rr-06-58.pdf

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Part I

Section 860E -- Treatment of Income in Excess of Daily Accruals on Residual
Interests

26 CFR 1.860E-2: Tax on transfers of residual interests to certain organizations
(Also §§ 511, 664, 702; 1.664-1, 1.702–1, 1.860E–1)

Rev. Rul. 2006-58

ISSUES
If a charitable remainder annuity trust or a charitable remainder unitrust,
as defined in section 664(d) of the Internal Revenue Code (collectively, charitable
remainder trusts), is a partner in a partnership or a shareholder in a real estate
investment trust (REIT), and if the partnership or the REIT has excess inclusion
income from holding a residual interest in a real estate mortgage investment
conduit (REMIC)—
(1) Does the charitable remainder trust have unrelated business taxable
income (UBTI) as defined in section 512, causing the charitable remainder trust
to lose its exemption from tax under section 664(c) for the taxable year?
(2) Is the charitable remainder trust a disqualified organization as defined
in section 860E(e)(5)?
(3) Is the partnership (or REIT) subject to the pass-thru entity tax under
section 860E(e)(6)?
FACTS
In the following situations, Trust TR1
and Trust TR2 meet all the
requirements for exemption from tax under section 664(c) for the taxable year,
except for the possible treatment of excess inclusion income as UBTI under
section 860E(b).
Situation 1

Trust TR1
, a charitable remainder trust, holds a ten percent partnership
interest in Partnership PRS
. Because PRS holds a residual interest in a REMIC,
section 860C(a) requires PRS
to take into account its daily portion of the
REMIC’s net income or net loss. For 2004, a portion of the REMIC net income
taken into account by PRS
was an excess inclusion, as defined in section
860E(c).

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Situation 2

Trust TR2, a charitable remainder trust, holds a ten percent equity interest
in Corporation R
, which has elected, and is qualified, to be treated as a REIT
under subchapter M of the Code. Because R holds a residual interest in a
REMIC, section 860C(a) requires R to take into account its daily portion of the
REMIC’s net income or net loss. For 2004, a portion of the REMIC net income
taken into account by R
was an excess inclusion, as defined in section 860E(c).
R
’s real estate investment trust taxable income (within the meaning of section
857(b)(2), excluding any net capital gain) was zero.
LAW
In general, section 702 requires each partner to take into account
separately its distributive share of partnership items. Section 702(a)(7) requires
a partner to take into account separately its distributive share of a partnership’s
“other items of income, gain, loss, deduction, or credit, to the extent provided in
regulations prescribed by the Secretary.” Section 1.702-1(a)(8)(ii) provides:
Each partner must also take into account separately the partner’s
distributive share of any partnership item which, if separately taken
into account by any partner, would result in an income tax liability
for that partner, or for any other person, different from that which
would result if that partner did not take the item into account
separately.
Section 702(b) provides:
The character of any item of income, gain, loss, deduction, or credit
included in a partner’s distributive share under paragraphs (1)
through (7) of [section 702(a)] shall be determined as if such item
were realized directly from the source from which realized by the
partnership, or incurred in the same manner as incurred by the
partnership.
Section 860E(d) requires REITs, regulated investment companies,
common trust funds, and subchapter T cooperatives, to allocate excess inclusion
income to the shareholders, participants, and patrons. Section 860E(d) provides:
If a residual interest in a REMIC is held by a [REIT], under
regulations prescribed by the Secretary—

(1) any excess of—

(A) the aggregate excess inclusions determined with respect
to such interests, over

3
(B) the real estate investment trust taxable income (within
the meaning of section 857(b)(2), excluding any net capital
gain),

shall be allocated among the shareholders of such trust in
proportion to the dividends received by such shareholders from
such trust, and

(2) any such amount allocated to a shareholder under
paragraph (1) shall be treated as an excess inclusion with respect
to a residual interest held by such shareholder.

Rules similar to the rules of the preceding sentence shall apply also
in the case of regulated investment companies, common trust
funds, and organizations to which part I of subchapter T
[(sections 1381–1383)] applies.

