CRT Distributions: Now A Little Less Taxing

The IRS recently updated the rules for characterizing distributions from charitable remainder trusts (CRTs). The updates were needed because of legislation that had passed since the rules were first established in 1972.

Prior to TRA 97, capital gains were subject to the 28% rate across the board. Then came TRA 97, which reconfigured the capital gains tax rate scheme by applying different rates to different types of capital gains (28%, 25%, 20% and 18%).

But the biggest tax break in years came under JGTRRA 2003, which lowered the 20% rate to 15% for both “qualified dividends” and certain long-term capital gains. Now, new proposed regulations incorporate all of the above changes, as well as previous IRS guidance (Notice 97-59, 1997-45 IRB 7) into a single, comprehensive document.

What the proposed regulations didnt change. It is important to note that the general rule hasnt changedthat is, a distribution from a CRT still is treated: first, as ordinary income (tier one); second, as capital gain (tier two); third, as other income (i.e., tax-exempt income–tier three); and fourth, as a distribution of trust principal (tier four). Furthermore, the general principlethat income subject to the highest federal income tax rate is deemed distributed prior to income subject to a lower, or no, federal income tax ratealso still applies.

What has changed is that exceptions now apply that will permit the trustee to get more lower-tax-rate income into the hands of beneficiaries.

The “worst-in, first-out” rule has changed! Under the traditional “worst-in, first-out” rule, the income items with the highest tax rates were treated as being distributed first, the second highest tax rate items were treated as being distributed next, and so on, until the lowest tax rate items were distributed. Under the old regime, the highest and lowest tax rates roughly paralleled the 4-tier system. Essentially, that meant that the highest rate items fell under tier one, the second highest rate items were included under tier two, the third highest rate items fell under tier three, and the lowest rate items were included under tier four.

Under current law, however, classes of income within the ordinary income category (tier one) and the capital gains category (tier two) now are assigned to different classes depending on the tax rate applicable to each type of income. Thus, under current law the ordinary income category may include two classes of income:

The “qualified dividend income” class–under JGTRRA 2003, qualified dividends are taxable at the same rate applicable to all other long-term capital gains (i.e., 15%–see item (4) below); and,

The “all other ordinary income” classconsisting of nonqualified dividends, interest, rents and royalties, all of which are taxable at the recipients top marginal tax rate (i.e., 10%, 15%, 25%, 28%, 33% or 35%).

Likewise, under current law the capital gains category may include:

The short-term capital gains classwhich are taxable at the individuals top marginal rate;

The 28% gain classthis includes collectibles gain and Section 1202 gain;

The 25% unrecaptured Section 1250 gain class; and,

The “all other long-term gains” classthese gains are taxable at 15% (or 5%) under JGTRRA 2003.

In a nutshell, the biggest benefit emerging from the new proposed regulations is that qualified dividend income (15%) is treated as being distributed before (1) short-term capital gains, (2) 25% gains, and (3) 28% gains, even though all 3 of these income items are subject to higher tax rates. This means that CRT trustees may now be able to shift some assets to provide much more lower-tax-rate-distributions to beneficiaries than previously has been possible.

Sonya E. King, J.D., LL.M., is an Assistant Editor of Tax Facts, a National Underwriter Company publication.

Reproduced from National Underwriter Life & Health/Financial Services Edition, February 13, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.