California Estate Planning

Transcription

1 California Estate Planning 24 Charitable Remainder Trusts Erik Dryburgh I. INTRODUCTION 24.1 II. EVALUATING USE OF CHARITABLE REMAINDER TRUST A. When To Recommend Charitable Remainder Trust 1. Charitable Intent Appreciated Assets Other Reasons 24.4 B. Disadvantages of Charitable Remainder Trust 1. Irrevocability Lack of Liquidity Difficulties of Administration Compliance With Private Foundation Rules 24.8 a. Self-Dealing Rules 24.9 b. Taxable Expenditures III. EVALUATING FINANCIAL IMPACT TO CLIENT IV. DESIGNING CHARITABLE REMAINDER TRUSTS A. Types of Trusts 1. Charitable Remainder Annuity Trust Charitable Remainder Unitrust a. Standard Type b. Net Income Unitrust (1) Definition (2) Determination of Income (3) Use as Retirement Vehicle c. Comparison of Standard Unitrust and Net Income Unitrust d. Flip Unitrust B. Considerations in Selecting Payout Rate C. Selecting Income Beneficiaries D. Selecting Charitable Beneficiaries E. Selecting Trustee 24.23

2 2 Charitable Remainder Trusts 24.1 V. FUNDING CHARITABLE REMAINDER TRUSTS A. Acceleration of Income B. Assignment of Income C. Trade or Business Issues D. Encumbered Property I. INTRODUCTION A charitable remainder trust is a form of trust that provides payments to one or more noncharitable beneficiaries (i.e., recipients) for their lifetimes or a term of years. On the death of the final recipient or at the end of the term, the trust terminates and the balance of the principal is distributed to charity. A trust remainder interest passing to charity will be deductible for federal and California income, federal estate, and federal gift tax purposes only if it is made in the form of a charitable remainder annuity trust (IRC 664(d)(1)) or a charitable remainder unitrust (or its alternative, a charitable remainder incomeonly unitrust) (IRC 664(d)(2) (3)). This chapter focuses on the question, Should I recommend that my client create a charitable remainder trust? It addresses how to evaluate whether a charitable remainder trust is appropriate (see ), and if so, what form of trust best suits the client s needs (see ). It also covers certain issues raised by the asset used to fund the trust. See This chapter does not discuss the technical issues involved in creating or drafting a charitable remainder trust. For detailed discussion of those issues, see Drafting California Irrevocable Trusts, chap 18 (3d ed Cal CEB 1997). II. EVALUATING USE OF CHARITABLE REMAINDER TRUST A. When to Recommend Charitable Remainder Trust Charitable Intent Clients are often motivated to create a charitable remainder trust because they sincerely want to make a gift to their favorite charity. A charitable remainder trust can be a very tax-effective gift vehicle for accomplishing this purpose. Although a genuine altruistic motive is not a statutory requirement, the lack of charitable intent should send up a red flag. PRACTICE TIP A client without genuine charitable intent should create a charitable remainder trust only after very careful consideration. It is certainly possible to assemble financial

3 3 Charitable Remainder Trusts 24.3 projections that indicate that it will be to a client s financial advantage to liquidate an asset via a charitable remainder trust as opposed to an outright sale, i.e., projections that show the client will net more funds, after tax, on a present value basis by using a charitable remainder trust than by not using a charitable remainder trust. See In the author s experience, however, clients who lack a meaningful charitable motive are more likely to be upset if the financial projections prove to be unduly optimistic and are less willing to tolerate the costs and restrictions generated by a charitable remainder trust. On other methods of charitable giving, see chap Appreciated Assets The classic candidate for a charitable remainder trust is a client with a highly appreciated asset that he or she wishes to sell. The benefits to contributing the asset to a charitable remainder trust and then selling the asset include: The gift to the charitable remainder trust generates an income tax deduction for the value of the remainder interest (IRC 170(a); Rev & T C 17201); The trust s sale of the asset does not generate any current capital gains tax because a qualified charitable remainder trust is a taxexempt entity (IRC 664(c)); The gift to the charitable remainder trust does not trigger gift or estate tax (assuming that the donor, the donor s spouse, or both are the only income beneficiaries); The income beneficiary receives an income stream for life or a term of years; and At the termination of the trust term, assets are distributed to the charities selected by the donor Other Reasons A charitable remainder trust can be an appropriate vehicle in other situations. A parent with a spendthrift child may find that a testamentary charitable remainder trust is a good means of providing income to the child without giving the child access to principal, and will generate a partial estate tax deduction as well. A charitable remainder trust may also be suitable when a mature child is supporting elderly parents and worries that his or her premature death would create a financial hardship for them. Creating a

