PRACTISING
LAW INSTITUTE
33rd
ESTATE PLANNING INSTITUTE
CHARITABLE
GIFT PLANNING
Monday,
September 23, 2002
12:00
noon
PHILIP T. TEMPLE, ESQ.
McCarthy, Fingar, Donovan, Drazen & Smith, L.L.P.
White Plains, New York
1.
Setting The Scene and, Hopefully, Whetting Your Appetites. An
extremely simplified example of the horrific estate tax on the death of a
surviving spouse (or, for that matter, a single person. Example where H
dies in 2002 and W dies in 2005.
H’s Estate
Gross
estate
$3,000,000
Less: Estimated
expenses -- at
5%
$ 150,000
Marital deduction --
balance of estate less
$1,000,000 equivalent
exemption
$1,850,000
$2,000,000
Taxable
estate
$1,000,000
Tentative federal estate
tax
$ 345,800
Less: Applicable credit
amount
$ 345,800
Federal estate
tax
-0-
W’s Estate
Her separate
assets
$3,000,000
Marital share from
H
$1,850,000
Gross
Estate
$4,850,000
Less: Estimated expenses --
at
5%
$ 242,500
Less: NY State Estate
Tax*
$ 347,640
Taxable estate
$4,259,860
Tentative federal estate
tax
$1,842,934
Less: Applicable credit
amount
$ 555,800
Federal estate
tax
$1,287,134
*As of 2005 the state death tax
credit is repealed after which there will be a deduction for
death taxes actually paid to the state.
2.
Integrating Split-Interest Charitable Gifts Into the Estate Plan to
Save Estate Tax
Assume that W is charitably
inclined. Her Will divides her estate into two parts. With the
first part, she creates a 6% charitable remainder unitrust (furnishing a
potential hedge against inflation) providing payments to her children in equal
shares for a term of 20 years after her death. The other half is placed
in a charitable lead trust providing for payment of 8.5% of the initial value
of the assets (a guaranteed annuity) to charity for a term of 20 years with the
remainder payable to children (or grandchildren) at the end of the 20 year
term. Here is what the estate tax calculation in W’s estate would look
like using the July 2002 discount rate of 5.6%:
Gross
estate
$4,850,000
Less: Estimated expenses --
at
5%
$ 242,500
Charitable deduction:
Gross principal into unitrust
of $2,303,750 x 30.403%
factor $
697,391.20
into lead annuity trust of
$2,303,750 x 100%
factor
$2,303,750.00
$3,001,141.20
NYS estate tax
deduction**
$ 77,565
Total
deductions:
$3,233,612
Taxable
estate:
$1,616,388
Tentative federal estate
tax
$ 608,175
Less: Applicable credit
amount
$ 555,800
Federal estate
tax
$ 52,375
NY State estate
tax
$ 77,565
Total
Tax
$ 129,939
The estate tax savings is
$1,504,835
*Tax attributable to non-charitable
portion of unitrust. Gross principal of each trust is reduced by ˝ of
estate tax, thereby reducing charitable deduction for each trust. Estate
tax is determined by interrelated calculation.
**As of 2005 the state death tax
credit is repealed after which there will be a deduction for death taxes
actually paid to the state.
3.
Overview of Various Trust Agreements
A.
Unitrust agreements.
(1)
Standard unitrust -- pays stated
percentage (at least 5% and no more than 50%) of net fair market value of trust
assets, revalued at least annually, out of income and, if income is
insufficient, out of principal. Excess income is retained in trust.
(2)
Net income with makeup unitrust (the NIMCRUT) -- pays lesser of (i) stated
percentage of annual net fair market value and (ii) actual trust income.
Deficiencies in distributions from an earlier year are made up in any later
year in which trust income exceeds stated percentage. Then excess income
retained in trust.
(3)
Net income without makeup unitrust -- pays lesser of (i) stated percentage of
annual net fair market value and (ii) actual trust income. Deficiencies in
distributions from an earlier year are not made up. Excess income
is retained in trust.
(4) In net income unitrust, agreement
can provide that realized capital
gain -- but only that portion representing post-gift appreciation -- can
be treated as income for purposes of distribution.
(5) Hybrid agreement (the “Flip”
unitrust). Net income unitrust becomes
standard unitrust on sale of, i.e., closely held corporate stock. First,
unpublished PLR said O.K. Then, IRS says it doesn’t work. PLRs
9506015 and 9516040. Then proposed §664 Regs again said O.K.
Final Regs confirmed viability of Flip.
(6) Why the Flip?
(a) In NIMCRUT, once non-income
producing asset is sold,
there is expectation that Trustee will invest so as to achieve
ordinary income at the stated percentage payout rate. Not easy
to do.
(b) Once crut flips and becomes
standard crut, can invest for
total return. Easier to achieve payout percentage and some
reasonable growth in trust assets.
(7) Some Specific Items Regarding
Nimcruts.
(a) Excess income in earlier year cannot
be used to make up
deficiency in later year.
(b) What is income? Generally
state law governs. Be careful
of specific unique situations; i.e., assets such as timber; assets
that have periodic large amounts of income. Defining income
to include realized gain attributable to post-gift appreciation.
