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.

PLR 200252096: CRUT – For-Profit Corporation – For-Profit LLC

In PLR 200252096, the Service considered the following situation. A charitable remainder unitrust (“CRUT”) intends to form and fund a wholly-owned for-profit corporation; neither the formation nor the funding will involve the incurring of any debt by the CRUT. It is expected that the corporation will invest in a for-profit LLC that engages in the business of leasing equipment, and which expects to use “debt financing” to pay part of its equipment acquisition costs. The ruling request indicated a number of business reasons for the arrangement, including the sheltering of the CRUT from liability, the ability of the CRUT to invest indirectly with the LLC, and the shielding of the CRUT from UBTI as to the debt-financed property acquisitions of the LLC. The IRS approved of this arrangement, ruling that the CRUT will not recognize UBTI in connection with the corporation’s allocable share under Code Section 704 of the LLC’s income and gains, and that the CRUT’s gain realized on the ultimate sale of its interest in the corporation would not constitute UBTI to the CRUT.

PLRs 2002516016 ff.: CRT – Limited Partnership – Foreign Corporation

The Service considered and approved a somewhat more complex format in PLRs 2002516016 – 018. In the situation considered in these rulings, a CRT is a limited partner in M partnership, which plans to create a foreign corporation, N, and will initially hold all of N’s stock. N is expected to acquire interests in a number of foreign funds, to which N will make capital contributions and in which N will receive minority interests. N may borrow from third parties to finance its commitment to the funds. The business purposes of this arrangement were said to include the following: (1) more flexibility in disposing of interests in the funds, as M will not need to obtain prior consent as to a disposition of N stock (as it would for a disposition of an interest in the funds); (2) the investments will further insulate the CRT from fund liabilities; (3) N will be able to manage M’s investments more efficiently; and (4) this format shelters the CRT from UBTI. The IRS ruled that the CRT will not recognize UBTI under this arrangement, as Code Section 512(b)(17) was not intended to apply to non-insurance income, such as the income derived from the funds, which will be taxed as UBTI-exempt dividends.

PLRs 200315028 ff.: CRUTs – Foreign Corporation – US Partnerships

In what is probably the most complicated structure in this UBTI arena it has yet considered, the Service in PLRs 200315028, 200315032, 200315034, and 200315035, ruled favorably on the following fact pattern: four CRUTs created and funded by the same two individuals intend to create a foreign corporation which will use funds contributed by the CRUTs to purchase interests in US partnerships. The foreign corporation will manage the investment of the CRUTs’ contributions, expected to be all cash, and will purchase interests in US partnerships that use debt financing to acquire investment assets. If the CRUTs owned interests directly in the US partnerships, the debt financing would trigger UBTI to the CRUTs, and would deprive them of exempt status for the years in which they recognized such UBTI. The ruling request specified that all corporate formalities would be followed as to the foreign corporation, and that its assets would be separate from the assets of the CRUTs. None of the CRUTs would incur any debt as a result of these transactions, the request noted. The debt-financed income received by the foreign corporation from the partnerships would either be reinvested by the corporation or distributed to the CRUTs as a dividend. Among the business purposes cited for this arrangement were the advantages of pooling the investment assets of the CRUTs (all of which were formed by the same individuals, as noted), to help reduce costs and provide access to more investment opportunities. Each CRUT was expected to contribute from 10% – 20% of its assets’ value to the foreign corporation. The IRS ruled that the CRUTs would not receive UBTI as a result of these investments and payments, as dividend income does not constitute UBTI. The IRS also ruled that, although because of their common founders, the CRUTs were all technically disqualified persons as to one another under Code Section 4946, this status did not present adverse effects, as the investments will not benefit any other disqualified persons.

Conclusions and Applications

Why didn’t the Service simply reject these indirect investments by the CRTs in enterprises using “debt-financing,” under the “step transaction” rules or similar doctrine? In all three rulings, the Service (and sometimes the representatives of the CRTs themselves) openly noted that, if the CRTs had invested directly in the “debt-financing” enterprises, they would have lost their exempt status for the years in which such investments triggered UBTI. A wag might observe that these rulings suggest that the Service imposes the “step transaction doctrine” only if it has to make the effort to “root out” an indirect series of steps, while if the taxpayers themselves openly call the Service’s attention to the transaction, then there is no problem, and the Service simply lets it pass. Perhaps a more satisfying explanation is that the Service just does not see UBTI in the CRT context as a very serious concern, and is therefore willing to let mildly creative UBTI-avoidance plans go unchallenged. Notable in this context is that the (ever-delayed) “CARE” legislation would greatly soften the impact of UBTI on CRTs, which would not lose their exempt status altogether in years in which UBTI is recognized, but rather would simply pay tax on the UBTI component of their income, a much more sensible approach.

While a CRT is certainly not well advised to carry on its own for-profit trade or business, a passive, indirect investment in an enterprise which uses “debt-financing” should no longer cost the CRT its exempt status, so long as the advisors are familiar with these intriguing new rulings.