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F. Trust Primer
by Elise Lin, Ron Shoemaker and Debra Kawecki
Introduction
The trust instrument can be a pretty powerful piece of paper. The trust form has always been considered as one of the foremost developments in the common law because of its flexibility. This flexibility allows the trust instrument to serve a number of tax planning purposes. With a little planning, a trust can create a current charitable tax deduction, avoid capital gains tax on the sale of appreciated assets, and significantly lower estate tax. For this reason, trusts are a common estate planning tool.
The Code recognizes this and provides several provisions designed specifically for estate planning. The Code frequently permits trusts with charitable interests to achieve legitimate estate planning goals. However, planners with a variety of tax objectives have used trusts to generate tax-free savings in conjunction with compensation arrangements, pension planning, and education savings. Because uses are not always appropriate, Congress and the Service have occasionally had to step in when tax planning borders on tax evasion. In many of these situations charitable objectives are decidedly subordinate to the desire to avoid capital gains tax or to control an asset into succeeding generations.
Financial advisors function in a highly competitive market. Thus, it is not surprising that some plans may promise more tax savings than they should. To effectively deal with these abusive, often highly-promoted situations, the Service is expanding its abusive trust program so that local units will be in place to coordinate the use of IRC 6700 penalties for abusive trust promotions at the local level. The 1999 CPE, Topic M; discusses using the IRC 6700 tax shelter promotion penalty when promoters market plans that misuse the IRC 170 charitable contribution deduction.
This article describes how IRC 4947 applies the Chapter 42 private foundation excise taxes to trusts that take advantage of charitable deductions. IRC 4947 controls the application of the private foundation excise tax rules contained in Chapter 42 of the Code to both nonexempt charitable trusts and trusts with both charitable and noncharitable interests, entities that can be complex. This article starts with basic trust concepts and then discusses charitable remainder trusts and charitable lead trusts. It also describes emerging IRC 4947 trust issues.
Part I - Basic Trust Principles
- Overview
In the simplest terms, a trust is a three-party arrangement in which the founder of the trust (commonly known as the donor, grantor, or settlor) transfers legal title of the trust property (a res) to a trustee (a fiduciary with respect to the property) to hold and to manage for a third party (the trust's beneficiary) in accord with the grantor’s intent. The beneficiary holds beneficial title to the property. A trust can be created either during the grantor's lifetime or at his or her death by an instrument such as a will that takes effect at death.
Some essential trust terms are:
Grantor - The grantor is also known as the trustor, settlor, or founder. The grantor is the person who transfers the trust property to the trustee.
Trust Property - A trust must have some assets, even if only one dollar. Trust property includes assets like cash, securities, real property, tangible personal property, and life insurance policies. The assets can be either transferred during life of the grantor (“inter vivos”) or at his or her death (“testamentary”). The trust property is also referred to as the corpus, principal, estate or trust res.
Trustee - The trustee is the individual or entity responsible for holding and managing the trust property for the benefit of the beneficiary. Trustees can be a corporate fiduciary or any competent individual who is not a minor. The trustee holds the legal title to the trust property. As such, the trustee has a fiduciary duty to the beneficiaries with respect to the trust property. In the event of a breach of fiduciary duty, a trustee may be held personally liable. Such breaches include failing to pay out distributions or misappropriation.
Beneficiary - The beneficiary is the individual or entity who will receive the benefits of the trust property. The beneficiary holds the beneficial title to the trust property. The trust document must clearly identify the beneficiary or beneficiaries.
- Purpose of the Trust
Every trust must have a legal purpose. The purpose is distinct from the grantor’s motives or objectives in establishing a trust. For example, a trust can benefit a specific beneficiary and achieve tax benefits for the grantor. Benefiting the beneficiary is the
anti-abuse rules treat the grantor as owner of all or a portion of the trust. The grantor is subject to tax on trust income so treated even if he or she does not actually receive the income.
D. Revocable Trust
If the grantor retains the ability to revoke the trust and revest the trust assets in the grantor, the trust is revocable and the income is taxable to the grantor under the grantor trust rules. Assets in a revocable trust are included in the grantor's gross estate for federal estate tax purposes.