(c) Net income provision does not
change calculation of
charitable deduction for income, gift or estate tax purposes.
B.
Annuity trusts.
(1)
Annuity amount couched in terms of stated dollars; trustee directed to pay X
dollars a year out of income and, if income is insufficient, out of
principal. Any excess income is retained in trust.
(2)
Annuity amount couched in terms of a percentage of initial fair market value of
assets transferred to trust. Once amount determined, stays constant for
trust term.
(3)
In either case annuity amount must be at least 5% (but no more than
50%) of initial value of assets transferred to trust.
C.
Pooled income fund.
Donor irrevocably transfers money,
long-term marketable securities or both to qualified charity's separately
maintained pooled income fund, where it is invested together with transfers of
others who make similar life income gifts. Donor (or other designated
beneficiary) receives his share of pooled income fund earnings each year.
On donor's death (or death of other designated beneficiary) payments terminate
and charity removes donor's gift from pooled fund and uses for charitable
purposes.
D.
Charitable gift annuities.
(1)
Immediate payment. Donor transfers money or property to charity in
exchange for promise to pay fixed amount annually to donor (and survivor, if
desired) for life. Transfer is part gift and part purchase of
annuity. Annual income (rate of return) paid by charity depends upon
beneficiary's (annuitant's) age at time of gift. Annual rate of return
remains constant for life.
(2)
Deferred payment. Donor makes gift to charitable institution in exchange
for charity's promise to pay him guaranteed life income starting at retirement
(or any other date specified).
E.
Charitable lead trusts.
(1)
Donor can avoid tax on income paid to charity, but the trust must not provide
reversion for donor or spouse. Trust should be lead unitrust or lead
annuity trust. Otherwise, value of charity's income interest will be
subject to Federal gift tax. And, if donor dies before property reverts
to him, there will be no estate tax charitable deduction.
(2)
Main drawback of law is that donor cannot get income tax charitable deduction
unless trust so drawn that he is taxed on income paid to charity -- a grantor
trust. Thus, except for very wealthy individuals, charitable lead trust
created during lifetime is generally not advantageous. Some create trust with
tax-exempt bonds so that income is not taxable.
(3)
Lead trusts paying income to charity are advantageous when created by donor's
will. Estate tax charitable deduction allowed for value of income stream
paid to charity under lead trust created by donor's will. To get estate tax
deduction, income interest must be guaranteed annuity (annuity trust) or fixed
percent of net fair market value of trust assets, determined yearly
(unitrust).
(4) The Jackie O Lead Trust:
Illusionary?
4.
Basic Tax Implications
A.
Income tax charitable contribution deduction allowed for charitable remainder
interest or other gift element. In order to qualify, value of
remainder must be at least 10%.
B.
Capital gain avoidance; the problem of prearranged sales.
(1)
Palmer still lives. [Palmer v. Commissioner, 62 T.C. 684
(1974), aff'd on other grounds, 523 F.2d 1308 (8th Cir. 1975)]; Rev. Rul.
78-197, 1978-1 CB 83; Letter Ruling 8639046.
(2)
What about Blake? [Blake v. Commissioner, 42 T.C.M. 1336
(1981), aff'd 697 F.2d 473 (2nd Cir. 1982)].
C.
Gift tax charitable deduction (unlimited) allowed for remainder interest.
D.
Estate tax charitable deduction (unlimited) allowed for charitable remainder
interest.
E.
Taxation of remainder trust beneficiary -- four-tier system:
(1)
Ordinary income.
(2)
Capital gain income. WIFO basis.
(3)
Other income, including tax-exempt interest.
(4)
Return of principal.
F.
Taxation of pooled income fund beneficiary.
5.
The Lifetime Uses of a NIMCRUT
A.
Use of securities.
(1)
Highly appreciated, but low-income stock to fund "net income with
makeup" unitrust.
(a)
Provide low percentage payout -- but, at least 5% -- to increase charitable
deduction.
(b)
By retaining securities with high appreciation potential but low income,
reduce income paid to donor when in higher income bracket and less need for
income.
(c)
Trust sells later when securities appreciated and invests proceeds in high
yield securities paying stated percentage of increased value plus make-up of
deficiencies from earlier years; donor now possibly in lower tax bracket (say,
at retirement) or needs higher income.
(2)
Transfer of closely held corporate stock (charitable stock bailout) to charity.
(a)
Donor transfers stock of close corporation to charity generating deduction for
fair market value with no tax on appreciation.
(b)
Corporation, although not legally obligated to do, redeems stock from
charity. Palmer; Rev. Rul. 78-197; but see Blake.
(c)
Transfer to charitable remainder trust.
(i)
Generally not good idea unless trust can sell without violating self-dealing
prohibitions.
(ii)
A way out: Offer to redeem all stock is made.
(iii) Query: Is close corporation
stock a "prudent" trust investment?
B.
Use of zero coupon bonds.
(1)
Basic rules.
(2)
Watch state law on questions of whether trust can make interest income on
redemption or sale principal.
(3)
Flexibility of timing.
C.
"The Spigot Trust." Use of commercial tax deferred annuity
contract.
(1) Donors funded a net income with
makeup unitrust with appreciated
common stock; the trustee plans to reinvest the trust assets in a
commercial
deferred annuity contract.
