4.76.5  Charitable Trusts (IRC 4947(a)(1) and 4947(a)(2))

Manual Transmittal

April 13, 2015

Purpose

(1) This transmits revised IRM 4.76.5, Exempt Organization Examination Guidelines, Charitable Trusts (IRC 4947(a)(1) and 4947(a)(2)).

Material Changes

(1) This manual underwent a complete revision. This manual now incorporates guidance previously contained in IRM 4.76.4, Private Foundations, concerning non-exempt charitable trusts. In addition, this manual provides both technical information and specific audit procedures.

(2) This manual incorporates a glossary of terms.

(3) This manual now features two exhibits containing line-by-line pre-audit analysis guides for the Forms 1041 and 5227.

Effect on Other Documents

This IRM supersedes IRM 4.76.5, Non-Exempt Charitable And Split Interest Trusts, dated April 1, 2003.

Audience

Tax Exempt and Government Entities
Exempt Organizations
Examinations

Effective Date

(04-13-2015)

Tamera L. Ripperda
Director, Exempt Organizations
Tax Exempt and Government Entities

4.76.5.1  (04-13-2015)
Introduction

  1. This manual provides technical information and audit procedures for cases involving charitable trusts. For more in depth technical information on charitable trusts, see IRM 7.26.15, IRC 4947 Trusts and the 2001 EO CPE text, Trust Primer. As charitable trusts don't file for tax exemption, agents may not see one during an audit, with the exception of those trusts filing the Form 990-PF, Return of Private Foundation (or Section 4947(a)(1) Nonexempt Charitable Trust Treated as a Private Foundation). "Agent" refers to the EO employee assigned to work the case regardless of whether the employee is in the GS-512, GS-526, or GS-987 series.

  2. A trust is a three-party arrangement among the creator of a trust, the manager of a trust (trustee), and a trust’s beneficiary, which may include more than one person or organization. A trust’s creator, also known as a grantor or donor, may form a trust during his or her lifetime or upon death.

  3. A trust is a legal entity that can incur federal income tax liability that is separate from that of the grantor. Trusts may be organized in different ways and serve a variety of grantor motives. Funds placed in trust can provide advantages for estate, financial, personal, or business purposes such as decreasing tax burden and controlling disbursements to beneficiaries.

  4. Frequently the amounts in trust are directed completely or in part to charitable interests, which serve as the trust's beneficiaries. When trusts receive income and distribute that income to charitable interests, a charitable deduction may be employed to reduce trust income tax liability for a given year.

4.76.5.2  (04-13-2015)
Glossary

  1. Annuity trust: An annuity trust is a trust in which the payments for the duration of the trust, either to a private or charitable beneficiary, are of a fixed amount. The trustee(s) determine the payment amount by multiplying a specified percentage by the fair market value of the assets initially placed in the trust.

  2. Beneficiary: Beneficiary(ies) refers to the person, persons, or organization that receives payments or assets from a trust. Beneficiaries can be either charitable or non-charitable, and can be either an income beneficiary or a remainder beneficiary. The beneficiary holds the beneficial title to the trust property. The trust document must clearly identify the beneficiary or beneficiaries.

  3. Charitable lead trust (CLT): Charitable lead trusts (CLT) are split-interest trusts in which a charity receives an income stream during the life of the trust and non-charitable beneficiaries receive the remaining assets when the trust terminates. Charitable lead trusts can be classified as either grantor or non-grantor lead trusts, and payments can be made on an annuity basis or a unitrust basis.

  4. Charitable remainder annuity trust (CRAT): A charitable remainder annuity trust (CRAT) is a charitable remainder trust in which the income payments to the non-charitable beneficiary are fixed throughout the life of the trust. The trustee(s) calculate the payment amount by multiplying the designated percentage by the fair market value of the assets initially placed in the trust.

  5. Charitable remainder trust (CRT): Charitable remainder trusts (CRT) are split-interest trusts in which a non-charitable beneficiary receives a stream of income for the duration of the trust, and a designated charity receives the remaining trust assets upon termination. Charitable remainder trusts can be either annuity trusts or unitrusts, depending on the method used to calculate the payment amounts. Further, unitrusts can be of the net income or net income with makeup variety.

  6. Charitable remainder unitrust (CRUT): A charitable remainder unitrust (CRUT), also called a unitrust, is a charitable remainder trust in which the income payments to the non-charitable beneficiary fluctuate with the fair market value of the assets in the trust. The trustee(s) calculate the payment amount by multiplying the designated percentage (called the unitrust percentage) by the fair market value of the assets, as they are valued each year. Unitrusts can have net income or net income with makeup provisions.

  7. Complex trust: A complex trust is any trust that doesn't meet the requirements for a simple trust. Complex trusts may accumulate income, distribute amounts other than current income and, make deductible payments for charitable purposes under IRC 642(c).

  8. Corpus (or Principal): The corpus (or principal) of a trust consists of the original assets transferred into the trust. Often referred to as the body of the trust, the corpus may generate income streams.

  9. Fair Market Value (FMV): The market price of the asset (or liability) as of a certain point in time.

  10. 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.

  11. Grantor trust: A grantor trust is a trust over which the grantor has retained certain interests or control. The grantor trust rules in IRC 671 - IRC 678 are anti-abuse rules. They prevent the grantor from taking tax advantages from assets that haven't left his or her control. 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 doesn't actually receive the income.

  12. Income beneficiary: The income beneficiary of a split-interest trust is the recipient of the stream of payments made over the duration of the trust. The income beneficiary of charitable remainder trusts and pooled income funds is the non-charitable beneficiary. In charitable lead trusts, the income beneficiary is the designated charitable organization.

  13. Inter vivos: (during life) An inter vivos trust is a trust created during an individual's lifetime.

  14. Irrevocable trust: An irrevocable trust is one that, by its terms, can't be revoked.

  15. Net income charitable remainder unitrust (NICRUT): Net income charitable remainder unitrusts are charitable remainder unitrusts that allow the annual payment to the non-charitable beneficiary to be the lesser of either the unitrust amount or the trust’s net income.

  16. Net income with makeup charitable remainder unitrusts (NIMCRUT): A net income with makeup charitable remainder unitrust allows the payment to the non-charitable beneficiary to be the lesser of the unitrust amount or the accounting income, however any deficiencies must be repaid when income allows. Deficiencies in the distributions, which occur when the net income is less than the unitrust payment amount, accrue year-to-year and are made up in subsequent years when the net income of the trust is greater than the unitrust amount.

  17. Pooled income fund (PIF): A trust administered by a charity in which multiple donors pool assets for investment. The trustee(s) distribute the resulting income to donors on a prorated basis until their death, when their assets are transferred to the charity.

  18. 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.

  19. Remainder beneficiary (or Remainderman): The remainder beneficiary of a split-interest trust is the recipient of the trust’s assets at the conclusion of the trust. In the case of charitable remainder trusts, the remainder beneficiary is the selected charity; in charitable lead trusts, the remainder beneficiary is the designated private beneficiary.

  20. 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 are also called living trusts. They are used primarily as a will substitute.

  21. Simple trust: A simple trust must distribute all its income currently. Generally, it can't accumulate income, distribute out of corpus, or pay money for charitable purposes. If a trust distributes corpus during a year, as in the year it terminates, the trust becomes a complex trust for that year.

  22. Split-interest trust: A split-interest trust is an arrangement which has both charitable and non-charitable beneficiaries. The amount and timing of the distributions depends on the type of arrangement.

  23. Testamentary: A testamentary trust is one created by a last will and testament.

  24. Trust: A trust is a legal arrangement between its creator (donor or grantor), the manager of the trust (trustee), and the beneficiary or beneficiaries of the trust. Trusts are legal entities in their own right, and can be responsible for any tax liabilities separate from the liabilities of the grantor and beneficiary. The trust document defines the conditions and provisions of a trust.

  25. 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 isn't 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. Trustees coordinate the preparation, verification, and submission of all required state and Federal tax forms and legal documents.

  26. See http://www.irs.gov/uac/SOI-Tax-Stats-Split-Interest-Trust-Study-Terms-and-Concepts for additional definitions.

4.76.5.3  (04-13-2015)
Non-Exempt Charitable Trusts (IRC 4947(a)(1))

  1. A non-exempt charitable trust (NECT) is one that designates all of its interests, or beneficiaries, as charitable (IRC 170(c)). With few exceptions, a NECT distributes all of its financial outlays for charitable purposes. The NECT makes charitable contributions annually until it expends all of its assets and income.

