Change in rules for CRTs with UBTI contains trap for the unwary.

• Author: Smith, Cara E.
• Position: Charitable remainder trusts

The Tax Relief and Health Care Act of 2006 changed the provisions for charitable remainder trusts (CRTs) that have unrelated business taxable income (UBTI). Beginning January 1, 2007, an excise tax in the amount of the UBTI earned by the CRT during the year will be imposed under Sec. 664(c)(2). Prior to this change, a CRT with UBTI would have lost its tax-exempt status for the year and been taxed as a complex trust.

What Is UBTI?

Under Sec. 512(a)(1), UBTI is defined as the gross income derived by any organization from any unrelated trade or business regularly carried on by it, less the deductions directly connected with the carrying on of such trade or business, both computed with certain modifications. One of these is a specific deduction of $1,000. Common sources of UBTI in CRTs are passthrough entities such as partnerships and debt-financed property (property held to produce income and with respect to which there is an acquisition indebtedness at any time during the tax year) (Regs. Sec. 1.514(b)-1(a)).

Good News for Trustees?

Prior to January 1, 2007, if a CRT had any UBTI, it lost its exempt status for the year and was treated as a regular complex trust for income tax purposes.

Example 1: In 2006, a CRT had $50,000 of net ordinary income and $400,000 of capital gains and made $100,000 of distributions. The ordinary income included $3,000 of UBTI from a partnership interest the trust held.

Under the old provisions, the CRT would automatically lose its exempt status for that year and would have taxable income of $348,900 ($450,000 income less $100,000 distribution deduction less $100 exemption and $1,000 specific deduction). This results in roughly $52,000 of federal income tax (some of which is due to the CRT's now being subject to the alternative minimum tax). This often caused state fiduciary income tax to be due as well. Using these same assumptions for 2007, under the new provisions, the total excise tax due would only be roughly $2,000--a dramatic...