Refreshing PLR Marred by Four Errors

• Published date: 01 June 2017
• Date: 01 June 2017
• DOI: http://doi.org/10.1002/npc.30327

Bruce R. Hopkins’ NONPROFIT COUNSEL

3

June 2017

THE LAW OF TAX-EXEMPT ORGANIZATIONS MONTHLY

Bruce R. Hopkins’ Nonprofit Counsel DOI:10.1002/npc

D announced to A that, in the words of this ruling, the

CRUT will “serve both as an estate planning vehicle and

a charitable giving vehicle.”

D represented to A and B that there would not be

any gift taxes due on creation of the CRUT because

there would not be any completed gifts. When D pre-

pared the trust instrument, however, D failed to include

a provision reserving A’s right to change the remainder

beneficiary/recipient. As a result, the gift to X became

vested when the trust agreement was executed, causing

gift tax owed. Nonetheless, D advised A’s accountant

that the taxes were not, in fact, due.

C represented to A and B that the CRUT’s assets would

generate a 2 percent annual return if invested as C rec-

ommended. C also advised them that the income interest

would be a guaranteed 3 percent return. The trust assets

were invested in annuities and insurance products that C

is licensed to sell. The CRUT never achieved a 3 percent

annual return, without incurring capital gain, which

under state law is allocable to principal, not income.

Moreover, the trust instrument limited the annual unitrust

payment to the trust’s annual net income; it also included

a net-income, make-up provision. Based on the errone-

ous advice of C and D, the trustees of the trust included

capital gain in trust income, paying the 3 percent unitrust

amount, including a make-up amount for one year.

C and D also advised A and B that the assets of the

trust would not be includible in A’s estate for estate tax

purposes, which was incorrect inasmuch as A retained

an income interest in the trust. Based on this erroneous

advice, A added assets to the trust in an attempt to

further reduce A’s taxable estate, claiming an additional

charitable contribution deduction.

A court issued an order that the CRUT was void ab

initio. This determination, however, was contingent on a

ruling from the IRS that the declaration would not result

in additional federal income tax. If that favorable ruling

is not received, the court order provides that all resulting

taxes be paid from the trust, with the remaining assets

paid to the income interest beneficiary. By this time, A

and B had passed away; B’s surviving spouse, E, became

that income recipient.

Analysis

The IRS first ruled that this trust has failed to operate

exclusively as a charitable remainder trust from its incep-

tion because it was not operated in accordance with its

terms. It has not been, therefore, tax-exempt. The IRS

then ruled that the CRUT is nonetheless subject to the

split-interest tax rules (IRC § 4947(a)(2)). It is not exempt,

has unexpired interests that are not devoted to chari-

table purposes, and there are amounts in trust for which

a charitable deduction was claimed (and allowed). Thus,

this trust is treated as a private foundation for purposes

of IRC Chapter 42 excise taxation until it terminates its

private foundation status (IRC § 507).

Then, the IRS ruled that a distribution of trust assets

to E, “without regard to the interest of the charitable

remainder beneficiary,” would be a taxable expenditure

(IRC § 4945(d)(5)) in the amount of the actuarial value

of the charitable remainder interest. Also, the IRS said,

the distribution would be an act of self-dealing (IRC §

4941). Further, the expenditure and self-dealing acts

would require correction (undoing the transaction), with

failure to timely correct triggering the additional taxes in

both categories. For good measure, the IRS noted that

the making of the distribution, in the aftermath of this

private letter ruling, would set E up for foundation man-

ager taxes for knowing participation in the act.

The IRS then helpfully observed that these taxes can

be avoided by voluntarily terminating the trust’s private

foundation status prior to distribution of its assets pursu-

ant to the court’s order. A distribution to E prior to termi-

nation of this status may, the IRS stated, be regarded as

a willful and flagrant act giving rise to tax liability, being

“grossly contrary” to the purpose of a split-interest trust.

This would justify an involuntary termination of the

trust’s foundation status, causing assessment of tax on

the aggregate tax benefit (IRC § 507(d)(1)), with trans-

feree liability for the taxes owed by the trust.

The IRS concluded its analysis by stating that the

trust must file income tax returns, paying tax, interest,

and penalties, as a taxable trust. [12.3] ◆

REFRESHING PLR MARRED

BY FOUR ERRORS

A nonprofit organization (N) was established to teach

muscle management for healthy backs, a form of health

and wellness intervention seen by it as charitable and

educational in nature. A program used for training pur-

poses is owned by a for-profit company (F). The program

teaches optimal therapeutic stretching techniques to

rehabilitate core muscles of the back and neck, and keeps

muscle movement symmetrical. F trains the instructors,

who are personal trainers and group exercise instructors.

N teaches students, coaches, and health teachers.

This program was developed by G, who is N’s secre-

tary and a paid consultant for both organizations. H is

the president and a director of N. G and H are brothers.

N’s treasurer is their sister. Another director of N is a

work associate of H. F is owned by H.

N will purchase books, e-books, and apps from F at

wholesale. It will not use the services of another entity.

H teaches classes through F, promoting a book written

by G. All of this is reflected in a website, owned by F.

The IRS ruled that N is not entitled to tax exemp-

tion because it fails the operational test (Priv. Ltr. Rul.

201714031). It was found to be operating the “same

program,” and providing the same “educational ser-