form 5227 reporting: mastering compliance with charitable split...

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Form 5227 Reporting: Mastering Compliance With

Charitable Split-Interest Trusts, NIIT Calculations, and More

THURSDAY, AUGUST 18, 2016, 1:00-2:50 pm Eastern

FOR LIVE PROGRAM ONLY

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Aug. 18, 2016

Form 5227 Reporting

Charles J. McLucas, Jr., CPA, PFS, Founder and CEO

Charitable Trust Administrators, San Clemente, Calif.

[email protected]

Joylyn Ankeney, CPA

AKT, Lake Oswego, Ore.

[email protected]





Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

Form 5227 Reporting: Mastering Compliance With Charitable Split-Interest Trusts, NIIT Calculations,

and More

Charles J. McLucas, Jr.,

President

CPA/PFS/AEP

Charitable Trust

Administrators, Inc.

5

Joylyn Ankeney, CPA Senior Manager

AKT LLP

Split Interest Gift Types

Charitable Gift Annuities

Charitable Lead Trusts (CLT)

Grantor Lead Trust

Non-grantor Lead Trust

Retained Life Estate Gifts

Charitable Remainder Trusts (CRT)

Charitable Remainder Unitrust (CRUT)

Charitable Remainder Annuity Trust (CRAT)

6

Considerations for Split Interest Gift Planning

Annuity or UniTrust

• Fixed payment amount

• Easy to zero out/ GST

• Kids or Grandkids

Grantor/ Non Grantor

• Income Tax deduction?

• Totally out of estate

Now or at Death

• Immediate benefits

• Estate Tax Wipeout

Market Performance

• What are expected returns

AFR

• What does the IRS say we will earn

Asset Issues

• Taxes due?

• Liquid?

7

Charitable Gift Annuity

A contract in which a donor transfers an asset to charity in exchange for a fixed income stream for life, not to exceed two lives. Donor receives an immediate charitable income tax deduction for the net present value of the calculated remainder interest. Upon termination of the contract (term or death), the charity receives the remainder of the value of the contract. Not a trust – no annual filing requirement.

8

Charitable Lead Trust (CLT)

A CLT is the opposite of a CRT: the income stream goes to charity for a term of years and at the end of the trust the remainder is returned to either the granter or a non-granter.

• There is no minimum payout requirement.

• There is no maximum limitation on the term.

• There may or may not be income tax, gift tax and/or estate tax consequences depending on the type of CLT.

9

Non-Grantor CLT

• Designed to pass income to a qualified exempt charity for a term of years and then distribute the remainder to family.

• Major advantage of the CLT is the ability to leverage the donor's gift exemption.

• Donors with larger estates can move major assets through to family with little or no gift or estate tax.

• One major contrast to the CRT is that CLT is a taxable trust.

• No income tax deduction.

10

Charitable Lead Trust

Charitable Lead Trust: Non-Grantor

Designated

Charity

Donor

Gift of cash, securities, or real estate

Remainder to Family

Annual payments to charity

Family

11

Grantor CLT

A qualifying grantor CLT generally allows the donor to take the net present value of all charitable gifts over the life of the trust and deduct them in the year the trust is created.

The donor/grantor will be subject to tax on all of the trust’s income during the charitable term.

12

Charitable Lead Trust

Charitable Lead Trust: Grantor

Designated

Charity

Donor

Remainder returned to donor

Annual payments to charity

Gift of cash, securities, or real estate Current income tax deduction

13

Charitable Lead Trust Tax Benefits

• Permits transfer of assets to heirs with significantly reduced estate or gift taxes.

• Can reduce income taxes.

• Flexible planning tool to zero out estate tax.

• Can create delayed inheritance/retirement benefit for heirs.

14

Retained Life Estate Gifts

A retained life estate gift allows a person to become a donor by irrevocably transferring ownership of a home or farm to a charity while retaining lifetime use of the property.

Life estate gifts create a current income tax deduction for individuals who want to make a testamentary gift of real property to charity.

15

Charitable Remainder Trust (CRT)

A CRT is a tax-exempt trust that provides for a specified distribution, at least annually, to at least one non-charitable income recipient for a period specified in the trust instrument (not to exceed 20 years), with the remainder interest paid to at least one charitable beneficiary.

CRT’s are governed by IRC Section 664.