    Note:

    Treas. Reg. 53.4947-(1)(b)(2)(vii) permits the trust to have IRC 170(c)(3) and IRC 170(c)(5) charitable interests. Treas. Reg. 53.4947-1(a) includes IRC 170(c)(1) within the scope of IRC 170(c)(2)(B) purposes.

  2. In addition to the charitable beneficiary requirement, the trust holds amounts for which charitable contributions were allowed under:

    Charitable contribution provisions:
    IRC 170 Charitable, etc., contributions and gifts
    IRC 545(b)(2) Charitable contributions (Personal holding companies)
    IRC 642(c) Deduction for amounts paid or permanently set aside for a charitable purpose (Estate and trust income taxes)
    IRC 2055 Transfers for public, charitable, and religious uses (Estate and trust excise taxes)
    IRC 2106(a)(2) Transfers for public, charitable, and religious uses (Estate excise taxes)
    IRC 2522 Charitable and similar gifts (Gift taxes)
  3. IRC 508(d)(2)(B) disallows a charitable deduction to any organization which isn't treated as an IRC 501(c)(3) organization for failure to meet the notice requirement of IRC 508(a). However, IRC 508(a) isn't applicable to non-exempt charitable trusts. As recognized by Treas. Reg. 1.508-2(b)(1)(viii), deductions for contributions to a non-exempt charitable trust won't be disallowed.

  4. Because the NECT doesn't necessarily distribute all of the income collected for charitable purposes, the NECT reports certain income each year as taxable. Since a NECT isn't tax-exempt, any income it receives and doesn't subsequently distribute for charitable purposes is taxable under Subtitle A, regardless of the source.

4.76.5.3.1  (04-13-2015)
Filing Requirements

  1. A NECT may qualify for recognition as a supporting organization under IRC 509(a)(3). This impacts the filing requirements:

    If recognized as a supporting organization, the NECT files: If not recognized as a supporting organization, the NECT files:
    Form 990, Return of Organization Exempt From Income Tax or Form 990-EZ, Short Form Return of Organization Exempt From Income Tax Form 990-PF, Return of Private Foundation (or Section 4947(a)(1) Nonexempt Charitable Trust Treated as a Private Foundation)
    Form 1041, U.S. Income Tax Return for Estates and Trusts, if the trust has net income Form 1041, if the trust has net income
      Form 4720, Return of Certain Excise Taxes on Charities and Other Persons Under Chapters 41 and 42 of the IRC (when applicable)
  2. To receive recognition as a supporting organization, the NECT files Form 8940, Request for Miscellaneous Determination and pays the applicable fee. For 2015, the fee is $400. To determine the current fee, see http://www.irs.gov/Charities-&-Non-Profits/User-Fee-Program-for-Tax-Exempt-and-Government-Entities-Division.

    Note:

    This isn't the same as receiving a conferred tax-exempt status, it just means that the NECT is treated as a public charity and files a Form 990 or Form 990-EZ

  3. When applying for recognition under IRC 509(a)(3), the NECT provides the following information:

    • The name, address, and Employer Identification Number of the beneficiary organizations.

    • A statement whether each such beneficiary organization is described in IRC 509(a)(1) or IRC 509(a)(2).

    • A list of all of the trustees that have served.

    • A statement stating whether such trustees were IRC 4946 disqualified persons (other than foundation managers).

    • A copy of the original trust instrument and all subsequently adopted amendments to that instrument.

    • Sufficient information to otherwise establish that the trust has met the requirements of IRC 509(a)(3).

    • Such other information as required under Rev. Proc. 2014-4 or any successor revenue procedure.

4.76.5.3.2  (04-13-2015)
Taxation

  1. The determination that a NECT is a supporting organization impacts the potential tax liabilities of the NECT and disqualified persons:

    If treated as exempt under IRC 509(a)(3): If not treated as exempt under IRC 509(a)(3):
    Employment taxes (if applicable) Employment taxes (if applicable)
    Excise tax: IRC 4911 (excess lobbying expenditures) Excise tax: IRC 4940(b) (net investment income)
    Excise tax: IRC 4912 (disqualifying lobbying expenditures) Excise tax: IRC 4941 (self-dealing)
    Excise tax: IRC 4943 (excess business holdings) Excise tax: IRC 4942 (failure to distribute)
    Excise tax: IRC 4955 (political expenditures) Excise tax: IRC 4943 (excess business holdings)
    Excise tax: IRC 4958 (intermediate sanctions) Excise tax: IRC 4944 (jeopardizing investments)
    Excise tax: IRC 4965 (being a party to prohibited tax shelter transactions) Excise tax: IRC 4945 (taxable expenditures)
    Excise tax: IRC 4966 (taxable distributions of sponsoring organizations maintaining donor advised funds) Excise tax: IRC 4955 (political expenditures)
    Excise tax: IRC 4967 (prohibited benefits distributed from donor advised funds) Excise tax: IRC 4965 (being a party to prohibited tax shelter transactions)
    Income tax (if it has net income) Income tax (if it has net income)
  2. If a NECT is a private foundation, the termination provisions of IRC 507 and governing instrument provisions of IRC 508(e) apply.

4.76.5.4  (04-13-2015)
Split Interest Trusts (IRC 4947(a)(2))

  1. Split-interest trusts make distributions to both charitable and non-charitable beneficiaries, while providing tax benefits to their donor. All split-interest trusts file Form 5227, Split-Interest Trust Information Return, annually to report financial activity, including asset holdings, income, and distributions, and to determine if they should be treated as a private foundation. This return doesn't calculate tax liability. Based on the method and timing of distributions, split-interest trusts divide into three categories:

    • Charitable remainder trusts

    • Charitable lead trusts

    • Pooled income funds

  2. A split-interest trust can be created by executing a will or a separate trust instrument. In either case, the instrument specifies the term of the trust, designates the trustee(s) and beneficiaries, and provides parameters for managing assets and distributing income.

  3. The instrument usually specifies the trust's corpus when created. The individual who owns, and then transfers, the assets that make up the trust corpus is the grantor. Individuals and entities receiving income and assets from the trust are the beneficiaries.

  4. A trustee holds, invests, and distributes the trust's income and assets. This may be an individual, a group of individuals, or an entity, such as a bank or charity. Each trustee must ensure that all transactions, including distributions, conform to the requirements of the trust instrument and to any applicable laws. Additionally, the trustee coordinates the preparing, verifying, and submitting of all required federal and state tax forms.

  5. Trustees for all split-interest trusts report any distributions of trust principal or income for charitable purposes on Form 5227, Split-Interest Trust Information Return. The details of these charitable distributions, as well as of the trusts' income and asset holdings, are available to the public.

    Note:

    This change became effective for filing year 2007 forward. The only portion of the Form 5227 not available for public inspection is Schedule A, which includes details of distributions to and donations from individuals and non-charitable entities.

    Exception:

    A CRT created before May 27, 1969, isn't required to file Form 5227 provided that no amount was transferred to the trust after such date.

  6. Per the Pension Protection Act of 2006 (PPA), split-interest trusts no longer have to file Form 1041-A, as all of the information previously reported on it are now included in the Form 5227. If a charitable remainder trust has any unrelated business taxable income (UBTI), the trust is liable for an excise tax consisting of 100% of the UBTI and must file a Form 4720 to pay this excise tax. It no longer has to file a Form 1041 in this instance.

  7. Split-interest trusts are often promoted by charities with the charity serving as the trustee, however this isn't a requirement. For charitable remainder trusts, there is no requirement that the named charity even know of its impending gift. A charity doesn't have to be specifically named as the remainderman (IRM 4.76.5.2 (19)) at the time the charitable remainder trust is created.

  8. The remainderman can be described by class (such as any organization exempt under IRC 501(c)(3)). The specific remainderman may be chosen at a later date by a trustee, with the specific power to choose the remainder beneficiary. A private foundation controlled by the grantor’s family can be the remainder beneficiary.

  9. Split interest trusts aren't subject to all of the Chapter 42 restrictions on private foundations. IRC 4941 and IRC 4945 apply in all cases, as do IRC 507 and IRC 508(e) . IRC 4943 and IRC 4944 apply except in two situations:

    1. If all of the income interests (and none of the remainder interests) are entirely charitable and all amounts held in trust for which a charitable deduction was allowed have a value of not more than 60 percent of the total value of all assets.

    2. If a charitable deduction was allowed for amounts payable under the terms of the trust to every remainder beneficiary, but not to any income beneficiary.

