IRS clarifies when CRATs must be reported

The Internal Revenue Service and Treasury Department issued final regulations earlier this month defining when charitable remainder annuity trusts, or CRATs, qualify as listed transactions and when material advisors and certain participants must file disclosure forms or face penalties.

A CRAT is an irrevocable trust in which a donor transfers assets so at least one beneficiary receives fixed annual payments for life or for up to 20 years. After the payment period the trust remainder-at least 10% of the trust’s original net fair market value-goes to a qualified U.S. charity. Assets placed in a CRAT cannot be removed by the donor.

The new rules identify as reportable those cases in which the trust is funded with property whose fair market value exceeds its tax basis. When that condition exists and advisors, planners or insurers design, facilitate or market the arrangement, the parties may have to file disclosures with the IRS. Failure to file can trigger civil penalties under the tax code.

The IRS highlighted a recurring pattern it views as abusive: highly appreciated property is transferred to a purported CRAT, the trust sells the property and uses the proceeds to purchase a single-premium immediate annuity, or SPIA. If taxpayers or beneficiaries then apply annuity tax rules incorrectly, taxable income can be understated and tax can be underpaid. IRS CEO Frank J. Bisignano wrote in a statement that the agency is watching for tax avoidance schemes and will continue to pursue abusive tax shelters and transactions.

Tax advisers say the guidance targets a narrow set of tactics rather than ordinary charitable planning. Lawrence Sprung, founder of Mitlin Financial, noted that CRATs can be appropriate for owners of highly appreciated assets who want to provide for charity while receiving lifetime payments. He contrasted proper use with earlier structures promoted by some planners and insurance professionals intended to sidestep tax rules.

Christina Taylor, vice president of tax development at April Tax Solutions, explained why planners sometimes use the combination of a CRAT and an annuity. Converting a highly appreciated asset into an annuity inside a CRAT can spread ordinary income recognition over time through annuity distributions, which may reduce the immediate capital-gains exposure compared with a straight sale.

Advisors should review past and current transactions to determine whether they meet the listed-transaction criteria, document legal and tax positions, verify asset valuations and bases, and confirm that annuity taxation is handled correctly. The regulations do not prohibit CRATs; they increase reporting and compliance requirements for arrangements that match the pattern the IRS describes.

Charles Failla, founder of Sovereign Financial Group, described a client who used a CRAT and a SPIA, received lifetime payments and left a large remainder gift to charity after many decades. That example illustrates a use of the tools that complied with intended charitable and income objectives.