Charitable Gifts

November 04, 2024

8072 / Can an individual deduct the fair market value of appreciated real estate or intangible personal property such as stocks or bonds given to a charity?

If an individual makes a charitable contribution of real property or intangible personal property to a public charity, the sale of which would have resulted in long-term capital gain (see below), the taxpayer is generally entitled to deduct the full fair market value of the property. However, the deduction for the gift is limited to the lesser of 30 percent of adjusted gross income or the unused portion of the 60 percent limit (see Q <a href="javascript:void(0)">9065</a>).<a href="#_ftn1">1</a> A deduction denied because it exceeds 30 percent of the individual's adjusted gross income may be carried over and treated as a contribution of capital gain property in each of the next five years.<a href="#_ftn2">2</a> <blockquote>Example: In 2026, Jaclyn had adjusted gross income of $600,000. She made a charitable contribution of long-term capital gain stock worth $200,000 to her church. Her deduction is limited to $180,000 (30 percent of $600,000). In 2027, Jaclyn's adjusted gross income is $700,000. She contributes $100,000 worth of long-term capital gain bonds to the church. She may deduct $120,000 in 2027 ($100,000 plus $20,000 carried forward from 2026), since the total does not exceed 30 percent of her adjusted gross income for 2027 ($210,000). </blockquote> An individual may elect to take a gift of long-term capital gain property into account at its adjusted basis instead of its fair market value. If the taxpayer makes this election, the income percentage limit for the contribution is increased to 60 percent instead of 30 percent. However, such an election applies to all such contributions made during the taxable year.<a href="#_ftn3">3</a> The election is generally irrevocable.<a href="#_ftn4">4</a> If the charitable contribution consists of property that, if sold at the time of the contribution, would result in income that would not otherwise qualify for long-term capital gain treatment (such as short-term capital gain property), the deduction must be reduced by the amount of gain that would not be long-term capital gain.<a href="#_ftn5">5</a> If the entire gain would be income other than long-term capital gain, the allowable deduction would be limited to the taxpayer's adjusted basis in the contributed property. Special rules apply to charitable contributions of S corporation stock in determining whether gain on the stock would have been long-term capital gain if the stock were sold by the taxpayer.<a href="#_ftn6">6</a> Donors making charitable contributions of the long-term capital gain portion of futures contracts must mark the contracts to market as of the dates the contracts are transferred to the donee and recognize the accrued long-term capital gains as income.<a href="#_ftn7">7</a> The amount of taxable gain or deductible loss recognized by the transferor at the time of the charitable transfer equals the difference between the fair market value of the futures contract at the time of the transfer and the transferor's tax basis in the futures contract, as adjusted under IRC Section 1256(a)(2), to account for gains and losses already recognized in prior tax years under the mark to market rules.<a href="#_ftn8">8</a> In one case, taxpayers who transferred appreciated stock to charitable organizations in the midst of an ongoing tender offer and merger were taxed on the gain on the stock under the "anticipatory assignment of income doctrine" where the charitable gifts occurred after the taxpayers' interests in a corporation had ripened into rights to receive cash.<a href="#_ftn9">9</a> But where taxpayers assigned warrants to four charities after receiving a letter announcing that all issued and outstanding stock of the company would be purchased, the Tax Court held that under Revenue Ruling 78-197<a href="#_ftn10">10</a> the IRS could treat the proceeds of the sales of the warrants by the charities as income to the donors only if at the time the assignments took place, the charitable donees were legally bound or could be compelled to sell the warrants.<a href="#_ftn11">11</a> A taxpayer who donated stock to a supporting organization where the voting rights had been transferred for a business purpose to a third party many years ago was permitted to claim a charitable deduction.<a href="#_ftn12">12</a><hr align="left" size="1" width="33%"></hr> <a href="#_ftnref1">1</a>. See IRC § 170(b)(1)(C); Treas. Reg. § 1.170A-8(d)(1). <a href="#_ftnref2">2</a>. IRC §§ 170(b)(1)(C); Treas. Reg. § 1.170A-10(c). <a href="#_ftnref3">3</a>. IRC §§ 170(b)(1)(C)(iii), 170(e)(1). <a href="#_ftnref4">4</a>. Woodbury v. Comm., 90-1 USTC ¶ 50,199 (10th Cir. 1990), aff'g TC Memo 1988-272. <a href="#_ftnref5">5</a>. IRC § 170(e)(1)(A); Treas. Reg. § 1.170A-4(a). <a href="#_ftnref6">6</a>. IRC § 170(e)(1). <a href="#_ftnref7">7</a>. Greene v. U.S., 79 F.3d 1348 (2d Cir. 1996). <a href="#_ftnref8">8</a>. Greene v. U.S., 185 F.3d 67, 84 AFTR 2d 99-5415 (2d Cir. 1999). <a href="#_ftnref9">9</a>. See Ferguson v. Comm., 174 F.3d 997 (9th Cir. 1999). <a href="#_ftnref10">10</a>. 1978-1 CB 83. <a href="#_ftnref11">11</a>. Rauenhorst v. Comm., 119 TC 157 (2002). <a href="#_ftnref12">12</a>. Let Rul. 200108012.

March 13, 2024

8109 / Is a gift of a real property interest deductible if the gift is less than the donor's entire interest?

<div class="Section1"> Editor’s Note: Late in 2015, Congress acted to make the tax treatment of qualified conservation easement contributions, discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8108">8108</a>, permanent. The IRC permits a deduction for a contribution of certain real property interests even though the gift is less than the donor’s entire interest if the gift is for the preservation of land for recreation or education, the protection of natural habitats, the preservation of open space, or the preservation of historically important land or buildings.<a href="#_ftn1" name="_ftnref1">1</a> If a donor contributes for any of these purposes his entire interest in real property (he may retain the right to subsurface oil, gas, or other minerals), a remainder interest in the property, or a restriction on the use of the property (a conservation easement), he may be entitled to a deduction. The contribution must be made to a qualified organization (a governmental unit and certain charities), and the restriction on use of the property must be protected in perpetuity.<a href="#_ftn2" name="_ftnref2">2</a> The Tax Court has held that in order to be protected in perpetuity, the deed of gift used to transfer the easement, once properly recorded as required by state law, must not be subordinate to a mortgage holder’s security interest.<a href="#_ftn3" name="_ftnref3">3</a> The mortgage subordination requirement applies even if the possibility of defaulting on the mortgage is remote. Failure to satisfy the mortgage subordination requirement at the time of donation will result in a denial of the charitable deduction even if a mortgage subordination agreement is later executed.<a href="#_ftn4" name="_ftnref4">4</a> A trust may not take a charitable deduction (under IRC Section 642(c)) or a distribution deduction (under IRC Section 661(a)(2)) with respect to a contribution to charity of trust principal that meets the requirements of a qualified conservation contribution (under IRC Section 170(h)).<a href="#_ftn5" name="_ftnref5">5</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC §§ 170(f)(3)(B)(iii), 170(h). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 170(h)(2); Treas. Reg. §§1 .170A-14(a),1.170A-14(b), 1.170A-14(c). <a href="#_ftnref3" name="_ftn3">3</a>. Satullo v. Comm., TC Memo 1993-614, aff’d without opinion, 67 F.3d 314 (11th Cir. 1995). <a href="#_ftnref4" name="_ftn4">4</a>. Mitchell v. Comm., 775 F.3d 1243 (10th hCir. 2015). <a href="#_ftnref5" name="_ftn5">5</a>. Rev. Rul. 2003-123, 2003 CB 1200, amplifying, Rev. Rul. 68-667, 1968 CB 289. </div></div>

March 13, 2024

8111 / What are the tax consequences of a charitable contribution of a partnership interest?

