Guidance Under Sections 642 and 643 (Income Ordering Rules), 34670-34672 [E8-13611]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 73, Number 118 (Wednesday, June 18, 2008)]
[Proposed Rules]
[Pages 34670-34672]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E8-13611]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-101258-08]
RIN 1545-BH66


Guidance Under Sections 642 and 643 (Income Ordering Rules)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed amendments providing guidance 
under Internal Revenue Code (Code) section 642(c) with regard to the 
Federal tax consequences of an ordering provision in a trust, a will, 
or a provision of local law that attempts to determine the tax 
character of the amounts paid to a charitable beneficiary of the trust 
or estate. The proposed regulations also make conforming amendments to 
the regulations under section 643(a)(5). The proposed regulations 
affect estates, charitable lead trusts (CLTs) and other trusts making 
payments or permanently setting aside amounts for a charitable purpose. 
This document also provides notice of a public hearing on these 
proposed regulations.

DATES: Written or electronic comments must be received by September 16, 
2008. Outlines of topics to be discussed at the public hearing 
scheduled for October 8, 2008, at 10 a.m., must be received by 
September 18, 2008.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-101258-08), Room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
101258-08), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC; or sent electronically via the Federal 
eRulemaking Portal at https://www.regulations.gov (IRS REG-101258-08). 
The public hearing will be held in the IRS Auditorium, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Vishal Amin, at (202) 622-3060; concerning submissions of comments, the 
hearing, and/or to be placed on the building access list to attend the 
hearing, Richard Hurst, at (202) 622-2949 (TDD telephone) (not toll-
free numbers) or e-mail at Richard.A.Hurst@irscounsel.treas.gov.

SUPPLEMENTARY INFORMATION: 

Background

    This document contains proposed amendments to 26 CFR part 1 under 
section 642 of the Code. Section 642 was added to the Code under the 
Internal Revenue Code of 1954 (68A Stat. 215). Section 642(c) of the 
Code provides that an estate or trust (other than a trust meeting the 
specifications of subpart B) shall be allowed a deduction in computing 
its taxable income any amount of the gross income, without limitation, 
which pursuant to the terms of the governing instrument is, during the 
taxable year, paid for a purpose specified in section 170(c) 
(determined without regard to section 170(c)(2)(A)).
    The regulations under Sec.  1.642(c)-3 provide guidance concerning 
adjustments and other special rules for computing the charitable 
contributions deduction. The regulations under Sec.  1.643(a)-5 provide 
guidance concerning rules for computing the amount of tax-exempt income 
included in distributable net income. These proposed regulations 
clarify the existing regulations under Sec. Sec.  1.642(c)-3(b) and 
1.643(a)-5(b). Section 1.642(c)-3(b)(2) provides that, in determining 
whether an amount of income paid to a charitable beneficiary includes 
particular items of income not included in gross income (for example, 
tax exempt income), provisions in the governing instrument will control 
if they specifically provide as to the source out of which amounts are 
to be paid to the charitable beneficiary. In the absence of specific 
provisions in the governing instrument or in local law, the amount of 
income distributed to each charitable beneficiary is deemed to consist 
of the same proportion of each class of the items of income of the 
estate or trust as the total of each class bears to the total of all 
classes.
    Section 1.643(a)-5(b) provides rules for reducing the amount of 
tax-exempt interest includable in distributable net income when tax-
exempt interest is deemed to be included in income paid, permanently 
set aside, or to be used for the purposes specified in section 642(c). 
As similarly provided in Sec.  1.642(c)-3(b), Sec.  1.643(a)-5(b) 
provides ``[i]f the governing instrument specifically provides as to 
the source out of which amounts are paid, permanently set aside, or to 
be used for such charitable purposes, the specific provisions control. 
In the absence of specific provisions in the governing instrument, an 
amount to which section 642(c) applies is deemed to consist of the same 
proportion of each class of the items of income of the estate or trust 
as the total of each class bears to the total of all classes.''
    The IRS and the Treasury Department believe that the current 
regulations under Sec. Sec.  1.642(c)-3(b) and 1.643(a)-5(b) require 
that such a specific provision in a governing instrument or in local 
law that identifies the source(s) of the amounts to be paid, 
permanently set aside or used for a purpose specified in section 642(c) 
must have economic effect independent of income tax consequences in 
order for the specific provision in the governing instrument or in 
local law to be respected for Federal tax purposes. This belief is 
based on the structure and provisions of Subchapter J as a whole, as 
well as on an analysis of the existing regulations with their 
interrelated cross-references. Section 1.642(c)-3(b) and Sec.  
1.643(a)-5(b) refer to examples in Sec. Sec.  1.662(b)-2 and 1.662(c)-4 
to illustrate the rules of Sec. Sec.  1.642(c)-3(b) and 1.643(a)-5(b). 
Section 1.662(b)-2 provides that, in determining the character of 
amounts distributed to a beneficiary when a charitable contribution is 
made, ``* * * the principles contained in Sec. Sec.  1.652(b)-1 and 
1.662(b)-1 generally apply.'' Section 1.652(b)-1 provides that ``[i]n 
determining the gross income of a beneficiary, the amounts includible 
under Sec.  1.652(a)-1 have the same character in the hands of the 
beneficiary as in the hands of the trust.'' Section 1.652(b)-2(a) 
elaborates on the general principle in Sec.  1.652(b)-1 by providing 
that the amount distributed to a beneficiary and includible in gross 
income under Sec.  1.652(a)-1 generally consists of the same proportion 
of each class of items included in the trust's distributable net income 
(DNI) as the total of each such class bears to the total DNI. These 
principles are repeated in Sec.  1.662(b)-1. In addition, Sec.  
1.652(b)-2(b) defines the exception to this rule by providing that 
``[t]he terms of the trust are considered specifically to allocate 
different classes of income to different beneficiaries only to the 
extent that the allocation is required in the trust instrument, and 
only to the extent that it has economic effect independent of

