A Strategy Too Good to be True

typing on computer

Albert and Gladys Gerhardt created a Charitable Remainder Annuity Trust (CRAT) in November 2015. They transferred real property worth $1.8 million to the trust, and reported the transfer on Form 709, the federal gift tax return. The adjusted basis of the property was reported to be $97,517. The trustee sold the property for $1.6 million, then used the proceeds to purchase a Single Premium Immediate Annuity (SPIA) for $1.5 million. The SPIA contract paid the Gerhardts $311,708 every April for five years.

The couple reported the annuity payment as a tax-free return of principal. Their view was that the CRAT was a tax-free entity, not subject to tax on the gain from the sale. They evidently believed that immunized them from taxation as well, rendering the CRAT a tax elimination scheme.

Similar arrangements were made in the same time frame by Alan and Audrey Gerhardt, Jack and Shelley Gerhardt, and Tim and Pamela Gerhardt. All the couples took the same tax position, that their annuity payments were tax-free returns of principal.

The IRS was not amused. Two years into the distribution period, deficiency notices were sent to all four couples. Their cases were consolidated in the Tax Court.

It is true, the Court held, that no gain is realized when appreciated property is transferred to a CRAT, and it is also true that the CRAT itself is not subject to tax when its appreciated assets are sold. But it is not true that the private beneficiaries pay no tax on distributions from the CRAT. “Distributions from a CRAT to income beneficiaries are deemed to have the following character and to be distributed in the following order:

(1) as ordinary income, to the extent of the CRAT’s current and previously undistributed ordinary income;

(2) as capital gain, to the extent of the CRAT’s current and previously undistributed capital gain;

(3) as other income, to the extent of the CRAT’s current and previously undistributed other income; and

(4) as a nontaxable distribution of trust corpus.”

Therefore, the capital gains of the CRATs became taxable to private beneficiaries when they were distributed. The Court upheld the IRS deficiencies [Gladys L. Gerhardt et al. v. Commissioner, 160 T.C. No. 9]. What’s more, an accuracy-related penalty was imposed upon Tim and Pamela, because they failed to meet their burden of proving that they relied upon competent legal counsel for their tax positions.

These taxpayers were duped

Why did these four couples all take these tax positions? This scheme, the CRAT tax elimination strategy, was created and promoted to the public by John Eickhoff, a licensed insurance agent and a senior advisor with Hoffman Associates. They learned of the scheme from him, and he referred them to a CPA for its implementation.

Last February, the U.S. Justice Department filed a complaint against Eickhoff and Hoffman Associates to end their peddling of the CRAT Tax Elimination Scheme. At least 70 other CRATs were organized under the abusive scheme, with an estimated $40 million going unreported, resulting in estimated lost tax revenue of $8 million.

In May, Hoffman Associates and Eickhoff were permanently enjoined from promoting this scheme. Hoffman Associates had to pay a judgment of $1.1 million, and Eickhoff, $400,000.

To get the word out on these abusive tax schemes, the IRS issued News Release 2023-65:

“In abusive transactions of this type, property with a fair market value in excess of its basis is transferred to a CRAT. Taxpayers may wrongly claim the transfer of the property to the CRAT results in an increase in basis to fair market value as if the property had been sold to the trust. The CRAT then sells the property but does not recognize gain due to the claimed step-up in basis. Next, the CRAT purchases a single premium immediate annuity (SPIA) with the proceeds from the sale of the property.

“By misapplying the rules under sections 72 and 664, the taxpayer, or beneficiary, treats the remaining payment as an excluded portion representing a return of investment for which no tax is due.”

The scheme doesn’t work, the IRS warned, and the taxpayer remains liable for all taxes due. Whether the taxpayer has any recourse against the promoter of the scheme was not addressed.

For philanthropically minded taxpayers who own substantially appreciated property, the CRAT continues to be a sound planning alternative to explore. But it will not magically erase taxable gains, and the IRS is on the lookout for claims that it does.

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