<div class="Section1"> A partnership interest is a capital asset that, if sold, would be given capital gain or loss treatment except to the extent of the partner’s share of certain partnership property that, if sold by the partnership, would produce ordinary gain (i.e., his share of “unrealized receivables” and “substantially appreciated inventory”).<a href="#_ftn1" name="_ftnref1">1</a> (See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7755">7755</a>. See also Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> regarding the treatment of capital gains and losses.) Thus, if a taxpayer makes a charitable contribution of his partnership interest, and if he has held the interest for long enough to qualify for long-term capital gain treatment (i.e., more than one year, as defined in IRC Section 1222(3); see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9067">9067</a>), he may deduct the full fair market value of his interest less the amount of ordinary gain, if any, that would have been realized by the partnership for his share of “unrealized receivables” and “substantially appreciated inventory.” (His deduction is subject to the applicable limits. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9067">9067</a>.) If the partnership interest includes a liability (mortgage, etc.), the amount of the liability is treated as an amount realized on the disposition of the partnership interest.<a href="#_ftn2" name="_ftnref2">2</a> Thus, the contribution is subject to the bargain sale rules, and the transfer will be treated, in part at least, as a sale (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8075">8075</a>).<a href="#_ftn3" name="_ftnref3">3</a> (If the partner’s share of partnership liabilities exceeds the fair market value of his partnership interest, he may have taxable income, but no deduction under the bargain sale rules.) In Goodman v. United States,<a href="#_ftn4" name="_ftnref4">4</a> the taxpayer contributed her partnership interest to charity, subject to her share of partnership debt. The district court held that the taxpayer recognized gain on the transfer equal to the excess of the amount realized over that portion of the adjusted basis of the partnership interest (at the time of the transfer) allocable to the sale under IRC Section 1011(b).<a href="#_ftn5" name="_ftnref5">5</a> In order to determine the taxable income and the amount of charitable deduction under the bargain sale rules, the following steps must be taken: <ol> <li style="list-style-type: none"> <ol> <li>Determine the taxable gain on the sale portion. Under the bargain sale rules, part of the donor’s basis is allocated to the portion sold. The basis allocated to the sold portion is the amount of basis that bears the same ratio to his entire basis as the amount realized bears to the market value of the property. Presumably, the sold portion includes the same proportionate part of his share of unrealized receivables and substantially appreciated inventory as it does basis.</li> </ol> </li> </ol> Example. Mr. Jones owns a 10 percent interest in a partnership that he has held for three years. The fair market value of his interest is $100,000 and his adjusted basis is $50,000. His share of a mortgage on partnership property is $40,000, and his share of “unrealized receivables” (potential depreciation recapture on the mortgaged property) is $5,000 in which the partnership’s basis is zero. He donates his entire interest to charity. He is deemed to have received $40,000, his share of partnership liabilities, on the transfer. In effect there are two transactions–a sale for $40,000 and a contribution of $60,000. Of Mr. Jones’ $50,000 basis in his partnership interest, $20,000 is allocated to the sale portion: $40,000 (amount realized)/$100,000 (fair market value) × $50,000 (total adjusted basis). The fair market value of the sold portion is $40,000 (amount realized). Mr. Jones must recognize a gain of $20,000 ($40,000 realized less $20,000 adjusted basis allocated to the sold portion). Of that gain, $2,000 is allocable to unrealized receivables ($5,000 unrealized receivables × $40,000/$100,000). Because the partnership has no basis in the unrealized receivables, the entire $2,000 would be ordinary income. Mr. Jones must report a taxable long-term capital gain of $18,000 and a taxable ordinary gain of $2,000. <ol> <li style="list-style-type: none"> <ol start="2"> <li>Determine the charitable contribution deduction. As a general rule, the fair market value of the portion given to charity is deductible except to the extent the property would have generated ordinary income if sold. Consequently, the allowable deduction for the gift portion must be reduced to the extent the portion of the partnership interest given to the charity would produce ordinary income if sold.</li> </ol> </li> </ol> Example. The fair market value of Mr. Jones’ gift to charity is $60,000. Because 60 percent of the partnership interest was given to the charity ($60,000/$100,000), 60 percent of Mr. Jones’ share of partnership “unrealized receivables,” or $3,000 ($5,000 × 60% = $3,000), is considered included in the gift. The balance of the gift would be long-term capital gain on sale. Because $3,000 would be ordinary income on a sale, Mr. Jones’ contribution is reduced by $3,000, and his charitable contribution deduction is $57,000. Other special rules may apply under certain circumstances, for example, if the partnership owns property subject to tax credit recapture, if it has made installment sales, or (as might occur in the case of an oil and gas partnership) if it is receiving income in the form of “production payments.” See also Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8076">8076</a> with regard to prepaid interest. Further, the IRS may examine the transaction in which a donation takes place and may disallow the charitable deduction based upon the doctrine of substance over form. In one case, a partner claimed a deduction for his donation of a partnership interest to a charitable organization. The IRS examined the transaction and found that the charity had received no membership rights in the transaction and was given only a promissory note from the partner claiming the deduction. The partner retained the right to determine when interest payments would be made on the note. The IRS found that, in substance, the partner had never transferred the interest to the charitable organization and, as such, denied the deduction.<a href="#_ftn6" name="_ftnref6">6</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 741. <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.1001. See Crane v. Comm., 331 U.S. 1 (1947). <a href="#_ftnref3" name="_ftn3">3</a>. Rev. Rul. 75-194, 1975-1 CB 80. <a href="#_ftnref4" name="_ftn4">4</a>. 2000-1 USTC ¶ 50,162 (S.D. Fl. 1999). <a href="#_ftnref5" name="_ftn5">5</a>. Citing Rev. Rul. 75-194 and Treas. Reg. § 1.1001. <a href="#_ftnref6" name="_ftn6">6</a>. ILM 201507018. </div></div>

March 13, 2024

8112 / What is a charitable IRA rollover or qualified charitable distribution?

