On October 31, 2008, the IRS issued Notice 2008-99, identifying a transaction as a “transaction of interest” subject to disclosure and list maintenance requirements. The IRS issued this Notice less than two months after issuing, on September 11, 2008, a series of proposed and temporary regulations that address the imposition of penalties for failure to include on a tax return any information required to be disclosed with respect to a reportable transaction (including transactions of interest).
Transactions of interest are not necessarily transactions the IRS considers abusive. Instead, they are transactions the IRS believes are the same as or substantially similar to transactions previously identified by the IRS as listed transactions. The IRS believes that these types of transactions have a potential for tax avoidance or evasion, but the IRS lacks sufficient information to determine if the transaction should be specifically identified as a tax avoidance transaction.
Nonetheless, in proposed regulations issued on November 2, 2006 and finalized on July 31, 2007, the IRS identified transactions of interest as reportable transactions subject to a variety of disclosure rules, list maintenance requirements, and potential penalties. The more recent proposed and temporary regulations further discuss the penalties applicable when taxpayers do not properly disclose reportable transactions, including transactions of interest.
Sale of Charitable Remainder Trust Interests Transaction
Notice 2008-99 describes a transaction involving a sale of all interests in a charitable remainder trust (after the contribution of appreciated assets to and their reinvestment by the trust), resulting in the grantor or other recipient receiving the value of his or her trust interest and claiming to recognize little or no taxable gain. It is not surprising that the IRS has chosen to address this type of transaction. In its 2008-2009 priority guidance plan, the IRS specifically addressed uniform basis rules for trusts as a project to which they intend to apply resources this year.
In this transaction, a grantor (the “Grantor”) of a charitable remainder trust (a “CRT”) contributes appreciated assets to the CRT, retains an annuity or unitrust interest in the CRT, and designates an appropriate charity as the remainder beneficiary of the CRT. It is irrelevant whether the Grantor controls the charity, retains the authority to change the charity designated as the remainder beneficiary, or establishes a new CRT as opposed to transferring the amount to a preexisting CRT.
After receiving the appreciated assets from the Grantor, the CRT sells them. The CRT then reinvests the proceeds from the sale in other assets. The Notice specifically identifies money market funds or marketable securities as potential reinvestment vehicles, since those types of assets allow for the establishment of a diversified portfolio for the CRT. However, the analysis in the Notice does not appear to depend on the type of reinvestment vehicle.
Because CRTs are generally exempt from federal income tax under Internal Revenue Code section (“Section”) 664, the CRT will not pay any taxes on the proceeds from the sale of the appreciated assets contributed to the CRT by the Grantor. In addition, the CRT will have a basis in the newly purchased assets equal to the purchase price of the new assets.
Then, the Grantor and the charity sell their interests in the CRT to an unrelated third party for the fair market value of all of the CRT’s assets, including the newly purchased assets. The CRT then terminates, distributing all of its assets, including the newly purchased assets, to the unrelated third party purchaser.
There are also variations of these facts identified in the Notice. For instance, instead of the Grantor using a CRT, the Grantor may use a net income with make-up provision charitable remainder unitrust, commonly referred to as a NIMCRUT. Also, the Grantor may have contributed the appreciated assets to the CRT before deciding to engage in the sale transaction. In addition, the Grantor may use a partnership or other pass-through entity as an intermediary, contributing the appreciated assets to the partnership or pass-through entity and then contributing the entity interest to the CRT.
The Grantor takes three tax positions based on the transaction and any of its variations. The IRS believes that these positions, based on this transaction, have the potential for tax avoidance or evasion.
First, the Grantor claims a charitable contribution deduction, as of the date of the contribution of the appreciated assets, for the actual value of the charitable remainder based on the fair market value of the assets contributed to the CRT which are attributable to the charitable remainder.
Second, the Grantor and the charity also claim that the sale of their interests in the CRT is a sale of all of the interests in the CRT and is therefore a transaction described in Section 1001(e)(3). As a result, the Grantor claims that Section 1001(e)(1), which would disregard the basis in the sale of a term interest in the CRT, does not apply.
Third, the Grantor claims that the relevant basis for purposes of calculating gain on the sale of the CRT interest is derived from the basis of the assets newly purchased by the CRT, not the basis of the appreciated assets originally contributed to the CRT. As a result, the taxable gain is much less than it might be otherwise.
As a result, the Grantor claims substantial benefits. One, the Grantor receives a charitable contribution deduction on the contribution of the appreciated assets to the CRT. Second, the Grantor receives the appreciation on the contributed assets through the sale of the CRT interest to a third party. Third, the Grantor avoids tax on receipt of the appreciation through the basis adjustment enabled through the inapplication of Section 1001(e)(1).
Notice 2008-99 makes it clear that the IRS is not concerned about the creation and funding of a CRT or the CRT’s reinvestment of the contributed appreciated property. Indeed, it specifically provides that those events alone do not constitute the transaction subject to the Notice and are not, in and of themselves, a transaction of interest.
Instead, the IRS is interested in the manipulation of the uniform basis rules to avoid tax on gain from the sale of appreciated assets. Therefore, the Notice indicates that the type of transaction subject to the reportable transaction rules is a transaction where the Grantor contemplates the contribution of appreciated assets to a CRT, the CRT’s reinvestment of those assets, and a coordinated sale or other disposition of the respective interests of the Grantor or other noncharitable recipient and the charity in a CRT in a transaction purportedly described in Section 1001(e)(3). In particular, the IRS is concerned about the Grantor’s claim to an increased basis in the CRT interest coupled with the termination of the CRT in a single coordinated transaction under Section 1001(e) in order to avoid tax on gain from the sale of the appreciated assets.
Taxpayers who have entered into these types of transactions, and advisors who have advised any taxpayers with respect to these types of transactions, may face fairly substantial disclosure and list maintenance requirements. There are substantial penalties for both taxpayers and material advisors who fail to comply with these rules in a timely manner. In addition, failure to properly disclose these transactions will extend the statute of limitations for the years in which the transactions occurred. As a result, the potential audit risk will be extended.
The McGuireWoods LLP Civil and Criminal Tax Controversy/Litigation Group routinely handles tax controversies and litigation against the Internal Revenue Service and has broad experience representing clients in matters related to reportable transactions, related penalty examinations, and transaction and penalty disclosure requirements.
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