You open up your iPhone and note an email from one of your supporters. He or she asks: “Is this advertisement legitimate?” The ad reads:
Capital Gains Tax Eliminated
CAPITAL GAINS tax legally eliminated on the Sale of Real Estate, Stocks, C-Corporations, S-Corporations, Livestock, Family Businesses and even if selling to family members without having to do a 1031 exchange. We have the capability of converting taxable income to Tax-Free Lifetime income.
Inheritance Taxes Eliminated
Maintain 100% control of your current assets. Magnify the value of your estate for your heirs Tax-Free.
What do you tell your supporter? Hopefully, your response matches that of the Internal Revenue Service.
On Feb. 23 of this year, the IRS issued a cease-and-desist order and filed a complaint seeking a court order prohibiting a “senior advisor,” lawyer, insurance agent, tax return preparer and others from prompting and selling an allegedly unlawful scheme using charitable remainder annuity trusts (CRATs).1 The steps2 in the scheme involved the identification of landowners with appreciated real estate looking to fund a CRAT. The CRAT sold the land, with the proceeds used to fund a single premium annuity. The promoters reported the income as tax-free returns of principal after inflating the cost basis to fair market value and relying (inappropriately) on sec. 72(b) of the Internal Revenue Code (IRC). The IRS alleged the defendants know or have reason to know the tax benefits advertised were false and fraudulent.
While it is certainly true that the sale by the CRAT is not taxable to the tax-exempt trust, there are still annual reporting requirements under Form 5227 (Split-Interest Trust Information Return) and Form 1041 (U.S. Income Tax Return for Trusts and Estates). The defendants in this litigation were also unaware or indifferent to the operating of the tier accounting rules under sec. 664(b). Any distributions by the CRAT are taxed to the recipient under the “Worst In, First Out” (WIFO) rules under sec. 664(b) of the IRC.
An auditing of 19 of 70 CRATs created through the scheme revealed an understatement of nearly $17,000,000 in taxable income. The facts involving Customer 2 typify the magnitude of the underreporting of income. Customer 2 contributed realty with a fair market value of $1,745,934 and a cost basis of approximately $619,468. The trustee of the CRAT sold the land for $1,750,000 within two months of its contribution. The trustee of the CRAT segregated the sales proceeds with 10% being distributed to charity and 90% being used to purchase a single payment insurance annuity (SPIA). The annuity would pay for five years. The CRAT characterized nearly 99% of the sales proceeds distributed to the customer as corpus or a tax-free return of principal.
The trustee treated the capital gain as the difference between the sales proceeds and fair market value at the time of funding, arguing the tax-exempt trust had a stepped-up basis not a carryover basis as required under sec. 1015(b) of the IRC. The 1099-R from the annuity issuer would show as taxable only a modest amount of interest and virtually all of the distribution as tax-free within the meaning of 72(c) of the IRC. The tax preparers took a deduction for the full fair market value of the gift, not the present value of the charitable remainder interest.
This litigation illustrates how many tax promoters operate. There is an affiliation of investment, legal and tax professionals to coordinate the identical tax consequences. Note in the complaint how the parties use portions of the Code that are inapplicable to the funding and administration of a charitable remainder trust (CRT).
Let me end with a question I am asked at least several times a year. If the CRT invests exclusively in tax-exempt bonds, will the distributions to the annuitant be tax-free? The answer is no because the tier accounting rules prevent this. Additionally, the trustee should not be investing all the proceeds in any one asset class, as that is likely imprudent. Remember, a trustee owes a duty of impartiality to the beneficiaries, balancing the needs of the annuitants for income versus the need of the remaindermen for capital appreciation.
By Professor Christopher P. Woehrle, JD, LLM
Endnotes
- See https://www.justice.gov/opa/pr/justice-department-sues-shut-down-multistate-tax-elimination-scheme-involving-charitable.
- See the complaint of the IRS at https://storage.courtlistener.com/recap/gov.uscourts.mowd.162472/gov.uscourts.mowd.162472.1.0.pdf