4 4 Charitable Remainder Trusts 24.5 testamentary trust for the parents might require substantial funds, all of which would be subject to estate tax, even though the parents need is only to receive an income stream for a relatively finite number of years. A testamentary charitable remainder trust payable to the parents can allow enough funds to be allocated to the trust to ensure a substantial income stream, while still generating a substantial estate tax deduction. Unmarried couples often find that creating a testamentary charitable remainder trust allows one partner to leave an income stream to the surviving partner while at the same time generating an estate tax deduction for a portion of the transfer. For couples without children, the remainder gift to charity often is in complete alignment with the decedent s overall testamentary wishes. B. Disadvantages of Charitable Remainder Trust Irrevocability Despite its attractiveness, a charitable remainder trust is clearly not advisable for all clients. Clients must be aware that a charitable remainder trust is irrevocable and many of its terms may not be amended. For example, the income beneficiary is entitled to receive only the stated annual payments. See IRC 664(d). Thus, a client who might need access to the trust s principal would not be a good charitable remainder trust candidate Lack of Liquidity As charitable remainder trusts have become an ever more common planning technique, they are increasingly recommended to clients of relatively modest net worth. Great caution needs to be taken before tying up too much of a client s liquid assets in an irrevocable trust. The limitations of a charitable remainder trust can also pose a problem to an entrepreneurial donor. Such clients need to understand that the charitable remainder trust assets may not be easily available for investment in business opportunities or other creative ventures, given the constraints imposed on the investment of trust funds by the Uniform Prudent Investor Act (Prob C ), the adverse consequences of earning unrelated business income (see 24.27), and the stringent self-dealing rules (IRC 4941, 4947(a)(2); see 24.9).

5 5 Charitable Remainder Trusts Difficulties of Administration The administration of a charitable remainder trust can be burdensome. For example, despite being a tax-exempt vehicle, a California charitable remainder trust must file four tax returns IRS Forms 5227 (Split Interest Trust Information Return) and 1041-A (Trust Accumulation of Charitable Amounts), and California Forms 541-A (Trust Accumulation of Charitable Amounts) and 541-B (Charitable Remainder and Pooled Income Trusts) in addition to providing the beneficiary with IRS and California Schedules K-1. Although there are no firm guidelines, in the author s experience, a charitable remainder trust with an asset balance of less than $250,000 usually requires very efficient administration to be economically viable Compliance With Private Foundation Rules Some of the excise tax provisions imposed on private foundations under Chapter 42 of the Internal Revenue Code also apply to charitable remainder trusts, specifically the rules prohibiting selfdealing (IRC 4941) and taxable expenditures (IRC 4945). IRC 4947(a)(2). NOTE IRS prototype documents (see Drafting California Irrevocable Trusts, chap 18 (3d ed Cal CEB 1997)) also attempt to impose the private foundation prohibitions against excess business holdings and jeopardizing investments, but the Internal Revenue Code clearly provides that these prohibitions are inapplicable. See IRC 4947(b)(3) a. Self-Dealing Rules The self-dealing rules essentially prohibit disqualified persons from engaging in certain prohibited transactions with the trust. See IRC 4941(a)(1). The term disqualified person includes (see IRC 4946(a)(1)(A) (G)): Anyone who is a substantial contributor to the trust (see IRC 4946(a)(1)(A)); Anyone who is a trustee of the trust; Anyone who owns more than 20 percent of an entity that is a substantial contributor;