<div class="Section1"> Editor’s Note: The SECURE Act 2.0 made significant changes to the rules governing qualified charitable distributions for tax years beginning in 2023 and thereafter. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for details. For tax years 2006 and thereafter, a taxpayer age 70½ or older is eligible to make a qualified charitable distribution from an IRA that is not includible in the gross income of the taxpayer. This provision was made permanent by the PATH Act of 2015.<a href="#_ftn1" name="_ftnref1">1</a> <hr> Planning Point: While the required beginning date for RMDs is age 73 for 2023032, taxpayers remain eligible to execute a QCD starting at age 70 ½. High-net worth taxpayers who don’t anticipate a need for their IRA funds and have yet to reach their RBD may consider executing a QCD earlier to reduce their overall IRA balance—and thus reduce their future RMD obligations. <hr> A qualified charitable distribution is any distribution: <ol> <li>not exceeding $100,000 in the aggregate during the taxable year (the $100,000 limit will be indexed for inflation after 2023; in 2024 the limit is $105,000);</li> </ol> <hr> <ol start="2"> <li>made directly, in a trustee-to-charity transfer;</li> <li>from a traditional or Roth IRA (distributions from SEPs and SIMPLE IRAs do not qualify); the prohibition on making a qualified charitable distribution from a SEP IRA or a SIMPLE IRA only applies to “ongoing” SEP IRAs or SIMPLE IRAs. Such an IRA is “ongoing” if a contribution is made to it for the taxable year of the charitable distribution;<a href="#_ftn2" name="_ftnref2">2</a></li> </ol> <hr> <ol start="4"> <li>to a public charity (but not a donor-advised fund or supporting organization);</li> </ol> <hr> <ol start="5"> <li>that would otherwise qualify as a deductible charitable contribution—not including the percentage of income limits in IRC Section 170(b);</li> <li>to the extent the distribution would otherwise be includible in gross income.<a href="#_ftn3" name="_ftnref3">3</a></li> </ol> No charitable income tax deduction is allowed for a qualified charitable distribution.<a href="#_ftn4" name="_ftnref4">4</a> <hr> Planning Point: Rollovers to charities by taxpayers who reside in states that tax IRA distributions and do not have a charitable deduction may not escape tax at the state level. Ted R. Batson, Jr., MBA, CPA, and Gregory W. Baker, JD, CFP®, CAP, Renaissance Administration, LLC. <hr> If a qualified charitable distribution is made from any IRA funded with nondeductible contributions, the distribution is treated as coming first from deductible contributions and earnings.<a href="#_ftn5" name="_ftnref5">5</a> This is contrary to the general rule that distributions from an IRA with both deductible and nondeductible contributions are deemed made on a pro-rata basis.<a href="#_ftn6" name="_ftnref6">6</a> Qualified charitable distributions may count toward a taxpayer’s unsatisfied required minimum distributions for the year.<a href="#_ftn7" name="_ftnref7">7</a> For guidance on qualified charitable contributions (including questions and answers), see Notice 2007-7.<a href="#_ftn8" name="_ftnref8">8</a> The American Taxpayer Relief Act of 2012 extended the ability to make qualified charitable distributions for tax years 2012 and 2013. Because the law was not passed until January 2013, the law included special provisions for donors to make gifts in January of 2013 to qualify for the 2012 year. The provisions were that an IRA owner can treat a contribution made to a qualified charity in January of 2013 as a 2012 qualified charitable distribution if: <ol> <li>The contribution was made in cash from the donor to the qualified charity of all or a portion of an IRA distribution made to the IRA owner in December 2012 provided that the contribution would have been a 2012 qualified charitable distribution if it had been paid directly from the IRA to the qualified charity in 2012, or</li> <li>The contribution is paid directly from the IRA to the qualified charity, provided that the contribution would have been a 2012 qualified charitable distribution if it had been paid in 2012.</li> </ol> A qualified charitable distribution made in January 2013 that was treated as a 2012 qualified charitable distribution satisfied the IRA owner’s 2012 required minimum distribution if the amount of the qualified charitable distribution was equal to or greater than the 2012 required minimum distribution. However, no part of such a qualified charitable distribution could be used to satisfy the 2013 required minimum distribution, even if the 2012 required minimum distribution had already been made. In determining the required minimum distribution for 2013, the 2012 qualified charitable distribution had to be subtracted from the December 31, 2012 IRA account balance. Post-SECURE Act, taxpayers who make both post-70½ (deductible) IRA contributions and take qualified charitable distributions (QCDs) are also subject to an anti-abuse rule. Future QCDs are reduced by the total amount of deductible post-70½ IRA contributions that have not offset another QCD, although the amount cannot be reduced below zero.<a href="#_ftn9" name="_ftnref9">9</a> Amounts that cannot be treated as a pre-tax QCD can be treated as an itemized deduction for the taxpayer. Example: An individual who turned age 70½ before 2020 deducts $5,000 for contributions for each of 2020 and 2021 but makes no contribution for 2022. The individual makes no QCDs for 2020 and makes QCDs of $6,000 for 2021 and $6,500 for 2022. The excludable amount of QCDs for 2021 is the $6,000 of QCDs reduced by the $10,000 aggregate amount of post-age 70½ contributions for 2021 and earlier taxable years. For this individual, these amounts are $5,000 for each of 2020 and 2021, resulting in no excludable QCDs for 2021 (that is, $6,000 – $10,000 = ($4,000)). The excludable amount of the QCDs for 2022 is the $6,500 of QCDs reduced by the portion of the $10,000 aggregate amount of post-age 70½ contributions deducted that did not reduce the excludable portion of the QCDs for earlier taxable years. Thus, $6,000 of the aggregate amount of post-age 70½ contributions deducted does not apply for 2022 because that amount has reduced the excludable amount of QCDs for 2021. The remaining $4,000 of the aggregate amount of post-age 70½ contributions deducted reduces the excludable amount of any QCDs for subsequent taxable years. Accordingly, the excludable amount of the QCDs for 2022 is $2,500 ($6,500 – $4,000 = $2,500). As described above, because the $4,000 amount reduced the excludable amount of QCDs for 2022, that $4,000 amount does not apply again in later years, and no amount of post-age 70½ contributions remains to reduce the excludable amount of QCDs for later taxable years.<a href="#_ftn10" name="_ftnref10">10</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 408(d)(8). The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 extended the law through 2011 and the American Taxpayer Relief Act of 2012 extended the law through 2013. The Protecting Americans Against Tax Hikes Act of 2015 made the provision permanent. <a href="#_ftnref2" name="_ftn2">2</a>. Notice 2023-75. <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 408(d)(8). <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 408(d)(8)(E). <a href="#_ftnref5" name="_ftn5">5</a>. IRC § 408(d)(8)(D). <a href="#_ftnref6" name="_ftn6">6</a>. IRC §§ 72, 408(d)(1). <a href="#_ftnref7" name="_ftn7">7</a>. IRC § 408(d)(8). <a href="#_ftnref8" name="_ftn8">8</a>. 2007-5 IRB 395. <a href="#_ftnref9" name="_ftn9">9</a>. IRC § 408(d)(8)(A). <a href="#_ftnref10" name="_ftn10">10</a>. Notice 2020-68. </div></div>

March 13, 2024

8110 / Is a gift of a "facade easement" deductible?