  10. The IRS published sample trust instrument provisions that, if followed, would meet IRC 508(e) requirements. A series of revenue procedures were issued in 2003 that presented approved sample trust documents covering the various scenarios that a CRAT would typically involve. Rev. Proc. 2003-53 through Rev. Proc. 2003-60. In 2005, a series of revenue procedures were issued that provided sample trust instruments for various scenarios involving CRUTs. Rev. Proc. 2005-52 through Rev. Proc. 2005-59.

  11. The PPA instituted a penalty for failure to file and failure to file complete and correct returns. This same penalty can be imposed on trustees who are required to file a return, but knowingly fail to do so. The penalty is $20 for each day the failure continues with a maximum of $10,000 for any one return. However, if the trust has gross income greater than $250,000, the penalty is $100 for each day the failure continues with a maximum of $50,000 for any one return. IRC 6652(c)(2)(C) provides that the IRS may make a written demand for a delinquent return to be filed or an information to be furnished, specifying a time to comply with the demand. If the trustee fails to comply with the demand by the specified date, the trustee can be charged a penalty of $10 for each day the failure continues with a maximum of $5,000 for any one return.

4.76.5.4.1  (04-13-2015)
Charitable Remainder Trusts

  1. 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 non-charitable beneficiary each year.

    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.

  2. Upon the creation of a charitable remainder trust the trust instrument can reserve a power for the non-charitable beneficiary to appoint by will the charitable remaindermen. Rev. Rul. 76-7, 1976-1 C.B. 179.

  3. 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.

  4. 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 isn't qualified at the time payments are to be made to it. Treas. Regs. 1.664-2(a)(6)(iv) and 1.664-3(a)(6)(iv)

  5. 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.

    Note:

    Only an independent trustee may have the power to allocate the annuity or unitrust amount among the various named recipients. Rev. Rul. 77-73, 1977-1 C.B. 175. The donor may not retain the power to name himself as trustee when the trustee has the power to allocate the annuity or unitrust amount among the various named recipients. Rev. Proc. 77-285.

  6. The non-charitable interest is payable to a "person" . The definition of "person" includes a trust, estate, partnership, association, company, or corporation (See IRC 7701(a)(1)). If the income recipient isn't an individual (or combination of individual and charity) the term of the trust must be a term of years, not more than 20 years.

  7. Payment of the annuity or unitrust amount may be made to the guardian of a minor. The payment of a portion of the annuity or unitrust amount may be made to an IRC 170(c) charitable recipient. Treas. Regs. 1.664-2(a)(3)(i) and 1.664-3(a)(3)(i).

    Note:

    The trust document may also provide the trustee with the discretion to distribute a portion of the annuity or unitrust amount to a charitable recipient. In all cases there must be at least one noncharitable recipient of the annuity or unitrust amount. IRC 664(d)(1) and IRC 664(d)(2).

  8. Commonly, the annuity or unitrust payment is payable, in succession, to the grantor and the grantor's spouse for life. The grantor may reserve the right to revoke, by a direction in the last will and testament, his or her spouse's income right in the trust. Rev. Rul. 74-149, 1974-1 C.B. 157.

  9. An inter vivos charitable remainder unitrust, created during the life of the grantor, may receive additions to the trust assets by transfers of property made during the grantor's life or at his death by a provision in his will. Rev. Rul. 74-149 indicates that additional property contributions may not be made to a charitable remainder annuity trust. Treas. Reg. 1.664-2(b).

  10. 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. Treas, Reg. 1.664-1(d)(5).

  11. IRC 4947(a)(2) doesn't apply any provisions to the income interests of individuals under a charitable remainder annuity or unitrust. IRC 4947(a)(2)(A) provides that IRC 4947(a)(2) doesn't apply to income beneficiaries unless a beneficiary is a charity under a lead trust in annuity or unitrust form.

4.76.5.4.1.1  (04-13-2015)
Charitable Remainder Annuity Trusts

  1. A charitable remainder annuity trust pays a specific amount of money to the non-charitable 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.

  2. 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).

  3. The payout doesn't vary and it doesn't matter how much income is earned by the trust during the year. If assets held by the trust are producing substantial gains, the non-charitable beneficiary won't 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 non-charitable recipient receives no benefit from any appreciation in trust assets from year to year.

  4. The amount that will actually pass to the charity can't be determined until the expiration of the non-charitable 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 non-charitable beneficiary, there may be little left for the charity.

4.76.5.4.1.2  (04-13-2015)
Charitable Remainder Unitrusts

  1. 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).

  2. If the value of the unitrust assets increases, the payout to the non-charitable beneficiary will increase. The advantage of the unitrust over the annuity trust to the non-charitable beneficiary is that the unitrust serves as a hedge against inflation.

  3. As with the annuity trust, the amount the charity will actually receive can't be determined until the non-charitable interest terminates.

4.76.5.4.1.2.1  (04-13-2015)
Net Income Charitable Remainder Unitrusts (NICRUT)

  1. In lieu of a fixed percentage, the trust document may instead provide that the trustee pays annually the lesser of the unitrust amount or the trust accounting income (IRC 664(d)(3)). Any amounts earned in excess of the amount paid to the income beneficiary become part of the corpus, and increase the amount the charity receives at the end of the trust term.

  2. Trust accounting income is the amount of income for the tax year as determined under the terms of the governing instrument and applicable state law. (IRC 643(b))

  3. Depending on the applicable state law, expenses may be charged against trust income when determining the payout amount. These include administrative, management, trustee expenses, and amounts expended to preserve trust property.

  4. When computing trust income, include most passive income, but not capital gains, unless so defined in the trust document or under state law.

4.76.5.4.1.2.2  (04-13-2015)
Net Income with Makeup Charitable Remainder Unitrusts (NIMCRUT)

  1. The NIMCRUT follows the same rules as the NICRUT, but with a twist. When the trust income is less than the fixed percentage amount for any given year, a shortfall is created because the beneficiary is getting less than the fixed percentage amount. The amount of shortfall may be "made up" in a later year. The make-up must come from extra trust accounting income, not from principal.

    Example:

    Trust A has a unitrust payout of 5%. In year 1 through 4, the trust has no net income and the unitrust payout is $0.00. In year 5 the trust earns 8%. The extra 3% can be used to make-up the short fall.

  2. A donor uses a NIMCRUT to place property that doesn't produce regular income and isn't readily marketable into a CRUT. A NIMCRUT frequently will hold real estate and stock or other interests in a closely held business. By using a NIMCRUT, the payment to the income beneficiary is $0.00, the lesser of the unitrust percentage amount or the trust accounting income.

  3. A grantor who wishes to have small current income payments and larger payments in the future use a NIMCRUT.

    Example:

    Grantor is 50 years old and is contemplating retiring in 10 years. He owns a parcel of appreciating real estate. He is in a high tax bracket and doesn't currently need any income. He places the property in a NIMCRUT. It makes no current payment to him, as it has no income. This continues for 10 years. In year ten he retires and the trustee sells the property. The settlement is used to invest in income producing assets. The trust now pays him the unitrust percentage, which is 7%. The trust is making 11%. The makeup provision of the NIMCRUT can now be used to pay him additional payments to make up the payments that weren't received in the earlier years. He now has additional retirement income at a time when he may be in a lower tax bracket.

4.76.5.4.1.2.3  (04-13-2015)
"Flip" Unitrust

  1. Another variety of unitrust is called the "flip" trust. This trust starts out as either a NICRUT or a NIMCRUT. On the occurrence of a specific event set forth in the trust document, it "flips" or converts automatically to a straight fixed percentage unitrust.

  2. Treas. 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.

  3. 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 isn't discretionary with, or in the control of, the trustees or any other persons.

  4. Treas. 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 aren't considered to be discretionary with any person. This list isn't all inclusive.

  5. 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. A flip qualifying under the requirements of the IRC 664 regulations won't constitute an act of self-dealing, including trust document reformations occurring under the effective date provisions of Treas. Reg. 1.664-3(a)(1)(i)(f).

4.76.5.4.2  (04-13-2015)
Charitable Lead Trusts

  1. The charitable lead trust (CLT) (defined in IRC 170(f)(2)(B)) 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.

  2. Charity comes first. The trustee pays the remainder interest in the trust to private interests, often the grantor or the grantor's heirs.

  3. In a non-grantor CLT, the trust pays the tax on income from the trust. The grantor doesn't 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.

  4. In a grantor CLT, the grantor pays the tax on the income from the trust. 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. Such trusts are inter vivos trusts.

