California (Finally) Conforms to Federal Treatment of UBTI in Charitable Remainder Trusts

California (Finally) Conforms to Federal Treatment of UBTI in Charitable Remainder Trusts

Article posted in Charitable Remainder Trust on 19 November 2014| 1 comments
audience: National Publication, David Wheeler Newman | last updated: 20 November 2014


California has recently passed new legislation that removes some of the onerous tax consequences caused by UBTI in Charitable Remainder Trusts.

by David Wheeler Newman, Mitchell Silberberg & Knupp LLP

The charitable remainder trust is one of the most effective vehicles to balance philanthropic objectives with financial and estate planning objectives.  These trusts, creatures of the Internal Revenue Code and, here in California, counterpart provisions of the Revenue and Taxation Code, are irrevocable trusts which during their term distribute a formula amount to an individual or other non-charitable beneficiaries and, at the end of that term, distribute whatever is left in the trust -- the remainder -- to a qualifying charity.

The ideal candidate for a charitable remainder trust is a client with an appreciated asset which he or she is willing to eventually dedicate to charitable purposes, but in the meantime is not prepared to give up the income stream that could be generated from the proceeds of selling that asset.

One of the most important tax attributes of charitable remainder trusts is that they are generally exempt from income tax.  To illustrate, assume that an investor plans to sell stock now worth $1 million that she originally purchased for $100,000.  She plans to retain the proceeds to re-invest to supplement her income, but intends that whatever is left will eventually go to her alma mater.  If she sells the stock herself, she might have only $700,000 remaining for re-investment, after paying California and federal tax on the capital gain along with the new 3.8% tax on investment income.  But if she contributes the stock to a CRT, retaining income in the form of formula distributions to herself for life, the stock could be sold in the tax-exempt environment of the trust, leaving the entire $1 million to produce much more income.

But planners have always needed to worry about one exception to the tax-exempt status of a CRT with unrelated business income (UBTI).  This might result, for example, if instead of stock the asset in question was real estate in connection with which certain services are provided, or an interest in a hedge fund or other investment partnership.  For decades the rule was that if a CRT had any UBTI at all, even an amount that was inconsequential compared to the overall net income of the trust, the trust would lose its tax exemption for the year, and become fully taxable just like any other complex trust.  This rule could undo some of the best tax planning with CRTs, of the type described above.  In our example, if the asset sold by the CRT was an apartment building that generated a few dollars every year from coin-operated laundry facilities that were provided for the convenience of the tenants, the trust would lose its tax exemption for the year of the sale, and end up with $700,000 after tax to be re-invested to produce income, rather than the $1 million upon which the planner – and the client – had been counting.

After years of proposals from the advisory community to fix this unfortunate result, Congress in 2006 enacted legislation that replaced the federal rule with a new Internal Revenue Code section 664(c)(2) that instead imposed an excise tax on UBTI of a CRT equal to the amount of that UBTI.  The general tax exemption of the CRT would be be preserved, while UBTI would be subject to federal excise tax of 100%.  While there was some grumbling about that 100% tax rate, the preservation of the general tax exemption of the CRT was generally applauded.  If the laundry generated $5,000 in net income during the period the apartment building was held by the CRT pending sale, even if that UBTI was taxed at 100%, at least the general tax exemption of the trust would be preserved and the sale would yield $995,000 after tax.

But then a curious thing happened in California.  Notwithstanding a general legislative tax policy of conforming the California Revenue and Taxation Code to changes in the Internal Revenue Code, the legislature in the Golden State didn’t go along with this one.  In fact, it went out of its way not to, enacting a statute in 2010 which provided that the new federal rules did not apply in California, and instead the old rule – that even a modest amount of UBTI would cause the CRT to lose its exemption – would continue in California.  For the last four years, a California CRT with UBTI would be federally tax exempt, but subject to a 100% excise tax on UBTI, and fully taxable in California on all of its income.  This was the proverbial trap for the unwary, and yielded a crazy result.  In addition to the federal excise tax on the laundry income, the entire gain from sale of the apartments would be subject to California income tax of as much as 13.3%, resulting in additional state tax of over $115,000 caused by this $5,000 of income!

This anomaly has happily been corrected.  A few weeks ago Governor Brown signed a new law that generally conforms California treatment to federal law starting in 2014, except that instead of the excise tax imposed on UBTI under federal law, a tax will be imposed on UBTI for California purposes at the normal trust rates up to 13.3%.  The result is that a California CRT with UBTI could be taxed at up to 113.3% on that UBTI (100% federal excise tax plus 13.3% California income tax), but remaining income of the CRT would remain exempt from federal and state taxation.  The 113.3% rate might cause the same grumbling we heard eight years ago when Congress changed to federal rule, but planners need to keep their eye on the prize – which is preservation of the general tax exemption:  in our example, a California transaction that would have netted about $880,000 after tax in 2013 will net about $994,000 in 2014.

California tax conformity is especially good news as CRTs are currently enjoying a level of popularity among planners not seen since the Nineties.  The reduction in the federal capital gains tax rate from 20% to 15% in 2001 made the tax benefit of deferring tax from the sale of an appreciated asset less attractive.  The decline in popularity continued through the Great Recession, when fewer clients had appreciated assets that would benefit from this type of planning, and those who were fortunate enough to have these assets may have been uncomfortable tying them up in an irrevocable trusts because they lacked confidence in the general health of the economy.  But now many asset classes have recovered value.  Moreover, capital gains tax rates have increased dramatically.  As a result of the 3.8% tax on investment income, and the return of the federal capital gains tax rate to 20%, taxes on Californians selling appreciated assets are suddenly more than 50% higher than they were just a few years ago.  These changes – combined with the new California tax conformity for UBTI in CRTs – once again make the CRT an attractive vehicle for planners to propose to their clients.

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Re: California (Finally) Conforms to Federal Treatment of ...

The 100% still stinks. There is no good policy reason Congress could not just have isolated the UBTI of the CRT and taxed that as opposed to taxing all the trust income. The rate is highly unusual and confiscatory, and in the class of excise penalty rates for second tier non-correction of the Chapter 42 rules prohibited transactions. That's the penalty for being a successful entrepreneur in this country nowadays and having productive business assets that generate income and then desiring to be philanthropic. And the planned giving community cheered this change??? What a sorry state of affairs. They should have fought for logical and sensible taxation, not capitulated to confiscation.

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