Take-Away: In a recent Chief Counsel Memorandum the IRS concluded that a charitable remainder annuity trust ‘marketing scheme’ resulted in a sham trust and, therefore, would not provide the claimed tax results as promised.

General Counsel Memorandum AM 2020-006, Released June 26, 2020

What was marketed was a purported charitable remainder annuity trust [IRC 664(d)(1)] that promised to permanently eliminate capital gain on the sale of highly appreciated property by the charitable trust and virtually no taxable income to the CRAT’s settlor. What was marketed was the following.

  • The taxpayer creates and funds a trust that purports to qualify under IRC 664 as a charitable remainder annuity trust.
  • In the Chief Counsel’s Memo, the property identified as transferred to the trust were closely held business interests, farmland, and crops produced by the farmland.
  • The trust form is a lifetime single life annuity trust with a charitable remainder. The form of the trust purports to follow the IRS’ model form for a charitable remainder annuity trust (CRAT) that the IRS has previously published about 17 years ago, but with a couple of ‘modifications.’ [Revenue Procedure 2003-53 provides the form.]
  • The CRAT was to be for a period of 5 years; if the annuitant dies during that five years, the annuity payments are made to the annuitant’s children.
  • The trustee is authorized to purchase one or more single premium immediate annuities. The total cost of these annuities had to be less than 90% of the initial fair market value of the property initially transferred to the CRAT.
  • Each taxable year of the CRAT, the trustee is directed to pay to the CRAT beneficiary for the duration of the CRAT an annuity amount equal to the greater of (i) 10% of the initial fair market value of all property transferred to the CRAT or (ii) the payments received by the trustee from one or more of the single premium immediate annuities purchased by the trustee.
  • However, the CRAT also provides that those annual annuity payments cannot exceed 49%  the initial fair market value of the property initially transferred to the CRAT.
  • The promoter claims that the capital gains in the property transferred to the trust are ‘trapped’ in the CRAT with the CRAT income beneficiary only taxed on the ordinary annuity income each year as if the beneficiary was the owner of the single premium immediate annuity, and not an asset of the CRAT.
  • The underlying premise behind the promoter’s claim is that the property used to purchase the single premium immediate annuities are principal, so that with the distribution from the CRAT to its beneficiary, almost all of the distribution will be a tax-free return of principal to the annuitant, thus making all of the capital gain miraculously disappear.

Sham Trust Doctrine: Normally the IRS will assume that taxpayers will observe the formalities of trust instruments and the transfer instruments used to fund the trust. To the extent that the formalities are not complied with, such that the transferor’s control over the property transferred to the trust does not really change, the trust can be disregarded, along with all of the claimed tax benefits dependent upon the trust’s validity being vitiated.

Multiple factors are reviewed in the determination if a trust is a sham. Examples can be found in Zmuda v. Commissioner, 731 F.2d 1417 (1984)- business purpose rule ignores a trust and  Markosian v. Commissioner, 73 Tax Court 1235 (1980)- economic substance rule ignores a trust.

  • The sham trust doctrine often arises with the IRS’ assertion of the lack of a business purpose and or the absence of any economic substance to go beyond the mere formalities of a trust or a transaction with a trust.
  • Both of these ‘rules’ look to the substance of a transaction or an entity over its form.
  • While an individual may structure a transaction or create a trust that satisfies the formal requirements of the Tax Code, the Commissioner of the IRS can deny legal effect to a transaction if its sole purpose is to evade taxation.
  • In sum, the sham trust or sham transaction doctrine is used to ignore formalism that otherwise impairs the effective administration of Congress’s tax policies.

General Counsel Conclusion: Applying the sham trust doctrine, the General Counsel found that the trust as described was disqualified as a charitable remainder annuity trust, regardless of how the trust was to be administered. Two trust provisions were the Achilles Heel to the promoter’s claims for how the trust would avoid almost all taxation.

  • First, the trust instrument authorized excessive authorized payments, yet a CRAT requires a sum certain to be paid. It was the payment of the greater of language that would cause the trust to fail as a CRAT. “Even if the trust was being correctly administered, this provision allowing a payment to the income beneficiary in excess of the amount determined at the funding to charity of the trust based on a percentage of the initial fair market value of the trust assets causes the trust to fail to qualify under IRC 664(d)(1)(B) since such excess payments are not described in IRC 664(d)(1)(A.)” In short, the trust instrument did not meet the ‘sum certain’ requirement of IRC 664, as that amount could change if the trust purchased single premium immediate annuities. [Treasury Regulation 1.664-2(a)(1)(i).]
  • Second, the trust instrument provides that in lieu of the remainder distribution from the trust to a charitable organization, the trustee was given the discretion to pay the charitable organization a cash sum equal to 10% of the initial fair market value of the trust property, plus $100. The marketing materials claimed that after the payment of the 10% of the initial value of the trust assets to the charity, the charity would have no further rights in the trust, and thus it would not receive the remainder of the trust assets at the end of the CRAT’s 5 years. “Under IRC 664(d)(1)(C), the payment of the remainder to charity is a mandatory definitional requirement for a CRAT. A trust which does not require such a payment is disqualified without regard to any actual distributions which it may make to charity during or at the end of its term. IRC 664(d)(1)(D) provides that the value of the remainder calculated at the creation of the trust must be at least 10% of the fair market value. It neither states nor implies that a current payment of the amount to charity vitiates the requirement to also pay the remainder at the end of the term.”

Observation: Charitable remainder trusts created under IRC 664 are tax-exempt entities. As a result, the rules with regard to obtaining the tax benefits that arise from a charitable remainder trust are tightly interpreted. It is no surprise then that being ‘creative’ with a charitable remainder trust is an invitation to trouble. Which is why the promoter’s two ‘modifications’ to the IRS’s model CRAT trust instrument invited the scrutiny that it did, with the ultimate finding that the trust was not a tax-exempt entity, and that the transfer of appreciated assets to the trust in exchange for the annuity stream was in effect a taxable ‘sale.’ This is also why the IRS years ago provided in several Revenue Procedures multiple form CRAT and CRUT trusts, both single life and joint life, both lifetime and testamentary, saying in effect, ‘use our form and you will be assured of achieving the intended tax consequences.’ Over the years I have read several articles where the IRS’ form charitable trusts were rightly criticized as being too regimented, or ‘vanilla’-like. While the proposed IRS model form trusts are admittedly ‘spartan’ they do assure the desired tax results for one who is interested in creating a charitable remainder trust.

Conclusion: You know you are in trouble with the IRS when in the first paragraph in its Memorandum it uses words like promoter, voluminous marketing materials, scheme, and tax avoidance. Once again the old adage appears that if its ‘too good to be true, then it probably isn’t true.’