Capital gains distributions from CRTs.

• Author: Berger, Harvey
• Position: Charitable remainder trusts

The Service recently issued Notice 98-20, which provides ordering rules for capital gains distributions from charitable remainder trusts (CRTs). A CRT makes annual distributions to its noncharitable beneficiary, based on a formula contained in the trust. The amount of the distribution is generally not related to the trust's taxable income for the year, as it is often a fixed percentage of the value of the trust's assets. The beneficiary is taxed on the distribution to the extent the trust has income in the current year or undistributed income from a prior year.

Sec. 664(b) and Regs. Sec. 1.664-1(d) established a "tier" system for determining the character of income in a beneficiary's hands. Distributions are taxed as ordinary income when the trust has ordinary income (e.g., dividends and interest) in the current year or accumulated in prior years. This is followed by short-term gains, long-term gains, other income (e.g., exempt bond interest) and corpus. Distributions include only a lower tier, after all the current and accumulated income of a higher tier is exhausted.

Example 1: A CRT has the following:

Dividends and interest (current year) $1,000 Dividends and interest (undistributed in prior years) 2,000 Short-term gains (current year) 2,000 Long-term gains (undistributed in prior years) 3,000 If the CRT distributes $6,500 in the current year, the beneficiary will report $3,000 of ordinary income, $2,000 of short-term gain and $1,500 of long-term gain. The CRT will carry $1,500 of long-term gain forward to future years.

The Taxpayer Relief Act of 1997 added several additional capital gains rates to the 28% rate. Therefore, advisers need to classify CRT capital gains and advise beneficiaries...