(2) Regular annuity payment tax rules
don't apply (payments partially
excludable; IRC '72(b)(1)); because contract not held by natural
person, it's all ordinary income -- but, that's good. Trustee will be
able to use entire later payments to make up deficits. Also, Donors
can
“control” when they will begin to receive income.
(3) IRS made noise that “retirement
unitrusts” are suspect. Then in
T.A.M. (LTR 9825001), IRS ruled in technical advice that purchase
of deferred annuity contracts doesn’t adversely affect qualification
of unitrust and would not be considered an act of self-dealing.
D.
Funding Charitable Remainder Trust With Individual Retirement Account (IRA).
(1)
The general rules on "income in respect of a decedent."
(2)
Other tax problems on IRAs and like plans.
(3)
IRS Private Letter Ruling. (LTR 9237020)
(a) D has
Individual Retirement Account. She plans to create testamentary CRUT for
son's benefit. To fund trust, D will name CRUT as beneficiary of her IRA.
(b) IRS
rules. Trust will qualify and entitle D's estate to estate tax charitable
deduction for value of remainder interest. Any IRD received by CRUT will have
same character in its hands as it would have had in D's hands, had she lived
and received it.
(c) IRS
also said that trust won't be taxable on its income unless it has unrelated
business income. This, CRUT won't be taxable on IRD; instead, that income
will be taxed to son piecemeal as it's paid to him in satisfaction of annual
unitrust amounts under four-tier provisions of IRC '664(b).
(d)
Generous individuals often disappointed to learn that IRAs and other pension
plans can't be "rolled over" tax-free into charitable remainder
trusts during lifetime. Resulting income is taxed to donor in year of transfer,
reducing funds available for trust. However, by funding testamentary
unitrust with her IRA, D has avoided up-front income tax. And unitrust
payments based on a percentage of assets in CRUT, as revalued each year.
Thus, the more (untaxed) assets pass to trust, higher payments will be - and
more pre-tax funds will be available for reinvestment.
(4) Current ruling -- LTR
9901023. IRS confirmed its holding in above
ruling, but made it clear that income tax deduction for estate tax
attributable to IRD belongs to CRT not its beneficiaries. Extent of
adverse impact?
E. Wealth Replacement
(1)
Create CRT
(2)
Use tax savings and/or increased income stream to purchase life insurance to
replace amount transferred to CRT. Perhaps use life insurance trust to
hold insurance.
6.
Some Potential Pitfalls
A.
Transfer of mortgaged property to remainder trust.
(1)
Don't do it.
(2)
Some possible outs.
(a)
Pay off mortgage or get lien released.
(b)
Sale to charity of undivided interest. Donor uses proceeds to pay debt
and transfers balance of his interest to CRT. Caveat: The
undivided interest problem and self-dealing.
B.
Installment obligations.
(1)
Transfer triggers unreported gain.
(2)
Better to use testamentary gifts.
C.
(1) S Corporation stock.
D. The Accelerated Unitrust
and the “Chutzpah Trust”
7.
Ethical Considerations.
1. Acting as fund-raiser and
not attorney.
2. Potential conflict of
interest.
APPENDIX
A PRIMER ON DEFERRED GIFTS
I.
INTRODUCTION
This portion of the outline is
designed to furnish a fuller discussion of the various types of planned (or
deferred) gifts available to institutions and their donors.
II.
CHARITABLE REMAINDER UNITRUSTS
A.
In Brief. Donor irrevocably transfers money, securities, real
property to trustee (often the charity) who invests and reinvests assets as
separate fund. Donor (or other designated beneficiary) receives amount
each year determined by multiplying fixed percent (minimum of 5%) by the fair
market value of trust assets, valued each year. On donor's death (or
death of other designated beneficiary) payments terminate and then assets are
absolute property of designated charitable remainderman.
B.
Three Types of Unitrusts Authorized:
1.
Plan 1: Specifies that "recipient" (income beneficiary)
receives annual payments based on fixed percent (cannot be less than 5% nor
more than 50%) of net fair market value of trust assets, as determined each
year. Percent, determined at time trust created, remains constant for
entire trust term. Any income not paid out added to principal. If
income is insufficient to pay required amount, capital gains and/or principal
make up deficit.
2.
Plan 2: Trustee pays beneficiary only trust income if actual
income is less than stated percent. Deficiencies in distributions (i.e.,
where trust income is less than stated percent) made up in later year(s) if
trust income in later year(s) exceeds stated percent.
3.
Plan 3. Trustee pays beneficiary only trust income if actual
income is less
than stated percent. Deficiencies in distributions (i.e., where trust
income
is less than stated percent) not made up.
C. The FLIP Charitable Remainder
Unitrust:
A second variation on the unitrust is a hybrid or “flip trust.” There had
been some confusion about these trusts which provide for a change in the method
of calculating the unitrust amount; first the Service said okay, then it said
they didn’t work.
In December 1998, the IRS issued regulations dealing with flip trusts.
These spell out the conditions under which the governing instrument may provide
for “flip” from a net income charitable remainder unitrust to a standard
unitrust during the term of the trust.
The flip trust is especially useful for unmarketable, low-income producing
assets that may take some time to sell. The flip unitrust allows the
trustee to invest for total return once the trust becomes a standard unitrust.