  5. All charitable lead trusts are irrevocable. In addition, no net income and net income markup variants are permitted.

  6. There are no minimum or maximum payout rate limitations. The 10% test present for charitable remainder trusts doesn't apply to charitable lead trusts. The trust document will either allow or disallow additional contributions.

4.76.5.4.2.1  (04-13-2015)
Charitable Lead Annuity Trusts

  1. In a charitable lead annuity trust, the trust pays a uniform payment to the charity. A grantor establishes the trust to benefit the remainder beneficiary, as it is usually the grantor or the grantor's designee. Any appreciation of property remains in the trust to benefit the remainder beneficiary.

  2. At the end of charitable lead annuity trust's term, the corpus and any income in the trust transfer to the remainder beneficiary. This means that the property could revert to the donor or pass to other non-charitable beneficiaries. The trust's term may be limited to a set number of years, the lifetime of either the donor, the donor's spouse, or a lineal ancestor (or spouse of a lineal ancestor) to all of the non-charitable beneficiaries.

  3. The trustee determines the amount paid to the charity based on the initial fair market value of the assets placed into the trust. Income and asset appreciation become part of the corpus. As a result, the payment to the charity becomes a smaller percentage of the trust's value over time.

  4. To determine the present value of the annuity, use the rate listed in the Section 7520 Interest Rates for the month in which the grantor establishes the trust. For guidance on how to compute the present value of the annuity, see Pub 1457, Actuarial Valuations Version 3A.

  5. In a CLAT, the presence of a provision permitting additional contributions to the CLAT is uncommon. Once funded, the donor can't claim additional charitable contributions. See Treas. Regs. 1.170A-6(c)(2)(i), 20.2055-2(e)(2)(vi)(a) and 25.2522(c)-3(c)(2)(vi)(a).

  6. For examples of a charitable lead annuity trust document, see Rev. Proc. 2007-45, 2007-29 I.R.B. 89 and Rev. Proc. 2007-46,2007-29 I.R.B. 102.

4.76.5.4.2.2  (04-13-2015)
Charitable Lead Unitrusts

  1. In a charitable lead unitrust (CLUT), the trust pays a percentage of the trust's assets to the charity. The trust annually revalues the assets to determine the amount to pay to the charity. The trust document specifies the percentage amount to pay to the charity.

  2. In a CLUT, the trust assets grow or shrink, depending on the type of asset, the income generated (if any), and the fluctuation in market values, all of which affect the computation of the amount paid to the charity. The following table illustrates the relationship between return on investment (ROI), the fixed percentage amount, and the remaining assets paid to the non-charitable beneficiary:

    If: Then:
    ROI is positive and consistently greater than the percentage payout amount The FMV of the assets at the end of the trust term are greater than the original FMV.
    ROI is positive but consistently less than the percentage payout amount The FMV of the assets at the end of the trust term are less than the original FMV.
    ROI is always negative The larger the loss on ROI, the less the final FMV of the assets. In all such situations, the FMV will be less than the original FMV of assets in the trust.
  3. When the return on investment is negative or less than the required percentage amount, the trustee pays the difference out of corpus. If the return on investment exceeds the payment to the charity for the year, the trust pays income tax on the excess.

  4. For examples of a charitable lead unitrust document, see Rev. Proc. 2008-45, 2008-30 I.R.B. 224 and Rev. Proc. 2008-46, 2008-30 I.R.B. 238.

4.76.5.4.3  (04-13-2015)
Pooled Income Funds

  1. Public charities establish and maintain pooled income funds to:

    1. Pay income to the grantor or an individual beneficiary named by the grantor.

    2. Pass the remainder interest to charity.

  2. The grantor contributes property to a commingled fund (pooled income). Yearly, the charity pays out income earned by the fund to each donor or other named beneficiary in proportion to the assets contributed. On the death of the donor or other named income beneficiary, a portion of the assets attributable to the income interest severs from the fund and transfers to the charity.

  3. There are a number of differences between a CRT and a PIF.

    1. For the PIF, the income beneficiary receives his full proportionate share of all trust accounting income earned by the PIF.

    2. There is no predetermined annuity or fixed percentage payment amount.

    3. Because the payment is based on income, there is never any invasion of corpus. If the fund earns no income, it makes no payment for the year.

    4. The exempt organization manages the PIF (usually with the assistance of a professional investment company). Virtually anyone, including the grantor can manage or be a trustee for a CRT.

    5. From the grantor's perspective, a CRT is much more flexible but a PIF has the advantage of simplicity.

  4. Pooled income funds (PIF) file Form 5227. However, a PIF created before May 27, 1969, won't file Form 5227 provided no amounts were transferred to the PIF after that date. If the PIF has any taxable income, gross income of $600 or more (regardless of taxable income), or a beneficiary who is a nonresident alien, the PIF files Form 1041. If the PIF isn't required to distribute currently all the income to beneficiaries, then PIF files Form 1041-A.

4.76.5.5  (04-13-2015)
Preaudit Procedures

  1. Before contemplating an audit of a trust, review the training publications, Training 10920-102, Fiduciary / Abusive Domestic Trusts (Participant Guide) and Training 33341-102, Income Taxation of Trusts and Decedents' Estates (Participant Guide).

  2. For guidance on domestic trusts from the Small Business/Self Employed (SB/SE) perspective, visit the Trusts (Domestic) web page. The links on the left side of the page include news, contacts, job aids, and court cases. Among the job aids are issues papers and an audit technique guide.

  3. If the trust filed Form 990-PF, review IRM 4.76.4, Private Foundations. When first reviewing the Form 990-PF, follow the procedures outlined at IRM 4.76.4.6, Pre-Examination Procedures. With respect to all cases, follow the guidance in IRM 4.75.10, Pre-Audit Procedures for general case development.

  4. For a line by line analysis of Form 1041, see Exhibit 4.76.5-1. For a line by line analysis of Form 5227, see Exhibit 4.76.5-2.

  5. If the trust has an ownership interest in any entity, pull Integrated Data Retrieval System (IDRS) research on those entities, using command code TRDBV to review any income or employment tax returns, and command code BMFOLU to view any payroll reports.

  6. When composing the initial information document request, consider asking for the following items:

    1. A complete copy of the trust instrument, including all attachments, schedules and any amendments made to date. (Treas. Reg. 1.6012-3(a) requires a trustee to furnish these documents to the IRS upon request.)

    2. A completed and signed Form 56, Notice Concerning Fiduciary Relationship, for the current trustee or trustees.

      Note:

      Where a trust instrument appoints more than one trustee, the names of all trustees must appear on Form 56 and all must sign the form. This requirement doesn't apply if the trust instrument provides that fewer than all have authority to sign agreements and bind the trust.

    3. All trustees' minutes and resolutions, from the inception of the trust to the present. These include records regarding the appointment, resignation, or termination of trustees, all assets transferred into the trust and the ownership of all certificates of beneficial interest.

    4. The identification of all former and current trustees, from the inception of the trust to the present. (Includes the name, address and telephone number, both business and personal for each trustee.)

    5. A listing of all certificate holders (beneficiaries) of the trust, including name, address, and Social Security Number or Employer Identification Number.

    6. Bank statements, deposit slips, debit/credit memos and cancelled checks for all trust accounts, whether U.S. and foreign, including checking and savings for the audit year(s).

    7. All accounting books and records for the trust for the year(s). Records should include but aren't limited to check registers, disbursements journals, receipts journals, general ledger, and other workpapers used in the preparation of the tax return(s) and financial statement(s).

    8. A list of all entities in which the trust holds an ownership interest.

    9. Payroll ledger and related records for the audit year(s).

    10. Copies of any lease agreements entered into or in effect during the audit year(s).

    11. Loan documents, including promissory notes, deeds of trust, security agreements, financial statements, etc., for all loans entered into or in effect during the audit year(s).

    12. Records to establish the basis of all assets held by the trust, whether acquired from the grantor or otherwise, from the inception of the trust through the end of the audit year. This includes invoices, purchase agreements, and the names and addresses of the persons who transferred property to the trust. For property acquired from the grantor, this includes information showing the grantor's basis in the property immediately before the transfer.

    13. Records for sales or other transfers of property from the trust during audit year(s).

    14. A statement explaining the purpose of any businesses operated within the trust. If someone who isn't a trustee manages the business, the statement would need to include that person's name, address, Social Security Number and explain the extent of their ability to control the funds and other property of the trust.

