Widely Promoted CRAT Tax Elimination Scheme Fails to Deliver

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A tax elimination strategy widely promoting the use of a charitable remainder annuity trust to fully escape federal income tax on the sale of appreciated property and to fund tax-free annuity payments to noncharitable beneficiaries of the CRAT hasn’t quite lived up to the promises of its promoters.

This too-good-to-be-true “tax strategy” has now been rejected by the Tax Court and shut down by the US Justice Department, and the names of the taxpayers who used the strategy have been disclosed to the IRS.

The CRAT tax elimination scheme was held out as a strategy whereby highly appreciated property could be transferred by a taxpayer to a CRAT and then sold in a manner that would eliminate the imposition of federal income tax, not only with respect to the gain realized on the sale of the property but also upon the receipt of subsequent annuity payments funded with the sale proceeds.

The scheme was promoted to the public through a variety of channels, including advertisements in newspapers and online media. The steps involved included the following:

• Convincing taxpayers to contribute property to a CRAT usually consisting of appreciated property having a fair-market value substantially greater than its tax cost basis
• Stepping-up the tax cost basis of the appreciated property contributed to the CRAT to its fair market value
• The CRAT promptly selling the appreciated property and then using most of the sale proceeds to purchase an annuity contract under which payments were made directly to the taxpayer who contributed the property to the CRAT
• Reporting to the IRS that the annuity payments funded by the sale proceeds were tax-free distributions of principal

Tax Court Loss

In Gerhardt v. Commissioner, six individuals who share the surname Gerhardt contributed substantially appreciated real property to newly established CRATs, under which they were to receive annuity payments over five years. The appreciated real property was then promptly sold by the trustee of CRATs, who used most of the sale proceeds to purchase single premium immediate annuity contracts, under which the Gerhardts were designated as the recipients of the annuity payments.

Notwithstanding that the proceeds realized on the sale of the real property by the CRATs substantially exceeded its tax cost basis, Form 5227—the split-interest trust information return—filed by the CRATs reported no taxable gain from the sale of the real property. Moreover, the Schedules K-1 in Form 1041 issued to the Gerhardts for the tax years at issue didn’t reflect that the annuity payments carried out any taxable gain attributable to the sale of the property. Therefore, the Gerhardts’ position was that both the sale of the appreciated real property and the subsequent annuity payments funded by the sale proceeds were wholly free of federal income tax.

The Tax Court applied a rather straightforward analysis in rejecting the Gerhardts’ position. First, it recognized that a CRAT is statutorily exempt from income tax under Section 664(c)(1), such that while a taxable gain must be recognized by a CRAT on the sale of appreciated property, the CRAT itself is not subject to tax on such a gain.

The court then recognized that under Section 664(b), the annuity payments made to its noncharitable beneficiaries “carry out [CRAT] taxable income that is subject to tax at the beneficiary level.” It concluded that the annuity payments made to the Gerhardts carried out taxable income required to be recognized by the CRAT upon the sale of the contributed real property, upon which federal income tax should have been paid.

The Gerhardts argued that the tax code “does a lot more than exempt the CRATs from paying tax on built-in gains realized when contributed property is sold.” They claimed it “also relieves them from paying tax on the distributions that were made possible by the CRATs’ realization of the built-in gains” and that “all taxable gains (on the sale of the assets contributed to the CRATs) disappear.” The court, however, found no support for these claims in the tax code, regulations, or caselaw.

DOJ Shutdown

The Justice Department had filed a complaint in the US District Court for the Western District of Missouri against the promoters of the CRAT tax elimination scheme in Gerhardt and other parties involved, alleging that the defendants organized, promoted, or facilitated “an abusive tax scheme” that they claimed legally forgave capital gains tax on income from the sale or disposition of property.

The DOJ, in US v. Eickhoff, said the defendants falsely claimed “that customers who participate in their scheme can sell property” through a CRAT “and thereby eliminate the taxable income that customers would (and should) otherwise lawfully realize.” The DOJ asserted the tax scheme has been used by at least 70 CRATs that has resulted in an estimated $40 million of taxable income going unreported and at least $8 million in tax revenue losses.

The DOJ sought a permanent injunction barring the defendants, individually or doing business through any entity, from promoting the CRAT tax elimination scheme or any other tax avoidance scheme, strategy, plan, or arrangement that claims to eliminate a taxpayer’s federal income tax obligations by reason of participation in the scheme, strategy, plan, or arrangement.

The district court last month ordered the CRAT tax elimination scheme to be shut down in its entirety. The promoters of the scheme were required to pay a combined judgment of $1.5 million and to identify to the IRS the names of their customers who participated in the scheme.

Conclusion

The widely promoted CRAT “tax strategy” used in the Gerhardt case has absolutely no basis in the law and clearly was too good to be true. While a CRAT can be a valuable tax planning tool for taxpayers with substantially appreciated property and a philanthropic intent, it is certainly not a device that can make a taxable gain simply disappear, as was promoted to potential customers of the promoters. This strategy is now clearly on the IRS radar screen and should be avoided by taxpayers at all costs.

The cases are: Gerhardt v. Commissioner, T.C., No. 11127-20, 4/20/23 and US v. Eickhoff, W.D. Mo., No. 2:22-cv-04027, 5/17/23.

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