The regulations will allow the flip trust if (1) the trust instrument requires
the flip, so that the trustee does not have discretion to change the type of
CRT, (2) the CRT uses a net income method (with or without make-up) until the
flip occurs, typically upon the sale of a specified asset or group of assets
contributed at the time the trust was created and (3) the trust thereafter is
required to convert to a standard charitable remainder unitrust for calculating
distributable amounts. Note that any deficit not “made up” by the time of
the flip is lost.
The regulations give examples of valid and invalid triggering events for the
flip.
Valid triggering events include: an individual’s marriage,
divorce, death or birth of a child; the sale of an unmarketable asset (more properly
thought of as a hard-to-market asset); and a fixed date.
Invalid triggering events include: the sale of marketable assets;
a request from the income beneficiary or his or her financial advisor that the
trust flip.
With many trustees moving to a total return concept, without regard to whether
the return is categorized as income or capital appreciation, the flip trust may
be increasingly popular.
D.
Income Tax Charitable Deduction:
1.
To qualify, value of charitable remainder interest must be at least 10%.
2.
Donor gets sizable income tax charitable deduction in year he creates
unitrust. Deduction is for value of charitable institution's right to
receive unitrust principal (the remainder) after donor's life. Determined
by official Treasury tables.
3.
Amount of charitable deduction depends on:
(a)
Donor's age (and age of any other beneficiary).
(b)
Percent to be paid.
(c)
Amount of money or fair market value of long-term securities or real property
contributed.
(d)
Discount rate of month. Can make election to use rate for either
of two months preceding month of gift.
4.
Donor's gift deductible up to 50% of adjusted gross income when unitrust is
funded with money and remainderman is a school, church, hospital or other
publicly supported charity. Any "excess" deductible, until
exhausted, over five following years -- up to 50% of each year's adjusted gross
income.
5.
For unitrusts funded with long-term appreciated securities or real property,
contribution deductible up to 30% of adjusted gross income -- with five year -
30 % carryover for any "excess." In some cases, ceiling can be
increased to 50% with five year carryover by electing to reduce amount of
charitable deduction by 100% of appreciation allocable to remainder
interest. Generally not good idea.
E.
Providing Income for Another: Donor's unitrust can provide income
for another -- his wife, parent, child, etc. He can also have income paid
to him for life and then to a family member. Contribution deduction lower
for two life unitrust since payments are for longer time than in one life plan.
F.
How Unitrust Payments Taxed:
1.
Amount paid to income beneficiary retains character it had in trust. Each
payment treated as follows:
First, as ordinary income to extent
of trust's ordinary income for year (and any undistributed ordinary income from
prior years).
Second, as capital gains to extent
of trust's capital gains for year (and any undistributed capital gains from
prior years). On WIFO
(Worst In, First Out) basis; first
short-term, then long-term.
Third, as other (usually
tax-exempt) income to extent of trust's other income for year (and any
undistributed other income from prior years).
Fourth, as tax-free distribution of
principal.
2.
Potential Favorable Tax Treatment for Trust Payments. Part of
income received by donor each year can often consist of capital gains (which
can be offset by beneficiary's capital losses or is taxed at somewhat more
favorable capital gains tax rates) or even be tax-free return of
principal. This achieved by growth rather than income oriented investment
policy. In Plan 1 unitrust (described above), income beneficiary receives
stated percent each year even though unitrust income less than stated
percent. Capital gains or principal are distributed to make up any
deficit.
G. Capital Gains Benefits When
Unitrust Funded With Appreciated Property:
1.
No capital gains tax on transfer of appreciated securities or real property to
fund unitrust. Furthermore, contribution deduction for gift of long-term
appreciated securities or real property determined by multiplying
appropriate actuarial factor from
Treasury tables by property's full fair market value -- not lower
cost-basis. Note: Appreciation element is tax preference
item for alternative minimum tax purposes.
2.
Gains on sales of appreciated securities by unitrust not taxed to trust; nor is
ordinary income. Exception: Unitrust not exempt from tax in
any year it has income which would be taxable unrelated business income if
trust were exempt organization. Unrelated business taxable income
includes debt-financed income. Payments made to income beneficiary taxed
as described above.
H.
Estate Taxes Reduced. Substantial estate tax savings also
achieved. When Donor is only beneficiary (or, in two life unitrust, is
not survived by second beneficiary), unitrust not taxed to estate. If
there is survivor beneficiary, only value of
survivor's right to life payments
(computed on donor's death) subject to tax in donor's estate. If survivor
beneficiary is spouse, qualifies for marital deduction. Charitable gift
-- charitable institution's right to unitrust principal on death of
survivor -- completely free from estate tax.
I.
Gift Tax Implications:
1.
One life unitrust. No gift tax implications if donor beneficiary.
If donor names another as beneficiary, gift made to that person for value of
life interest (reciprocal of remainder interest). If spouse, qualifies
for marital deduction.
2.
Two-life unitrusts. Donor who funds unitrust with own property and
provides for income first to himself and then survivor, makes gift to
survivor. However, proper drafting of trust agreement -- donor retains
right, by his Will, to revoke survivor's interest -- makes gift to survivor
free of gift tax. If spouse is survivor beneficiary, qualifies for
marital deduction.
