Case:

Jim, a retired engineer, and his wife Janet, a retired nurse, are currently considering funding a term-of-years charitable remainder unitrust with the remainder designated for an arts charity. The charity is raising money for the construction of a new building which would house a state-of-the-art theatre and museum. Jim and Janet are active investors and have amassed quite a portfolio over the past few years. In particular, they have investments in a medical services company that has significantly increased in value. They would like to use $800,000 of stock with a cost basis of $100,000 to fund a five-year CRUT with a 15% quarterly payout. However, they believe this company is a great investment with acceptable risk and prefer that the trustee of the CRUT not sell this stock for the duration of the trust. Furthermore, Jim and Janet would like their CRUT payouts to be the actual stock – an in-kind distribution – as opposed to cash payouts. Jim and Janet then wonder if such a distribution would avoid capital gain tax since technically the stock has never been sold.

Question:

Can Jim and Janet accomplish their goal of a tax-free ‘in-kind’ distribution of their medical services stock? What are the tax consequences to the CRUT and to Jim and Janet of such a transaction?

Solution:

Internal Revenue Code Regulation Section 1.664-1(d)(5), which deals with distributions in-kind, states that the amount paid shall be considered as an amount realized by the trust from the sale of the property. With respect to Jim and Janet, their basis in the stock will be its fair market value (FMV) at the time it was paid to them as a trust payout. Therefore, the trust has an amount transferred of $120,000 ($800,000 x 15%) in its first year. The trustee will report for tax purposes $105,000 of the $120,000 as capital gain and $15,000 ($100,000/$800,000 x $120,000) as corpus for tax purposes. Under the four-tier accounting rules of Section 664(b), Jim and Janet will report $105,000 of capital gain and the remaining $15,000 will not be taxable as it is a return of basis. Finally, their new basis in the stock will be $120,000, which was its FMV at the time it was distributed.

Under this plan, Jim and Janet receive a partly tax-free distribution. However, when taking into account their income tax deduction of $364,000, the nearly $500,000 of projected income over the five-year term and an estimated gift to charity of $490,000, they are very pleased with this arrangement. Because of their wonderful generosity, Jim and Janet have the gratification of knowing they helped build a home for the arts that will last a lifetime.