6 6 Charitable Remainder Trusts Certain family members of someone who is a substantial contributor, trustee, or owner of more than 20 percent of an entity that is a substantial contributor; and Entities in which any of the persons described above have more than a 35-percent interest. Prohibited transactions include (IRC 4941(d)): The sale, exchange, or lease of property; Lending of money, or any extension of credit; Furnishing of goods, services, or facilities; Payment of compensation or reimbursement of expenses, unless the compensation is for personal services that are reasonable and necessary to the trust s purposes and the amount of compensation or reimbursement is reasonable; and Transfer or use of the trust s income or assets (which is a general provision that bars the transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the trust). PRACTICE TIP The self-dealing rules are not based on fairness or the rule of reason, and they can apply even if the transaction is fair to the trust in every respect. As a consequence, a donor cannot rent property held by the trust or purchase an investment held by the trust, even at more than fair market value b. Taxable Expenditures Internal Revenue Code 4945 imposes penalties on taxable expenditures. Although this provision was drafted with private foundations in mind, and thus does not necessarily translate perfectly in the context of a charitable remainder trust, taxable expenditures include amounts paid for (IRC 4945(d)): Lobbying; Attempting to influence the outcome of a public election; Making grants to individuals; Making grants to organizations that are not public charities; and Expenditures other than for charitable purposes III. EVALUATING FINANCIAL IMPACT TO CLIENT The majority of situations in which a charitable remainder trust is proposed involve an asset that is about to be sold. If a client wishes to

7 7 Charitable Remainder Trusts retain the asset, contributing it to a charitable remainder trust will generate an income tax deduction at the cost of imposing significant limitations on the ability to use and deal with the asset due to the trust s irrevocable nature (see 24.5) and the federal self-dealing rules (see 24.9). Although these limitations are acceptable to some clients, many may decide instead to retain ownership of the asset. For clients who are actively considering the sale of an asset, it is relatively easy to prepare projections of the economic consequences of employing a charitable remainder trust. Several companies offer software focusing on charitable remainder trusts and other charitable giving vehicles. The software allows the attorney to calculate the charitable contribution deduction generated by the gift to the trust and the projected after-tax cash flow, using selected earnings, actuarial factors, tax rates, and other assumptions. The attorney can then discount the after-tax cash flow stream back to present value dollars. The present value of the cash flow, when added to the tax savings generated by the income tax deduction, is one measure of the financial benefit to the client from selling an asset via a charitable remainder trust. That amount, when compared to after-tax sales proceeds from an outright sale of the asset, can show the benefit (or cost) of employing a charitable remainder trust. PRACTICE TIP If the attorney does not own charitable giving software, some charities with an active planned giving office will prepare calculations at no cost. The above analysis ignores many important factors, such as the legal complexities and costs of establishing and administering a charitable remainder trust, and the practical consequences to the client of having to live with having a portion of his or her wealth held in a fairly restrictive trust vehicle. It also assumes that the income beneficiary will receive income for the full expected term of the trust (typically the beneficiary s life). If the risk of a premature death is of concern to the client, he or she might consider using a portion of the additional cash flow generated by the charitable remainder trust to purchase permanent life insurance (especially if an irrevocable life insurance trust is employed). Alternatively, a client can protect a portion of the principal contributed to the trust by using the tax savings to purchase a single premium life insurance policy. Often, the deduction generated by using a charitable remainder trust creates sufficient tax savings to purchase a policy with a face value of up to 50 percent of the trust principal. Another technique is to structure the charitable remainder trust to run for life or a term of years (not to exceed 20), whichever is longer.

8 8 Charitable Remainder Trusts See Reg (a)(5), (a)(5). If the income beneficiary dies prematurely, the charitable remainder trust will continue for the balance of the term. The trust document will need to direct the remaining payments if the income beneficiary predeceases the term (e.g., to another named individual or heirs-at-law). NOTE Designing a trust to run for life or a term of years is a technique that works best in a single-life trust. In a joint husband and wife trust, adding other contingent beneficiaries can defeat the gift and estate tax marital deductions otherwise available for one party s transfer of the successive income interest in his or her portion of the trust to the other. See IRC 2056(b)(8), 2523(g). Despite this financial analysis, it should be noted that focusing too intently on the projected economic consequences ignores the positive aspects of making a charitable gift, which is often an important motivation for clients. See IV. DESIGNING CHARITABLE REMAINDER TRUSTS A charitable remainder trust can provide one of several different formulas for determining the amount of the income beneficiary s annual payout. The selection of the payout formula and payout percentage can have a dramatic impact on the income beneficiary s payments and the remainder beneficiary s gift. A. Types of Trusts Charitable Remainder Annuity Trust A charitable remainder annuity trust (CRAT) pays the recipient a fixed annuity, set forth in the trust document as either a fixed dollar amount or a fixed percentage of the initial value of the trust. See IRC 664(d)(1). The amount must be at least 5 percent and not more than 50 percent of the initial net fair market value of the trust. IRC 664(d)(1). This sum may be paid to any person, as defined in IRC 7701(a)(1). If the person is other than an individual, the term of the trust may not exceed 20 years. If the person is an individual, the trust term may run for the life or lives of the individual or individuals in being when the trust is created or for a term not to exceed 20 years. The property remaining in the trust passes to charitable beneficiaries on the recipient s death or the expiration of the term of years. The value of the charitable remainder must be at least 10 percent of the initial fair market value of the trust assets, and the probability that the