Revocable trusts also called living trusts, are one of the more frequently misunderstood trust concepts. They are used primarily as a will substitute. Assets in trust avoid the cost, time, expense, and publicity of probate.
Because a revocable trust may be a will substitute, it may provide for direct gifts to charity as well as establishing a split interest trust, a charitable remainder trust, or a charitable lead trust. For example, a revocable trust may establish a charitable remainder trust upon the grantor's death to benefit a surviving spouse or child. The noncharitable beneficiary can receive an income payment for life, or for a term of years. The remainder will pass to charity at the death of the noncharitable income recipient or the end of the term.
Similarly, a grantor may use a will or a revocable trust to establish a charitable lead trust, with an interest for charity during a term of years or for the life of certain individuals, and the remainder to the grantor's spouse, child or other heir.
E. Irrevocable Trust
An irrevocable trust is one that, by its terms, cannot be revoked.
Part II - IRC 4947
The Tax Reform Act of 1969 imposed a new tax plan on charitable organizations and charitable giving. Congress was responding to abuses, particularly from charities controlled by limited (typically family) interests. The most significant changes are the distinction between public charities and private foundations, and the excise taxes in Chapter 42 of the Code that apply to restrict the activities of private foundations. The provisions of Chapter 42 are anti-abuse rules designed to insure private foundations operate to achieve charitable purposes rather than benefit the limited interests that control them.
Private foundations are not the only narrowly controlled entities that enjoy tax advantages available for charitable giving. Trusts with only charitable beneficiaries and trusts with both charitable and noncharitable beneficiaries enjoy the benefit of tax deductible contributions. These trusts are also subject to the same abuses that led to the imposition of Chapter 42 on private foundations. The benefits sought by the private foundation reforms of the Tax Reform Act of 1969 would have been substantially undercut if charitable and split interest trusts were not also subject to the anti-abuse rules.
IRC 4947 subjects trusts with charitable interests to some or all of the Chapter 42 excise taxes. It is a “loophole” closer. Without it, narrowly controlled foundations could achieve most of the benefits of tax exempt status without the safeguards created by the Chapter 42 excise taxes. In calculating the taxable income of a trust, an unlimited charitable deduction is available. Thus a charitable trust not exempt under section 501(c)(3) would not pay tax or pay very little tax after deducting its charitable contribution.
IRC 4947(a)(1) provides that nonexempt charitable trusts will be subject to all Chapter 42 excise taxes. A nonexempt charitable trust has assets held in trust for charitable beneficiaries only. There are no noncharitable interests. A nonexempt charitable trust can be created during the life of the grantor or to take effect at the grantor's death. The trustee may see no benefit in applying for exemption under section 501(c)(3) but because of IRC 4947, the trust is subject to Chapter 42. A split interest trust described in IRC 4947(a)(2) has both charitable and noncharitable interests. In a charitable remainder trust, noncharitable interests terminate when the person or persons holding the life interest dies or when the specified term of years in completed. After a reasonable period of settlement, these trusts if they continue in existence rather than terminate are no longer split-interest trusts. They have metamorphosed into nonexempt charitable trusts now subject to all of Chapter 42.
A charitable lead trust is also subject to IRC 4947. Unlike charitable remainder trusts, the charitable lead trust pays the charity a stream of payments with the remainder going to individual beneficiaries. In certain tax planning situations, the lead trust can provide advantages to the grantor.
- IRC 4947 (a)(1) Trusts
The nonexempt charitable trust is subject to all Chapter 42 private foundation provisions as well as IRC 507 through IRC 509. The split-interest trust is never subject to IRC 4940 and IRC 4942 and only rarely to IRC 4943 and IRC 4944. The statute reads that a nonexempt charitable trust will be treated as an organization described in IRC 501(c)(3), thus subjecting it to all of Chapter 42. While treated as if it were described in IRC 501(c)(3) for certain purposes, the nonexempt charitable trust is not actually tax exempt by virtue of IRC 501(c)(3).
