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).

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.

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 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).

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.

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 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).