<div class="Section1"> A variation on the conservation easement (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8108">8108</a>) is the use of a “facade easement,” wherein the grantor agrees not to alter the facade or modify the architectural characteristics of a building. If the building, structure, or land is listed in the National Register or is located in a registered historic district, any easement that is a restriction with respect to the exterior of the building must preserve the entire exterior and its historical character.<a href="#_ftn1" name="_ftnref1">1</a> If a deduction in excess of $10,000 is claimed with respect to such an exterior easement, a $500 filing fee is required with the tax return.<a href="#_ftn2" name="_ftnref2">2</a> The amount of the deduction for the contribution of a facade easement is the full fair market value of the easement at the time of the contribution.<a href="#_ftn3" name="_ftnref3">3</a> The fair market value of the facade donation has been determined by applying the “before and after” approach.<a href="#_ftn4" name="_ftnref4">4</a> A substantial record of sales of easements comparable to the one donated results in valuation of the fair market value of the donation based on the sale prices of the comparable easements.<a href="#_ftn5" name="_ftnref5">5</a> If the donation of a facade easement increases the value of the property it would appear that the donation would be reduced by the amount of such increase.<a href="#_ftn6" name="_ftnref6">6</a> A taxpayer who claims an investment credit for the rehabilitation of a historic structure may be required to recapture a portion of the credit upon the gift of a facade easement for the rehabilitated building. The qualified easement contribution is reduced if a rehabilitation credit was taken. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC §§ 170(h)(4)(B), 170(h)(4)(C). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 170(f)(13). <a href="#_ftnref3" name="_ftn3">3</a>. Let. Rul. 8449025. <a href="#_ftnref4" name="_ftn4">4</a>. Hilborn v. Comm., 85 TC 677 (1985); Nicoladis v. Comm., TC Memo 1988-163; Dorsey v. Comm., TC Memo 199042; Griffin v. Comm., TC Memo 1989-130, aff’d, 90 USTC ¶ 50,507 (5th Cir. 1990). <a href="#_ftnref5" name="_ftn5">5</a>. See Akers v. Comm., 799 F.2d 243 (6th Cir. 1986). <a href="#_ftnref6" name="_ftn6">6</a>. See Treas. Reg. § 1.170A-14(h)(3). </div></div>

March 13, 2024

8105 / Can a deduction be taken for a charitable contribution to a charitable lead trust of a right to payment to the charity?

<div class="Section1"> Yes, if certain requirements are met. A charitable lead trust is essentially the reverse of a charitable remainder trust; the donor grants a right to payment to the charity, with the remainder reverting to the donor (or his named beneficiaries). Such trusts are commonly called charitable “lead” trusts because the first or leading interest is in the charitable donee. Even though a gift of such an interest in property is less than the entire interest of the donor, its value will be deductible if the interest is in the form of a “guaranteed annuity interest” or a “unitrust interest.”<a href="#_ftn1" name="_ftnref1">1</a> A guaranteed annuity interest is an irrevocable right to receive payment of a determinable amount at least annually. A unitrust interest is an irrevocable right to receive payment at least annually of a fixed percentage of the fair market value of the trust assets, determined annually. In either case, payments may be made to the charity for a term of years or over the life of an individual (or lives of more than one individual) living at the date of the transfer to the trust. Only one (or more) of the following individuals may be used as measuring lives: (1) the donor; (2) the donor’s spouse; (3) a lineal ancestor of all the remainder beneficiaries; or (4) the spouse of a lineal ancestor of all the remainder beneficiaries. A trust will satisfy the requirement that all noncharitable remainder beneficiaries be lineal descendants of the individual who is the measuring life (or that individual’s spouse) if there is less than a 15 percent probability that individuals who are not lineal descendants will receive any trust corpus. This probability must be computed at the time property is transferred to the trust taking into account the interests of all primary and contingent remainder beneficiaries who are living at that time. The computation must be based on the current applicable Life Table in Treasury Regulation Section 20.2031-7.<a href="#_ftn2" name="_ftnref2">2</a> A guaranteed annuity may be made to continue for the shorter of a term of years or lives in being plus a term of years.<a href="#_ftn3" name="_ftnref3">3</a> The IRS determined that an annuity met the requirements for a “guaranteed annuity” even though neither the term nor the amount was specifically stated; the term was ascertainable as of the death of the grantor, based on a formula described in the trust instrument.<a href="#_ftn4" name="_ftnref4">4</a> The annuity cannot be for the lesser of a designated amount or a fixed percentage of the fair market value of trust assets, determined annually.<a href="#_ftn5" name="_ftnref5">5</a> After termination of the charity’s right to payment, the remainder interest in the property is returned to the donor or his designated beneficiaries. Example: Walter gives $1,000,000 to a charitable lead trust. The trust’s term is 21 years paying 5 percent each year to his favorite charity. At the end of the 21 year period, the assets in the trust will be distributed to Walter’s three children. The gift tax charitable deduction is $741,870 assuming annual trust payments and a 3.4 percent 7520 rate. Over the course of 21 years, the charity will receive $1,050,000. The children will receive the trust assets free of any further estate or gift taxes. According to regulations, an income tax charitable deduction is allowable for a charitable annuity or unitrust interest that is preceded by a noncharitable annuity or unitrust interest. In other words, the regulations eliminate the requirement that the charitable interest start no later than the commencement of a noncharitable interest in the form of a guaranteed annuity or unitrust interest. However, the regulations continue to require that any amounts payable for a private purpose before the expiration of the charitable annuity or unitrust interest must be in the form of a guaranteed annuity or unitrust interest, or must be payable from a separate group of assets devoted exclusively to private purposes. The regulations conform the income tax regulations to the Tax Court’s decision in Estate of Boeshore.<a href="#_ftn6" name="_ftnref6">6</a> The IRS determined that the requirements for a charitable lead annuity trust were met even though the trust authorized the trustee, who was the grantor’s son, to choose among various charities to receive the annuity interest and apportion the payouts among them.<a href="#_ftn7" name="_ftnref7">7</a> The IRS has also found that the requirements for a CLAT were met when the taxpayer first established a revocable trust that would make payments to cover certain debts and expenses after his death, and then make payments to individual and trust beneficiaries, before eventually funding the CLAT. The IRS found that it would eventually be possible to calculate the payout term based upon the fair market value of the CLAT assets after the original revocable trust made the other payments.<a href="#_ftn8" name="_ftnref8">8</a> The Service ruled that so long as a donor was treated as the owner of a guaranteed annuity interest for purposes of the grantor trust rules, the income interest transferred in trust to a private foundation qualified as a “guaranteed annuity interest” under IRC Section 170(f)(2)(B). Even though the present value on the date of the transfer exceeded 60 percent of the aggregate fair market value of all the amounts in trust, the Service reasoned that this did not prevent the income interest from being a “guaranteed annuity interest” because the trust agreement provided that the acquisition and retention of assets that would give rise to an excise tax if the trustee had acquired the assets was prohibited, in accordance with Treasury Regulation Section 1.170A-6(c)(2)(i)(D).<a href="#_ftn9" name="_ftnref9">9</a> The partition of a charitable lead annuity trust into three separate trusts to address differences of opinion among trustees as to the choice of charitable beneficiaries and the investment of trust assets did not cause the original trust, the new trusts, or any of the trusts’ beneficiaries to realize income or gain.<a href="#_ftn10" name="_ftnref10">10</a> The Service has privately ruled that the sale of assets, which were pledged as collateral for a promissory note to the family’s charitable lead annuity trust, to a limited liability company would not constitute self-dealing so long as the value of the collateral remained as required under the terms of the note, and would not give rise to tax liability under IRC Section 4941 to the CLATs, related family members, the estate, or the marital trusts.<a href="#_ftn11" name="_ftnref11">11</a> Sample Trusts. The IRS has released sample forms, annotations, and alternate provisions for inter vivos and testamentary charitable lead annuity trusts and unitrusts.<a href="#_ftn12" name="_ftnref12">12</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 170(f)(2)(B). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. §§ 1.170A-6(c)(2)(i)(A), 1.170A-6(c)(2)(ii)(A). <a href="#_ftnref3" name="_ftn3">3</a>. Rev. Rul. 85-49, 1985-1 CB 330. <a href="#_ftnref4" name="_ftn4">4</a>. Let. Rul. 9118040. <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 1.170A-6(c)(2)(B). <a href="#_ftnref6" name="_ftn6">6</a>. 78 TC 523 (1982), acq. in result, 1987 CB 1. See Treas. Reg. §§ 1.170A-6(c)(2)(i)(E), 1.170A-6(c)(2)(ii)(D); TD 9068, 68 Fed. Reg. 40130 (7-7003), revoking, Rev. Rul. 7625, 1976-1 CB 281. <a href="#_ftnref7" name="_ftn7">7</a>. See Let. Rul. 9748009. See also Let. Ruls 200138018, 200043039, 200030014 (charitable gifts were not incomplete even though one or more family members would serve as directors of the charitable beneficiary of the grantors’ CLUTs). <a href="#_ftnref8" name="_ftn8">8</a>. Let. Rul. 201933007. <a href="#_ftnref9" name="_ftn9">9</a>. Let. Rul. 9810019. <a href="#_ftnref10" name="_ftn10">10</a>. Let. Rul. 199930036. See also Let. Rul. 200149016. <a href="#_ftnref11" name="_ftn11">11</a>. See Let. Rul. 200124029. <a href="#_ftnref12" name="_ftn12">12</a>. See Rev. Proc. 2007-45, 20079 IRB 89 (inter vivos CLATs); Rev. Proc. 2007-46, 20079 IRB 102 (testamentary CLATs); Rev. Proc. 2008-45, 2008-30 IRB 224 (inter vivos CLUTs); Rev. Proc. 2008-46, 2008-30 IRB 238 (testamentary CLUTs). </div></div>