J.
Generation-Skipping Transfers
1.
If charitable remainder unitrust deemed to create a "generation-skipping
transfer," no income, gift or estate tax charitable deductions will be
allowable. Reason: Tax on generation-skipping transfer is payable
out of trust assets. Charitable remainder trust disqualified if
possibility exists that payments will be made from trust assets -- other than
those required to be made to trust beneficiaries or for good and valuable
consideration.
2.
Most charitable remainder trusts will not run afoul of generation-skipping
rules because they provide payments to only donor or to donor and spouse.
3.
Generation-skipping trust generally one in which there are two or more
generations of trust beneficiaries younger than the donor's generation.
4.
Generation-skipping implications should always be considered before creating
charitable remainder trust.
K. Applicability of spousal
election rule. Under New York law, a surviving spouse has the choice
of receiving that part of the estate passing to him or her by will and other
testamentary provision or renouncing this interest and claiming his or her
elective share. Prior to September 1, 1992, the spousal share could be
satisfied with a transfer of assets in trust if the surviving spouse would
receive all of the income annually from the trust. Under the revised law,
only an outright interest in property will satisfy the elective share.
EPTL Section 5-1.1-A.
The base against which the elective share may be claimed has been expanded, and
now includes property transferred by the decedent in which he or she retained
some interest. A transfer to a charitable remainder trust in which the
decedent retained a life-time income interest is included in this base, as well
as gifts over $10,000 made in the year before death.
As a result, it is possible that a gift to charity - - either outright in the
year before death, or through a charitable remainder trust in which the
decedent retained an interest - - will be reduced to contribute to the spousal
election. For example, if a donor dies within a year of making a gift of
art to a museum, the museum may be compelled to return up to one-third of the
value of the gift in contribution to the
elective
share. Because a charity may be required to return a portion of a gift,
there is a risk that the IRS will disallow part of the charitable deduction.
A more serious risk is that the charitable remainder trust will not qualify
because the trust would not be exclusively for a charitable remainderman from
its inception. As a result, not only would the charitable income tax deduction
be denied, but the remainder trust would not be tax exempt and would not
qualify for estate and gift tax benefits.
Example:
Tom Jones contributes low basis, highly appreciated stock to a charitable
remainder trust. He and his wife, or the survivor of them, will receive a
unitrust amount. Mrs. Jones did not waive her right of election under New
York law. If the IRS were to take the position that no charitable
deduction would be permitted, because the trust does not qualify, the trust
would be taxed on the capital gains realized when the stock is sold, and on
future income and gains from investment. In addition, the gift would not
qualify for the gift tax deduction, so the value of the transfer to charity, if
worth more than $10,000, would be subject to gift tax.
To avoid unintended consequences to estate plans, a non-contributing spouse
should waive a right of election as to a charitable remainder trust at the time
the trust is created. If a waiver was not obtained at the time the trust
was established, consider a late waiver as a reformation of the original
charitable remainder trust.
III.
CHARITABLE REMAINDER ANNUITY TRUSTS
A.
In Brief. Donor irrevocably transfers money, securities, real
property to trustee (often the charity) who invests and reinvests the assets as
separate fund. Donor (or other designated beneficiary) receives annually
fixed dollar amount (at least 5% but no more than 50% of initial net fair
market value of transferred property). No annual valuation (or variation of
amount of payment) as with unitrust. Any income not paid out added to
principal. If income insufficient to pay required amount capital gains
and/or principal make up deficit. On donor's death (or death of other
designated beneficiary) payments terminate and then assets are absolute
property of designated charitable remainderman.
B.
Stated dollar amount may be expressed as fraction or percentage of initial net
fair market value of property irrevocably passing in trust as finally
determined for Federal tax purposes: But governing instrument must then
provide: If such initial net fair market value is incorrectly determined
by Trustee, Trustee shall pay to each recipient (in case of undervaluation) or
be repaid by each recipient (in case of overvaluation) amount equal to
difference between (i) amount which Trustee should have paid recipient if
correct value were used and (ii) amount which Trustee actually paid recipient.
Payments or repayments must be made within
reasonable period after final
determination of correct value.
C.
Income Tax Charitable Deduction:
1.
To qualify, value of charitable remainder interest must be at least 10%.
2.
Donor gets sizable income tax charitable deduction in year he creates annuity
trust. Deduction is for value of charitable institution's right to
receive annuity trust assets (the remainder) after donor's life.
Determined by official Treasury tables.
3.
Amount of deduction depends on:
(a)
Donor's age (and age of any other beneficiary).
(b)
Amount of annual payments.
(c)
Value of assets used to fund annuity trust.
(d)
Discount rate of month. Can make election to use rate for either
of two months preceding month of gift.
4.
Donor's gift deductible up to 50% of adjusted gross income when annuity trust
is funded with money and gift is to school, church, hospital or other publicly
supported charity. Any amount not deductible in year of gift deductible
over five following years, until exhausted, up to 50% of adjusted gross income
each year.
5.
