[Federal Register Volume 77, Number 73 (Monday, April 16, 2012)]
[Rules and Regulations]
[Pages 22483-22485]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-8996]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 9582]
RIN 1545-BH66
Guidance Under Sections 642 and 643 (Income Ordering Rules)
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final Regulations.
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SUMMARY: This document contains final regulations under Internal
Revenue Code (Code) section 642(c) with regard to the Federal tax
consequences of an ordering provision in a trust, a will, or a
provision of local law that attempts to determine the tax character of
the amounts paid to a charitable beneficiary of the trust or estate.
The final regulations also make conforming amendments to the
regulations under section 643(a)(5). The final regulations affect
estates, charitable lead trusts (CLTs), and other trusts making
payments or permanently setting aside amounts for a charitable purpose.
DATES: Effective Date: These regulations are effective on April 16,
2012.
FOR FURTHER INFORMATION CONTACT: Melissa Liquerman, at (202) 622-3060
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background and Explanation of Provisions
On June 18, 2008, proposed regulations (REG-101258-08) were
published in the Federal Register [73 FR 34670]. The proposed
regulations contain proposed amendments to the Income Tax Regulations
26 CFR part 1, confirming that a provision in a trust, a will, or a
provision of local law that specifically indicates the source out of
which amounts are to be paid, permanently set aside, or used for a
purpose specified in section 642(c) must have economic effect
independent of income tax consequences in order to be respected for
Federal tax purposes. If such provision does not have economic effect
independent of income tax consequences, income distributed for a
purpose specified in section 642(c) will consist of the same proportion
of each class of the items of income as the total of each class bears
to the total of all classes. The proposed regulations also make
conforming changes in the corresponding language in the Income Tax
Regulations under section 643(a)(5). The trusts and estates that are
the subject of the proposed regulations include, without limitation,
charitable lead trusts (CLTs) and trusts and estates making payments or
permanently setting aside amounts for a charitable purpose.
The proposed regulations are based on the structure and provisions
of Subchapter J (of Chapter 1, Subtitle A, of the Code) as a whole, as
well as on an analysis of the existing regulations with their
interrelated cross-references. The IRS and Treasury Department believe
that the current regulations under Sec. Sec. 1.642(c)-3(b) and
1.643(a)-5(b) require that a specific provision of the governing
instrument or a provision under local law have economic effect
independent of income tax consequences in order to be respected for
Federal income tax purposes. To make this clearer, the proposed
regulations add the principle of economic effect directly to the
regulations under sections 642(c) and 643(a), rather than leaving this
principle to be reached by cross-reference to other regulations.
Finally, the proposed regulations remove Sec. 1.642(c)-3(b)(4)
because the provisions of section 116 referenced therein were repealed
by the Tax Reform Act of 1986 (Pub. L. 99-514).
Written comments were received on the proposed regulations. Because
there were no requests to speak at the scheduled public hearing, the
public hearing was cancelled. The proposed regulations, with certain
changes made in response to the written comments received, are adopted
as final regulations.
Summary of Comments and Explanation of Provisions
Specific Provisions Must Have Economic Effect Independent of Income Tax
Consequences
Commentators suggested that the clarification in the proposed
regulations, that a specific provision in a governing instrument or in
local law that identifies the source(s) of the amounts to be paid,
permanently set aside, or used for a purpose specified in section
642(c) must have economic effect independent of income tax consequences
in order for the specific provision in the governing instrument or in
local law to be respected for Federal tax purposes, is an
interpretation contrary to the clear language of section 642(c) and
643(a)(5) and the existing regulations.
The IRS and Treasury Department have carefully considered these
arguments and the analyses suggested by the commentators. The IRS and
Treasury Department continue to believe that the position clarified in
the proposed regulations, requiring that a specific provision of the
governing instrument or a provision under local law have economic
effect independent of income tax consequences in order to be respected
for Federal tax purposes, is the proper interpretation of the relevant
Code provisions and is a principle that applies throughout Subchapter
J.
The general rule provided in Subchapter J, which mandates that the
tax character of distributions to beneficiaries consists of a pro rata
portion of all types of a trust's income, appears in section 652(b) and
in several different sections of the regulations under the subchapter.
