[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

[[Page 22484]]

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).

[[Page 22485]]

0
2. Revising paragraph (b)(2).
0
3. Adding a heading to paragraph (b)(3).
0
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. * * *
* * * * *

0
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]
BILLING CODE 4830-01-P