    15. Copies of any contacts for business services to be rendered by the trust during audit year(s).

  7. In drafting the initial interview, consider asking the following:

    Sample Questions:
    1. When was this trust created?
    2. Why was this trust created (for what purpose)?
    3. How did you find out about trusts?
    4. Were any tax benefits explained to you?
    5. What made you think the information was accurate?
    6. Did you consult with an attorney or CPA? If so, whom? If not, why?
    7. What advice did they give you? Was it written? Provide copies.
    8. Who assisted you in the formation of this trust? (get names of everyone involved in the creation of the trust)
    9. Was a trust "package" used? If so, who was it purchased from?
    10. What services did they provide?
    11. How much were you charged for these services?
    12. Do you have a copy of the invoice for services rendered?
    13. Who paid for the services?
    14. How were the services paid for?
    15. Was this amount deducted? If so, where?
    16. Did you receive any promotional materials or instructional manuals? If yes, describe and provide copies.
    17. What assets were contributed or transferred into this trust, and by whom?
    18. Was control of these assets given up? If so, who controls them now?
    19. What, if anything, was received in exchange for these assets?
    20. Did you file gift tax returns reporting the assets transferred into the trust? If not, why? If so, provide copy of return.
    21. Describe the business activity of the trust.
      a. How is it operated?
      b. Who manages the business?
      c. Who controls the business assets?
      d. Who makes the day-to-day decisions?
      e. Where does the trust do its banking? (Bank, account number)
      f. Who has signature authority over the trust bank accounts?
      g. How are bills approved for payment?
      h. How are the checks actually signed? (i.e. rubber stamped, in advance, by whom, etc.)
    22. Do you hold any position with respect to this trust? (general manager, agent, employee)
    23. Are you compensated by this trust in any way?
    24. Do you have possession or use of any of the trust's assets?
    25. Does the trust pay rent for any property? If so, what is rented and for what amount?
    26. Does the trust make payments for services or products to any other trust?
    27. Were any loans made out of this trust? If so to whom, when, and for what amount?
    28. Have the loans been repaid?
    29. Who appointed the trustee?
    30. Why was he/she selected?
    31. Is there any relationship?
    32. Explain the trustee's participation in the operation of the business.
    33. Please provide the names (and TINs) of any and all trusts associated with this trust. Name, TIN, trustee, protector, beneficiaries, domestic or foreign.
    34. Please provide the names and TINs of all other trusts in which you have any type of involvement. (i.e. grantor, investor, trustee, beneficiary, protector, manager, etc.)

4.76.5.6  (04-13-2015)
Field/Office Correspondence Audit Procedures

  1. Conduct a careful review of the trust instruments. The trust instrument should identify the purpose of the trust, the property transferred, and the appointment and authority given to the trustees. Some trust instruments may discuss the role of a "protector" or similar device to allow the beneficiaries to retain control over the trustees. This person has the power to remove a trustee at the direction of the beneficiary, who may be the grantor.

  2. Direct questions to the person involved in the operation of the business. In particular, determine who has control over the bank accounts, makes the day-to-day decisions, and has use and control over trust assets. Does the trustee exercise control over the business operations?

  3. Question taxpayers regarding how they were introduced to trusts as a method of doing business. This could indicate whether a knowledgeable professional was advising them or they were sold a trust package from a promoter of trusts that advocates tax avoidance.

  4. For Forms 990-PF, see IRM 4.76.4.7, Field/Office Correspondence Exam Procedures, for procedures to follow in addition to those provided in:

    • IRM 4.75.11, On Site Examination Guidelines

    • IRM 4.75.12, Required Filing Checks

    • IRM 4.75.13, Issue Development

  5. If needing to adjust a Form 1041, visit the Estate and Gift Tax Share Point site to obtain a copy of the Form 1041 Workcenter and its user guide. The Excel template generates a Form 4549, Income Tax Examination Changes, for use in an audit report.

  6. If you encounter an issue that falls under the jurisdiction of Estate and Gift Tax, request assistance via the Specialist Referral System website.

4.76.5.7  (04-13-2015)
Case Closing Procedures

  1. Revocation procedures don't apply to IRC 4947(a)(1) and 4947(a)(2) trusts.

  2. Even though an IRC 4947(a)(1) trust may be treated as an IRC 509(a)(3) supporting organization, the trust may lose such recognition and instead be treated as a private foundation. Final adverse determination letter procedures apply in such situations.

    Example:

    An IRC 4947(a)(1) trust previously qualified for recognition as an IRC 509(a)(3) supporting organization (operated in connection with a supported organization). After the implementation of the Pension Protection Act of 2006, the trust no longer qualified due to the elimination of the alternative responsiveness sub-test #2. The trust would now be treated as a private foundation.

  3. In audits of IRC 4947(a)(1) and 4947(a)(2) trusts, there may be several related issues to resolve:

    • Employment tax cases such as worker reclassification, fringe benefit treatment, and unreported amounts.

    • Income tax cases (Forms 1041, discrepancy adjustments).

    • Excise tax cases (gaming and/or Chapter 42 taxes).

  4. Discuss with your group manager whether to close the related cases separately at the earliest opportunity, or to close them together.

  5. A Form 990 (IRC 4947(a)(1) trusts only) can close as a no change/no change with advisory if there is no modification to the foundation status.

  6. A Form 990-PF can close as a no change/no change with advisory if there is no modification to the IRC 4940 tax or foundation status. See IRM 4.75.16, Case Closing Procedures for case file assembly and other common closing procedures.

  7. For agreed cases involving employment, income, or gaming excise taxes:

    1. Issue a report of examination.

    2. Secure the agreement.

    3. Collect payment or complete a request for an installment agreement. See IRM 4.75.16.

    4. Prepare the appropriate closing letter. See IRM 4.75.15, Closing Letters and Reports of Examination.

    5. Close the case to your manager, who in turn closes it to Examination Special Support (ESS).

  8. For agreed cases involving Chapter 42 taxes:

    1. Request correction.

    2. Obtain verification of correction.

    3. Correction made: Issue report of examination..

    4. Correction not made: Treat as unagreed. Go to paragraph IRM 4.76.5.7 (12).

    5. Secure the agreement on Form 870-E, Waiver of Restriction on Assessments and Collection of Deficiency and Acceptance of Overassessment.

    6. Collect payment and/or complete the installment agreement request.

    7. Prepare the appropriate closing letter.

    8. Close the case to your manager, who in turn closes it to ESS.

    Note:

    If planning to impose excise taxes on the trustee(s) (foundation manager(s)), issue a Thorne letter. See IRM Exhibit 4.76.4-16 for sample language used in a Thorne letter for a theoretical IRC 4945 scenario. Consult with Area Counsel for pre-issuance review of the Thorne letter.

  9. For cases requiring correction, follow the procedures below:

    1. If correction is acceptable, issue the acceptance letter. See Letter 5305.

    2. If correction is inadequate or unacceptable, issue the rejection letter. See Letter 5306.

    3. If uncorrected, determine whether additional time is needed for correction.

    4. Grant an extension of time with managerial approval for the correction to be made.

    5. If uncorrected as of the end of the extension date, close as unagreed, even if the taxpayer previously signed an agreement to the 1st tier tax on Form 870-E.

  10. For agreed cases involving foundation status modification:

    1. Secure Form 6018, Consent to Proposed Action.

    2. Obtain a statute extension, if less than 180 days remaining on the statute of limitations.

    3. Prepare a Form 3198-A, completing the Mandatory Review/Operations, Planning & Review section.

    4. Close the case to your manager, who closes the case to Mandatory Review.

  11. For agreed cases involving terminations of the trust, see IRM 4.75.16.5.10, Terminations.

  12. For unagreed cases, regardless of the type of tax or action (termination/foundation status modification):

    • Obtain a full copy of the tax form under protest showing the date received, if not already present in the file or on the Reporting Compliance and Case Management System (RCCMS). Use Online SEIN if obtaining a Form 990-PF or a filed Form 4720.

    • Issue a formal audit report with the appropriate waiver/agreement form(s).

    • Issue a Thorne letter if proposing excise taxes on the trustee(s) (foundation manager(s)). (See IRM Exhibit 4.76.4-16 for sample language used in a Thorne letter for a theoretical IRC 4945 scenario.)

    • Ensure that there are 455 days remaining on the statute of limitations when closed from the group.

      Note:

      Effective September 2, 2014, all cases received in Appeals require 365 days remaining on the assessment statute of limitations.

    • Prepare a Form 3198-A, completing the Mandatory Review/Operations, Planning & Review section.