The only
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regulatory exception to this pro rata rule is for a specific provision
in a governing instrument or a provision under local law that provides
as to the tax character of distributions to beneficiaries. This
exception to the pro rata rule must have the same meaning throughout
the Subchapter J regulations. The chain of regulatory references from
Sec. Sec. 1.642(c)-3(b) and 1.643(a)-5(b), detailed in the preamble to
the proposed regulations, incorporates into each of those provisions,
by cross-reference to Sec. 1.662(b)-2, ``the principles contained'' in
Sec. 1.652(b)-1 and, in turn, Sec. 1.652(b)-2(a) and -2(b), which
require a specific provision to have economic effect independent of
income tax consequences in order to be respected. The proposed
regulations confirm this uniform principle by inserting the terms of
Sec. Sec. 1.652(b)-1 and 1.652(b)-2(a) and -2(b) explicitly into
Sec. Sec. 1.642(c)-3(b) and 1.643(a)-5(b).
Moreover, section 643(a)(7) grants express regulatory authority to
``prescribe such regulations as may be necessary or appropriate to
carry out the purposes of this part, including regulations to prevent
avoidance of such purposes.''
Income Ordering Provisions and Economic Effect Independent of Income
Tax Consequences
A commentator suggested that income ordering provisions in CLTs
have economic effect independent of income tax consequences because
disregarding an income ordering provision could increase a CLT's tax
liability, thereby reducing the value of the trust and in turn reducing
the annual unitrust payments to the charitable beneficiaries and
increasing the risk that the trust's assets will be depleted before the
end of the trust term. Although the general pro rata allocation rule
may increase a trust's tax liability and thereby reduce the value of
the trust's corpus, the effect of the payment of the trust's income tax
liability is not an economic effect independent of income tax
consequences as described in these regulations. Any possible reduction
in the unitrust amount subsequently paid to the charitable beneficiary
would be the direct result of the payment of income taxes by the
unitrust. The use of an income ordering rule in a CLT, directing the
tax characteristics of the unitrust or annuity payments to the charity,
is primarily, if not exclusively, an attempt to minimize the tax
liabilities of the trust and its remainder beneficiaries. The only
effects of the use of an ordering rule are in fact dependent solely
upon tax consequences: specifically, the reduced amount of tax paid and
the trust's retention of the income tax savings.
Ordering provisions in CLTs will never have economic effect
independent of their tax consequences because the amount paid to the
charity is not dependent upon the type of income it is allocated. An
annuity payment is a fixed amount from year to year, and although a
unitrust amount may fluctuate annually, the amount is based upon a
predetermined percentage of the trust's value.
Permitting an ordering rule with no economic effect independent of
income tax consequences to supersede the pro rata allocation rule
generally applicable under Subchapter J would, in effect, permit
taxpayers to deviate at will from the general rule imposed throughout
Subchapter J in the case of all kinds of complex trusts.
Encouragement of Charitable Gifts
A commentator suggested that the proposed regulations are contrary
to the Federal government's long standing policy to encourage
charitable gifts and to benefit and protect charities.
The IRS and Treasury Department have carefully considered the
merits and implications of this suggestion. The IRS and Treasury
Department believe, however, that the proper interpretation of the
relevant Code sections does not permit the creation of a special rule
for CLTs. A CLT is treated and taxed in the same way as any other
complex trust under Subchapter J. Subchapter J does not differentiate
between a CLT and a different type of complex trust, and there is no
provision of Subchapter J that applies exclusively and expressly to
CLTs. Thus, any income tax rule applicable to a CLT will apply in the
same way to every other complex trust.
Principal/Income Ordering Rules
A commentator requested that the proposed regulations be expanded
to provide that trusts that make distributions to both charitable and
noncharitable beneficiaries in the same taxable year must allocate the
distributions equally to principal and income as between charitable and
noncharitable beneficiaries, unless there is a provision that has
economic effect independent of income tax consequences.
This request is beyond the scope of the proposed regulations and
might implicate other well settled income tax rules applicable to
complex trusts. Section 662 and the regulations thereunder provide the
rules for distributions by complex trusts with a charitable
beneficiary, and sufficiently address the commentator's concern. If the
commentator believes that further guidance is needed or would be
helpful to taxpayers, a request for additional guidance may be
submitted for consideration to be added to the Priority Guidance Plan.
Economic Effect Independent of Income Tax Consequences Example
A commentator requested an example of a provision in a governing
instrument that would have economic effect independent of income tax
consequences. Such an example has been added to the final regulations
as Example 2.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866, as
supplemented by Executive Order 13563. Therefore, a regulatory
assessment is not required. It has also been determined that section
553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does
not apply to these regulations, and because these regulations do not
impose a collection of information on small entities, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a
Regulatory Flexibility Analysis is not required. Pursuant to section
7805(f) of the Code, the notice of proposed rulemaking preceding this
regulation was submitted to the Chief Counsel for Advocacy of the Small
Business Administration for comment on its impact on small business,
and no comments were received.