A charitable remainder trust is generally exempt from tax under IRC 664 of Subchapter J, not under 501(a). Exemption under section 501(c)(3) would not be appropriate because of the private interest present in each split interest trust.
- Charitable Remainder Trusts, IRC 664
A. In General
Like Chapter 42, IRC 664 and related provisions (IRC 170(f), 2055(e), and 2522(c)) were enacted as a part of the Tax Reform of 1969. See section 201(a), (d), and (e) of the Act.
B. Current Beneficiary and Remainder Beneficiary
A charitable remainder trust consists of two distinct components:
(1) A private interest in the form of a right to a stream of payments from the trust for life or a term certain (not in excess of 20 years). A charity may be the recipient of part of the annuity or unitrust amount so long as there is at least part of the amount going to a noncharitable beneficiary each year. For simplicity, the recipient of the annuity or unitrust amount is referred to as the noncharitable beneficiary and,
(2) A charitable interest in the assets remaining in the trust payable to an organization(s) described in IRC 170(c) at the expiration of the preceding non-charitable interest. A charitable remainder trust is irrevocable.
C. Two Types of Charitable Remainder Trusts
The charitable remainder trust takes two forms; (i) the charitable remainder annuity trust (CRAT) and (ii) the charitable remainder unitrust (“CRUT”). IRC 664(d)(1) and 664(d)(2) and (d)(3), respectively. The primary distinction between the CRUT and the CRAT is the manner used to determine the amount of the payment to the noncharitable beneficiary.
D. Charitable Remainder Annuity Trust
A charitable remainder annuity trust pays a specific amount of money to the noncharitable beneficiary every year. The annuity can be either a stated dollar amount or a fixed percentage of the fair market value of the assets on the date contributed to the trusts. The annuity may not be less than 5 percent. For transfers after June 18, 1997, the
annuity may not be greater than 50 percent of the fair market value of trust assets as of the date of the transfer of assets to the trust. See IRC 664(d)(1).
The payout does not vary and it does not matter how much income is earned by the trust during the year. If assets held by the trust are producing substantial gains, the noncharitable beneficiary will not benefit. If income is insufficient to support the payout the difference is made up from the principal of the trust. Because the annuity is fixed, the noncharitable recipient receives no benefit from any appreciation in trust assets from year to year. The amount that will actually pass to the charity cannot be determined until the expiration of the noncharitable interest. However, the present value of the remainder interest is determined at the time of the contribution using actuarial tables. If the assets have been appreciating, the charity will benefit. If the corpus has been invaded to pay the annuity to the noncharitable beneficiary, there may be little left for the charity.
E. Charitable Remainder Unitrust
The charitable remainder unitrust pays a fixed percentage (of not less than 5 percent) of the net fair market value of its assets valued annually and for transfers after June 18, 1997, not more than 50 percent. The unitrust payout will be different each year because the payout is based on an annual valuation. IRC 664(d)(2). If the value of the unitrust assets increases, the payout to the noncharitable beneficiary will increase. The advantage of the unitrust over the annuity trust to the noncharitable beneficiary is that the unitrust serves as a hedge against inflation.
As with the annuity trust, the amount the charity will actually receive can not be determined until the noncharitable interest terminates.
F. NICRUTs and NIMCRUTS
Two varieties of CRUTS are permitted under the Code. They can be used to avoid the invasion of corpus when the trust’s income is not sufficient to make the unitrust payment. Both the NICRUT and the NIMCRUT permit the trustee to pay the lesser of the fixed percentage or the trust’s actual income. NIMCRUT stands for net income with make-up charitable remainder unitrust. This type of trust pays to the noncharitable beneficiary the lesser of:
(1) The fixed percentage (not less than 5 percent nor more than 50 percent) of net fair market value of assets of the trust valued annually (the same as the CRUT) or
(2) The amount of the actual trust accounting income (not tax income) for the year. IRC 664(d)(3).
A and B, husband and wife, want to be able to help fund the college expenses of their granddaughter, C. C is 10 years old. A and B own property that is currently appreciating without producing income. They are advised to set up a flip unitrust. The unitrust amount is set at 10%. For the first 8 years the trust will be a NIMCRUT. C is the beneficiary but she receives no income during the 8 year NIMCRUT period. The triggering event to flip the trust is C’s 18th^ birthday. The property has significantly appreciated in value. It is sold and the proceeds are invested in income producing assets.