When funded with appreciated long-term securities or real estate, ceiling on
deductibility 30% of adjusted gross income with five year - 30% carry-over for
any "excess." In some cases, possible to increase ceiling to
50% of adjusted gross income (with five year carryover) by electing to reduce
charitable deduction by 100% of appreciation allocable to remainder
interest. Generally not beneficial.
.
D.
Providing Income for Another: Annuity trust can provide income for
wife, parent, child, etc. Donor can also receive income for life and then
have income go to family member. Charitable deduction lower for two-life
annuity trust since payments are made for longer time.
E.
Taxation of Annual Payments. Same as for unitrust. See
above.
F.
Capital Gains Benefits When Annuity Trust Funded With Appreciated Property.
Same as for unitrust. See above.
G.
Estate Tax Implications. Same as for unitrust. See above.
H.
Gift Tax Implications. Same as for unitrust. See above.
I.
Generation-Skipping Transfers. See discussion above in unitrust
section.
J.
Annuity Trust Differs From Classic Charitable Gift Annuity In Number Of Ways:
1.
Donor looks to separately invested annuity trust income, and principal if
necessary, to provide annual payment. If annuity trust runs dry because
payments set too high or because of
poor investments, annual payments terminate. For classic charitable gift
annuity, charity makes payments from own funds or reserves.
2.
For classic charitable gift annuity, amount of annual payment depends upon
beneficiary's age at date annuity starts -- older the beneficiary, higher the
rate of return. For annuity trust, annual payment can be set without
regard to standard rate structure. But, watch out for 5% probability test
and 10% minimum remainder requirement.
3.
Way in which annual payments taxed to beneficiary differs between two types of
gifts.
4.
Capital gain implications: When classic charitable gift annuity is funded
with highly appreciated property, there are capital gains implications.
Capital gains can be avoided with annuity trust. This not as big a
problem as first appears.
K. Applicability of spousal
election rule. Same as for unitrust. See above.
IV.
POOLED INCOME FUNDS
A.
In Brief. Donor irrevocably transfers money, long-term marketable
securities or both to qualified charity's separately maintained pooled income
fund, where it is invested together with transfers of others who make similar
life income gifts. Donor (or other designated beneficiary) receives his
share of pooled income fund earnings each year. On donor's death (or
death of other designated beneficiary) payments terminate and charity removes
donor's gift from pooled fund and uses for charitable purposes.
B.
To qualify as pooled income fund, the charitable remainderman must be
organization described in clauses (i), (ii), (iii), (iv), (v) or (vi) of IRC
Sec. 170(b)(1)(A).
C.
Income Tax Charitable Deduction:
1.
Donor gets sizable charitable contribution deduction in year he makes
gift. Amount of deduction determined by official Treasury tables, which
discount gift by value of life income interest.
2. Exact amount of deduction
depends on:
(a)
Donor's age.
(b)
Pooled income fund's earning experience in recent years. Funds with less
than three years experience are deemed to have an assumed rate of return (which
fluctuates depending on discount rate) for purposes of computing the charitable
deduction. If a
fund has more than three years
experience, the highest rate earned in the last three years is used in
computing the deduction.
3.
Ceiling on income tax charitable deduction. See discussion of ceiling in
sections on unitrusts and annuity trusts above.
D.
Capital Gains Benefit To Funding Life Income Contract With Appreciated
Securities.
1.
Life income contract way to shift investments without paying penalty capital
gains tax. No capital gain when donor transfers appreciated securities to
pooled income fund.
2.
Pooled income funds pay no capital gains taxes on sales by fund of securities
held long-term. Fund takes over donor's holding period; if donor held
securities long-term before transfer to pooled income fund, there is no capital
gains tax on sale by fund. Nor is there capital gain if combined holding
period -- time donor held securities plus time fund holds securities -- is
long-term before sale by fund. In brief, only time there is capital gain
is on sale by fund of short-term securities; and tax is paid by the fund
itself. Donor not personally subject for gains tax.
E.
Estate Tax Benefits. See discussion in section on unitrusts above.
F.
Gift Tax Implications. See discussion in section on unitrusts
above.
G.
Some Non-Tax Advantages.
1.
Donor gains advantage of diversified investment portfolio when he invests in
pooled income fund.
2.
Donor may prefer not to manage his funds any longer. Pooled income fund
takes over chore for him. Or, he may be reluctant to permit inexperienced
members of his family to manage his estate.
3.
The life income contract provides for distribution of property at death -- just
as surely as through a Will.
V.
CHARITABLE GIFT ANNUITIES
A.
In Brief. Donor transfers money or property to charity in exchange
for promise to pay fixed amount annually to donor (and survivor, if desired)
for life. Transfer is part gift and part purchase of annuity.
Annual income (rate of return) paid by charity depends upon beneficiary's
(annuitant's) age at time of gift. Annual rate of return remains constant
for life. Annuitant is considered to be his age at his nearest birthday.
B.
Most institutions use rates recommended by American Council on Gift Annuities,
2401 Cedar Springs, Dallas, Texas 75201.
C.
The Texas lawsuit -- Ritchie vs. “All.” Antitrust claims have now been
dismissed.
D.
Income Tax Contribution Deduction:
1.
Donor entitled to immediate charitable contribution deduction on his income
tax return for year of gift. Amount established by official U.S. Treasury
tables.