Drafting Information
The principal author of these proposed regulations is Melissa
Liquerman, Office of the Associate Chief Counsel (Passthroughs and
Special Industries).
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
0
Par. 2. Section 1.642(c)-3 is amended by:
0
1. Revising the heading of paragraph (b) and adding a heading for
(b)(1).
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2. Revising paragraph (b)(2).
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3. Adding a heading to paragraph (b)(3).
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4. Removing paragraph (b)(4).
The revisions and addition read as follows:
Sec. 1.642(c)-3 Adjustments and other special rules for determining
unlimited charitable contributions deduction.
* * * * *
(b) Determination of amounts deductible under section 642(c) and
the character of such amounts--(1) Reduction of charitable
contributions deduction by amounts not included in gross income. * * *
(2) Determination of the character of an amount deductible under
section 642(c). In determining whether the amounts of income so paid,
permanently set aside, or used for a purpose specified in section
642(c)(1), (2), or (3) include particular items of income of an estate
or trust, whether or not included in gross income, a provision in the
governing instrument or in local law that specifically provides the
source out of which amounts are to be paid, permanently set aside, or
used for such a purpose controls for Federal tax purposes to the extent
such provision has economic effect independent of income tax
consequences. See Sec. 1.652(b)-2(b). In the absence of such specific
provisions in the governing instrument or in local law, the amount to
which section 642(c) applies is deemed to consist of the same
proportion of each class of the items of income of the estate or trust
as the total of each class bears to the total of all classes. See Sec.
1.643(a)-5(b) for the method of determining the allocable portion of
exempt income and foreign income. This paragraph (b)(2) is illustrated
by the following examples:
Example 1. A charitable lead annuity trust has the calendar year
as its taxable year, and is to pay an annuity of $10,000 annually to
an organization described in section 170(c). A provision in the
trust governing instrument provides that the $10,000 annuity should
be deemed to come first from ordinary income, second from short-term
capital gain, third from fifty percent of the unrelated business
taxable income, fourth from long-term capital gain, fifth from the
balance of unrelated business taxable income, sixth from tax-exempt
income, and seventh from principal. This provision in the governing
instrument does not have economic effect independent of income tax
consequences, because the amount to be paid to the charity is not
dependent upon the type of income from which it is to be paid.
Accordingly, the amount to which section 642(c) applies is deemed to
consist of the same proportion of each class of the items of income
of the trust as the total of each class bears to the total of all
classes.
Example 2. A trust instrument provides that 100 percent of the
trust's ordinary income must be distributed currently to an
organization described in section 170(c) and that all remaining
items of income must be distributed currently to B, a noncharitable
beneficiary. This income ordering provision has economic effect
independent of income tax consequences because the amount to be paid
to the charitable organization each year is dependent upon the
amount of ordinary income the trust earns within that taxable year.
Accordingly, for purposes of section 642(c), the full amount
distributed to charity is deemed to consist of ordinary income.
(3) Other examples. * * *
* * * * *
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Par. 3. Section 1.643(a)-5 is amended by revising paragraph (b) to read
as follows:
Sec. 1.643(a)-5 Tax-exempt interest.
* * * * *
(b) If the estate or trust is allowed a charitable contributions
deduction under section 642(c), the amounts specified in paragraph (a)
of this section and Sec. 1.643(a)-6 are reduced by the portion deemed
to be included in income paid, permanently set aside, or to be used for
the purposes specified in section 642(c). If the governing instrument
or local law specifically provides as to the source out of which
amounts are paid, permanently set aside, or to be used for such
charitable purposes, the specific provision controls for Federal tax
purposes to the extent such provision has economic effect independent
of income tax consequences. See Sec. 1.652(b)-2(b). In the absence of
such specific provisions in the governing instrument or local law, an
amount to which section 642(c) applies is deemed to consist of the same
proportion of each class of the items of income of the estate or trust
as the total of each class bears to the total of all classes. For
illustrations showing the determination of the character of an amount
deductible under section 642(c), see Examples 1 and 2 of Sec.
1.662(b)-2 and Sec. 1.662(c)-4(e).
Linda M. Kroening,
(Acting) Deputy Commissioner for Services and Enforcement.
Approved: April 9, 2012.
Emily M. McMahon,
(Acting) Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2012-8996 Filed 4-13-12; 8:45 am]
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