CHARITABLE REMAINDER TRUST IS TAXABLE ON ALL ITS INCOME

By Martin E. Greif, CPA, Goldstein Golub Kessler & Company, PC

A recent Tax Court case, Leila G. Newhall Unitrust v. Com., 104 TC No. 10 March 6, 1995, reveals a severe trap for the unwary in investing charitable remainder trust assets. The case concludes that when a charitable remainder annuity trust or a charitable remainder unitrust has unrelated business taxable income (UBTI) in any year, it is not exempt for such taxable year. Consequently, the trust is taxable on all of its income for that year as a complex trust. Of course, the annuity paid to the beneficiary is deductible against the trust's income.

In general, an exempt organization is subject to tax only on its unrelated business income, which is income from a trade or business regularly carried on by the organization, provided such activity is not substantially related to its exempt purpose or function aside from the organization's need for funds.

In computing unrelated business taxable income, gross income and deductions are subject to certain exclusions, specific deductions, and other special rules. Generally, UBTI does not include dividends, interest, and annuities. Also excluded are gains and losses from the sale, exchange, or other disposition of property, other than inventory-type property or property held primarily for sale to customers in the ordinary course of business. The exclusions under these categories, however, do not apply to debt-financed property nor to the disposition of such property (see IRC Sec. 514). Consequently, UBTI will be derived, for example, where securities are bought on margin.

The Lelia G. Newhall Unitrust is a charitable remainder unitrust created in 1975, pursuant to a testamentary bequest. In 1983 and 1995, the trust acquired limited partnership interests in three publicly traded limited partnerships.

IRC Sec. 512(c) requires that the distributive share of partnership income of an organization that is a partner be considered as UBTI if the conduct of the partnership's business activities directly by the partner would have resulted in UBTI. Therefore, this section prevents a taxpayer from avoiding UBTI by becoming a member of a partnership that carries on what would be, if conducted directly, an unrelated trade or business. In Newhall, the unitrust conceded that the businesses conducted by the partnerships would generate UBTI if conducted by the unitrust. Therefore, the Tax Court affirmed the IRS determination that the trust received unrelated business income under IRC Sec. 512 (c) on the income it earned from its partnership investments in the years in question.

The Court then considered the tax consequences resulting from the receipt of UBTI. The trust argued that the appropriate interpretation of IRC Sec. 512(c) results in the taxation of only that portion of income attributable to UBTI, as in the case of other types of exempt organizations. The Court, however, in citing IRC Sec. 664 (c) and related regulations, held that charitable remainder trusts are tax exempt, only if they do not receive UBTI. The Court relied upon the regulations which state that if any portion of the income constitutes UBTI, for that taxable year, "the trust is taxable on all of its income as a complex trust" [Regs. Sec. 1.664-1 (c)].

The Court found that the trust received a substantial amount of UBTI, causing it to be taxable on all of its income. Therefore, it declined to address the petitioner's argument that the trust should not forfeit its exempt status merely because it derived a de minimis amount of UBTI, stating in part as follows:

In arguing against an interpretation of the statute that requires all the income to be subject to tax if there is some UBTI, petitioner says that such interpretation would result in the trust's forfeiture of its exempt status "no matter how de minimis..." such UBTI might be. However, no such situation is involved here. Petitioner's UBTI in this case was substantial, $176,829 in 1988 and $291,689 in 1989. We therefore need not address the question whether the statute and regulation can be interpreted in such manner as to call for a different result in the case of a de minimis level of UBTI."

Accordingly, perhaps the door may be open for a different tax result where the trust receives a de minimis amount of UBTI. If so, subsequent guidance is needed as to possible criteria in defining what is considered de minimis. For example, it would be helpful if there were 1) a "safe harbor" based on a certain percentage of UBTI compared to total trust income or 2) a safe harbor based upon the deployment of assets used to generate UBTI, as opposed to total value (or basis) of trust assets. If so, the statute then could be interpreted to tax only the entity's UBTI for the year in question.

If a de minimis rule cannot be established judicially, or by regulation because the statute has established a rigid rule, then perhaps Congress should revisit this area from the standpoint of equity. Congress might conclude that a charitable remainder trust should not be burdened with a greater tax cost (on amounts destined to ultimately go to charity) than, for example, a private foundation with an identical amount of UBTI.

It should be noted that Reg. Sec. 1.664-1(c) provides that UBTI of a charitable remainder trust is determined within the meaning of IRC Sec. 512 and the regulations thereunder. Therefore, expenses directly connected with unrelated business income are subtracted in determining unrelated business taxable income. Recordkeeping becomes important, for example, when facilities and personnel are utilized both in carrying out exempt purposes and in conducting unrelated business activities. If the deductible expenses exceed the amount of unrelated business income, the charitable remainder trust would retain its exempt status for the taxable year and escape the onerous result stipulated in the regulations.

Further, it should be noted that where an organization carries on two or more unrelated business activities, UBTI is the aggregate of gross income from all unrelated business activities less the aggregate deductions allowed for all such activities. *

Editor:
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editor:
Richard M. Barth, CPA

SEPTEMBER 1995 / THE CPA JOURNAL