Requirements: The Tax Code imposes strict substantiation requirements in order to claim a charitable income tax deduction. One such requirement is that that for a gift of property in excess of $5,000 (other than publicly traded securities) to a charity, the donor generally must: (i) obtain a qualified appraisal of the property; and (ii) attach to the tax return on which the charitable income tax deduction is claimed a fully completed appraisal summary on Form 8283. A ‘qualified appraisal’ must be prepared by a ‘qualified appraiser’ no later than the due date of the income tax return, including extensions. [IRC 170(f)(11)(E).] The donor must also maintain records that substantiate the income  tax deduction. [Regulation 1.170-13(b)(2)(ii)(D), which mandates written records that demonstrate the fair market value of the donated property, the methodology used to determine the fair market value, and a copy of the signed report of the appraiser, when applicable.] In sum, no  charitable income tax deduction will be allowed for a gift of property (described in IRC 170(f)(11) unless these strict substantiation requirements are met by the donor.

Tax Deduction for Inventory: Inventory that is held primarily for sale to customers in the regular course of a trade or business is ordinary income property. However, the charitable income tax deduction for a contribution of ordinary income to charity, including a CRAT,  is typically limited to the donor’s cost basis in the donated property. If the donor has a zero tax basis in the ordinary income property, the Tax Code requires that the income  tax charitable deduction for donating that property must be reduced by the property’s entire value. In short, this leaves the donor with no charitable income tax deduction whatsoever. [IRC 170(e)(1)(A).]

All of these ‘rules’ were on full display in a recent Tax Court case where the donors were denied charitable income tax deductions for substantial gifts to two CRATs.

Reported Decision: Furrer v. Commissioner, Tax Court Memo, No. 7633-19, September 28, 2022.

Facts: The donors made in-kind transfers of agricultural crops to two CRATs in 2015 and 2016. The CRATs sold the crops, i.e. corn and soybeans, and the CRATs used the sales proceeds to purchase annuities. The annuity plans then made cash distributions from the CRATs to the donors. The CRATs designated the donors as the life beneficiaries of the CRATs, with three eligible publicly supported charities as the CRAT remainder beneficiaries.

  • In CRAT #1, 100,000 bushels of soybeans were sold for $469,003; $47,000 of sales proceeds was distributed to the donors as the lifetime beneficiaries of CRAT #1, with the balance used top purchase a single premium annuity.
  • The donors funded CRAT #1 with the transfer of bushels of soybeans and corn, resulting in a sale of these crops by the CRAT for $691,921. With CRAT #2, $69,294 was distributed to the donors, with the balance of the sales proceeds used to purchase an annuity that made annual annuity payments to the donors of $124,921 in each of years 2016 and 2017. The issuing annuity company [Symetra Life Insurance Company] issued 1099-R’s to the CRAT trustees listing the annuity payments as ‘gross distributions’ and showing only a small amount as the ‘taxable amount.’
  • For 2015, the donors reported that CRAT #1 had received proceeds of $469,003 with a basis of $471,000 for a reported loss of $1,997. For 2016, the donors reported that CRAT #2 had received proceeds of $691,827 with a tax basis of $666,975 resulting in a reported gain of $24,852.
  • The donors on their 2015 and 2016 Form 1040 tax returns claimed charitable contributions deductions for ‘cash gifts’, but they claimed no deductions for their in-kind transfers to the CRATs. On the 2015 tax return the donors reported a contribution to CRAT #1 of corn and soybeans with a fair market value of $469,003 and a cost basis of $0.00. On the 2016 return, the donors reported a contribution of corn and soybeans to CRAT #2 of $666,975 and a cost basis of $0.00.
  • For each calendar year the CRAT trustee filled a Form 5227, Split-Interest Trust Information Return. The Trustee attached to each of these 2015 and 2016 information returns [Form 4797] where the sale of crops contributed by the donors was reported.

Notice of Deficiency: The IRS issued timely Notices of Deficiency to the donors of $55,040, $56,904 and $95,907 for 2015-2017, along with accuracy related penalties. The IRS then moved for Summary Judgment.

Issues in Controversy: (1) Were the donors entitled to a non-cash charitable income tax contribution deduction for each of 2015 and 2016 for portions of the crops transferred to the CRATs? (2) Whether the annuity distributions to the donors were taxable to the donors as ordinary income.

Tax Court: The Tax Court granted the IRS’ Motion for Summary Judgment.

No Charitable Income Tax Deduction: With regard to the first question, the Tax Court held that the donors were not entitled to an income tax charitable deduction. Because the crops, treated as inventory, had no basis, and the crops were ‘ordinary income assets, no income tax charitable deduction was allowed

Annuity Distributions as Ordinary Income: With regard to the second question, the Tax Court held that the donors had to report 100% of the annuity payments that they received as ordinary income. The CRATs each had purchased single premium immediate annuities to cover the payments to the donors. The insurance company issued Form 1099 to the CRAT showing the gross distribution, but only indicated a small amount of interest income. Consequently, the CRAT trustee assumed that this was the only income of the trust other than the loss or small amount of income reported from selling the crops. As income was distributed back to the donors from the CRATs the rules require that all ordinary income is reported first, capital gain second, tax-free income third, and then a return of basis last. Since each CRAT had a substantial amount of ordinary income, all distributions to the donors from the CRATs would be taxed as ordinary income.

Donor’s Argument: The donors had argued that they had in fact sole the grain to the CRAT and therefore the CRAT had basis in the crops. However, the donors did not report any grain sales on Schedule F of their Form 1040, which would have defeated the purpose for setting up the CRAT in the first place.

Conclusion: If an asset has no income tax basis, then contributing that asset to a CRAT will not create any income tax charitable deduction. While this case dealt with crops, i.e. inventory, it also applies to other assets where the income tax basis in the asset had been fully deducted through depreciation deductions. In these situations, any distribution from the CRAT will likely be ordinary income to the donor.