9 9 Charitable Remainder Trusts annuity will exhaust the trust cannot exceed 5 percent. IRC 664(d)(1)(D); Rev Rul , Cum Bull 329. A CRAT provides no inflation protection, but does protect against a reduction in income payments if the portfolio value drops. A CRAT is generally used with elderly clients (and occasionally in other situations) when security is more essential than inflation protection. Note that no additional contributions are allowed to a CRAT. Reg (b). 2. Charitable Remainder Unitrust a. Standard Type A standard charitable remainder unitrust (CRUT) pays a fixed percentage of the trust s net fair market value, as annually determined. IRC 664(d)(2). The amount paid to the recipient must be at least 5 percent and not more than 50 percent of the assets valued annually. IRC 664(d)(1). This sum may be paid to any person, as defined in IRC 7701(a)(1). If the person is other than an individual, the term of the trust may not exceed 20 years. If the person is an individual, the trust term may run for the life or lives of the individual or individuals in being when the trust is created or for a term not to exceed 20 years. The property remaining in the trust passes to charitable beneficiaries on the recipient s death or the expiration of the term of years. The value of the charitable remainder with respect to each contribution of property to the trust must be at least 10 percent of the net fair market value of the contribution. IRC 664(d)(2)(D). This form of charitable remainder trust can provide for a measure of inflation protection. If the payout percentage is less than the trust s net investment returns over time, the income payments will increase over time as excess earnings are added to principal. On the other hand, payments from a unitrust can decrease from year to year when the payout percentage exceeds trust earnings. b. Net Income Unitrust (1) Definition A net income unitrust pays the lesser of (IRC 664(d)(2), (3)): A fixed percentage of the trust s net fair market value (i.e., the same approach as used in the standard unitrust; see 24.14), or The trust s actual net income for the year. This form of trust is often coupled with a makeup provision that allows the trustee to record a deficiency each year in which the payout

10 10 Charitable Remainder Trusts is less than the standard unitrust amount (i.e., the net income limitation is effective). IRC 664(d)(3)(B). If in a subsequent year the trust s net income exceeds the amount determined under the standard unitrust formula, the excess income can be paid out up to the amount of the accumulated deficiency. This type of trust is also known as a charitable remainder incomeonly unitrust. It may also be referred to as a NICRUT (if there is no makeup clause) or a NIMCRUT (if there is a makeup clause). A net income unitrust is appropriate for a client who does not want to invade trust principal and is willing to receive only the trust s annual income. It is also useful when the contributed asset is illiquid and non-income producing (2) Determination of Income Income from a net income unitrust is generally determined under California law and the terms of the trust instrument. Reg (a)(1)(i)(b)(3). See IRC 643(b). A long-running issue with the IRS has been whether capital gains can be defined as income in the trust instrument (absent a specific provision, gains are generally allocated to principal under Prob C 16355). Proposed regulations expressly allow the trust instrument to define net realized capital gains earned by the trust (other than the pre-contribution gain inherent in the asset at the date of contribution) as income for this purpose. See Prop Reg (a)(1)(i)(b)(3). The trustee cannot, however, have a discretionary power to allocate gains to income; as a result, gains must either be defined as income in the instrument or be allocated pursuant to state law. The proposed regulations also accept the power a trustee has under Prob C to adjust between principal and income. However, this adjustment power may not be exercised by a trustee who is also a beneficiary (Prob C 16336(b)(7)), which is often the case (3) Use as Retirement Vehicle Some clients use a net income unitrust as a form of retirement vehicle. The general plan is to structure trust investments so that, for some period of time, the trust corpus grows but the trust does not earn distributable net income. Then, when the client desires additional income, the trust investments are revised to generate income. Done successfully, the trust can grow for a period of time essentially taxfree, providing an even larger trust corpus to generate income in the retirement years. The difficulty lies in coordinating the definition of income in the trust document and the investment strategy so as to be