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Charitable Remainder Trust

Standard Charitable Remainder Trust

Designated

Charity

Donor

Gift of cash, securities, or real estate

Income Tax Deduction Plus Annual Income

Remainder to charity

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Tax Benefits of a CRT

• Donor avoids capital gains taxes on sale of assets contributed to the trust

• Donor receives an immediate charitable deduction

• The trust income that stays inside the trust is tax exempt

• Donor avoids estate taxes on any assets of the CRT that pass to charity

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CRT’s: Things to bear in mind

• Properties subject to an encumbrance: mortgage or a debt can cause the CRT to loose its exempt status, run afoul of self dealing rules or cause an adverse tax consequence

• Grantor Trust: trust will not qualify as a CRT if the donor is treated as the owner of the trust. i.e. trust caused to make payments on a debt that is deemed as a debt of the grantor

• Self Dealing: transactions that are deemed to benefit the donor or the donor’s family. i.e. sale or exchange of the property by a disqualified person, use of the property by a disqualified person

• Prohibited Payments: Payments are limited to the named income beneficiaries per the specified payout (annuity versus unitrust) and to the named charity or charities

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Funding a CRT with Appreciated Real Estate

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Appreciated Real Estate

• Like the dramatic declines in the financial markets, the value of real estate in across the U.S. has fluctuated over the same time period.

21

Options for Real Estate Owners

• Keep the asset

• Exchange the asset

• Sell the asset

• Gift the asset

• Other options?

22

Reasons for Selling Real Estate

• Capitalize on the appreciation in value.

• Tired of property management: ready to receive “passive income vs. “active” from your investment.

• Need more income from a low-income producing, yet highly-appreciated property.

• Exchanging/trading-up is no longer appealing; want to get out.

• Receive an offer they “cannot refuse.”

• Diversification

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Obstacles to Selling Real Estate

• Capital Gain Taxes – Federal

• 20% on long-term gains due to appreciation. Plus 3.8%

• 25% on gains due to straight-line depreciation

– State • 1% - 10%

• Personal Attachment

• Market Conditions

24

Charitable Gifting Strategies

• Case Studies

25

Income/Investment Properties

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• George owns a property with an appraised fair market value of $1,000,000. He paid $140,000 for the property 25 years ago. After taking depreciation, his tax basis is $50,000. The property produces net annual income of $30,000 or 3%. He is in a 33% combined federal and state marginal income tax bracket and 23.9% capital gain bracket.

• He recently turned age 75 and would like to retire. He does not want to manage real estate and would like to sell the property.

Option #1 Charitable Remainder Unitrust

Rather than a fixed income, let’s assume George would like something that has the potential for an “up-side” in the income it generates.

A Charitable Remainder Unitrust would be a more appropriate charitable life-income plan for him to consider.

With this type of trust the income is based upon the value of the assets inside the trust. In years where the value of the principal grows, the person receives an increased income based upon that value. However, in years where the value of the trust principal declines, the income beneficiary is going to receive a lesser amount of income. (Options/solutions for this situation will be addressed in the next case study).

Let’s assume George establishes a 6% CRUT and that it will have an average annual net investment return of 8.5%.

The projected results are as follows…

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Option #1 Charitable Remainder Unitrust

• By-pass capital gains of $950,000 saving $227,050.

• Receive income tax deduction of $422,840 saving $101,059.

• Tax-free exit from the property.

• 1st year income from trust is $60,000, an increase of $30,000 doubling his income.

• Assuming the trust’s principal grows, the annual income will also increase.

• A significant charitable legacy will ensue after the death of its income beneficiary.

• Out of property management. Now receiving passive income vs. active income.

• Downside: potential for income to decrease in years when the trust’s principal decreases.

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• Gift of Asset

Income for Life

Tax Deductions

• Income

• Capital Gain

Charitable

Remainder

Trust

Remainder

to Charity

at death of

donor.