    • Verify that a formal protest to Appeals is valid. See IRM 4.76.5.7 (13). If invalid, secure a valid protest.

    • Prepare and issue a full rebuttal to any protests.

    • Close the case to your manager as unagreed (with or without protest.)

    Note:

    If applicable, consider offering to enter into a Fast Track Settlement prior to issuing the formal report of examination. Acceptance of a request to enter into fast track negotiations requires both agent and manager approval. See IRM 4.75.15.14 for Fast Track Settlement procedures.

  13. A valid protest contains the following elements:

    • The taxpayer’s name, address, Employer Identification Number (EIN) and a daytime phone number

    • A statement that they (the taxpayer) want to protest the proposed determination

    • A copy of the 30-day letter showing the findings that they disagree with (or the date and IRS office symbols from the letter)

    • An explanation of their reasons for disagreeing, including any supporting documents

    • The law or authority, if any, on which they are relying

  14. The protest must also contain a valid jurat statement: "Under penalties of perjury, I declare that I have examined this protest statement, including accompanying documents, and to the best of my knowledge and belief, the statement contains all relevant facts, and such facts are true, correct and complete." Representatives submitting the protest must also include a substitute declaration stating that the representative prepared the protest and any accompanying documents, and personally knows (or doesn't know) that the statement of facts in the protest and any accompanying documents are true and correct. Organization officers or representatives may sign the protest. (Pub 892)

  15. For unagreed cases subject to IRC 7428 declaratory judgment procedures, prepare an administrative record. See IRM 4.75.32, Declaratory Judgment Cases And The Administrative Record.

Exhibit 4.76.5-1 
Form 1041 Line By Line Pre-Audit Analysis

Types of Entities

Simple trust:

  • Charitable contributions aren't deductible.

  • Capital gains shouldn't be included in distributable net income (schedule D, line 16, column 1).

  • The trust must distribute all ordinary income currently, and the taxed is on the beneficiaries whether or not distributed.

  • Returns showing tax merit further consideration, unless the tax is based entirely on capital gain.

Complex trust:

  • If the Schedule D indicates that distributable net income includes capital gains, and return isn't final, treat this as a large, unusual, or questionable (LUQ) item.

  • If the distribution deduction (line 18) exceeds the adjusted total income (line 17), deem the issue of accumulated income distribution as an LUQ item.

Grantor type trust:

  • Look for an attachment stating name of grantor and types of income to be reported on Form 1040.

  • Check the Form 1040 if the Form 1041 reports large amounts of income to see if these amounts carry over properly to the individuals’ returns.

Pooled income fund: Check for charitable deduction issues.

Entity Information

With respect to the name of the trust, titles containing the following terms may be indications of sham entities:

  • Asset management

  • Business

  • Enterprises

  • Equipment

  • Equity

  • Holding

  • Incorporated

  • Leasing

  • Machinery

  • Resources

  • Services

  • Unincorporated

  • Vehicle

Consider the following as additional potential sham entity indicators:

  • The same trust and/or trustee name appears on various related or unrelated trusts.

  • The trust has a name with abbreviations in the title, especially one with no discernible meaning.

  • The trust has a name ending in Co. that suggests a company.

  • The name includes Heritage Asset, Family Charitable or Family.

  • The name includes UBO (Unincorporated Business Organization) or Pure Trust.

With respect to the beneficiary(ies), the following may be indicators of sham entities:

  • Beneficiaries are trusts or foreign trusts.

  • Beneficiary is a trust but lists a SSN instead of an EIN (could be the SSN is actually an EIN.)

  • Beneficiary SSN or EIN is missing.

  • Beneficiary and trustee EIN’s appear to be sequenced (go 10 up and 10 down).

  • Beneficiaries are UBI’s (Units of Beneficial Interest) rather than names.

With respect to fiduciaries, the following may be unusual:

  • The return lists a trust as the fiduciary

  • The fiduciary and the beneficiary are the same.

In regards to preparers, the following items may trigger LUQ classification:

  • The same preparer prepares related trust returns.

  • The preparer didn't sign the Form 1041 or didn't list a SSN or EIN.

  • The preparer is connected to known promoter.

  • The preparer is a trust.

  • The preparer's address and the address associated with the preparer's EIN are inconsistent.

On the topic of returns, consider the following as possibly unusual:

  • There are multiple returns for one taxpayer or address.

  • For returns with no Schedules K-1, check whether the trust claimed the income distribution deduction.

  • The tax returns have a post office box as an address but don't have a bank as trustee.

  • The trust didn't file a gift tax return (Form 706) in initial year.

  • Personal service returns.

    Example:

    Chiropractors, dentists, insurance agents, real estate agents, day care operators, etc.

Final elements of the entity information to consider include:

  • Concealment of the identity of grantor, trustees, and beneficiaries.

  • The entry "religious objection" in place of an EIN/SSN.

  • Omitted information (date created, name of fiduciary or beneficiary, etc).

  • Current creation dates (1994 forward).

  • Initial or final year return is checked.

  • The trustee is also a trust.

  • Any indication of tax haven country involvement.

Income

Each type of income retains its character in the entity and when distributed to any beneficiary. The trust doesn't distribute losses except for the final year. Any time the income is from a trust entity, this may indicate a tier usage situation.

Line # Title Issue
1 Interest income Look for netting of losses against interest, dividend and/or capital gains
2a Total ordinary dividends
2b Qualified dividends
3 Business income or (loss) Generally a trust can’t operate a trade or business. If there is a Schedule C, treat the schedule as a LUQ item.
4 Capital gain or (loss) Issue may be related to basis or related party transaction.
5 Rents, royalties, partnerships, other estates and trusts Consider whether personal residence "rental" or unallowable passive activity loss. Trusts aren't entitled to the $25,000 deduction for rental real estate. No losses can be passed through to the beneficiary.
6 Farm income or (loss) May be active business that should be reported as a sole proprietorship, corporation or partnership.
7 Ordinary gain or (loss) Issue may be basis or related party transaction.
8 Other income May be used to report management fees, fiduciary fees or amounts from other trust. Amount but not source may be listed to hide identity of source. Consider negative entries such as net operating losses being deducted by the trust.

Deductions

If the trust has tax exempt income, the trust must allocate expenses for various deductions.

Line # Title Issue
10 Interest Personal interest isn't deductible, i.e. revolving charge accounts; personal notes for money borrowed from a bank, credit union or other persons; installment loans on personal use property; interest attributable to underpayments of federal, state or local income taxes. Interest that is paid or incurred on indebtedness allocable to a trade or business, including rental activity, should be deducted on the appropriate line of Schedule C, E or F.
11 Taxes Non-deductible taxes include federal income taxes, estate, inheritance, gift, and most state and local taxes except for property taxes.
12 Fiduciary fees Large fiduciary fees may indicate a potential issue, such as unreasonable fees, and/orpayments made to the grantor.
13 Charitable deduction Significantly large charitable contribution deduction may indicate the trust’s attempt to transfer monies to a related entity. Review Trust Agreement for authorization of contributions. Simple trust may not take a charitable deduction. Consider that the wrong box (simple verse complex trust) may have been checked.
14 Attorney, accountant, and return preparer fees Large fees may indicate a potential issue, such as: unreasonable fees, allocation between the estate tax return (Form 706) and the fiduciary income tax return (Form 1041), and payments made to the grantor. Hidden trust package fees may be buried in other line item expenses.
15a Other deductions not subject to the 2% floor Review for the following:
• NOL’s claimed with no explanation provided.
• NOLD in excess of net income.
• Losses deducted by trust.
• Personal expenses deducted.
• Funeral expenses, not deductible.
• AMT preference items
Note: Investment advisory fees are subject to 2% floor and are preference items for AMT purposes.
Additional items not subject to 2% floor include:
• Non-business casualty and theft losses
• Net operating losses.
• Fiduciary’s share of depreciation, depletion, and amortization not deducted elsewhere on the return
• Deductions in respect of a decedent.
Audit tip: Deductions subject to the 2% floor are often misclassified into this category.
15b Net operating loss deduction Check for AMT preference items. If there is an entry on this line there should be an entry on the AMT schedule.
15c Allowable miscellaneous itemized deductions subject to the 2% floor Expenses subject to the 2% floor include safe deposit box rental, collection fees, investment advisory fees, and appraisal fees.
19 Estate tax deduction If deduction claimed, review Form 706. Review the computation. If not attached, request it.
20 Exemption Simple trust is limited to $300. Complex trust is limited to $100. Decedent’s estate is limited to $600. No exemptions allowed in the final year for an estate.