Section 664(c) provides that a charitable remainder trust “shall, for any
taxable year, not be subject to any tax imposed by [subtitle A], unless such trust,
for such year, has [UBTI] (within the meaning of section 512, determined as if
part III of subchapter F [(unrelated business income tax (UBIT) provisions under
sections 511–515)] applied to such trust).”
Section 1.664-1(c) provides:
If a charitable remainder trust has any [UBTI] (within the meaning of
section 512 and the regulations thereunder, determined as if part III,
subchapter F, chapter 1, subtitle A of the Code applied to such trust) for
any taxable year, the trust is subject to all of the taxes imposed by subtitle
A of the Code for such taxable year. . . . The taxes imposed by subtitle A
of the Code upon a nonexempt charitable remainder trust shall be
computed under the rules prescribed by subparts A and C, part 1,
subchapter J, chapter 1, subtitle A of the Code [(sections 641–646 and
661–664)] for trusts which may accumulate income or which distribute
corpus.
Section 860E(b) provides, “If the holder of any residual interest in a
REMIC is an organization subject to the tax imposed by section 511, the excess
inclusion of such holder for any taxable year shall be treated as [UBTI] of such
holder for purposes of section 511.”
Section 860E(e)(6)(A) imposes a tax on certain REITs, partnerships and
other pass-thru entities (as defined under section 860E(e)(6)(B)). Section
860E(e)(6)(A) provides, “If, at any time during any taxable year of a pass-thru
entity, a disqualified organization is the record holder of an interest in such entity,
there is hereby imposed on such entity for such taxable year a tax equal to the
product of--(i) the amount of excess inclusions for such taxable year allocable to

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the interest held by such disqualified organization, multiplied by (ii) the highest
rate of tax specified in section 11(b)(1).” For purposes of section 860E(e)(6),
section 860E(e)(6)(B) defines the term “pass-thru entity” to include any REIT and
any partnership. Section 860E(e)(5)(B) defines the term “disqualified
organization” to include “any organization (other than a cooperative described in
section 521) which is exempt from tax imposed by [chapter 1] unless such
organization is subject to the tax imposed by section 511.”

Section 1.860E-2(b) of the Income Tax Regulations contains rules relating
to the application of the pass-thru entity tax under section 860E(e)(6)(A). Among
other things, § 1.860E-2(b)(4) provides, “Dividends paid by a RIC or by a REIT
are not preferential dividends within the meaning of section 562(c) solely
because the tax expense incurred by the RIC or REIT under section 860E(e)(6)
is allocated solely to the shares held by disqualified organizations.”
ANALYSIS
1. Effect of allocation of excess inclusion income to a charitable remainder trust
on its eligibility for exemption from tax under section 664(c) for the taxable year.
As a partner of PRS, TR1 has a distributive share of the excess inclusion
income of PRS, as determined under section 702(a) and (b). If section 860E(b)
characterizes the excess inclusion income allocated to TR1 as UBTI, TR1 will
lose its exemption under section 664(c) for 2004. Section 860E(b) treats excess
inclusion income as UBTI to the holder of a REMIC residual interest but only if
the holder “is an organization subject to the tax imposed by section 511” (that is,
subject to the UBIT). In the case of a charitable remainder trust, section 664(c)
employs the definitional rules of section 512 and the other UBIT provisions to
determine whether any of the trust’s income is UBTI, but it does not subject the
trust to section 511. (See the discussion below under Issue 2.)
Whether section 860E(b) characterizes the excess inclusion income of
charitable remainder trusts as UBTI should be determined in light of the intent
underlying section 860E and other REMIC provisions. A number of the REMIC
provisions are comprehensive and complementary by design. If a tax-exempt
entity holds the REMIC residual interest, the REMIC provisions ensure the
taxation of excess inclusion income in all events, whether or not the tax-exempt
holder of the REMIC residual interest is a disqualified organization. A
disqualified organization (as defined in section 860E(e)(5)(B)) is a tax-exempt
entity that is not subject to UBIT. Thus, a disqualified organization cannot be
subject to a tax on any excess inclusion income allocable to it. But other tax
exempt entities are generally subject to UBIT and could be subject to a tax on
excess inclusion income, subject to other requirements.
With respect to disqualified organizations, a REMIC is required to have in
place “reasonable arrangements designed to ensure that . . . residual interests in
[the REMIC] are not [transferred to] disqualified organizations . . . .” Section

