Charitable Remainder Trusts: Robust Yet Underused Scenarios
Charitable gifts, like financial plans, should be tailored to individual circumstances and can often improve the client’s position. This article features novel client situations in which a charitable remainder trust (CRT) is used to save the day. As is true with any creative planning idea, these techniques work in these particular circumstances, but they hopefully will lead you to recommend a charitable gift, particularly a CRT, in situations where it may not be immediately obvious.
Sale of the Building to a Charitable Organization
The requirements for this transaction are fairly simple: an owner of real estate wishes to sell and is open to the concept of a CRT, and a charitable organization wishes to own the real estate. This transaction focuses on a hospital that wanted to acquire the medical office building across the street, and a charitable organization focusing on troubled children that wanted to acquire the office building it rented as administrative space.
The plan is deceptively simple: The owner contributes the building to the CRT, and the organization purchases the building. It is much easier for the charitable organization to decide that it can afford to buy the building when it understands that it will essentially get its purchase price back upon the termination of the CRT. Make certain that there is no legally binding prearrangement between the donor and the charitable organization requiring the purchase of the property. If there is, the IRS might try to attribute the gain to the donor. The safest approach is to have the trustee and the charitable organization negotiate the sale of the building after the trust is created and funded.
Form of Payment—The charitable organization can structure its purchase from the CRT with several different forms of payment. The most simple is to buy the building for cash. This approach allows the CRT trustee to invest the proceeds in securities and otherwise administer the trust as any other CRT.
Occasionally an organization will want to buy the building with a small down payment and a promissory note for the balance. The obvious advantage is that the organization does not have to come up with the full purchase price in cash. At first glance, if the principal and interest payments on the note equal or exceed the payments due to the CRT beneficiary, this approach can work. This scenario works best with an annuity trust, however, where the payments to the beneficiary are fixed (as are the note payments). Used with a unitrust, the fixed note payments pose a problem.
Consider a 6 percent unitrust holding a $2 million note issued several years ago with an interest-only payment of 8 percent. Initially, the interest payments on the note exceed the 6 percent unitrust payment. What happens when interest rates drop to 5 percent? The value of the note jumps, because it is paying well over market rate interest. Unfortunately, although the value of the note (and the 6 percent payment required) increases, the interest payments do not change, and the trust could receive payments that no longer equal the 6 percent unitrust requirement. Even if this problem can be averted, the fact that the CRT is receiving fixed payments essentially negates the growth potential of a unitrust. In addition, the note will require annual valuations, which must be performed by an independent trustee or pursuant to a qualified appraisal.
While trying to use a promissory note for the bulk of the purchase price may be problematic with a unitrust, the donor’s attorney suggested the charitable organization purchase the building by providing half of the price in cash, and the balance in a note. His client was a conservative investor and would, if given all cash, invest half of the portfolio in fixed-income obligations anyway. So, the attorney suggested that the trustee accept the organization’s note as the fixed-income portion of the CRT portfolio. The note, however, would still have to be valued in this scenario.
Trusteeship—Generally, the charitable organization should not be the initial trustee of a CRT holding real estate that it hopes to buy—the potential for breach of fiduciary duty claims is too great. Further, a professional trustee might feel compelled to market the property aggressively to ensure it receives the best price (which can work against the donor and charitable organization arriving at a quick sale at an agreeable price). It is generally better if the donor (or a close family member) serves as the initial trustee through the sale of the property. In the long term, however, the charitable organization should have a measure of control over trusteeship, so it can assure itself that the trust will be administered properly and the trust corpus maintained. Part of the real estate purchase transaction can then include that the donor resign as trustee and appoint the charitable organization as trustee (through, for example, a power of appointment provided in the CRT document).
Designation of Remainder Beneficiary—The donor will often want to retain the right to amend the charitable beneficiary designation, especially if he fears that the charitable organization may not ultimately buy the property. If the organization does purchase the property, it needs assurance that it will remain as the remainder beneficiary. Alternatively, the charitable remainder trust can irrevocably designate the charitable beneficiary and not give the donor the right to change the remainder beneficiary.
Short-term, in this case, is not the abusive short-term, high-payout CRTs of a few years ago, but rather the use of a short-term, low-payout rate CRT as a substitute for an outright gift. The following scenarios introduce the charitable remainder trust as a gift solution to three different problems.
“Cleanse” a Problem Asset—Consider a donor who wishes to give a run-down apartment building in a bad neighborhood to his high school so it could build a new track facility. Not surprisingly, the school does not want to take title. Faced with this situation, the problem was solved with a two-year, 5 percent net-income unitrust to be self-trusteed by the donor. He sold the property in six months, managed the trust conservatively for the next 18 months (with an eye toward not generating too much income), at which point the school got the money for the track facility. The donor’s deduction was approximately 91 percent of the property value, and he even got a little cash back.