Any trust accounting income received during the year of C's 18th^ birthday that exceeds the 10% unitrust amount may be paid to C under the IRC 664(d)(3)(B) make-up provisions upon the flip to a standard fixed percentage unitrust, any unpaid makeup amount is forfeited. The trust assets have greatly appreciated in value so that the 10% received by C should be sufficient to fund her college expenses. Even if the trust income is not sufficient, because the trust in now a regular CRUT, corpus can be invaded to pay the unitrust amount. A and B will get a charitable deduction based on the present value of the remainder interest upon setting up the trust, but, the present value of C's unitrust interest will be subject to gift and generation skipping transfer tax. They will not have to pay capital gains on the sale of the property. Income from the trust will be taxed at C’s lower tax rate. The property will be removed from A and B’s estate, lowering their estate tax.
Reg. 1.664-3(a)(1)(i)(c) provides the authority for the flip provision. Specifically, that regulation permits the net income method for a unitrust for an initial period and then fixed percentage amount for the remaining period of the trust only if the governing instrument provides for certain conditions. These conditions include the requirement that the change in unitrust payment method is triggered on a specific date or by a single event whose occurrence is not discretionary with, or in the control of, the trustees or any other persons. Reg. 1.664-3(a)(1)(i)(d) provides that the sale of unmarketable assets, or the marriage, divorce, death, or birth of a child are permissible triggering events because they are not considered to be discretionary with any person. This list is not all inclusive.
There are provisions in the regulations for the effective date of the “flip” provision that are complex and beyond the scope of the article. But, the reformation of a trust to add a flip provision could result in a self-dealing transaction under IRC 4941 in the absence of authority to the contrary. The issue of self-dealing under IRC 4941 was discussed in the FY 1999 EO CPE Text, Topic P, pages 333-335. It is clear that a “flip” qualifying under the requirements of the IRC 664 regulations will not constitute an act of self-dealing, including trust document reformations occurring under the effective date provisions of Reg. 1.664-3(a)(1)(i)(f).
For example, under Reg. 1.664-3(a)(1)(i)(f)(3), if a unitrust without a flip provision in its governing instrument begins legal proceedings to reform the governing instrument to add a flip provision by a certain date, it will not commit an act of self-dealing under IRC 4941 or fail to qualify as a valid IRC 664 trust. The deadline for starting the reformation proceeding, or for amending the trust if permitted, is June 30, 2000. Of course, if the governing instrument is not reformed according to the regulations, an act of self-dealing may have occurred. For additional information on the issue of the flip provision and self-dealing in the context of governing instrument reformations, see the FY 2000 CPE Text, Topic P, pages 226-229.
H. CRUT and CRAT Creativity
Not all CRUTS and CRATS look alike. The Grantor has a number of options in drafting the trust agreement to meet special needs.
(1) Upon the creation of a charitable remainder trust the trust instrument can reserve a power for the noncharitable beneficiary to appoint by will the charitable remaindermen. Rev. Rul. 76-7, 1976-1 C.B. 179.
(2) Upon the creation of an inter-vivos charitable remainder trust, the grantor may reserve a power to substitute another charity as the remainderman in place of the charity named in the trust document. Rev. Rul. 76-8, 1976-1 C.B. 179.
(3) The charitable remainder interest need not be named in the trust document and the trustee may be vested with the power to name the charitable recipient of the remainder interest. However, all charitable remainder trusts must provide that the trustee will transfer the remainder to a qualified charitable organization if the named organization is not qualified at the time payments are to be made to it. Regs. 1.644-2(a)(6)(iv) and 1.644-3(a)(6)(iv)
NOTE: Contrast these rules with the more restrictive rules applied to IRC 501(c)(3) exempt organizations for designating charitable recipients subsequent to the date of the gift. Consider; (a) the material restriction or condition requirement of the community trust regulations and Regs. 1.507-2(a)(8); (b) the limited rights under IRC 170(b)(1)(E)(iii) for pooled common funds; and (c) the limits for naming charitable recipients under the organizational test for supporting organizations. See Rev. Rul. 79-197, 1979-1 C.B. 204.