March 13, 2024

8107 / Is the deduction for a gift to a charitable lead unitrust of a right to payment taken in the year of the gift?

<div class="Section1"> An immediate deduction of the present value of all the annual payments to be made over the period may be taken if the trust is structured so that the donor is taxable on the income of the trust each year (under the “grantor trust rules”). If the trust is structured so that he is not taxable on trust income, he will not get an income tax deduction for the gift.<a href="#_ftn1" name="_ftnref1">1</a> The IRS has determined that a donor was to be treated as the owner of a charitable lead trust where the donor retained the power to substitute trust property. The donor was entitled to a current deduction in an amount equal to the present value of the unitrust interest.<a href="#_ftn2" name="_ftnref2">2</a> In general, the amount of the charitable contribution deduction allowable for the transfer of property to a charitable lead unitrust is equal to the present value of the unitrust interest. If the unitrust payments are made annually at the beginning of each year and the annual payout rate is equal to an adjusted payout rate for which factors are given, the present value of the unitrust interest can be calculated simply by multiplying the value of the property transferred to the charitable lead unitrust by the appropriate unitrust factor (see Appendix A). If the unitrust payments are made other than annually at the beginning of each year or the annual payout rate falls between adjusted payout rates for which factors are given, the calculation of the deduction for a contribution to a charitable lead unitrust is more complex. Example 5. In September, Mr. Smith (age 85) transferred property worth $100,000 to a charitable lead unitrust that is a grantor trust. The trust is to make annual payments (at the beginning of each year) of 5 percent of the value of the trust corpus (valued annually) to charity during his lifetime (i.e., a 5 percent annual payout rate). The value of the unitrust payable to charity is calculated as follows: (1) Find the single life unitrust remainder factor for a person age 85 at a 5.0 percent adjusted payout rate: .74516 (from Single Life Unitrust Remainder Factors Table in Appendix A). (2) Calculate the single life unitrust factor for a person age 85 at a 5.0 percent adjusted payout rate by subtracting the factor in (1) from one – 1 – .74516 = .25484. (3) Multiply the value of the property transferred to the charitable lead unitrust ($100,000) by the single life unitrust factor for a person age 85 at a 5 percent payout rate (.25484) – $100,000 × .25484 = $25,484. The amount of the charitable contribution deduction is $25,484. Example 6. If the unitrust payments in Example 5 were to be made for 20 years (at the beginning of each year) rather than for Mr. Smith’s life, the present value of the unitrust remainder interest is calculated as follows: (1) Find the term certain unitrust remainder factor for 20 years at a 5.0 percent adjusted payout rate: .358486 (from Term Certain Unitrust Remainder Factors Table in Appendix A). (2) Calculate the term certain unitrust factor for 20 years at a 5.0 percent adjusted payout rate by subtracting the factor in (1) from one – 1 – .358486 = .641514. (3) Multiply the value of the property transferred to the charitable lead unitrust ($100,000) by the term certain unitrust factor for 20 years at a 5 percent payout rate (.641514) – $100,000 × .641514 = $64,151. The amount of the charitable contribution deduction is $64,151. Example 7. Assume the same facts as in Example 5, except that payments are to be made at the end of each year. Assume the valuation table interest rates for September and the two preceding months, July and August, were 3.4 percent, 3.2 percent, and 3.0 percent. Mr. Smith elected to use the 3.0 percent rate. The value of the unitrust payable to charity is calculated as follows: (1) Find the unitrust payout adjustment factor for annual payments to start 12 months after the valuation date at a 3.0 percent interest rate: .970874 (from Unitrust Payout Adjustment Factors Table in Appendix A). (2) Multiply the factor in (1) by the annual payout rate to obtain the adjusted payout rate: .970874 × 5 percent = 4.854 percent. (3) Find the single life unitrust remainder factor for a person age 85 at a 4.8 percent adjusted payout rate: .75352 (from Single Life Unitrust Remainder Factors Table in Appendix A). (4) Find the single life unitrust remainder factor for a person age 85 at a 5.0 percent adjusted payout rate: .74516 (from Single Life Unitrust Remainder Factors Table in Appendix A). (5) Subtract the factor in (4) from the factor in (3): .75352 – .74516 = .00836. <table style="margin-left: 40px"> <tbody style="padding-left: 40px"> <tr style="padding-left: 40px"> <td style="padding-left: 40px" rowspan="2" width="29"> (6) </td> <td style="padding-left: 40px" width="91"> 4.854% – 4.800% </td> <td style="padding-left: 40px" rowspan="2" width="18"> = </td> <td style="padding-left: 40px" width="37"> X </td> </tr> <tr style="padding-left: 40px"> <td style="padding-left: 40px" width="91"> 5.000% – 4.800% </td> <td style="padding-left: 40px" width="37"> .00836 </td> </tr> <tr style="padding-left: 40px"> <td style="padding-left: 40px" width="29"> </td> <td style="padding-left: 40px" colspan="3" width="146"> X = .00226 </td> </tr> </tbody> </table> (7) Subtract X in (6) from the factor at 4.8 percent from (3): .75352 – .00226 = .75126. (8) Subtract the interpolated unitrust remainder factor in (7) from one – 1 – .75126 = .24874. (9) Multiply the value of the property transferred to the charitable lead unitrust ($100,000) by the interpolated unitrust factor in (8) (.24874). The amount of the charitable contribution deduction is $24,874. [The same procedure applies to calculating a unitrust interest for a term certain. However, Term Certain Unitrust Remainder Factors are used instead of Single Life Unitrust Remainder Factors.] If the donor of a right to payment ceases to be taxable on the trust income before the termination of the interest, he must “recapture,” that is, include in his income, an amount equal to the deduction less the discounted value of all amounts required to be, and which actually were, paid before the time he ceased to be taxable on trust income.<a href="#_ftn3" name="_ftnref3">3</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. Treas. Reg. § 1.170A-6(c). See, e.g., Let. Rul. 200108032. <a href="#_ftnref2" name="_ftn2">2</a>. Let. Rul. 9247024. <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. § 1.170A-6(c)(4). </div></div>

