Washington News

On April 19, 2023, the Internal Revenue Service (IRS) published a letter reminding taxpayers who missed the April 18 tax-filing deadline to file quickly. A prompt filing may limit the penalties and interests for those who owe a tax payment. The IRS also reminded over one million taxpayers that they are missing a potential tax refund by not filing. These taxpayers should be using the Free File program or another method to file and claim a refund.

There are several categories of taxpayers who may automatically qualify for extra time to file and pay tax. Military active duty members who are serving in a combat zone qualify for an extension of 180 days. This may also apply to some support personnel in combat zones. Taxpayers living overseas generally qualify for a two-month filing and payment delay. Finally, a number of U.S. regions have been declared a disaster zone by the Federal Emergency Management Agency (FEMA). These taxpayers also may have an extended filing and payment due date.

Filing for taxpayers who potentially may receive a refund is particularly important. Many individuals with modest income qualify for the Earned Income Tax Credit or the Child Tax Credit. If taxpayers have not filed and qualify for a refund, there is no penalty for missing the April 18 deadline. For income qualified taxpayers, the IRS Free File program is available until October 16, 2023. If filing and the taxpayer qualifies for a refund, the IRS recommends you use the "Where's My Refund?" tool on IRS.gov or the smartphone app IRS2Go to track the status of the refund. The refund information updates each night.

If taxes are owed, taxpayers should file promptly and pay the taxes due. The IRS also reminds taxpayers that extending your filing date until October 16 does not mean your tax payment date has also been extended. The taxes should be paid in full as soon as possible.

If a taxpayer is unable to pay the full amount and have paid taxes timely for the past three years, he or she may qualify for abatement of the tax penalty. There is explanation on how to qualify for this penalty relief on IRS.gov.

The best way to pay overdue taxes is through an IRS Online Account or IRS Direct Pay. The Direct Pay or the Electronic Federal Tax Payment System (EFTPS) enables the taxpayer to receive email confirmation for payment. If taxpayers need assistance, finding an available tax professionals in their area may be a good option. There is a Directory of Federal Tax Return Preparers with Credentials and Select Qualifications on IRS.gov.

CRAT Annuities Are Ordinary Income

In Gladys L. Gerhardt et al. v. Commissioner; No. 11127-20; No. 11128-20; No. 11129-20; No. 11146-20; 160 T.C. No. 9, the taxpayers and their children donated low-basis real estate to multiple charitable remainder annuity trusts (CRATs). The CRATs sold the property and the proceeds were used to purchase single premium immediate annuities (SPIAs). The tax preparers claimed that the basis was stepped up on the transfer to the CRAT and a high percentage of the annuity payouts were not taxable.

The taxpayers had been engaged in farming for six decades. As they considered retirement, they learned about a CRAT strategy where they could sell their appreciated farm assets, retire and receive substantial payouts – all with little or no taxes.

The taxpayers transferred farm assets to multiple annuity trusts for both parents and their children. All CRATs were audited by the IRS. While the tax preparers claimed on the IRS Form 5227 trust tax return and the Schedules K-1 sent to annuity recipients the payments were over 95% corpus and nontaxable, the IRS disputed that. Because the farm assets were ordinary income under Sec. 1245, the IRS issued a notice of deficiency and increased the income of Albert and Gladys Gerhardt by $307,656 in 2016 and 2017.

There were similar results for the CRATs for children Alan and Audrey, Jack and Shelley and Tim and Pamela. Taxpayers claimed all CRATs distributed more than 95% nontaxable payments, but the IRS determined that 100% of distributions were ordinary income.

A CRAT is qualified under Sec. 664 of the Code. The transfer of an appreciated asset to a CRT does not trigger recognition of gain. Therefore, a CRAT that complies with Sec. 664(c)(1) may receive appreciated property and sell without paying tax on the sale.

However, under Sec. 1015(a) and (b), the basis of the property in the hands of the donor or grantor is transferred to the CRT. Therefore, the CRT may sell the property without tax, but the CRT accountant will record as gain the amount of the sale that exceeds the adjusted basis.

Under Sec. 664(b), CRAT distributions to recipients will be Tier 1: ordinary income, whether current or previously undistributed, Tier 2: capital gain, whether current or previously undistributed, Tier 3: other income or Tier 4: nontaxable distribution of corpus. The full amount of each category must be distributed before moving to the next category. Income recipients receive a Schedule K-1 that describes the tax character of the distributions.

Taxpayers claimed there was an increase in basis and "all taxable gains disappear and the full amount of the proceeds [is] converted to principal to be invested by the CRAT." The Tax Court stated, "The gain disappearing act the Gerhardts attribute to the CRATs is worthy of a Penn and Teller magic show. But it finds no support in the Code, regulations or caselaw."