[[Page 34671]]

the income tax consequences of the allocation.''
    Section 1.681(a)-2(b)(2) provides guidance on the method of 
allocating gross income to unrelated business income that is not 
deductible under section 642(c). This regulation provides that 
``[u]nless the facts clearly indicate to the contrary * * *'' the 
payment to charity consists of the same ratio of unrelated business 
income as the ratio of unrelated business income to all of the trust's 
taxable income. Examples given in this regulation confirm that a 
specific allocation of income items will be recognized when such 
specific allocation has economic effect independent of its tax 
consequences, such as when the amount of the charitable distribution 
will be dependent upon the amount of the class of income.

Explanation of Provisions

    The IRS and the Treasury Department believe that the chain of 
references discussed above requires that a specific provision of the 
governing instrument or a provision under local law has economic effect 
independent of income tax consequences in order to be respected for 
Federal income tax purposes, and that this principle applies throughout 
Subchapter J. To make this concept clearer and easier to understand, 
the proposed regulations amend the regulations under section 642(c) to 
add the principle of economic effect directly into the language of the 
regulation itself, rather than being incorporated by reference to other 
regulation provisions. Thus, the proposed regulation will amend the 
regulations under section 642(c) to confirm that a provision in a 
governing instrument or in local law that specifically provides as to 
the source out of which amounts are to be paid, permanently set aside 
or used for a purpose specified in section 642(c) must have economic 
effect independent of income tax consequences in order to be respected 
for Federal tax purposes. If such provision does not have economic 
effect independent of income tax consequences, income distributed for a 
purpose specified in section 642(c) will consist of the same proportion 
of each class of the items of income as the total of each class bears 
to the total of all classes. See Sec.  1.642(c)-3(b)(2).
    As an example, CLTs pay an annuity or unitrust amount to a charity 
for a determinable period, measured by a term of years or by reference 
to the life of one or more individuals. See section 170(f)(2)(B). At 
the end of the term, the remainder passes to one or more non-charitable 
beneficiaries. CLTs may earn various types of income (such as ordinary 
income, capital gains, unrelated business tax income and tax-exempt 
income) in any given taxable year. Some trust instruments attempt to 
source the payments to charity so as to maximize the tax benefits to 
the trust and beneficiaries. For example, the governing documents might 
include a provision directing that the charity's annuity or unitrust 
payment be made first out of ordinary income and capital gains in order 
to minimize the trust's tax liability. Thus, the trust attempts to 
retain the unrelated business taxable income and tax-exempt income (for 
which no section 642(c) deduction may be claimed or for which the 
deduction is limited by section 681). Such a provision in the governing 
instrument does not have economic effect independent of the income tax 
consequences, because the amount paid to the charitable beneficiary is 
not dependent upon the type of income it is allocated. Rather, such 
amount is the same regardless of the source of the income. An annuity 
payment is a fixed amount from year to year, and a unitrust amount is 
based upon a predetermined percentage of the trust's value. Thus, the 
amount of each type of income the trust earns is irrelevant to the 
amount the charity is entitled to receive.
    Accordingly, a provision under local law or in the governing 
instrument of a CLT that provides that the payment to charity (eligible 
for a deduction under section 642(c)) is deemed to consist of 
particular classes of income, determined on a non-pro rata basis, will 
not be respected because such a provision does not have economic effect 
independent of income tax consequences. Instead, such a payment to a 
charity will consist of the same proportion of each class of the items 
of income of the trust as the total of each class bears to the total of 
all classes. See Sec.  1.642(c)-3(b)(2). This proposed amendment to the 
regulation serves only to confirm the economic effect requirement of 
the current regulations.
    The proposed regulations also similarly clarify the corresponding 
language in Sec.  1.643(a)-5(b).
    Finally, the proposed regulations remove Sec.  1.642(c)-3(b)(4) 
because the provisions of section 116 were repealed by the Tax Reform 
Act of 1986 (Pub. L. 99-514).