March 13, 2024

8106 / Is the deduction for a gift to a charitable lead annuity trust of a right to payment taken in the year of the gift?

March 13, 2024

8108 / What is a conservation easement? Is a gift of a conservation easement deductible?

<div class="Section1"> Editor’s Note: As required under the SECURE Act 2.0, the IRS released Notice 2023-30 containing safe harbor deed language for extinguishment and boundary line adjustment clauses in conservation easement deeds. The new law provides donors the opportunity to amend certain conservation easement deeds to substitute the IRS' safe harbor language for the language that was contained in the original deed. Taxpayers have until only July 24, 2023, to record their safe harbor deed amendments. These amendments must be effective as of the date when the original easement deed was recorded. As long as the safe harbor language is substituted and the amended deed is signed by July 24, 2023, the amendment is treated as effective on the original date regardless of whether state law would render the amendment retroactively effective. A conservation easement is a restriction on the owner’s use of the property. A popular form is the open space or scenic easement, wherein the owner of land agrees to set the land aside to preserve natural, scenic, historic, scientific and recreational areas, for public enjoyment.<a href="#_ftn1" name="_ftnref1">1</a> The Tax Court held that taxpayers’ contributions of conservation easements (encumbered shoreline) were qualified conservation contributions because: (1) they protected a relatively natural habitat of wildlife and plants (in accordance with Treasury Regulation Section 1.170A-14(d)(3)); and (2) were exclusively for conservation purposes.<a href="#_ftn2" name="_ftnref2">2</a> The Tax Court held that a taxpayer did not make a contribution of a qualified conservation easement because the attempted grant did not satisfy the conservation purposes required under IRC Section 170(h)(4)(A. Specifically, the deed did not preserve open space, an historically important land area, or a certified historical structure.<a href="#_ftn3" name="_ftnref3">3</a> The IRS approved a contribution of a conservation easement in which the taxpayer retained limited water rights; the conditions of the use of those rights were sufficiently restricted that the Service determined their exercise would not adversely affect the purposes for which the easement was established.<a href="#_ftn4" name="_ftnref4">4</a> The IRS also determined that the proposed inconsistent use of some of a farm (i.e., construction of eight single-family homes) to be burdened by a conservation easement was not significant enough to cancel the conservation purpose of the easement because the conservation easement would still maintain over 80 percent of the entire tract in its presently undeveloped state, thereby preserving the habitat.<a href="#_ftn5" name="_ftnref5">5</a> Open space easements have been approved by the Service in several instances.<a href="#_ftn6" name="_ftnref6">6</a> (Although some of these rulings were made under prior law, they remain valid under the current IRC Section.) The deductible value of the easement is generally determined using a “before and after” approach. That is, the value of the total property owned by the taxpayer (including adjacent property that is not encumbered by the easement) before granting the easement is determined. Then, the value of the property after granting the easement is subtracted to determine the value of the easement.<a href="#_ftn7" name="_ftnref7">7</a> For purposes of determining the value of the property before granting of the easement, the Tax Court determined that the highest and best use of the property had to be taken into account.<a href="#_ftn8" name="_ftnref8">8</a> General guidelines for valuing property can be found in Revenue Procedure 66-49.<a href="#_ftn9" name="_ftnref9">9</a> If there is a substantial record of sales of easements comparable to the one donated, the fair market value of the donation can be based on the sale prices of the comparable easements. However, where previous sellers of easements to the county had generally intended to make gifts to the county by way of bargain sales, the Tax Court determined that the comparable sales approach was inappropriate in a bargain sale of a conservation easement.<a href="#_ftn10" name="_ftnref10">10</a> Increases in the value of any property owned by the donor or a related person that result from the donation, whether or not the other property is contiguous to the donated property, reduce the amount of the deduction by the amount of the increase in the value of the other property.<a href="#_ftn11" name="_ftnref11">11</a> The Service privately ruled that an estate could properly claim an estate tax deduction for the value of a conservation easement attributable to a 68.8 percent tenancy in common interest includible in the decedent’s gross estate notwithstanding the fact that the co-tenants would claim an income tax deduction for the conservation easement granted with respect to the interests in the property they owned.<a href="#_ftn12" name="_ftnref12">12</a> The Service determined that a taxpayer’s exchange of a conservation easement in real property under IRC Section 1031(a) would qualify as a tax-deferred exchange of like-kind property, provided that the properties would be held for productive use in a trade or business, or for investment.<a href="#_ftn13" name="_ftnref13">13</a> In a legal memorandum, the Service analyzed the issues regarding the Colorado conservation easement credit, including: (1) to the extent a taxpayer is effectively reimbursed for the transfer of the easement through the use, refund, or transfer of the credit, whether that benefit is a quid pro quo that either reduces or eliminates a charitable contribution deduction under IRC Section 170; and (2) whether the benefit of the state conservation easement credit is, in substance, an amount realized from the transfer of the easement under IRS Section 1001, generally resulting in capital gain.<a href="#_ftn14" name="_ftnref14">14</a> Improper deductions for conservation easements. The Service has determined that some taxpayers have been claiming inappropriate contribution deductions for cash payments or easement transfers to charitable organizations in connection with purchases of real property. In some of these questionable cases, the charity purchases the property and places a conservation easement on the property. Then, the charity sells the property subject to the easement to a buyer for a price that is substantially less than the price paid by the charity for the property. As part of the sale, the buyer makes a second payment – designated as a “charitable contribution” – to the charity. The total of the payments from the buyer to the charity fully reimburses the charity for the cost of the property. The Service warned that in appropriate cases, it will treat these transactions in accordance with their substance rather than their form. Accordingly, the Service may treat the total of the buyer’s payments to the charity as the purchase price paid by the buyer for the property. Taxpayers are advised that the Service intends to disallow all or part of any improper deductions and may impose penalties, and also intends to assess excise taxes (under IRC Section 4958) against any disqualified person who receives an excess benefit from a conservation transaction, and against any organization manager who knowingly participates in the transaction. In appropriate cases, the Service may challenge the tax-exempt status of the organization based on the organization’s operation for a substantial nonexempt purpose or impermissible private benefit.<a href="#_ftn15" name="_ftnref15">15</a> Taxpayers must maintain written records of the property’s fair market value before and after the donation, and the conservation purpose involved.<a href="#_ftn16" name="_ftnref16">16</a> Guidance on qualified conservation contributions made in 2006 and thereafter. A charitable contribution of a qualified conservation easement is available to the extent the contribution does not exceed 50 percent of adjusted gross income (AGI). (The limit was 100 percent of AGI for certain farmers or ranchers.) A qualified conservation easement contribution disallowed because it exceeds the percentage of AGI limitation can be carried over for up to 15 years.<a href="#_ftn17" name="_ftnref17">17</a> The Service has released question-and-answer guidance relating to the increased percentage limitation and increased carryover period for qualified conservation contributions (see above) made in taxable years beginning after 2005. According to the Service, if a taxpayer has made a qualified conservation contribution, which is subject to the special 50 percent limitation (under IRC Section 170(b)(1)(E)), and one or more contributions subject to the other percentage limitations (i.e., the 60 percent (50 percent prior to 2018), 30 percent, or 20 percent limitations under IRC Sections 170(b)(1)(a), 170((b)(1)(B), 170(b)(1)(C), and 170(b)(1)(D)), the qualified conservation contribution may be taken into account only after taking into account the contributions subject to the other percentage limitations. The Service also states that the 50 percent limit applies to qualified conservation contributions only, not to all contributions of real property interests. The guidance also includes several questions and answers relating to the rules for qualified farmers and ranchers.<a href="#_ftn18" name="_ftnref18">18</a> The qualified easement contribution must be reduced if a rehabilitation credit was taken with respect to the property.<a href="#_ftn19" name="_ftnref19">19</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 170(h); Treas. Reg. § 1.170A-14(d). <a href="#_ftnref2" name="_ftn2">2</a>. Glass v. Comm., 124 TC 258 (2005), aff’d, 2007-1 USTC ¶ 50,111 (6th Cir. 2006). <a href="#_ftnref3" name="_ftn3">3</a>. Turner v. Comm., 126 TC 299 (2006). <a href="#_ftnref4" name="_ftn4">4</a>. Let. Rul. 9736016. <a href="#_ftnref5" name="_ftn5">5</a>. Let. Rul. 200208019. <a href="#_ftnref6" name="_ftn6">6</a>. See Rev. Rul. 74-583, 1974 CB 80; Rev. Rul. 75-373, 1975 CB 77; Let. Ruls. 200002020, 199952037, 9603018, 8641017, 8313123, 8248069. <a href="#_ftnref7" name="_ftn7">7</a>. Symington v. Comm., 87 TC 892 (1986); Fannon v. Comm., TC Memo 1986-572; Rev. Rul. 73-339, 1973 CB 68; Rev. Rul. 76-376, 1976 CB 53. See also Thayer v. Comm., TC Memo 1977-370. <a href="#_ftnref8" name="_ftn8">8</a>. Schapiro v. Comm., TC Memo 1991-128. <a href="#_ftnref9" name="_ftn9">9</a>. 1966 CB 1257, as modified by Rev. Proc. 96-15, 1996 CB 627. <a href="#_ftnref10" name="_ftn10">10</a>. See Browning v. Comm., 109 TC 303 (1997). <a href="#_ftnref11" name="_ftn11">11</a>. Treas. Reg. § 1.170A-14(h)(3). <a href="#_ftnref12" name="_ftn12">12</a>. Let. Rul. 200143011. <a href="#_ftnref13" name="_ftn13">13</a>. Let. Rul. 200201007. See also Let. Ruls. 200203033, 200203042. <a href="#_ftnref14" name="_ftn14">14</a>. IRS CCA 200238041. <a href="#_ftnref15" name="_ftn15">15</a>. Notice 2004-41, 20048 IRB 31. See also IR004-86 (6-30004). <a href="#_ftnref16" name="_ftn16">16</a>. Treas. Reg. § 1.170A-14(i). <a href="#_ftnref17" name="_ftn17">17</a>. IRC § 170(b)(1)(E). As added by PPA 2006 and extended by the Food, Conservation and Energy Act of 2008 and the American Taxpayer Relief Act of 2012. This provision was made permanent by the PATH Act of 2015. <a href="#_ftnref18" name="_ftn18">18</a>. Notice 2007-50, 20075 IRB 1430. <a href="#_ftnref19" name="_ftn19">19</a>. IRC § 170(f)(14). </div></div>

March 13, 2024

8101 / What are the ordering rules that are used to characterize distributions from a charitable remainder trust?