(4) The donor may be named as trustee or retain the power to substitute himself as trustee. Rev. Rul. 77-285, 1977-2 C.B. 213. However,
(10) Charitable remainder trusts are commonly established during the grantor's lifetime under a trust document. More infrequently, charitable remainder trusts are established at death under a provision of the decedent's last will and testament. A revocable trust can also be used, which creates a charitable remainder trust at death. The Service has published, in several revenue procedures, sample documents of provisions that meet the requirements of IRC 664 and the regulations.
(11) The trust may satisfy the annuity or unitrust amount by making a distribution of property rather than cash. A property distribution to satisfy the annual payout requirement is treated as a sale or exchange by the trust. Regs. 1.664-1(d)(5).
- Tax Benefits of Charitable Remainder Trusts
A number of tax benefits are associated with charitable remainder trusts:
(1) The donor of a lifetime gift generally receives a current income tax deduction under IRC 170 even though the trust principal may not be distributed to charity for many years.
(2) The trust is generally exempt from tax on the income earned by the trust.
(3) The grantor has a choice.
a. Sell the property first, pay the tax and put cash in trust.
b. Place the asset in trust and have the trust sell it without paying tax.
If the grantor transfers appreciated property to a CRUT (CRATS don't work as well), a subsequent sale of the property by the trust will usually not be taxable to the trust. Thus, a tax-free sale by the trust increases corpus, which increases the income available to the recipient of the unitrust amount.
Although the trust is generally exempt on the income it earns under IRC 664(c), the annuity or unitrust payments distributed to the noncharitable recipient may be taxable to the recipient. The distributions are characterized as ordinary income, capital gain income, other income, or as a distribution of trust principal under ordering rules for establishing priorities under IRC 664(b). Thus, the noncharitable recipient is taxed on
amounts received from the trust to the extent that the trust has current or previously undistributed ordinary or capital gain income
- Charitable Lead Trust
A charitable lead trust (CLT) pays the charity first. It is defined in IRC 170(f)(2)(B). IRC 4947(a)(2) applies to a charitable lead trust. There is an annuity version and a unitrust version. The charitable lead trust is a split-interest trust that is the reverse of the charitable remainder trust. In the charitable lead trust, the charitable payment is a guaranteed annuity or fixed percentage of fair market value of trust property, valued annually, payable to charity for a term of years or for the life or lives of specified individuals. Charity comes first. The remainder interest in the trust is paid to private interests, often the grantor or the grantor's heirs.
A CLT can be either a grantor trust or a complex trust.
(1) Non-grantor CLT. The income from this trust is taxed to the trust not the grantor. The grantor does not get an income tax charitable deduction for the transfer to the trust. The trust is entitled to a charitable deduction for any amount of gross income paid to a charity during the year. This trust is mostly used to avoid transfer taxes.
(2) Grantor CLT. The income from the trust is taxed to the grantor but the grantor gets an income tax charitable deduction for the present value of the annuity or unitrust interest at the time the assets are transferred. This must be an inter vivos trust because the income has to be taxed to the grantor.
The reason CRATS are not preferred over CRUTS is that an annuity, being fixed, benefits the charitable remainderman because the income beneficiary does not share in the appreciation of the trusts assets. In lead trusts, charitable lead annuity trusts are usually preferred rather than charitable lead unitrusts. The grantor wants to benefit the remainderman because the remainderman is the grantor or the grantor's designee. A charitable lead annuity trust pays out a uniform payment to the charity. Any appreciation remains in the trust to benefit the remainderman.
- Pooled Income Fund
A pooled income fund is established and maintained by a public charity, that
(1) Pays income to the grantor or an individual beneficiary named by the grantor; and
Part III - UBI
A charitable remainder trust that realizes any amount of unrelated business income, as defined in IRC 512, is taxed as a complex trust for that year. Regs. 1.664-1(c). Typically, IRC 514 creates the problem, as a trust has debt financed income if it takes property subject to a mortgage. There are two exceptions.