2.
When funded with money, donor's contribution deductible up to 50% of adjusted
gross income. Any "excess" deductible over five following years
-- up to 50% of adjusted gross income each year until exhausted.
3.
When funded with long-term appreciated property, contribution deductible up to
30% of adjusted gross income, with five year carryover for any
"excess." Possible to increase ceiling to 50% -- with five year
carryover -- in some instances by electing to reduce amount of deduction by
100% of appreciation allocable to gift element.
E.
Tax-Free Income. Significant portion of each annuity payment
annuitant receives is tax-free. Tax-free amount each year for life (but
not to exceed life expectancy -- after investment in contract is recovered,
payments fully taxable) is fixed by
annuitant's age at time of
gift. Determined by official Treasury tables. Called the exclusion
ratio.
F.
Capital Gains Implications On Transfer Of Appreciated Property:
1.
Transfer of appreciated property is deemed to be bargain sale.
2.
In computing amount of gain, cost-basis of transferred property must be
allocated between gift portion and "investment in contract" (value of
annuity received).
3.
Amount of capital gain is difference between investment in contract and
allocated basis.
4.
Gain so determined is taxed to donor over his life expectancy, if annuity is
nonassignable. Capital gain divided by annuitant's life expectancy and
reported over his life expectancy, but only from that portion of annual
payments which is return of investment in contract. Still not bad deal.
5.
Gain reported ratably over life expectancy only if donor is sole annuitant or
is one of annuitants in two-life annuity.
G.
Estate Tax Benefits:
1.
Annuity for donor's sole life completely excludable from his estate.
2.
In two-life annuity, estate of first annuitant (purchaser) not subject to
estate tax if second annuitant does not survive. If second annuitant
survives: Includable in estate of first annuitant (purchaser) is only
value of survivor's annuity -- what it would cost to purchase annuity paying
survivor same annual amount that was paid to annuity purchaser. This
value based on survivor's age at annuity purchaser's death. If no gift
annuity purchased, entire amount used to purchase annuity subject to estate
tax. If survivor annuitant is spouse, can qualify for marital deduction.
3.
Survivor receives same amount tax-free each year as first annuitant did.
In addition, survivor gets income tax deduction spread over his life expectancy
for any Federal estate tax paid by first annuitant's estate on value of
survivor's annuity.
H.
Gift Tax Implications of Two-Life Gift Annuities. Donor who funds
annuity with own property and provides annuity payments first to himself and
then to survivor,
makes gift to survivor.
However, proper drafting of annuity agreement -- donor retains right to revoke
survivor's interest -- can make gift to survivor free of gift tax.
VI.
DEFERRED PAYMENT GIFT ANNUITIES
A.
Many donors with sufficient current income from employment or other sources
would like to make sizable charitable gift of capital now, but are concerned
that on retirement they will need income their capital earns. They would
also like to reduce their current income taxes. Deferred payment gift
annuity often
answer. It provides
retirement income and saves income taxes now -- and lets donor make important
charitable gift. Now sometimes called the IRA substitute.
B.
In Brief. Donor makes gift to charitable institution in exchange
for charity's promise to pay him guaranteed life income starting at retirement
(or any other date specified).
C. Advantages:
1.
Satisfaction of making significant charitable gift.
2.
Donor gets sizable charitable deduction now when he is in higher tax bracket
than he will probably be after retirement. Charitable gift now (rather
than after retirement) generates greater tax savings. Reason:
Higher the tax bracket, larger are tax savings generated by charitable gift.
3.
Donor receives guaranteed annual income at retirement when his income will
probably be lower than current income. Thus, receives income at time when
it is needed and when it may be taxed in lower income tax brackets.
4.
Part of each guaranteed payment will be tax-free.
5.
Donor rids himself of management and investment worries.
6.
Donor will save estate taxes and probate costs.
D.
Determining Payments To Be Made:
1.
Annual income charity pays (rate of return) depends upon (1) annuitant's age now,
and (2) age annuitant will be when payments are to start.
2.
American Council on Gift Annuities recommends this procedure:
(a)
Take amount transferred and compound annually at 6% a year from date of
transfer until six months before first payment. However, period of
compounding is then rounded off to first even number of years six months before
date of first payment.
Example: On February
1, 1995 donor transfers $100,000 for deferred payment annuity with first
payment to be made on February 1, 2115. Period of compounding would be 19
years. That is, 20 years until first payment, reduced by six months and
then rounded off to nearest whole year before first payment.
(b)
Once amount transferred compounded as provided above, determine amount of
annuity to be paid by multiplying rate of return charitable organization
currently offers for immediate annuities for individuals who are now age
annuitant will be when annuity payments are to start.
E. Income Tax Savings:
1.
Donor receives income tax charitable deduction in the year he makes
transfer. Amount of contribution established by official U.S. Treasury
tables.
2.
When funded with money, contribution deductible up to 50% of donor's adjusted
gross income. Any “excess” deductible over five following years -- up to
50% of adjusted gross income each year -- until exhausted.
3.
When funded with long-term appreciated securities, contribution deductible up
to 30% of adjusted gross income, with five year - 30% of adjusted gross income
carryover for any "excess." Possible to increase ceiling to 50%
of adjusted gross income with five year - 50% of adjusted gross income
carryover in some instances. Same transfer is made but amount deemed
contributed reduced by 100% of appreciation allocable to gift part of annuity.