<div class="Section1">In 2005, the Service released final regulations on the ordering rules of IRC Section 664(b) for characterizing distributions from charitable remainder trusts. The final rules reflect changes made to income tax rates, including the rates applicable to capital gains and certain dividends, by TRA 1997, IRSRRA 1998, and JGTRRA 2003.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> Assignment of income to categories and classes. A trust’s income, including income includible in gross income and other income, is assigned to one of three categories in the year in which it is required to be taken into account by the trust. These categories are: (1) gross income, other than gains and amounts treated as gains from the sale or other disposition of capital assets (the “ordinary income category”); (2) gains and amounts treated as gains from the sale or other disposition of capital assets (the “capital gains category”); and (3) other income.<a href="#_ftn2" name="_ftnref2">2</a> Items within the ordinary income and capital gains categories are assigned to different classes based on the federal income tax rate applicable to each type of income in that category in the year the items are required to be taken into account by the trust. For example, the ordinary income category may include a class of “qualified dividend income” as defined in IRC Section 1(h)(11) (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a>) and a class of all other ordinary income. In addition, the capital gains category may include separate classes for short-term and long-term capital gains and losses, such as: (1) a short-term capital gain class; (2) a 28 percent long-term capital gain class (i.e., gains and losses from collectibles and IRC Section 1202 gains); (3) an unrecaptured IRC Section 1250 long-term capital gain class (i.e., long-term gains not treated as ordinary income that would be treated as ordinary income if IRC Section 1250(b)(1) included all depreciation); (4) a qualified five-year long-term capital gain class (as defined by IRC Section 1(h)(9) prior to amendment by JGTRRA 2003); and (5) an all other long-term capital gain class.<a href="#_ftn3" name="_ftnref3">3</a> After items are assigned to a class, the tax rates may change so that items in two or more classes would be taxed at the same rate if distributed during a particular year. If the changes to the tax rates are permanent, the undistributed items in those classes are combined into one class. However, if the changes to the tax rates are only temporary (for example, the new rate for one class will “sunset” (i.e., expire) in a future year), the classes are kept separate.<a href="#_ftn4" name="_ftnref4">4</a> Order of distributions. The categories and classes of income (determined under Treasury Regulation Section 1.664-1(d)(1)(i)) are used to determine the character of an annuity or unitrust distribution from the trust in the hands of the recipient regardless of whether the trust is exempt from taxation under IRC Section 664(c) for the year of the distribution. The determination of the character of amounts distributed or deemed distributed at any time during the taxable year of the trust must be made as of the end of that taxable year. The tax rate or rates to be used in computing the recipient’s tax on the distribution will be the tax rates that are applicable in the year in which the distribution is required to be made, to the classes of income deemed to make up that distribution, and not the tax rates that areh applicable to those classes of income in the year the income is received by the trust.<a href="#_ftn5" name="_ftnref5">5</a> The character of the distribution in the hands of the annuity or unitrust recipient is determined by treating the distributions as being made from each category in the following order: (1) First, from ordinary income to the extent of the sum of the trust’s ordinary income for the taxable year and its undistributed ordinary income for prior years; (2) Second, from capital gain to the extent of the trust’s capital gains (determined under Treasury Regulation Section 1.664-1(d)(1)(iv)); (3) Third, from other income to the extent of the sum of the trust’s other income for the taxable year and its undistributed other income for prior years; and (4) Finally, from trust corpus (with “corpus” defined for this purpose as the net fair market value of the trust assets minus the total undistributed income (but not loss) in Treasury Regulation Sections 1.664-1(d)(1)(i)(a)(1)-(3)).<a href="#_ftn6" name="_ftnref6">6</a> If the trust has different classes of income in the ordinary income category, the distribution from that category is treated as being made from each class, in turn, until exhaustion of the class, beginning with the class subject to the highest federal income tax rate and ending with the class subject to the lowest federal income tax rate.<a href="#_ftn7" name="_ftnref7">7</a> If the trust has different classes of net gain in the capital gains category, the distribution from that category is treated as being made first from the short-term capital gain class and then from each class of long-term capital gain, in turn, until the exhaustion of the class, beginning with the class subject to the highest federal income tax rate and ending with the class subject to the lowest rate.<a href="#_ftn8" name="_ftnref8">8</a> If two or more classes within the same category are subject to the same current tax rate, but at least one of those classes will be subject to a different tax rate in a future year (e.g., if the current rate “sunsets,” or expires), the order of that class in relation to other classes in the category with the same current tax rate is determined based on the future rate or rates applicable to those classes.<a href="#_ftn9" name="_ftnref9">9</a> Within each category, if there is more than one type of income in a class, amounts treated as distributed from that class are to be treated as consisting of the same proportion of each type of income as the total of the current and undistributed income of that type bears to the total of the current and undistributed income of all types of income included in that class. For example, if rental income and interest income are subject to the same current and future federal income tax rate and, therefore, are in the same class, a distribution from that class will be treated as consisting of a proportional amount of rental income and interest income.<a href="#_ftn10" name="_ftnref10">10</a> Treatment of losses. In the ordinary income category, a net ordinary loss for the current year is first used to reduce undistributed ordinary income for prior years that is assigned to the same class as the loss. Any excess loss is then used to reduce the current and undistributed ordinary income from other classes, in turn, beginning with the class subject to the highest federal income tax rate and ending with the class subject to the lowest federal income tax rate. If any of the loss exists after all the current and undistributed ordinary income from all classes has been offset, the excess is carried forward indefinitely to reduce ordinary income for future years.<a href="#_ftn11" name="_ftnref11">11</a> A net loss in the other income category for the current year is used to reduce undistributed income in this category for prior years. Any excess is carried forward indefinitely to reduce other income for future years.<a href="#_ftn12" name="_ftnref12">12</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.See TD 9190, 70 Fed. Reg. 12793 (3-16005). <a href="#_ftnref2" name="_ftn2">2</a>.Treas. Reg. § 1.664-1(d)(1)(i)(a). <a href="#_ftnref3" name="_ftn3">3</a>.Treas. Reg. § 1.664-1(d)(1)(i)(b). <a href="#_ftnref4" name="_ftn4">4</a>.Treas. Reg. § 1.664-1(d)(1)(i)(b). <a href="#_ftnref5" name="_ftn5">5</a>.Treas. Reg. § 1.664-1(d)(1)(ii)(a). <a href="#_ftnref6" name="_ftn6">6</a>.Treas. Reg. § 1.664-1(d)(1)(ii)(a). <a href="#_ftnref7" name="_ftn7">7</a>.Treas. Reg. § 1.664-1(d)(1)(ii)(b). <a href="#_ftnref8" name="_ftn8">8</a>.Treas. Reg. § 1.664-1(d)(1)(ii)(b). <a href="#_ftnref9" name="_ftn9">9</a>.Treas. Reg. § 1.664-1(d)(1)(ii)(b). <a href="#_ftnref10" name="_ftn10">10</a>.Treas. Reg. § 1.664-1(d)(1)(ii)(b). <a href="#_ftnref11" name="_ftn11">11</a>.Treas. Reg. § 1.664-1(d)(1)(iii)(a). <a href="#_ftnref12" name="_ftn12">12</a>.Treas. Reg. § 1.664-1(d)(1)(iii)(b). </div></div>