IRS Targets Abusive CRAT Schemes With New Final Regs
As if charitable remainder annuity trusts aren’t complicated enough, there’s now another reason to be cautious when implementing one as part of a client’s estate plan. When done properly, CRATs can be powerful tools to provide income streams to individuals before distributing assets to charity. Taxpayers receive an immediate income tax deduction equal to the present value of the future gift the charity will eventually receive, and taxpayers can preserve the value of highly appreciated assets. Sometimes, however, taxpayers try to take the tax benefits too far and end up on the wrong side of the regulations.
How CRATs Work
On a basic level, a funded CRAT will distribute periodic payments in a fixed annuity amount to the grantor or another non-charitable beneficiary during the trust term, and then at the end of the term, the remainder interest is distributed to one or more charities. The term can be a set number of years (not to exceed 20 years) or one or more lifetimes. CRATs pay no income tax. The fixed percentage payout to the beneficiary must not be less than 5% and not more than 50%, and the actuarially computed value of the charity’s remainder interest must be at least 10%. CRATs are often better suited for a high-interest-rate environment. A higher Internal Revenue Code Section 7520 rate means the value of the annuity is discounted more. This will produce a larger remainder interest passing to charity and a larger available charitable deduction.
‘Dirty Dozen’ List
In 2023, the Internal Revenue Service included misusing CRATs on its “Dirty Dozen” list. In these abusive transactions, taxpayers transfer appreciated property to the CRAT and improperly claim that the basis is increased to fair market value as if the property was sold to the trust. When the CRAT later sells the property, it doesn’t recognize gain because of the stepped-up basis. The CRAT then uses the proceeds to buy a single premium immediate annuity. The taxpayer claims that the remaining payment is an excluded portion representing a return of investment, which would not be subject to tax. In doing so, the taxpayer misapplies the rules under IRC Sections 72 and 664.
Proposed Regs
A year after the scheme appeared on the “Dirty Dozen” list, the IRS released proposed regs. These regs looked for new consequences for irrevocable trusts that paid an annuity to the grantor, with a charitable organization receiving the remaining assets at the grantor’s death or at the end of the term. The final regs became effective July 9, 2026. They identify certain CRAT transactions and substantially similar transactions as listed transactions.
Listed Transaction
According to the IRS website, a “listed transaction” is a structure that’s the same as or substantially similar to one of the types of transactions that the IRS has determined to be a tax avoidance transaction and identified by notice, regulation or other form of published guidance as a listed transaction. The IRS will consider a taxpayer to have engaged in a listed transaction if the taxpayer’s return reflects the tax consequences or a tax strategy described in Treasury Regulations Section 1.6011-4(c)(3)(i)(A).
Specifically with respect to CRATs, a transaction is a listed transaction if: (1) the grantor creates a trust purporting to be a CRAT; (2) the grantor funds the trust with appreciated property; (3) the trustee sells that property; (4) the trustee uses some or all of the proceeds to purchase an annuity; and (5) the beneficiary of the trust treats the annuity payment as if each payment is split into a tax-free return of the original investment and taxable ordinary income instead of carrying out to the beneficiary amounts in the ordinary income and capital gain tiers of the trust. Any taxpayer using this type of structure during a tax year the IRS can still audit has 90 days to file a disclosure. Failure to do so could earn a penalty of $100,000 for individuals with no good faith excuse. The IRS can call the transaction into question unless the taxpayer discloses. At that point, the IRS has 1 year after the disclosure to challenge the transaction.
‘Material Advisors’ Face Consequences
It’s not just the taxpayer who faces consequences if they take part in a listed transaction. Material advisors and other participants must file certain disclosures with the IRS that detail any gift tax consequences. If they fail to disclose, they’ll incur penalties. The IRS website states that a material advisor is anyone who provides material aid, assistance, or advice with respect to organizing, promoting, selling, implementing, insuring, or carrying out any reportable transaction and who directly or indirectly derives gross income in excess of the threshold amount for such aid, assistance, or advice. The threshold for listed transactions is $10,000 for natural persons and $25,000 for all other entities. The threshold for non-listed transactions is $50,000 for natural persons and $250,000 for all other entities. A material advisor may be required to file Form 8918, which is the disclosure statement. Generally, a material advisor must keep a list identifying each entity or individual with respect to whom the advisor acted as a material advisor on a reportable transaction.
Importantly, however, the regs clarify that an organization named as the charitable remainderman isn’t treated as a participant and is exempt from any reporting requirements. The proposed regs requested comments on whether the charitable remainder beneficiary could be a material advisor. While charitable remainder beneficiaries might provide general information about CRATs to the taxpayer, that information doesn’t rise to the level of material aid, assistance or advice. Additionally, the charitable remaindermen don’t usually receive gross income equal to the thresholds for providing that information.
The taxpayer takeaway from these regs is to closely follow the rules governing CRATs and avoid listed transactions. Implementing this type of listed transaction could not only land the taxpayer in trouble, but also a material advisor. When used properly, CRATs can be a great option for individuals and charities, but taxpayers should remember they’re responsible for what’s on their tax returns.