11 11 Charitable Remainder Trusts able to achieve both deferral in the early years and distributable income in the later years. For example, defining income to exclude gains facilitates the deferral of income payments in the early years, but makes it difficult to generate sufficient income in the later years. Conversely, defining gains as income can make it difficult to defer payments in the earlier years. PRACTICE TIP To facilitate using the trust as a retirement vehicle, certain creative investment vehicles can be used that grant the trustee some measure of control over the timing of income, including investing the charitable remainder trust assets in a deferred variable annuity product or closely held partnership. However, careful coordination is required between trust drafting and investment approach. Additionally, the IRS has expressed some discomfort with charitable remainder trusts that appear to provide too much control over the timing of income. (Although the IRS approved a charitable remainder trust that involved a deferred annuity in IRS Letter Ruling , the issue is still on its no-ruling list. See Rev Proc , 4, Int Rev Bull 111) c. Comparison of Standard Unitrust and Net Income Unitrust A standard unitrust (CRUT) (see 24.14) is easier to administer than a net income unitrust (see 24.15). Careful tracking of income and principal is not required. The beneficiary s payment can be calculated easily as the payout percentage multiplied by the net fair market value of the trust on the valuation date. With a net income unitrust, careful tracking of trust income is required, and the actual payment due to the beneficiary is not known until after the close of the year when the trust s net income is calculated. Additionally, the investment adviser of a CRUT is not restricted to earning the amounts included in the trust s definition of income. Even if a net income trust defines net realized gains as income (so the adviser is at least not confined to generating ordinary income), the adviser may have to accelerate gains or defer selling loss positions in order to maintain the desired level of trust income. Although a CRUT may be easier to administer, there is another difference that favors a net income unitrust. The trustee of a CRUT (or a CRAT) is required to make the payment provided for in the trust document. At best, the regulations allow the payment to be deferred under certain circumstances for only a reasonable time after the close of the taxable year. See, e.g., Reg (a)(1)(i). If an illiquid or

12 12 Charitable Remainder Trusts non-income-producing asset is contributed to a CRUT or a CRAT and does not sell by year end, the trustee may not have sufficient funds to make the required payment. On the other hand, when such an asset is contributed to a net income unitrust, income payments are required during the time the trust holds the asset only to the extent the asset actually generates net income. Once the asset is sold, the proceeds can be reinvested to earn income, hopefully in an amount sufficient to satisfy the beneficiary s payout desires. On the use of flip trusts for illiquid assets, see d. Flip Unitrust A flip unitrust is a combination of the net income unitrust and standard unitrust payment formulas, specifically allowed under Reg (a)(1)(i)(c). A flip unitrust operates as a net income unitrust (with or without a makeup provision) for a period of time, and then flips to a standard unitrust. The flip triggering event must be a specific date or event not in the control of the donor or trustee, e.g., marriage or divorce. Reg (a)(1)(i)(d). The payout formula must actually change as of the beginning of the year following the triggering event. Reg (a)(1)(i)(c)(3). If the payout formula pre-flip included a makeup provision, any unpaid deficiency is lost. PRACTICE TIP Flip unitrusts are commonly used in lieu of net income unitrusts when illiquid, non-income-producing assets are contributed. Once the trust has flipped, it is, in the author s experience, noticeably easier to administer than is a net income unitrust, both from an investment and an accounting standpoint B. Considerations in Selecting Payout Rate The payout rate in a charitable remainder trust must be at least 5 percent and cannot be more than 50 percent. IRC 664(d)(1)(A), (d)(2)(a). The most obvious consequence of selecting a particular payout rate is its impact on the charitable deduction: the higher the payout rate, the lower the charitable deduction (as determined under IRC 7520). NOTE The value of the remainder interest in each contribution to a charitable remainder trust must be at least 10 percent of the asset s value. IRC 664(d)(1)(D), (d)(2)(d). This rule has the impact of limiting how high a payout rate can be used in any particular trust situation. In fact, very young clients may find that they cannot create a charitable remainder trust that pays for life

