Rr 2006-58

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Rev. Rul. 2006-58; 2006-2 C.B. 876;
2006 IRB LEXIS 609, *; 2006-46 I.R.B. 876
Revenue Ruling 2006-58
Rev. Rul. 2006-58; 2006-2 C.B. 876; 2006 IRB LEXIS 609; 2006-46 I.R.B. 876
October 27, 2006
[*1]
SUBJECT MATTER: Treatment of Income in Excess of Daily Accruals on Residual Interests
SUMMARY:
A charitable remainder trust held an interest in a partnership. Because the partnership held a
residual interest in a real estate mortgage investment conduit (REMIC), section 860C(a)
required it to take into account its portion of the REMIC's net income, and a portion of that net
income was an excess inclusion under section 860E(c). A second charitable remainder trust
held an interest in a corporation qualified as a real estate investment trust. The corporation
held a residual interest in a REMIC and was required to take into account its portion of the
REMIC's net income, which, for the year in question, was an excess inclusion. The IRS
concluded that the excess inclusion income allocated to the first charitable remainder trust
from the partnership was not unrelated business taxable income (UBIT) and thus did not affect
its tax exemption under section 664(c). Both trusts were disqualified organizations under
section 860E(e)(5) because they could never be subject to UBIT as charitable remainder trusts.
The partnership and corporation, as pass-thru entities, were subject to tax under section 860E
(e)(6)(A) on the amount of the excess inclusion income allocable to the trusts.
APPLICABLE SECTIONS:
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)

TEXT:
Charitable remainder trust; real estate investment trust (REIT). This ruling illustrates the
application of section 860E of the Code where a charitable remainder trust is a shareholder of a real
estate investment trust (REIT) or a partner of a partnership, and the REIT or the partnership has
excess inclusion income.
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?

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(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 [*2] 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).
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 [*3]
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

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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,
[*4] 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

(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 [*5] 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

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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 [*6] 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 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) [*7] 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 [*8] 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 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, [*9] the
pass-thru entity must pay a tax on the amount of excess inclusion income that is allocable to the

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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 [*10] 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 [*11] 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 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 [*12] 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).

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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.

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