Teaching an old dog new tricks: CRTs and UBTI.

• Author: Batson, Jr., Ted R.
• Position: Charitable remainder trusts, unrelated business taxable income

Dec. 20, 2006 marked a unique day in the taxation of charitable remainder trusts (CRTs)--President Bush signed into law the Tax Relief and Health Care Act of 2006 (TRAHCA '06). Buried in that legislation is revised Sec. 664(c), which significantly alters the tax treatment of unrelated business taxable income (UBTI) received by a CRT in tax years ending after 2006.

Old Law

Since 1969, CRTs have been tax-exempt under Sec. 664. This exemption was permitted as long as the CRT did not receive UBTI, as defined in Sec. 512. (1) For CRTs, UBTI typically arises from ownership of an interest in a passthrough operating entity (e.g., a partnership or limited liability company (LLC)) or from unrelated debt-financed income generated from property subject to acquisition indebtedness. (2)

If a CRT lost its tax exemption due to the receipt of UBTI, it was taxed under subchapter J as though it were a nonexempt complex trust. (3) Sec. 661(a) permits a complex trust to claim a deduction for income distributed to income beneficiaries under the terms of the trust agreement. Thus, if all of the trust's income was distributed, no tax would be due. The danger has always been that a CRT would receive UBTI in a year when it realized substantial gains from the sale of an appreciated asset--gains in excess of its distribution deduction. In the typical worst-case scenario, this convergence of events would occur in the year in which a substantially appreciated asset that had been contributed to the CRT was sold. The realized gain would then be subject to tax, thereby nullifying one of the significant tax benefits of creating and funding a CRT.

Example 1: On March 1, 2006, S funded a CRT with $500,000 of appreciated securities, with a $75,000 basis. T, a trustee, liquidated the securities on March 3, 2006 for $510,000, realizing a $435,000 long-term capital gain. T then invested 85% of the proceeds in a diversified portfolio of securities and 15% in a real estate investment partnership. During the year, T received $15,000 of dividends, interest and partnership distributions--all of which were distributable to S under the trust terms. At the end of the year, the Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., received from the partnership disclosed that the CRT's allocable share of partnership income was $2,500, all of which was UBTI.

As a result of receiving the UBTI from the partnership, S's CRT lost its exemption for 2006. T can take a deduction for...