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860D(a)(6). If an entity nonetheless transfers a REMIC residual interest to a
disqualified organization, section 860E(e)(1) imposes a tax on the transferor.
Further, if a pass-thru entity has a record equity owner that is a disqualified
organization, the pass-thru entity must pay a tax on the amount of excess
inclusion income that is allocable to the disqualified organization. Section
860E(e)(6)(A). With respect to other tax-exempt entities (which are not
disqualified organizations), section 860E(b) generally provides that, if a tax-
exempt entity that is subject to the UBIT holds a REMIC residual interest, the
excess inclusion income of that holder is UBTI.
Sections 860E(e)(6)(A) and 860E(b) are complementary provisions that
should be interpreted consistently. If a pass-thru entity (whose equity owners
may be disqualified organizations or other tax-exempt entities) holds REMIC
residual interests, the two sections ensure that the excess inclusion income is
taxable either to the pass-thru entity (under section 860E(e)(6)(A)) or to its tax-
exempt equity owner that is subject to UBIT (under section 860E(b)).
Characterizing as UBTI only the excess inclusion income that is allocable to tax
exempt entities that are actually subject to the UBIT causes the two sections to
operate consistently.
As discussed below, a charitable remainder trust can never be subject to
the UBIT. Accordingly, TR1
’s distributive share of PRS’s excess inclusion
income is not UBTI under section 860E(b).
2. Status of a charitable remainder trust as a disqualified organization
.
TR1 and TR2 are charitable remainder trusts. Under section 664(c), a
charitable remainder trust is exempt from tax under subtitle A of the Code,
including chapter 1, unless it has UBTI for the taxable year (determined as if
UBIT applied to the charitable remainder trust). But if a charitable remainder
trust has UBTI, it loses its section 664(c) tax exemption for the taxable year, and
the resulting tax liability is determined under the trust tax provisions of the Code.
See § 1.664–1(c). Thus, if a charitable remainder trust has UBTI, that trust
becomes an organization subject to the tax imposed by sections 1 and 641 but
not
to the UBIT. Because a charitable remainder trust can never be subject to
the UBIT, it is a disqualified organization, as defined in section 860E(e)(5). As
charitable remainder trusts, TR1
and TR2 are disqualified organizations.
3. Application of the pass-thru entity tax under section 860E(e)(6)(A).
PRS
and R are pass-thru entities, as defined in section 860E(e)(6)(B).
For purposes of section 860E(e)(6)(A), PRS
is treated as having allocated
excess inclusion income to TR1
, a disqualified organization, equal to its
distributive share of the excess inclusion income of PRS determined under
section 702. Because R
’s real estate investment trust income is zero, all of R’s
excess inclusion income is allocable to its shareholders. R
’s excess inclusion
income is allocable to TR2
, also a disqualified organization, in proportion to the

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dividends paid to TR2
(determined without regard to any special allocation to
TR2 of the expense for the tax under section 860E(e)(6)). See § 1.860E–2(b)(4)
(providing an exception to the preference dividend rule in section 562(c)).
PRS
and R have record equity owners that are disqualified organizations,
to which excess inclusion income is allocable. Thus, PRS and R are subject to a
tax under section 860E(e)(6)(A) on the amount of the excess inclusion income
allocable to TR1
and TR2, respectively, at the highest rate specified in
section 11(b)(1).
HOLDINGS
(1) Excess inclusion income allocated to a charitable remainder trust is not
UBTI to the charitable remainder trust and thus does not affect the charitable
remainder trust’s exemption from tax under section 664(c) for the taxable year.
(2) A charitable remainder trust is a disqualified organization for purposes
of section 860E.
(3) A pass-thru entity that has excess inclusion income allocable to a
charitable remainder trust is subject to the pass-thru entity tax under section
860E(e)(6)(A).
DRAFTING INFORMATION
The principal author of this revenue ruling is Anna Kim of the Office of the
Associate Chief Counsel (Financial Institutions and Products). For further
information regarding this revenue ruling contact Anna Kim at 202-622-3735.