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CHARITABLE REMAINDER TRUSTSEXAMPLE 12.15On the death of D, the proceeds of a life insurance policy on D’s life are payable to a CRAT. Theterms of the CRAT provide that, for a period of three years, commencing on D’s death, theCRAT shall pay an annuity amount annually to A, the child of D. After the expiration of thisthree-year period, the remainder interest in the CRAT is to be transferred to a charitableorganization. In year 1, the CRAT receives payment of the life insurance proceeds and pays theappropriate pro rata portion of the annuity amount to A from the proceeds. During year 1, theCRAT has no income.This entire distribution is attributable to a cash contribution (the insurance proceeds) to theCRAT for which an estate tax charitable deduction was allowable, with respect to the presentvalue of the remainder interest passing to charity. Thus, under the rule, the CRAT will not betreated as selling a pro rata portion of the trust assets. The distribution is thus characterized inA’s hands as a tax-free return of corpus. aaFor purposes of IRC § 664(b)(2). This example is based on Reg. § 1.643(a)-8(c), example 3.As to distributions of this nature before the effective date, the IRS announcedthat it has several enforcement options: It may: (1) apply an “appropriate legaldoctrine” to recast the transaction, characterize the distribution as gross incomerather than corpus, or challenge the qualification of the trust; 340 (2) impose the selfdealingtax; 341 (3) subject the trust to the tax on unrelated business income; 342 and/or (4) assess one or more penalties on the participants to the transaction. 343 Thisapproach is nearly identical to that announced in 1994 when attempts were underwayto stop the use of another type of accelerated charitable remainder trust. 344(f) Characterization and Ordering Rules – Proposed RevisionsThe rules for characterizing a distribution from a CRT are in the process of beingrevised, to take into account the differences in the federal income tax rates applicableto items of income. As discussed, 345 a CRT’s income is assigned, in the yearit is required to be taken into account by the trust, to one of three categories: theordinary income category, the capital gains category, or the other income category.Within the ordinary income and capital gains categories, items are alsoassigned to different classes based on the federal income tax rate applicable toeach type of income in the category. Overall, a CRT distribution is treated asbeing made from the categories in the following order: ordinary income, capitalgain, other income, and trust corpus. Within the ordinary income and capitalgains categories, income is treated as distributed from the classes of income inthat category beginning with the class subject to the highest federal income taxrate and ending with the class subject to the lowest federal income tax rate. Thelaw on this point has been made somewhat more complex because of lawchanges in 1997, 1998, and 2003. 346340 That is, challenge the qualification of the trust under IRC § 664.341 See § 12.9.342 See § 3.5.343 See § 10.14.344 Notice 94-78, 1994-2 C.B. 555.345 See § 12.5(a).346 See § 2.15, 2.16(b). 460