(1) A trust will not have UBI for a period of ten years following a gift as long as it does not assume the debt.
(2) An inter vivos trust will not have UBI for a period of 10 years following a gift as long as the debt was placed on the property for more than 5 years from the making of the gift and the debt is not assumed.
Many situations, such as borrowing on an insurance policy, or receiving income from a working gas and oil interest, create UBI. Because unrelated debt financed income can arise after the creation of the trust, a trustee without a tax background may not be aware of these complex rules.
The treatment of unrelated business taxable income to a charitable remainder trust was the subject of recent Court of Appeals opinion. The trust received unrelated taxable income through no action of its own. Leila G. Newhall Unitrust v. Commissioner, 105 F.3d 482 (9th^ Cir. 1997) concerns the treatment of a charitable remainder unitrust trust which received unrelated business taxable income. The trust was a shareholder in a publicly traded company. In 1983 the company underwent a partial liquidation and transferred certain of its assets to two newly formed publicly traded limited partnerships. The trust received interests in the two limited partnerships. There was an additional transfer of publicly traded partnership interest when the company completely liquidated. IRC 512(c) requires that partnership income be included in unrelated business taxable income (“UBTI”) if the conduct of the partnership’s business directly by the organization would have resulted in UBTI. IRC 664(c) provides that a charitable remainder antirust shall be exempt from tax unless that trust has UBTI. Sec. 1.664-1(c), Income Tax Regs., states that a charitable remainder unitrust that receives UBTI is taxable on all of its income. The Court concluded that the trust had partnership income that was subject to unrelated business income tax and thus it was taxable as a complex trust on all of its income and not merely to the extent of UBTI.
Part IV - Estate Administration
- An Exception to Self-dealing
IRC 4941, which provides that any sale, exchange or leasing of property between a private foundation and a disqualified person is an act of self-dealing, could make it vary difficult to administer an estate.
For example, an individual’s will or trust may establish several trusts to be administered after the grantor's death. The testator may have specified the assets to be used to fund each bequest but the choices may not be appropriate to achieve the testator's intent. Or the testator may not make any specific bequest, giving the residue of his or her estate to charity after the specific bequests.
Testator A bequeathed $100,000 to his wife and a piece of unimproved real estate of equivalent value to private foundation Z, of which A was the creator and manager. In keeping with state law and to meet the needs of the private foundation and the spouse, the executor exercises his power and distributes the $100,000 cash to the foundation and the real estate to A’s wife.
The spouse and the private foundation are both pleased with the outcome, but has an indirect act of self-dealing occurred? The regulations under IRC 4941 specifically provide an exception to the general rules on self-dealing to ease estate administration.
The term “indirect self-dealing” shall not include a transaction with respect to a private foundation’s interest or expectancy in property... held by an estate (or revocable trust, including a trust which has become irrevocable on a grantor’s death), regardless of when title to the property vests under local law, if-
This exception applies if certain specific conditions are met. The purpose of the exception is to allow flexibility to shift assets during administration of the estate to facilitate the carrying out of the decedent’s intent provided in the will or revocable trust instrument. One important condition for the application of this exception is that exchanges of assets must be at equal fair market values. Reg. 53.4941(d)-1(b)(3)(iv). The other requirements for qualifying for the estate administration, found generally in Reg. 53.4949-1(b)(3)(i) through (v), are as follows:
(i) The administrator or executor of an estate or trustee of a revocable trust either, possesses a power of sale with respect to the property, has the power to reallocate the property to another beneficiary, or is required to sell the property under the terms of any option subject to which the property was acquired;
(3) The trust is a disqualified person to the foundation under IRC 4946.
The exception is not available because of the below market rate sale.