Benefits Analysis

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Present Income $150,000 Year-old Male 75 Year-old Female 73 Child(ren) 3 Net Estate $12,000,000

Fair Market Value $1,000,000 Less Cost Basis $ 50,000

Taxable Capital Gain $ 950,000 Combined Tax Rate 33.80%

Capital Gains Tax $ 321,100

•Mortgage $ -

•Capital After Tax $ 678,900 8.50% Investment

= $ 65,701 Annual Earnings

$ 834,786 Lifetime Earnings

•Estate Tax Rate 40.00% •Total Estate Tax $ 271,560

Net To Heirs $407,340 59.27% Loss To Taxes

Benefits Analysis

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Charitable Trust

Property Transferred

$1,000,000

Income Tax Deduction

1)

42.28% $ 422,840 2016 + 5 Years

No Tax On Capital Gain

2)

Projected Trust Cash Flow Unitrust

3) Percentage

6.00%

$73.359 Average Per Year $ 1,320,454 Lifetime Income

Charity

$1,508,100

Wealth Replace Trust

Annual Premiums

$23,256

Insurance Policy

Net To Heirs

$ 1,000,000

Income Tax __________

Gift __________

Estate Tax __________ FREE! Probate _________

Benefits Analysis

31

Without Unitrust Planning With Unitrust Planning

Capital Gains Tax $ 321,100 $ 0

Estate Taxes $ 271,560 $ 0

Cost $ 592,600 Savings $592,600

Net To Heirs $ 407,340 $ 1,000,000

Charity $ 0 $ 1,508,100

Tax Deduction $ 0 $ 422,840

Trust Income $ 0 $ 1,320,454

Without Trust $ 834,786 $ 834,786

$ 485,668 Higher Lifetime

Earnings

Option #2 Trust & Sale—Zero-Tax CRT

Let’s assume George likes the idea of a charitable gift annuity or charitable remainder trust BUT wants to get cash out of the real estate as well.

He could contribute an undivided interest into the CRT and retain an undivided interest. Together, George and the trustee would sell their respective interests prorating the selling costs, basis and capital gain proportionate to their interests.

By gifting a sufficient interest to the CRT it will generate enough income tax savings (from the charitable deduction) to off-set the capital gain tax liability on the interest George personally keeps and sells.

Assuming George contributed an undivided 65% interest in the property to a CRT here’s how the numbers work out.

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Option #2 Trust & Sale—Zero-Tax CRT

RESULTS

Sale $503,893

Prorated Basis $ 25,195

Selling Costs $

Capital Gain $478,702

C.G. Tax @ 26% $ 71,805

Trust $496,103

Income Tax Ded. $205,158

Tax Savings @33% $ 71,805

• Net of Capital Gain Tax Liability

and Income Tax Savings is zero.

• Total cash to donor $503,897

• Capital Gains by-passed with CRT

$496,702 saving $71,805 in taxes.

• Lifetime Income starting at $29,776 per year.

• Charitable Legacy

Real Estate

$1,000,000

1. Gift $496,103

Charitable Income

Tax Deduction

$205,158

2. Sell $503,897

for cash

Zero-Tax

Charitable

Remainder Trust

$496,103

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CRT: Donor Profile

• Not age specific but generally speaking:

• For a CRUT, younger donors

• For a CRAT, older donors

• Has highly appreciated property that may or may not be generating an income stream.

• Would like increased cash-flow/income from their assets.

• Generally Adverse to Capital Gains Taxes

• Has a desire to benefit charity and would like to benefit from their charitable gifting.

• Would like asset diversification and professional management.

• Would like more flexibility in the design of their gift.

• Would like to provide an income stream to their spouse and/or children.

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Six Key Decisions in Establishing a Charitable Remainder Trust

35

Six Key Decisions in Establishing a CRT Trust

• Type of Trust:

• Type I – Standard Payout Option: This type of Unitrust requires a distribution of a fixed percentage amount of at least 5% of the annual value from the trust’s assets. This percentage is distributed regardless of the income earned. Accordingly, if the income earned for any year is less than the required distribution, principal will be distributed.

• Type II – Net Income Payout Option: This option provides for the lesser of the Unitrust percentage amount (Type I above) or the trust’s income to be distributed annually. IRS Section 643(b) defines the term “income” to whatever definition is provided within the governing instrument or applicable state laws. Unless defined in the document, or in state law, income does not include capital gain or corpus.

36

Six Key Decisions in Establishing a Charitable Trust….continued

• Type of Trust:

• Type III – Net Income with Make-up Option: This trust may be designed to pay income in excess of the full Unitrust amount. It can extend the aggregate amounts paid in prior years less the aggregate of the fixed amounts of prior years (by reason of the income only exception). In other words, this trust can make-up past deficiencies of prior years by paying out the actual income earned in the current year. (This is just like a TYPE II with the addition “make-up” option.)

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Six Key Decisions in Establishing a CRT

Six Key Decisions in Establishing a Charitable Trust; continued

• Type of Trust:

• The “FLIP” Unitrust: This option became available after 12/10/98. It provides the feature of beginning as a TYPE II or III trust, but then drops the income limitation feature, converting to a TYPE I, on the occurrence of a qualifying “Triggering Event.” The “Triggering Event” is a “Specific date or single event whose occurrence is not in control of the trustee”. This type of trust is typically used in real estate and other non-liquid assets.

• Charitable Annuity Trust: A charitable remainder annuity trust is a trust from which a sum certain (not less than 5% of the initial fair market value of all assets) is to be paid to one or more persons, not less often then annually. The annuity amount may be stated as a fixed percentage of the initial fair market value, or a fixed sum. This is a fixed percentage or amount that cannot be changed regardless of fluctuations in portfolio value. For this reason, additional contributions to annuity trusts are prohibited

38


Six Key Decisions in Establishing a Charitable Trust…continued

• Term:

• A Charitable Remainder Trust (CRT) can be established for one or more lives or a term of years (maximum of 20) or a combination of both. However, the term of the trust may not be established for a time period that would not provide an actuarially calculated 10% remainder interest for the charity.

• Percentage Payout to Income Beneficiary:

• The distribution % must be established at the inception of the trust. It cannot be changed! It must be at least 5% (see notes on NIMCRUT’s in #1 above). It cannot exceed a % which combined with the age or term described above would give the charity less than 10% of the initial value of the trust at the trust’s termination. (Note – less is sometimes more over a long payout period when using a NIMCRUT type of CRT.

39


Six Key Decisions in Establishing a Charitable Trust…continued

• The Name of the Charity or Charities:

• Any 501c3 can be named as your charitable remainderman (beneficiary).This includes Private Foundations and Donor Advised Funds also known as Gift Giving Funds

• Definition of Income:

• Changes in the IRS regulations (2003) provide the definition of income in a CRT to include post-contribution capital gains. This change was made to allow the trustee of the trust to manage the investment portfolio. Under modern portfolio theory for “total returns”, the donor can be flexible in choosing how much capital gain to distribute annually. The trust document must include such language and provide for a “special independent trustee” to make these decisions.

40


Six Key Decisions in Establishing a Charitable Trust; continued

• Trustee:

• The decision of who or what type of entity should be the trustee of a CRT is sometimes difficult. In many situations it may be advisable for the donor to be trustee, or at least have the authority to hire or fire the trustee. A bank or qualified trust company may also provide trustee services. Unless a donor has specialized knowledge of tax and investment duties, a donor-trustee should retain the services of a third-party administration firm (such as CTAI).

A trustee of a CRT has the fiduciary duty (stewardship responsibilities) to manage the trust in such a manner as to not favor either the income or the remainder beneficiary. This can be a more difficult task when the donor is both the trustee and income beneficiary.

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Preparing Form 5227

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Who must file Form 5227

Split-interest trusts

Charitable Remainder Trusts

Charitable Lead Trusts

Pooled Income Funds

Any other trust described in IRC § 4947(a)(2)

The form is an “information return”

No tax due

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Form 5227 is open to public inspection

Information about trusts that filed Form 5227 has been included in the IRS Business Master File

Commercial companies downloaded this list and created publicly searchable databases

Search for your client’s CRT, CLT, or PIF on Google!

Consider not using the client’s name in the name of the trust Note that the trustee’s name and address are disclosable

Portions of the return are not disclosable

Trust agreement (including amendments), Schedule A, Schedules(s) K-1, attachments referencing contributor info

44

Other complementary forms

Form 1041 for CLTs Grantor lead trusts file as any other grantor trust would and

provide the grantor with a statement of items of income, deduction, and credit to include on the grantor’s return

Because nongrantor CLTs claim a section 642(c) deduction, charitable beneficiaries should not be issued a Schedule K-1

Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code

Used to report self-dealing and other private foundation type excise taxes

Used by CRTs to report unrelated business taxable income

45

Other complementary forms (continued)

• Form 709 – Transfers to charitable trusts do not meet any of the

exceptions to filing gift tax return section under 6019(3)

• State forms – State filing requirements vary widely – California requires the completion of Form 541-B,

which duplicates much of Form 5227 – Indiana requires that Form 5227 be attached to a

blank state fiduciary return – Pennsylvania and New Jersey require that CRTs pay tax

on any undistributed income

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Filing Deadlines

• All split-interest trusts are calendar year taxpayers by statute

– The form is due on April 15

– An automatic 6-month extension is available starting with the 2016 tax year.

• Form 1041 is extended to September 30 (with 2016 tax year)

• Form 4720 requires a separate extension

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Failure to File or Filing Late

The penalty is $20 for each day the form is late up to a maximum of $10,000

– If the trust’s gross income is greater than $250,000, this penalty increases to $100 per day up to a maximum of $50,000

– Note that in the year of the sale of a large appreciated asset, this gross income threshold may easily be met

– For 2015 and beyond penalties are indexed for inflation

The penalty is an obligation of the trust, not the trustee – Exception: Knowingly failing to file the return results in the

additional imposition of the penalty on the person who knowingly failed to file and they are personally liable for this additional penalty

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The Trust Instrument

Attach a copy of the trust instrument to the return in the first year

• Include a declaration signed under penalty of perjury that the copy is a “true and complete copy”

• Attach a copy of any amendments to the trust instrument to the return covering the year in which the amendment is made

49

Common preparation errors

• Most preparation errors result from failing to read the trust agreement – Don’t prepare a return without the trust agreement

• Preparing Form 1041 but not preparing Form 5227 – Note that CRTs should never file a Form 1041

• Not properly identifying the trust type – Confusing a CRAT and CRUT – Not recognizing NICRUT, NIMCRUT, or Flip-CRUT

provisions – Not identifying a CLT as grantor vs nongrantor CLT

50

Recognizing trust types/formats

One means of recognizing a trust type is where the trust agreement cites a Rev. Proc. as the type of trust it is trying to create.

• CRAT Payment of Annuity Amount. In each taxable year of the trust during the

annuity period, the Trustee shall pay to [permissible recipient] (hereinafter

“the Recipient”) an annuity amount equal to [a number no less than 5 and

no more than 50] percent of the initial net fair market value of all property

transferred to the trust, valued as of the above date (that is, the date of the

transfer).

51


• CRUT Payment of Unitrust Amount. In each taxable year of the trust during the unitrust

period, the Trustee shall pay to [permissible recipient] (hereinafter “the Recipient”)

a unitrust amount equal to [a number no less than 5 and no more than 50] percent

of the net fair market value of the assets of the trust valued as of the first day of

each taxable year of the trust (hereinafter “the valuation date”).

• NICRUT Payment of Unitrust Amount. In each taxable year of the trust during the unitrust

period, the Trustee shall pay to [permissible recipient] (hereinafter “the Recipient”)

a unitrust amount equal to the lesser of (a) a fixed percentage amount equal to [a

number no less than 5 and no more than 50] percent of the net fair market value of

the assets of the trust valued as of the valuation date (hereinafter “the fixed

percentage amount described in (a) of paragraph 2”) or (b) the trust income for the

taxable year as defined in § 643(b) of the Code and the applicable regulations.

52


• NIMCRUT Payment of Unitrust Amount. In each taxable year of the trust during the

unitrust period, the Trustee shall pay to [permissible recipient] (hereinafter "the

Recipient") a unitrust amount equal to the lesser of (a) a fixed percentage

amount equal to [a number no less than 5 and no more than 50] percent of the

net fair market value of the assets of the trust valued as of the valuation date

(hereinafter "the fixed percentage amount described in (a) of paragraph 2") or

(b) the trust income for the taxable year as defined in § 643(b) of the Code and

the applicable regulations. The unitrust amount for a taxable year shall also

include any amount of trust income for the year that is in excess of [the fixed

percentage amount determined under (a) of this paragraph for the year], but

only to the extent that the aggregate of the amounts paid to the Recipient in

prior years was less than the aggregate of the amounts determined for all prior

years under (a) of this paragraph and (a) of paragraph 5.

53


• Flip-CRUT Conversion to fixed percentage method of determining unitrust amount.

Notwithstanding paragraph 2(i), upon the occurrence of [permissible triggering

event as described in § 1.664-3(a)(1)(i)(c) and (d) of the Income Tax

Regulations] (hereinafter "the triggering event") and effective as of the first day

of the taxable year that immediately follows the triggering event (hereinafter

"the effective date of the triggering event"), the Trustee shall pay to the

Recipient in each remaining taxable year of the trust during the unitrust period

a unitrust amount equal to [same percentage used in (a) of paragraph 2(i)]

percent of the net fair market value of the trust assets as of the valuation date.

Beginning on the effective date of the triggering event, the Trustee shall no

longer pay the amount equal to the lesser of (a) or (b) in paragraph 2(i).

54


• CLAT Payment of Annuity Amount. In each taxable year of the trust during the annuity period, the Trustee shall pay to [designated charitable recipient] an annuity amount equal to [number representing the annual annuity percentage to be paid to the designated charitable recipient] percent of the initial net fair market value of all property transferred to the trust, valued as of the date of the transfer.

• CLUT Payment of Unitrust Amount. For each taxable year of the trust during the unitrust period, the Trustee shall pay to [designated charitable recipient] a unitrust amount equal to [number representing the annual unitrust percentage to be paid to the designated charitable recipient] percent of the net fair market value of the assets of the trust, valued as of the first day of each taxable year of the trust (hereinafter “the valuation date”).

55


• Grantor Trust

– Look for a reference to the remainder reverting back to the donor/grantor

– The CLT Rev. Proc. make reference to the power to substitute assets Retained Powers and Interests. During the Donor's life, [individual other

than the donor, the trustee, or a disqualified person as defined in §

4946(a)(1)] shall have the right, exercisable only in a nonfiduciary capacity

and without the consent or approval of any person acting in a fiduciary

capacity, to acquire any property held in the trust by substituting other

property of equivalent value.

56

Common preparation errors (continued)

• Improperly computing the amount to which the beneficiary is entitled – CRAT vs. CRUT – CRUT vs. NICRUT, NIMCRUT, of Flip-CRUT – Self-dealing concern – Caution: Older NICRUTs or NIMCRUTs may have been amended

between December 1998 and June 30, 2000

• Failing to identify net-income affecting provisions – Net income is trust accounting income as determined under

state trust law – State law permits a trust to override state law – One common overriding provision is the inclusion of realized

capital gains in trust income

57


• Failing to identify that the triggering event has occurred – A date certain or sale of an unmarketable asset is

determinable without reference to external events – Other triggers (death, birth, marriage, divorce) require

referring to event external to the administration of the trust

• Failing to identify the end of a beneficiary’s right to income or end of the trust term – Beneficiary interests are not always for life – A trust for a term of years can be on autopilot and the

trustee may forget which year is the last year of the trust term

58


• Failing to properly maintain the makeup amount – Most common problem is that it is ignored altogether

– Tracked on lines 67a through 69 on the Form 5227

• Failure to report a Flip-CRUT triggering event – Note that in the year following the triggering event,

you must report information on the triggering event at Part V-B, Line 64 of Form 5227.

– Include in the disclosure the nature of the event, the date, and the payment method previously used (NICRUT or NIMCRUT)

59


• Column (c) on the Balance Sheet in Part IV

– Must be completed by all forms of CRUT

– May be completed by CLUTs

– Presents the fair market value of the assets as determined under the terms of the trust agreement for the purpose of computing the unitrust amount

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Four-tier accounting

• This is an income accumulation and distribution scheme

• Income is accumulated into four buckets (called tiers or categories) representing (broadly) four tax characters: – Tier 1: Ordinary income (income taxed at ordinary

rates) – Tier 2: Capital gain (income taxed at capital gain

rates) – Tier 3: Other income (nontaxable income) – Tier 4: Corpus or Principal

61

Four-tier accounting (continued)

Within the tiers maintain:

• Classes based on highest potentially applicable tax rate – Pre-2013 dollars are maintained in classes that do not

include the net investment income tax (Excluded)

– Post-2012 dollars are maintained in classes that include the net investment income tax

• Income types within each class (e.g., U.S. Gov’t interest, corporate bond interest, nonqualified dividends, qualified dividends)

62


• Characterizing distributions

– Distributions are characterized by reducing each category in turn starting with Tier 1 and progressing to Tier 4.

– Within a Tier, each tax rate class is reduced in turn, beginning with the highest tax rate class and progressing to the lowest tax rate class.

– Within a tax rate class, types of income are reduced on a pro rata basis.