Under Sec. 1015(a), the basis of the property transferred to the CRAT "shall be the same as it would be in the hands of the donor." Sec. 72 does not change this rule. Distributions by the CRAT are governed by Sec. 664(b) and Sec. 72 does not override that rule.

Because the property was used for farming and the raising of hogs, the Commissioner determined that they fell under Sec. 1245(a)(3)(A) and (D) as a single-purpose agricultural structure. The recapture of depreciation on Sec. 1245 property is ordinary income. Therefore, the sale of the property used for raising hogs produced ordinary income inside the CRAT. Because the CRAT is required under Sec. 664(b) to distribute all ordinary income prior to moving on to Tier 2 for capital gain, Tier 3 for other income or Tier 4 for principal, all distributions from the CRATs were to be paid out as ordinary income.

There also was an accuracy-related penalty under Sec. 6662(A) for children, Tim and Pamela Gerhardt. The accuracy penalty is not applicable if there is reasonable reliance on professional advice. The standard is that the advisor was a competent professional, the taxpayer provided the necessary and accurate information and the taxpayer relied on the advisor in good faith. Because the taxpayers were not able to provide evidence of compliance with the reasonable cause defense, the penalty was applicable.

Editor's Note: Your editor has assisted numerous farm families with successful retirement plans. Typically, the parents have built substantial equity over six decades and now are prepared for retirement. They are family and charitably oriented. Often, a portion of the farm is transferred to a two-life charitable remainder unitrust (CRUT) for parents, a portion is transferred to a 20-year term of years CRUT to distribute substantial income to children and a portion is sold for cash. There are no net taxes to pay when the plan is created because the tax on the cash out is offset by the charitable deductions. While the distributions are taxable, all family members receive substantial income and the parents enjoy a relaxed and fulfilling retirement.

Creative CRAT Formula Disqualified

In Estate of Susan R. Block et al. v. Commissioner; No. 10618-19; T.C. Memo. 2023-30, the Tax Court determined that an additional provision for net income added to the annuity payout amount caused a charitable remainder annuity trust (CRAT) to be disqualified.

Decedent Susan Block created a revocable trust prior to her passing on October 21, 2015. Article 4 of the trust created a CRAT for her sister, Harriet Katz and her sister's spouse, I.W. Katz. The trust provided that an annuity payment would be paid in the amount equal to $50,000 per year or all net income, whichever was greater. Upon the death of Harriet and I.W. Katz, the CRAT remainder would be distributed to a qualified exempt nonprofit.

The Katz trust paid an annual $50,000 annuity payment to Harriet from 2015 through 2019. The Block estate filed IRS Form 706 and claimed a charitable deduction for the remainder value of the trust. The IRS audited and denied the $352,085 charitable deduction.

A CRAT generally qualifies for a Sec. 2055(a) charitable deduction for the value of the remainder interest. The charitable trust may be either an annuity or a unitrust interest under Sec. 664. The Katz trust stated that the trust would pay "the greater of (a) all net income, or (b) the sum of Fifty Thousand Dollars ($50,000), at least annually."

If a CRAT is not written in conformance with the requirements, Sec. 2055(e)(3)(A) permits a qualified reformation. The remainder interest must be exclusively charitable and payments to noncharitable beneficiaries must be expressed in dollar amounts or a fixed percentage.

A CRAT generally must pay an annuity or a sum certain that is at least 5% but not more than 50% of the initial fair market value. No additional payments may be made to noncharitable beneficiaries. The entire remainder must be transferred to a qualified exempt charity. At the inception of the trust, the value of the remainder interest must be at least 10% of the initial fair market value. Sec. 664(d)(1)(D).

Because the Katz trust included the additional "all net income" provision, the estate attempted to create an amendment. However, this was done after August 2017 and was completed more than 90 days after the estate tax return due date.

The Tax Court determined that the Congressional intent was to have strict construction of the requirements. Sec. 2055(e) reformations must strictly comply with the requirements. Because the reformation was not within the 90-day period under Sec. 2055, it did not strictly comply. The Tax Court determined that an exception was not applicable because Congress requires strict construction. Even though the estate claimed that it had the right under the document to amend the defect effective as of the date of death, the amendment by a trustee does not comply with the federal requirement.

Under Sec. 664(d)(1)(A), the "all net income" provision deviates from the required CRAT sum-certain annuity. The intent of Congress is to remove the ability for a trustee to produce a result that is not certain or manipulable. Therefore, the Katz trust failed to qualify as a CRAT.

Applicable Federal Rate of 4.4% for May -- Rev. Rul. 2023-9; 2023-19 IRB 1 (15 April 2023)

The IRS has announced the Applicable Federal Rate (AFR) for May of 2023. The AFR under Sec. 7520 for the month of May is 4.4%. The rates for April of 5.0% or March of 4.4% also may be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable. During 2023, pooled income funds in existence less than three tax years must use a 2.2% deemed rate of return.