In another charitable twist, after the property is sold in six months and before any income has been distributed, the donor could contribute his remaining term interest to the charitable organization and get a second charitable deduction for the actuarial value of the unexpired term.
Retain Donor Control—This technique works well for donors who want to give an asset to a charitable organization but cannot seem to turn over the control of the asset. For example, some entrepreneurs can be persuaded to give shares of their company, but often they feel they know best when those shares should be sold or how the proceeds should be reinvested. If the donor attempts to give the asset to a charitable organization and retain these powers, he may have an incomplete gift problem—no deduction and potential capital gains exposure. Further, even if the charitable organization agrees to take some direction from the donor on these issues, the organization is unlikely to be able to move fast enough to satisfy the donor when he says, “Sell.” If the donor can agree to a future date when he is willing to give up control (for example, three years), a short-term, self-trusteed CRT can give the donor the control he wants. Of course, he would be well-advised to consider his fiduciary duties to the remainder beneficiary when making investment decisions.
Complete the Gift Before the Foundation Is Ready—This example uses the CRT as an alternative gift option for the donor who wished to create a private foundation and fund it with a very significant amount of highly appreciated securities. While most donors in this situation will just form and fund the foundation, doing so in this case would have triggered several problems:
- First, the donor needed time to prioritize his charitable goals and get his foundation grant-making staff up and running. Private foundations must make annual qualifying distributions, and this donor did not want to be rushed into making grants before he and his staff were fully prepared.
- Second, the donor’s securities attorney pointed out that the foundation would be considered an “affiliate” for securities law purposes (because the donor would control the board), triggering certain reporting requirements and/or sale restrictions.
- Third, private foundations are subject to a 2 percent excise tax on net investment income under IRC Section 4940. With a large enough contribution of essentially zero-basis stock, the 2 percent tax can be significant.
The donor’s counsel suggested that the donor transfer some stock to get the foundation started but transfer the majority of the shares to a short-term CRT for the ultimate benefit of the foundation. This transfer would secure the time needed to complete the foundation, and if the donor were willing to have an independent party serve as trustee of the CRT, it would not be deemed an affiliate. Because the CRT is not subject to the excise tax, the donor could also realize substantial tax savings.
Issues—One question common to all of the above situations is “How short a term can you use?” There is no firm answer. However, IRC Section 664(d)(2)(A) provides that a unitrust must run for a life or lives in being or “a term of years not to exceed 20” years. The use of the plural “years” indicates that the CRT must have at least a two-year term.
A second common question is how to minimize the income payable to the donor during the CRT term. Using a net-income (without make-up) unitrust employing a narrow definition of income can help, especially if the trustee invests for growth and not income. Finally, consider adding the charitable organization as one of the income beneficiaries (see Regulation Section 1.664-3(a)(3)).
Sale of a Professional Practice
Many retiring professionals such as doctors, dentists, lawyers and veterinarians have built a valuable practice that can be sold to a new practitioner. Using a CRT to sell such a business involves many of the same issues that arise with any business, as well as one additional issue: the unauthorized practice of the profession. Most states allow only a licensed professional or his/her professional corporation to conduct a professional practice. While a CRT would not appear to be either a licensed professional or a professional corporation, in this instance, permission was granted to transfer a practice into a CRT.
The proposal to the regulatory body was that the professional was going to create a CRT in which he was the sole trustee and initial income beneficiary (with his spouse as successor beneficiary). It was contended that with such a CRT, the professional still held all legal title to the practice (as trustee) as well as all equitable title (as sole income beneficiary). Equally important was the fact that the professional would continue to operate the practice. In other words, the argument focused on the unique nature of a trust. While a trust is a separate legal entity for tax purposes, for most state law purposes it is not so much an entity as a fiduciary obligation imposed on the trustee.
The regulatory body agreed, concluding that there would not be an unauthorized practice problem as long as the professional was the sole trustee and beneficiary for the period of time the practice was held in trust. Obviously, whether this argument will work in other states or with other regulatory bodies is far from clear.
There are many techniques to assist donors in replacing the wealth they have given to charitable organizations when they create a CRT. One technique is for the donors to give part of their annual CRT income to an irrevocable life insurance trust, which in turn buys joint and survivor life insurance. The problem is that the donors are required to forgo part of the CRT income stream, which is one the CRT’s greatest selling points.
Consider a different approach: Use the cash savings generated by the income tax deduction earned from creating a CRT to purchase a single premium life insurance policy. Your clients will often find that the tax savings can buy a policy with a face value of one-third to one-half of the principal contributed to the trust. The attraction of this idea is that it does not reduce the donor’s net cash flow from the CRT. Most clients are more focused on the increased cash flow afforded by a CRT than on the initial income tax deduction. While this technique may not replace the entire amount contributed to the trust, it can be a relatively painless way to recoup some of the gift. Keep in mind that a donor need not purchase insurance equal to the total contributed to the trust, because only a portion of the full amount would have been left after estate taxes in any event.
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