Gerald B. Treacy, Jr.

This article was prepared for educational purposes only and may or may not reflect the most current legal developments. All sample provisions herein are for illustrative purposes only and do not constitute a representation or warranty of their appropriateness or suitability for any purposes whatsoever. These materials are not legal advice, and persons should consult an attorney for legal advice pertinent to his or her situation. Individuals seeking clarification should contact Gerry Treacy.

De-UBIT-izing CRTs: Recent Rulings

Charitable remainder unitrusts and annuity trusts (collectively, “CRTs”) are effectively barred from investing in for-profit enterprises holding “debt-financed” assets, under Internal Revenue Code (“Code”) Section 664(c). Under that provision, a CRT forfeits its exemption from federal income tax for any taxable year in which, in the quaint terminology of the tax legislation, “such trust, for such year, has unrelated business taxable income (within the meaning of section 512, determined as if part III of subchapter F applied to such trust).”

While this provision generally blocks CRTs from carrying on their own active for-profit trades or businesses, it can also have the effect of significantly limiting the sorts of for-profit entities in which CRTs may safely invest. The tricky “back door” into unrelated business taxable income (UBTI) which can have so devastating an effect on a CRT’s exempt status, are the “debt-financed income” rules under Code Section 514. Even if the CRT is not so foolhardy as to carry on its own unrelated trade or business, it can still lose its exempt status for the year if it happens to invest in a for-profit business which uses debt-financing to acquire its assets (which is not at all unusual in the business world).

Recently, however, the Service has shown itself to be surprisingly liberal in permitting CRTs to side-step this “debt-financed income” bar, and invest indirectly in enterprises which use debt-financing to acquire their assets. As enunciated in several private letter rulings issued in the last two years, the Service’s position appears to be that, so long as the CRT is not invested directly in the “debt-financing” enterprise, but instead is invested in another entity which in turn invests in the “debt-financing” enterprise, and so long as there are plausible business reasons for this arrangement, the “debt-financing” will not trigger unrelated business income tax (UBIT) at the CRT level. To the surprise of some observers, the Service has, so far, refrained from seeking to challenge these indirect investment arrangements (some of them fairly attenuated and complex, as will be seen) under the “step transaction” doctrine.

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