13 13 Charitable Remainder Trusts at all; even with a 5-percent payout rate, the deduction falls below 10 percent due to their long life expectancy. Although the deduction issue is relevant, clients are often more concerned about the impact of the payout rate on the trust s long-term performance. With unitrusts, a higher payout results in less growth (growth that is tax-free or on which tax is deferred) in the trust. At some point in the future, a lower payout unitrust will actually begin to pay more to the beneficiary than a higher payout trust due to the accelerated growth in trust corpus. Good software can assist the attorney in determining the likely crossover point. See It is also important to take the effects of inflation into account. EXAMPLE If the client and his or her financial advisers believe that inflation will average 3 percent over the life of the trust, selecting a payout rate 3 percent less than the projected net investment return should produce a unitrust payment that grows over time at roughly the rate of inflation, thereby providing the beneficiary with constant purchasing power over the life of the trust. PRACTICE TIP The example above is simplistic, if for no other reason than that earnings and inflation do not proceed on a steady basis over the life of the trust. Careful coordination with the trust s investment adviser and economic modeling can be very helpful. However, the author has seen far more beneficiaries disappointed by a high payout trust that is paying out more than its earnings (and thus starting to lose value) than by a trust with a payout rate that is too low. The issue is more extreme with a CRAT. Because the payout selected is fixed over the life of the trust, the dollar amount paid to the income beneficiary is generally not affected by the earnings history of the trust (the effect is solely on the remainder beneficiary). However, if the trust fails to earn a sufficient return to meet the payout over an extended period of time, causing an annual invasion of principal, the trust may literally run out of money before the stated termination date. NOTE Once an annuity trust starts to invade principal to meet a high payout rate, the consequences may be irreversible. For example, a $10,000 annuity payment due from a trust with a $100,000 corpus is a 10-percent payout rate. If the trust balance drops to $80,000, the payout rate effectively rises to 12.5 percent. A charitable remainder trust s payout rate can also impact the trustee s investment strategy. Selecting a high payout rate can force a trustee to adopt a more aggressive investment strategy than he or she

14 14 Charitable Remainder Trusts might otherwise recommend, subjecting the trust to more volatility and risk C. Selecting Income Beneficiaries Often the client is both the donor and the only income beneficiary of the charitable remainder trust. In that situation, transfers to the trust completely escape gift tax because the value of the remainder interest qualifies for a gift tax charitable deduction (IRC 2522(c)(2)(A)), and the retention of the interest does not constitute a transfer to begin with. At death, the value of the trust is included in the donor s estate (IRC 2036), but qualifies fully for a charitable deduction (IRC 2055). If the donor s spouse is an income beneficiary (either solely or with the donor), the spouse s interest will qualify for a gift and estate tax marital deduction. IRC 2056(b)(8), 2523(g). Gift and estate tax issues will arise, however, if anyone other than the donor and his or her spouse is included as a beneficiary. The actuarial value of the other beneficiary s interest is subject to gift and estate tax. Further, unless the spouse is the only income beneficiary (other than the donor), his or her interest will fail to qualify for the marital deduction for gift and estate tax purposes. IRC 2056(b)(8), 2523(g). NOTE The IRS has held that a charitable remainder trust cannot be funded by more than a single donor, at least if the donors are also beneficiaries. IRS Letter Ruling The theory of this ruling was that a trust funded by multiple donors failed to qualify as a trust, and was more appropriately classified as an association. Although not stated in the ruling, IRS personnel have stated in various private and public conversations that the holding of the ruling would not apply to a charitable remainder trust funded by husband and wife D. Selecting Charitable Beneficiaries It is not required that the donor irrevocably designate a single charitable remainder beneficiary. The donor can name multiple beneficiaries, and can keep the right to amend the designation of the charitable beneficiaries. Rev Rul 76 8, Cum Bull 179. The trust document must contain language providing that if a named charity is no longer qualified at the termination of the trust, the trustee must select a new entity that is qualified. The IRS has provided the following language for this purpose (Rev Proc 90 31, Cum Bull 539):