- Rockefeller v. U.S., constitutionality confirmed
The possibility of self-dealing and the estate administration exception was pivotal in Rockefeller v. United States, 718 F.2d 290 (8th^ Cir. 1983), cert. den. 466 U.S. 962 (1984), in which the court considered a case where the Service imposed a self-dealing penalty on an executor. On February 22, 1973, Winthrop Rockefeller died. Pursuant to the terms of his Last Will and Testament, dated November 14, 1972, he left the residue of his estate to a charitable trust created under his Will. The Will contemplated that property known as Winrock Farms would constitute a substantial part of the residue and would compose a substantial part of the trust.
On September 30, 1975, plaintiff, the son of Winthrop Rockefeller, and the executor of the estate of Winthrop Rockefeller, executed an agreement with the executor of Winthrop Rockefeller’s estate to purchase all the stock of Winrock Farms. The plaintiff and the estate obtained an independent appraisal of the fair market value of the Winrock Farms' stock, and petitioned the Probate Court of Conway County, Arkansas, the probate court with jurisdiction over the estate for approval of the sale. The Probate Court entered an order approving the sale at the appraised fair market value, and plaintiff purchased the stock at that value on December 19, 1975.
After auditing the estate's 1975 tax return, the Internal Revenue Service issued a report proposing certain adjustments in the estate's tax return. The proposed adjustments were based on certain findings of fact, one of which was that the sale of the stock to the plaintiff was not at fair market value. The Commissioner relied on the definition of self dealing in § 4941(d)(1), which includes indirect sales between a disqualified person and a private foundation, and failure to meet the requirements of Reg. § 53.4941(d)-1(b)(3). The plaintiff argued that IRC 4941 was unconstitutional and that even if the statute was constitutional, the regulation is unconstitutional. The Court upheld the Service, holding both the Code section and the estate administration regulation constitutional.
- Estate of Reis, gives a broad reading to 4941
Estate of Bernard J. Reis v. Commissioner, 87 T.C. 1016 (1986) was an important win for the Service. Mark Rothko was a well-known American abstract expressionist painter who died in 1970. Bernard J. Reis, was one of the executors of his estate. Reis also was one of the directors of the Mark Rothko Foundation. In his will, after making certain specific bequests to family members, Mark Rothko bequeathed all his remaining property to the foundation.
Reis also was an officer and employee of the Marlborough Gallery, Inc. In May of 1970, shortly after Rothko's death, the executors of the estate, including Reis, entered into contracts on behalf of the estate with the gallery. The agreement provided that Rothko’s paintings, which comprised the bulk of the estate's assets could be sold only by the gallery or its affiliated corporations throughout the world. The contracts were to last 12 years, and the gallery was to receive a commission of 50 percent of the proceeds from the sale of each painting.
The Service argued that because the foundation was a beneficiary under Mark Rothko's will, it had a vested beneficial interest in the property of the estate. The Service maintained that Reis' acts with respect to the property of the estate simultaneously and adversely affected the foundation's beneficial interest and constituted an indirect use of foundation assets by or for the benefit of Reis. The Service cited section 53.4941(d)- 1(b)(3) of the regulations, as authority for the general proposition that acts of self-dealing with respect to property of an estate also will be regarded as acts of self-dealing with respect to assets of a private foundation that has a beneficial interest in the property of the estate.
The court agreed, explaining:
In summary, regardless of whether the foundation is considered to have had a vested or merely an expectancy interest under New York law in the property of the Mark Rothko Estate, under section 4941 and the relevant Treasury regulations, the expectancy interest the foundation had in the estate is treated as an asset of the foundation, and transactions affecting property of the estate are treated as affecting assets of the foundation. Such transactions are excepted from the definition of acts of self-dealing under section 4941 only if they qualify for the exception described in section 53.4941(d)-1(b)(3), Excise Tax Regs., or under one of the other available exceptions (e.g., the exception for transactions which provide only incidental benefits to disqualified persons).
Part V - Termination of an Estate Issues for Trusts and Estates
The termination issue is important. The date of termination controls when the provisions of IRC 4947 apply. The nature of the beneficiaries determines whether IRC 4947(a)(1) or IRC 4947(a)(2) applies.
- 4947(a)(1)
Reg. 53.4947-1(b)(2)(ii) concerns the application of IRC 4947(a)(1). IRC 4947(a)(1) will apply when:
