Noncompetition payments are taxable to donor of CRUT.

• Author: Lerman, Jerry L.
• Position: Charitable remainder unitrust

The difficult twists and turns associated with creative tax planning are no better displayed than in John T. Jorgl and Sharon Illi, TC Memo 2000-10. Despite the use of a charitable remainder unitrust (CRUT) for effective income and estate planning, this decision demonstrates that economic realities must be thoroughly understood to anticipate the ultimate tax impact.

John Jorgl and Sharon Illi were involved in a successful daycare center operated through a corporation. Jorgl owned 100% of the stock, and he and his wife Sharon were employees of the center. Over the years, the excellent relationships they had established with parents, teachers and staff frequently led to repeat business. As with many taxpayers, the desire for a succession plan involved the sale of the business. The taxpayer, his attorney and accountant determined that a CRUT could provide tax benefits and fulfill a number of personal (and charitable) goals. After contributing the stock to the CRUT, the couple was to receive a lifetime annual annuity of 9% of the trust's value (as measured under the CRUT document). Once the lifetime beneficiaries were deceased, the remainder would go to a charity specifically designated in the memory of a young child who had died of leukemia. The trust was established before negotiations began in connection with a specific transaction to sell the stock.

In initial offerings, the seller had outlined a noncompetition provision for a five-year period and a 100-mile surrounding geographic area. As negotiations with the ultimate buyer progressed, the covenant not to compete became a serious component for the buyer, who feared the potential effect that the husband and wife's popularity could have on the business. Although the actual dollar amount associated with this covenant did not seem to be discussed in detail, the ultimate documentation separated the purchase price for the business into $350,000 for the stock and $300,000 for the agreement not to compete.

The trust received the entire $650,000 of the sale proceeds, despite the allocation between stock and noncompetition payment. Therefore, the taxpayers did not report any income from the transaction in their personal returns. At trial, they testified that the transaction was in substance a sale by the CRUT. The IRS took the position that covenant-not-to-compete payments were not earned by the trust, but instead by the donors as officers, capable of signing a promise to avoid competition in the...