Schedule A

A simple trust can't take a charitable deduction. If it is determined that the trust isn't a simple trust, reduce the exemption from $300 to $100.

For all charitable deductions, was the contribution made to a qualified organization as defined in IRC §501(c)? Was it actually made?

If line 13, (charitable deduction), is greater than line 9, (total income), excess may be disallowed. You can't create or increase a net operating loss with a charitable deduction. The charitable deduction is limited to 100% of gross income. Gross income not previously distributed or deducted is includible in the limitation amount.

If a Form 1041-A wasn't filed, consider asserting late-filing penalty on the trust.

Is there an allocation for the charitable deduction as related to tax exempt income?

For a pooled income fund, if there is a deduction for a charitable contribution, select the return to verify that the deduction is calculated at net present value rather than fair market present value. See Regs for net present value tables.

Large charitable contributions deduction may indicate the trust’s attempt to transfer monies to a related entity.

Review Trust Agreement for authorization of contributions.

Audit Tip: If Schedule A has an entry for an amount permanently set aside for charitable purposes and the trust was created on or after October 2, 1969, no deduction is allowable for that amount. If there is an IRC §642(c) election attached to the return, was the election properly filed per Treas. Reg. 1.642(c))-1(b). If not, disallow the deduction. If the election was properly filed, were the amounts actually paid to qualified charitable organizations in a subsequent year? If not, disallow the deduction.

Audit Tip: A trust is claiming to be a charitable trust or split-interest trust, was tax exempt status approved by the I.R.S.? If not, no deduction is allowed. If tax exempt status was approved but the trust isn't operating as a charitable entity (e.g., is paying expenses of the grantor or the grantor’s family,) propose revocation.

Schedule B

If IDD exceeds Distributable Net Income - NTEI, throwback provisions could apply. (Income Distribution Deduction, Distributable Net Income, Net Tax Exempt Income)

In general, except for the final year, the percentage of fees allocated to tax-exempt income isn't deductible on the 1041. (Classification tip: If yes is checked on line 1 of Other Information (located at the bottom of page 2 of the 1041) then there is tax- exempt income and an allocation computation needs to be made to lines 10, 12, 14 and 15 of the Deductions area on the front of the 1041).

If an income distribution deduction is claimed, ensure K-1’s are attached. (Ensure EIN/SSN information is included.) Where a large income distribution deduction is claimed, check the beneficiary returns to ensure the income has been properly reported. If beneficiaries aren't listed, the beneficiaries may not have picked up income. (Check K-1s).

Normally an estate isn't required to distribute all income currently. Unless the 65 day rule has been elected, all distributions must be made within the year in order to be deductible. (65 day rule applies to complex trusts as well).

No losses or excess deductions allowed to be distributed unless in termination year.

In the year of termination, all income and losses are deemed distributed. Each item retains its character upon distribution (i.e., ordinary income, capital gain, passive, active, etc.)

If capital gains are being distributed on Schedule D (line 16 column one) and Schedule B (Line 3) in a year other than the termination year, perfect the return.

If there is an Income Distribution Deduction and Schedule B hasn't been completed, select the return for perfection.

Audit Tip: Review the trust agreement to ensure distributions are made per the terms of the document. If the trustee refuses to cooperate, then the trust is probably an abusive trust.

Schedule C

An active business shouldn't operate in a trust. Any Schedule C reported on a Form 1041 should be considered for audit.

Exception:

Trusts containing a decedent’s business and trusts in bankruptcy.

Questionable items:

  • Does the name of the trust contain the same name as the trustee and/or beneficiary? (Refer to the Entity section above.)

  • Does the name of the trust include names such as "enterprises" , "resources" or similar titles?

  • Does the same trustee appear on various related or unrelated trusts?

  • Is the beneficiary another trust?

  • Does the beneficiary have a foreign address?

  • Are there any wages or management fees paid?

  • Is the PIA Code on Schedule C 8888?

  • Was the trust created recently?

  • Is the preparer known for setting up abusive trusts?

  • Does the Schedule C show a loss which is providing tax benefit to the trust? If so, a passive loss issue may be present.

  • Does the trust pass out the Schedule C loss to the beneficiaries? If yes, are K-1’s included with the return?

  • Are personal expenses deducted?

    Example:

    Mortgage interest, utilities, personal residence depreciation.

  • Is the business address different from the trust address or other return.

Does the return show an assignment of income?

  • Does it appear that the trustee and/or beneficiary are doing the work?

  • Are the gross receipts generated from personal service? Assignment of income isn't allowed and all income must be reported at the 1040 level.

  • Is the Schedule C activity management, consulting or "making loans for profit" ? (These may be coming from other Schedule Cs.)

  • Are there few expenses?

  • Is the PIA code of the activity a personal service such as chiropractor, doctor, insurance agent, real estate agent, etc.?

What type of expenses are incurred? Is there a large rental expense or other type of expense that could be paid to a related party?

Schedule D

The Uniform Principal and Income Act considers capital gain income and losses as corpus in most cases. Most states have adopted the act. However, the trust document may give the trustee power to change this allocation. Capital gain income from an installment sale made by a decedent represents income in respect of a decedent. For that reason, the basis of the asset sold doesn't step up to the date of death value and the capital gain income is the same as that reported by the decedent prior to his death. Treat income in respect of a decedent as corpus and not as part of distributable net income. If the date acquired for property listed on the Schedule D is the same date as the trust created date, the trust’s basis in the assets is generally the grantor’s basis plus any gift tax paid by the grantor.

Capital losses can only apply against capital gain income or any other income designated as corpus under the Uniform Principal and Income Act.

Capital gain income can be part of distributable net income only where the terms of the instrument provide for the distribution of corpus.

If the trust distributes capital gain income, the trust lists the amount on Schedule B, line 3 and Schedule D, line 16, column 1.

Select all returns where the capital loss shown on line 4 is greater than $3,000.

Select all returns with an entry on line 4 if Schedule D is missing.

If the trust is in its final year and it is passing out a capital loss to the beneficiaries, the beneficiaries must retain the capital classification of these losses. Select the trust return and the beneficiaries return to ensure the losses are being properly limited.

Schedule D: Simple Trusts

The trust must distribute all income to the beneficiaries. Capital gain income isn't distributable to the beneficiary and is taxable to the fiduciary. If the trust claims to have made capital gain distributions, the trust has changed to a complex trust for that taxable year. Check the trust agreement to see if the trustee has the power to distribute corpus. In the year of termination, the trust may distribute capital gain income or any unused capital loss to the beneficiaries.

Schedule D: Complex Trusts

The trustee distributes income at his/her discretion. The trust may be able to distribute capital gain income based upon the governing instrument. If distributing capital gain income, the trust reports it on Schedules B and D. Where the return shows large gains, select the return for audit to make sure the trust treats the capital gains properly in accordance with the Trust Agreement. In the year of termination, the trust may distribute capital gain income or any unused capital loss to the beneficiaries.

Schedule D: Grantor Trusts

All items of income and deductions are taxable to the grantor directly under IRC 671 - IRC 678. The grantor’s personal return should show any capital gains or losses on Schedule D.

Schedule E

In general, a Schedule E loss is passive. The trust can’t distribute or deduct the loss. Trusts may not take the $25,000 rental real estate loss. If the return is the final year trust return with Schedule E losses and there is no Form 4797 indicating a sale, the beneficiaries can’t take the losses. The trusts add the losses to the basis of the Schedule E activities’ assets on the trust return. The beneficiary to whom the trust distributes the property accounts for the adjusted basis for determining his/her gain or loss on his/her eventual sale of the property.

Note:

Land rent, interest, dividends, and royalties aren't passive income. (IRC 469.)

Rental Real Estate Losses:

  • What is the nature of the rental property?

  • Is the address of the rental property the grantor’s residence’s address?

  • Is the address of the rental property another trust’s address?

  • Does it appear that the rental property is personal use property?

  • Does it appear that the rental income is coming from a related entity?

  • Is land rent used to offset rental real estate losses?

  • Are royalties used to offset rental losses?

Other Loss Issues:

  • Are interest, dividends, and royalties entered on Form 8582, Passive Activity Loss Limitations, as passive income used to offset passive losses?

  • Was the rehabilitation credit or low income housing credit taken without passive income?

    Note:

    The taxpayer must have passive income to use the credits.

  • Is the income/loss from a partnership or S-corporation?