Proposed Effective/Applicability Date

    The regulations, as proposed, apply to trusts and estates for 
taxable years beginning after the date final regulations are published 
in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
these regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Therefore, a Regulatory Flexibility Analysis is not required. 
Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and the Treasury Department also request comments on the 
clarity of the proposed rules and how they can be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for October 8, 2008, at 10 a.m. 
in the auditorium of the Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC. Due to building security procedures, 
visitors must enter at the Constitution Avenue entrance. In addition, 
all visitors must present photo identification to enter the building. 
Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance area more than 30 minutes before the hearing 
starts. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments by September 16, 2008, and an outline of the topics to 
be discussed and the time to be devoted to each topic (signed original 
and eight (8) copies) by September 16, 2008. A period of 10 minutes 
will be allotted to each person for making comments. An agenda showing 
the scheduling of the speakers will be prepared after the deadline for 
receiving outlines has passed. Copies of

[[Page 34672]]

the agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these proposed regulations is Vishal R. 
Amin, Office of the Chief Counsel (Passthroughs and Special 
Industries).

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.642(c)-3 is amended by:
    1. Revising the paragraph heading of paragraph (b) and add a 
heading to paragraph (b)(1).
    2. Revising paragraph (b)(2).
    3. Adding a heading to paragraph (b)(3).
    4. Removing paragraph (b)(4).
    The revisions and additions read as follows:


Sec.  1.642(c)-3  Adjustments and other special rules for determining 
unlimited charitable contributions deduction.

* * * * *
    (b) Determination of amounts deductible under section 642(c) and 
the character of such amounts--(1) Reduction of charitable 
contributions deduction by amounts not included in gross income. * * *
    (2) Determination of the character of an amount deductible under 
section 642(c). In determining whether the amounts of income so paid, 
permanently set aside, or used for a purpose specified in section 
642(c)(1), (2), or (3) include particular items of income of an estate 
or trust, whether or not included in gross income, a provision in the 
governing instrument or in local law that specifically provides the 
source out of which amounts are to be paid, permanently set aside, or 
used for such a purpose controls for Federal tax purposes to the extent 
such provision has economic effect independent of income tax 
consequences. See Sec.  1.652(b)-2(b). In the absence of such specific 
provisions in the governing instrument or in local law, the amount to 
which section 642(c) applies is deemed to consist of the same 
proportion of each class of the items of income of the estate or trust 
as the total of each class bears to the total of all classes. See Sec.  
1.643(a)-5(b) for the method of determining the allocable portion of 
exempt income and foreign income. This paragraph (b)(2) is illustrated 
by the following example:

    Example. A charitable lead annuity trust has the calendar year 
as its taxable year, and is to pay an annuity of $10,000 annually to 
an organization described in section 170(c). A provision in the 
trust governing instrument provides that the $10,000 annuity should 
be deemed to come first from ordinary income, second from short-term 
capital gain, third from fifty percent of the unrelated business 
taxable income, fourth from long-term capital gain, fifth from the 
balance of unrelated business taxable income, sixth from tax-exempt 
income, and seventh from principal. This provision in the governing 
instrument does not have economic effect independent of tax 
consequences because the amount to be paid to charity is not 
dependent upon the type of income from which it is to be paid. 
Accordingly, the amount to which section 642(c) applies is deemed to 
consist of the same proportion of each class of the items of income 
of the trust as the total of each class bears to the total of all 
classes.

    (3) Other examples. * * *
* * * * *
    Par. 3. Section 1.643(a)-5 is amended by revising the text of 
paragraph (b) to read as follows:


Sec.  1.643(a)-5  Tax-exempt interest.

* * * * *
    (b) If the estate or trust is allowed a charitable contributions 
deduction under section 642(c), the amounts specified in paragraph (a) 
of this section and Sec.  1.643(a)-6 are reduced by the portion deemed 
to be included in income paid, permanently set aside, or to be used for 
the purposes specified in section 642(c). If the governing instrument 
or local law specifically provides as to the source out of which 
amounts are paid, permanently set aside, or to be used for such 
charitable purposes, the specific provision controls for Federal tax 
purposes to the extent such provision has economic effect independent 
of income tax consequences. See Sec.  1.652(b)-2(b). In the absence of 
specific provisions in the governing instrument, an amount to which 
section 642(c) applies is deemed to consist of the same proportion of 
each class of the items of income of the estate or trust as the total 
of each class bears to the total of all classes. For illustrations 
showing the determination of the character of an amount deductible 
under section 642(c), see Examples 1 and 2 of Sec.  1.662(b)-2 and 
Sec.  1.662(c)-4(e).

 Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
[FR Doc. E8-13611 Filed 6-17-08; 8:45 am]
BILLING CODE 4830-01-P