Biden Administration Releases Details on Proposed Taxation of Split-Interest Trusts

On May 28, the Biden Administration released a general explanation of its revenue proposals for Fiscal Year 2022. The so-called “Green Book” provides more detail on these proposals than had been available previously. Of especial interest to gift planners, under the heading “Treat transfers of appreciated property by gift or on death as realization events,” pages 62-64 discuss the Administration’s proposed changes to the taxation of capital gain when assets are transferred during life and at death. I reviewed some of these proposed changes regarding outright gifts and bequests of appreciated assets in a previous blog post, but until now there was no detail on how transfers to split-interest gifts would be treated.

After describing that an owner who transfers an appreciated asset, either during life or at death, would realize a capital gain at the time of transfer, the explanation discusses exceptions to that general treatment, saying:

Certain exclusions would apply. Transfers by a decedent to a U.S. spouse or to charity would carry over the basis of the decedent. Capital gain would not be recognized until the surviving spouse disposes of the asset or dies, and appreciated property transferred to charity would not generate a taxable capital gain. The transfer of appreciated assets to a split-interest trust would generate a taxable capital gain, with an exclusion allowed for the charity’s share of the gain based on the charity’s share of the value transferred as determined for gift or estate tax purposes.

The implication for split-interest trusts, which we presume to include charitable remainder trusts (CRTs), pooled income funds (PIFs), and charitable lead trusts (CLTs), appears to be that capital gain allocable to the non-charitable portion would be taxed to the donor at the time of transfer. For example, if a CRT were funded with an asset in which the donor has a $100,000 capital gain and the CRT earned a charitable deduction equal to 60% of the funding amount, the donor would be taxable on $40,000 of the capital gain.

For years, the deferral or avoidance of capital gains tax has been a popular selling point for funding a CRT or PIF with appreciated assets. Applying an immediate tax to some of this gain would reduce this tax incentive and depress donor interest in CRTs or PIFs. The explanation raises some questions, however, whose answers could moderate the effect.

The donor would have a $1 million lifetime exclusion ($2 million per married couple) available to offset the reportable gain. The donor would also have a $250,000 exclusion ($500,000 per married couple) for all residences (not only principal residences). The exclusion under current law for capital gain on certain small business stock would also be available. Donors whose gain is within these exclusions should not be taxed under the new realization rules. Donors who will exceed these exclusions will also face the new capital gains tax with other types of transfers by gift or at death. The ability not to pay tax on the portion of the gain allocated to the charity and offset the remaining gain with a charitable deduction may be relatively appealing.

The excerpt quoted above includes the following:

  1. Capital gain in a transfer by a decedent to a U.S. spouse will not be recognized until the surviving spouse disposes of the asset or dies.
  2. Appreciated assets transferred to charity would not generate a taxable gain.

What does this mean for a CRT or PIF whose income beneficiaries are the donor and the donor’s spouse? Whatever doesn’t go to the donor or the donor’s spouse will go to charity, so arguably no gain should be taxable at the time of the gift in this case. From a tax policy standpoint, the charitable community could point out to Congress that the four-tier taxation that applies to CRTs already ensures that capital gain is taxed unless it goes to charity, so imposing a tax on some of this gain at the outset is unnecessary regardless of who the beneficiaries are. Likewise, for PIFs, income distributions from the trust are already taxable, and the trust almost always allocates capital gains to the charitable remainder.

For grantor lead trusts, the question is whether they will be governed by the timing rules set forth in the proposals for certain other grantor trusts, by the rules set forth for split-interest trusts, or by some combination of the two. For non-grantor lead trusts, as with CRTs and PIFs, the gain allocable to the non-charitable portion of the non-grantor lead trust would be taxable to the donor in the year the trust is created. Most non-grantor lead trusts are lead annuity trusts (CLATs) and many of those are designed to generate an income tax charitable deduction equal to or approaching 100% of the gift principal. In these cases, presumably there would be little or no capital gain for the donor to report when the CLAT is funded since the value of the non-charitable portion would be zero or close to it.

A gift annuity is a form of bargain sale. The percentage of capital gain that must be reported by the donor of a gift annuity already is determined under current law much as is proposed for split-interest trusts. One question is whether gift annuity donors might lose the current ability to spread this gain over the donor’s life expectancy when the donor is the primary annuitant. The proposals do not mention changing this treatment, but with such big changes to capital gain taxation being contemplated, it is worth keeping an eye out for.

How will retained life estates be treated? Will granting a remainder interest to charity with a life estate retained for the donor and/or the donor’s spouse be exempt, as it would seem it should? If not, will the gain exclusion for the charity’s share of the value or the $250,000/$500,000 exclusion for residences be available? The proposals are silent on these questions.

Lastly, the Administration proposes January 1, 2022, as the effective date for these changes. That leaves open a window for donors to make split-interest gifts in 2021 before the new rules, whatever their final form, would take effect.

There’s a lot to digest in the Administration’s revenue plan, and many modifications surely are in store before a final bill is reached. There’s also time for the charitable community to influence what those changes are. The treatment of capital gain in assets used to fund a split-interest trust would be a good place to start.