  • If the trust owns an interest in an S Corporation, partnership or trust, how did the trust acquire the interest? (Potential gift tax issue.)

  • Was the rental property or partnership interest gifted and losses taken upon its disposition?

  • Was the rental property or partnership interest sold to a beneficiary?

  • Does the back of the Schedule E show other trusts?

For amounts categorized as non-passive the trustee must actively participate.

Passive Losses

The following is a discussion of Form 1041 in light of the passive loss limitations.

Rental losses (almost in their entirety) and business losses in which the fiduciary fails to actively or materially participate generally can't reduce interest, dividends, capital gains or any other investment income. The trust suspends such losses on Form 8582. The participation of the trustee or fiduciary determines whether the activity is passive or non-passive. If the trustee/fiduciary is a bank trust officer, losses are almost always passive. The amount of participation by any of the beneficiaries is inconsequential.

Line # Title Issue
3 Business income or (loss) The trustee/fiduciary must be actively participating in the day-to-day operation of the business. In addition, should the business be operating in the trust?
5 Rents, royalties, partnerships, other estates and trusts Rental income is passive regardless of whether the trust generates income by the rental of property or equipment. No $25,000 loss is allowable to a trust. A trust isn't a "natural person."
5 Rents, royalties, partnerships, other estates and trusts The trustee/fiduciary must actively participate in the day-to-day operation of the business. Look for out of state EIN’s and any indication that the partnership (or S- corporation) is real estate based. If necessary, pull a BRTVU (Business Return Transaction File View (IDRS)) for the entity in question and check the PIA code. If the trust is a limited partner or minority shareholder, the losses are probably passive.
6 Farm income or (loss) The trustee/fiduciary must be actively participating in the day-to-day operation of the farm. In addition, should the farm be operating in the trust?
7 Ordinary gain or (loss) The trust uses Form 4797 to report gains and losses on dispositions of assets used in a business or rental. This could reflect passive or non-passive income/losses.
8 Other income A NOL may be a passive loss carryforward. This would be applicable to any NOL’s. NOL’s can only be composed of losses created from lines 1 through 8. Administrative expenses can't create or increase an NOL.
Passive losses can't be distributed to a beneficiary. Check the K-1’s for this distribution. A portion of the suspended passive losses can be used in the Form 1041 tax calculation if the property/entity in question was completely disposed of during the tax year. The gain on the sale of a passive activity creates passive income, assuming that the activity was still passive in the year of disposition. Gains flowing through from other entities, such as partnerships or S-corporations, can be passive income if the involvement is passive.
The rental of leased fields, parking lots, campgrounds and trailer parks isn't passive income, and can't be used to offset any passive losses.

Schedule F

As a general rule, a trust isn't allowed to operate an active trade or business. In a decedent’s estate an active business should be wrapped up within a reasonable period of time, generally 2-3 years. Farm land rental isn't a Schedule F activity. This should generally be reported on Schedule E. See IRC 469(c)(7)(C). Trusts may not pass losses through to the beneficiaries except in year of termination.

Farm Loss Issues:

  • Is the activity an ongoing business?

  • What is the nature of the business?

  • Does it appear to be a legitimate farming activity?

  • Is the PIA Code on Schedule F 8888? PIA 8888 means unable to classify.

  • Is the address on Schedule F and K-1’s the same? This is an indicator that personal expenses may be deducted.

  • Are there any wages or management fees paid? Could be to another trust or to the grantor or beneficiary.

  • What types of expenses are incurred?

  • Is there a large rental expense or other type of expense that could be paid to a related party?

  • Does the Schedule F show a loss which is providing tax benefit to the trust? If so, a passive loss issue may be present.

  • Does the trust pass out the Schedule F loss to the beneficiaries?

  • Are Schedules K-1 included with the return?

  • Is there interest expense claimed? Could be personal.

Schedule K-1

Items on the Schedule K-1 that may warrant further review:

  • No Schedule K-1 attached when line 18 shows a distribution.

  • Beneficiary is another trust.

  • Trustee is also the beneficiary.

  • Beneficiary has a foreign address (especially a known tax haven address).

  • Beneficiary is a trust, but lists an SSN instead of an EIN.

  • Beneficiary SSN or EIN is missing.

  • No beneficiaries listed.

  • Items erroneously present on the Schedule K-1

    Example:

    Losses or credits except in the final year return.

  • Charitable contributions listed (not permitted.)

  • Review any handwritten entries on a computer generated Schedule K-1.

  • Compare the Schedule K-1 entries against the Form 1041. If the trust made a distribution, check the corresponding EIN/SSN to verify the reporting of the distribution.

Exhibit 4.76.5-2 
Form 5227 Line By Line Pre-Audit Analysis

Items in the Heading:

Box E: Note whether it is an initial or final return, if so the trust must complete Part III of Schedule A.

Box F: Trust creation date is the date the trust first received assets.

Box G: If trust has substantial unrelated business taxable income, then question the validity of the CRT.

Part I Income and Deductions

Lines Notes
1-3 CRTs typically only report interest, dividend and/or capital gain income (or losses). The trust generally distributes most or all of this income to the income beneficiary(ies).
4-7 Flow-through income generally retains same character as it had at the initial tier. Rents and royalties are common; other sources listed aren't common. Entity shouldn't be claiming a net operating loss.
9-13 The trust only reports capital gains as income if the trust instrument states that capital gains are to be included in income, otherwise the trust adds them to corpus.
17-23 Trustee, attorney, accountant, and return preparer fees are very common. Charitable deduction isn't common, unless it is a charitable lead trust.
24-26 Allocable deductions: If there is nontaxable income, then it is critical the trust properly allocates deductions to it proportionate to the amount of the nontaxable income divided by the total amount of income.

Part II Schedule of Distributable Income

This schedule tracks the distributable income that the trust eventually must pay to the income beneficiaries of the trust. Ordinarily, this income is mostly distributed in the current year, so that there wouldn't be much carried over from prior years. However, if the trust is a net income with makeup provision charitable remainder unitrust (NIMCRUT), then there typically would be a significant carryover amount on Line 27.

The income categorizes into three tiers of income:

  • Tier 1: ordinary

  • Tier 2: capital gain

  • Tier 3: nontaxable

This is also the order by which the trust must distribute income:

  1. The trust must first deplete ALL of the income from Tier 1.

  2. The trust then distributes ALL of the income from Tier 2.

  3. Then if there is still income left, the trust treats it as Tier 3 (nontaxable).

Note:

There is also a Tier 4 not reflected in this schedule, which is return of capital and nontaxable to the recipient.

The amounts on Line 29 are transferred to Schedule A, Part 1-A.

Part III-A Distributions of Principal for Charitable Purposes

In general, the trust should only complete this section if it is the final year and the CRT is making final distributions to the charitable remainder interest, or the entity is a charitable lead trust, so the trust must make distributions from principal sometimes to fulfill the payout requirement to the charity.

Part III-B Accumulated Income Set Aside and Income Distributions for Charitable Purposes

This section should rarely contain amounts, as Congress eliminated the permanent set-aside deduction for post-1969 trusts. A CRT may claim a charitable deduction for qualified amounts paid to charitable organizations not deemed to be a distribution to one of the beneficiaries. The trust would have to pay this amount from the income of the CRT, and not from corpus. (IRC 642(c))

Part IV Balance Sheet

Look for items that you would ordinarily look for when auditing a Form 990 or Form 990-PF.

There should generally only be investment-type assets.

If a business appears to operate through the CRT, consider excise taxes.

CRTs are subject also to the private foundation excise taxes, so closely review loans to/from officers.

Watch for large reductions in FMV of assets without cause. The income payout amount for a CRUT is based on the net FMV and can fluctuate year-to-year.

Parts V-A and V-B

If the trust checked the "Yes" box on Line 63, review the trust instrument to assure that it also reflects that the entity is a "NIMCRUT." Also, verify that Line 67a is correct. The trust eventually pays this amount to the income beneficiaries. Reconcile the amount reported as much as possible to the amounts reported for "Undistributed Income from prior tax years" (line 27) in the preceding years.

Line 66a is a "loophole" for not reporting flow-through income from a flow-through entity, such as a LLC or partnership. If the flow-through entity doesn't flow-through any income items (i.e. cash, property), then the fiduciary accounting income of the CRT would be zero. (IRC 643(b))

This allows for a deferral of reporting the income from the flow-through entity for many years, with the understanding that the trust eventually has to pay it to the CRT. There are no checks and balances in-place to assure that the trust eventually pays out the income.


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