63


• Applying Deductions – Deductible items generally fall in four categories:

• Direct expenses which are deducted against the income to which they relate

• Indirect expenses (1) which are chargeable to a tier, but are not identified to a specific type of income within the tier – These items are allocated pro rata among the items within the

tier, ignoring any negative balances – No type of income may become negative as a result of this

allocation

• Indirect expenses (2) which are related to any income items (e.g., trustee fees) which may be charged any any manner the trustee chooses

• Nondeductible expenses which must be charged to Tier 4

64


• Allocating losses

– Ordinary losses

• Deduct current ordinary losses against any prior year undistributed income from the same or like source

• Next deduct any remaining ordinary loss against the highest tax rate income in the ordinary income tier, then the next highest tax rate income, and so on

• Any remaining loss is carried forward indefinitely

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• Allocating losses (continued)

– Capital losses

• Within the short-term and long-term subtiers, capital losses are netted against the highest tax rate class, and then the next highest tax rate class, and so on

• Excess long-term capital losses (regardless of tax rate class) are then used to reduce any short-term gain

• Excess short-term capital losses are used to reduce any long-term gain, starting with the highest tax rate long-term gain

• Any remaining capital loss is carried forward indefinitely and retains its duration and tax rate class character

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Net Investment Income Tax

• CRT’s are not subject to the Net Investment Income Tax

– Beneficiaries are subject to the tax to the extent their distributions include NII amounts

– Undistributed amounts from prior to 2013 are not included in NII

• CLT’s are not exempt from the tax

– But amounts of income distributed to charitable and non-charitable beneficiaries carry out NII and reduce the trust’s taxable amount

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• Two methods are allowed for CRTs to capture Net Investment Income Tax information

– Section 664 Method: This method integrates with the category and class system to create tax rate classes that are the sum of the income tax rate and the 3.8% net investment income tax rate

– Then as each tax rate class is drawn from, net investment income taxable amounts flow out to the beneficiary

Net Investment Income Tax (continued)

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Section 664 Method Illustrated

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Net Investment Income Tax (continued)

Simplified Method: Cumulative totals of net investment income and non-net investment income buckets are maintained – Each year the amount of the distribution that is net investment

income is determined by • First looking to the cumulative, undistributed net investment income • If the distribution is larger than the cumulative, undistributed net

investment income, then look to the cumulative, undistributed non-net investment income

– For trusts created prior to 2013, the Simplified Method had to be adopted on the 2013 return. • The Simplified Method can be elected on an amended return so long as

the year to be amended and all intervening years for both the CRT and the beneficiaries are open

• For trusts created after 2012, the Simplified Method must be elected the first year the trust is required to file Form 5227

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Schedule K-1 reporting

Net investment income • All items of income are grouped together for Schedule K-1

reporting. • E.g., included and excluded interest is all included on Schedule K-1 line

1

• An adjustment amount is added on line 14 using code H for the “excluded from net investment income” amount

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Unrelated Business Taxable Income (UBTI)

• Just $1 of UBTI triggers a tax – The tax on UBTI is 100% of the UBTI amount – Old rule (pre TRHCA 2006): CRT was fully taxable in any year there

was even $1 of UBTI

• Report the tax using IRS Form 4720 – Use Form 990-T as an attachment to provide relevant details

• Common sources of UBTI – Publicly Traded Partnerships (see Box 20, Code V) – Unrelated debt financed income

• Trading on margin • Mortgaged Property

• Remember the $1,000 specific deduction in arriving at taxable UBTI

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Self-Dealing and Other Chapter 42 Excise Taxes

• Split-Interest trusts are prohibited from

– Engaging in self-dealing IRC § 4941

• Purchase from, sale to, loan to/from, lease to/from, use of income or assets of trust by a disqualified person (see IRC § 4946)

– Possessing excess business holdings IRC § 4943

• See exception for CRTs IRC § 4947(b)(3)(B)

• See exception for certain CLTs IRC § 4947(b)(3)(A)

– Purchasing jeopardizing investments IRC § 4944

• See exception for CRTs IRC § 4947(b)(3)(B)

• See exception for certain CLTs IRC § 4947(b)(3)(A)

– Making taxable expenditures IRC § 4945

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Self-Dealing and Other Chapter 42 Excise Taxes (continued)

• Compliance (or lack of compliance) with these prohibited activities is self-reported in Part VI-B

• Exercise care in completing this portion of the return – the trustee signs the return under penalty of perjury

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Questions?

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form 5227 reporting: mastering compliance with charitable split...

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