15 15 Charitable Remainder Trusts If the charitable organization is not an organization described in sections 170(c), 2055(a), and 2522(a) of the Code at the time when any principal or income of the Trust is to be distributed to it, then the Trustee shall distribute such principal or income to such one or more organizations described in 170(c), 2055(a), and 2522(a) as the Trustee shall select in its sole discretion. PRACTICE TIP The language quoted above contains a potential trap for the unwary. If used as is, with only a reference to IRC 170(c), the language would permit the trustee to redirect the trust assets on termination to a private foundation, rather than to a public charity (which are described in IRC 170(b)(1)(A), as well as in 170(c)). In that situation, the donor s deduction would be determined as if he or she were contributing the remainder interest to a private foundation, which could result in a less generous charitable contribution tax deduction. See IRC 170(b)(1)(A) (D), (e)(1)(b)(ii), (e)(5). Unless the donor actually wishes to direct the charitable remainder trust assets to a private foundation, a reference to IRC 170(b)(1)(A) should be added to the IRS text E. Selecting Trustee The trustee of a charitable remainder trust is faced with many of the same duties and obligations as is the trustee of any other trust. See California Trust Administration, chaps 2 8 (2d ed Cal CEB 2001). However, there are additional obstacles imposed by the unique characteristics of a charitable remainder trust that complicate the role of trusteeship. These include the need to: Monitor investments to ensure that the trust does not earn unrelated business income (see 24.27); Monitor trust transactions to guard against acts of self-dealing (see 24.9); Understand and comply with the intricate payout and four-tier accounting rules (see Drafting California Irrevocable Trusts (3d ed Cal CEB 1997)); and Complete and file a unique set of four tax returns (see Irrevocable Trusts 18.31). NOTE Failure to administer a charitable remainder trust properly can lead not only to a breach of fiduciary action by the income or remainder beneficiaries, but also to loss of tax-exempt status for the trust and possible action by the State Attorney General s Office. Thus, careful selection of the trustee is essential.

16 16 Charitable Remainder Trusts Any individual, including the donor, can serve as trustee. IRS Letter Rulings , Donors often prefer to name themselves as trustees, as it gives them a sense of control over the trust and their future income streams. However, a donor may not serve as trustee if the trust document grants the trustee the power to sprinkle the annuity or unitrust amount among a class of income beneficiaries. Rev Rul , Cum Bull 213. PRACTICE TIP Because most individuals are not well equipped to manage either trust investments or reporting requirements, an individual trustee should usually hire, as agents, both an investment adviser and a tax preparer. The author finds that this approach works best if both agents are familiar with charitable remainder trusts and are willing to stay in communication with the donor-trustee and other agents. Even with such a team, the donor-trustee needs to realize that he or she is the fiduciary, and has the responsibility to ensure that nothing is overlooked. PRACTICE TIP A professional or corporate trustee is often a good choice, especially if the donor is not particularly interested in staying closely involved in the trust management. Although corporate trustees are often viewed as expensive, their fees are often not much greater than the combined fees of an investment adviser and a tax preparer. Because some banks and trust companies have far more experience with charitable remainder trusts than others, it is worth interviewing potential corporate trustees as to the number of these types of trusts they have administered. A California nonprofit corporation can serve as trustee of a trust incidental to its purposes. Corp C 5140(k). Many large California charities serve as trustees of numerous charitable remainder trusts, often at a nominal charge to the trust. Of course, to secure such a beneficial relationship, the charity usually requires that it be named as the sole irrevocable remainder beneficiary of the trust. The charity may be willing to have its legal advisers prepare the draft trust document at no cost to the donor. NOTE For purposes of determining the annuity or unitrust amount, an independent trustee (as defined in Reg (a)(7)(iii)) is required to value any unmarketable assets held by the trust, unless the assets are valued pursuant to a qualified appraisal. Reg (a)(7).

17 17 Charitable Remainder Trusts V. FUNDING CHARITABLE REMAINDER TRUSTS In addition to ensuring that a charitable remainder trust is appropriate and properly designed, questions often arise regarding the asset to be contributed. Issues can arise under contract law (e.g., whether the property is subject to a buy-sell agreement that prevents a gift), securities law (e.g., whether the shares are subject to SEC restrictions), and tax law (e.g., whether the mere transfer of the asset will trigger adverse tax consequences), just to name a few. Although a detailed discussion is beyond the scope of this chapter, include an overview of some common issues that arise in funding charitable remainder trusts A. Acceleration of Income Federal tax law provides that the mere transfer of certain types of assets will accelerate any untaxed gain or income. For example, transferring an installment note to a charitable remainder trust will cause the acceleration of the remaining gain. IRC 453B(a). Likewise, transferring shares received through the exercise of an incentive stock option (see chap 22) before the expiration of the requisite holding periods will trigger compensation income. See IRC 422(a). Obviously, a donor should not transfer these types of assets to a charitable remainder trust with the expectation that the gain or income will be realized by the trust B. Assignment of Income Under the assignment of income doctrine, if a donor transfers appreciated property to a charitable remainder trust after his or her right to the sale proceeds has matured, the donor will realize the gain despite the fact that the sale was technically consummated by the trustee. See Morgan Guar. Trust v U.S. (Ct Cl 1978) 585 F2d 988. On the other hand, the mere anticipation that a sale will occur does not constitute an assignment of income. See Greene v U.S. (2d Cir 1994) 13 F3d 577. Whether a particular transaction has crossed the line obviously depends on the specific facts and circumstances. It also depends on the legal standard to be applied, which is unclear. Practitioners have long relied on Daniel D. Palmer (1974) 62 TC 684, aff d (8th Cir 1978) 523 F3d 1308, acq Cum Bull 2, nonacq Cum Bull 4, for the proposition that the proceeds of a sale will be attributed back to the donor only if the charitable remainder trust is legally bound or could be compelled by the buyer to sell. This relatively bright-line standard has been potentially undercut by a Ninth

18 18 Charitable Remainder Trusts Circuit case, Ferguson v Commissioner (9th Cir 1999) 174 F3d 997. The court in Ferguson stated that it is the reality and substance of events that determine the tax consequences, and that the question of whether there is a legally enforceable right to income is merely one factor to be considered. The question is whether the sale is practically certain to occur. 175 F3d at C. Trade or Business Issues Although a charitable remainder trust is generally exempt from taxation, it will lose its tax-exempt status for any year during which it has unrelated business taxable income (UBTI) within the meaning of IRC 512. IRC 664(c). UBTI is the gross income derived from an unrelated trade or business regularly carried on, less any allowable deductions. IRC 512(a)(1). Certain types of income, such as dividends, interest, rent from real property, and capital gains, are generally excluded from UBTI. See IRC 512(b). Transferring a sole proprietorship into a charitable remainder trust can thus be problematic. If the asset resides in the charitable remainder trust for a period of time before it is sold, the trust is likely to earn UBTI and lose its exemption for the year. Note that in such a situation all income earned by the charitable remainder trust would be taxable, including income that is not UBTI and (in particular) any gain on the sale of the contributed asset. Leila G. Newhall Unitrust v Commissioner (9th Cir 1997) 105 F3d 482. On the other hand, contributing the asset on Friday afternoon and selling it on Monday morning is likely to raise assignment of income issues. NOTE It is important to remember, as the taxpayer in Newhall discovered, that seemingly passive investments can occasionally generate UBTI. In Newhall, the asset in question was a limited partnership interest in a partnership that conducted a trade or business. Because the character of the income generated by the partnership flowed through to the partners, the charitable remainder trust was deemed to have received UBTI (see IRC 512(c)). 105 F3d at D. Encumbered Property Contributing encumbered property to a charitable remainder trust is particularly problematic. At a minimum, the following issues must be considered: Gift value. The value of the gift must be reduced by the amount of the liabilities. See Reg 1.170A 3(d).

19 19 Charitable Remainder Trusts Bargain sale. Under Reg , the amount of the liabilities that the donor is relieved of because of the gift constitutes an amount realized; the donor is thus considered to have engaged in a bargain sale potentially generating taxable gain. Self-dealing. Unless the mortgage was placed on the property more than 10 years before the gift, the sale portion of a bargain sale may constitute self-dealing. IRC 4941(d)(2)(A). Unrelated business income. Property acquired subject to a mortgage or lien can be considered debt-financed property if it is in a charitable remainder trust. IRC 514(c)(2). The sale of debt-financed property can generate unrelated business taxable income (UBTI) to the charitable remainder trust. As discussed in 24.27, recognizing UBTI inside a charitable remainder trust can be fatal. Grantor trust status. The IRS has ruled that if a donor transfers property to a charitable remainder trust that is subject to a recourse debt, the trust is to be taxed as a grantor trust under Reg 1.677(a) 1(d). IRS Letter Ruling As such, it is disqualified as a charitable remainder trust.