F.
Favorable Taxation Of Annuity Payments. Substantial part of each
payment received is tax-free until investment in contract is recovered.
Tax-free amount depends on : (1) annuitant's age now, (2) age when
payments start, (3) Treasury's life expectancy tables in effect when payments
start, and (4) income tax laws in effect when payments begin. This
information enables computation of "exclusion ratio."
G. Capital Gains Consequences:
1.
There are capital gains implications when deferred payment gift annuity funded
with appreciated securities. However:
(a)
Gain is smaller than gain would be on sale of appreciated securities (instead
of transfer for deferred payment gift annuity).
(b)
Gain should not be reportable in year of transfer for deferred payment gift
annuity (as it would be if securities sold). Should be reported ratably
over donor-annuitant's life expectancy, starting when payments begin.
2.
Treasury regulations give capital gains implications for "immediate"
gift annuities (when payments start within one year of gift). Assumed
that rules will be same for deferred payment gift annuities. Private
letter ruling so holds.
H. Benefiting Family Member:
1.
Donor can have deferred payment gift annuity pay income to him for life
(starting when he chooses) and then to his wife (or other designated family
member) for life.
2.
How two-life annuities work: Payments made to one individual for life
(starting at specified date) and then to survivor for life; or payments can be
made jointly and then to survivor. Which way best depends on donor's
wishes and how assets used to fund annuity are owned. Deferred payment
gift annuities can generally be written so that family member's right to
payments not subject to Federal gift tax.
3.
Rate of return lower for two-life deferred payment gift annuity because period
of payments is actuarially longer.
I.
Estate Tax Benefits:
1.
If donor is only annuitant (or, in two-life annuity, is not survived by second
annuitant) annuity not taxed to estate at all.
2.
If there is survivor annuitant, only amount includable in estate of first annuitant
(purchaser) is value of survivor's annuity - what it would cost to purchase
annuity, paying survivor same annual amount that was paid to annuity
purchaser. This value based on survivor's age at annuity
purchaser's death.
J.
Income Tax Benefits For Survivor. Survivor receives same amount
tax-free each year as first annuitant did. In addition, survivor gets
income tax deduction spread over his or her life expectancy for any Federal
estate tax paid by first annuitant's estate on value of survivor's annuity.
VII. CHARITABLE
INCOME (LEAD) TRUSTS
A.
Pre-1986 Tax Reform Act:
1.
Donor could transfer money or property to trustee and provide that income be
paid to designated charity for number of years before it returned to him.
In order for donor not to be taxable on income paid to charity, trust term had
to be at least 10 years.
2.
Income tax charitable deduction allowed only if:
(a)
Charity's income interest is guaranteed annuity (short-term annuity trust) or
trust specifies charity is to receive fixed percent each year of net fair
market value of trust assets, determined yearly (short-term unitrust); and
(b)
Donor taxed on income paid to charity (e.g., his reversionary interest would or
might take effect within 10 years).
3. Income Tax Charitable
Deduction. In limited case where deduction was allowed, limited
o 20% of donor’s
adjusted gross income, with no five year carryover for any “excess.” This
is gift “for the use of.”
B.
Law still allows donor to avoid tax on income paid to charity, but the trust
must not provide reversion for donor or spouse. Trust should be lead
unitrust or lead annuity trust. Otherwise, value of charity's income
interest will be subject to Federal gift tax. And, if donor dies before
property reverts to him, there will be no estate tax charitable deduction.
C.
Main drawback of law is that donor cannot get income tax charitable deduction
unless trust so drawn that he is taxed on income paid to charity. Thus,
except for very wealthy individuals, charitable lead trust created during
lifetime is generally not advantageous. Some create trust with tax-exempt
bonds so that income is not taxable.
D.
Lead trusts paying “income” to charity are advantageous when created by donor's
will. Law allows estate tax charitable deduction for value of income paid
to charity under lead trust created by donor's will. To get estate tax
deduction, income interest must be guaranteed annuity (annuity trust) or fixed
percent distributed yearly of net fair market value of trust assets, determined
yearly (unitrust). However, income paid to charity need not be taxed to
donor's estate in order for estate to get Federal estate tax charitable
deduction.
1.
Example of lead annuity trust. Donor's will creates $100,000 trust
providing that trustee pay
ABC College $6,000 each year for 15 years. Then trust principal is to be
distributed to donor's children.
2.
Example of lead unitrust. Donor's will creates $100,000 trust
providing that trustee pay ABC College each year for 15 years amount determined
by multiplying 6% by net fair market value of trust assets, as valued each
year. Then trust principal is to be distributed to donor's nephews and
nieces.
E.
Be careful, in large trusts, of generation-skipping problems.
VIII. GIFTS
OF PERSONAL RESIDENCE OR FARM WITH RETAINED LIFE ESTATE
A.
Charitable deduction (for income, gift and estate tax purposes) allowed for
gift of remainder interest in real property (not made by transfer to charitable
remainder unitrust, annuity trust or pooled income fund trust) only if
remainder interest is in personal residence or farm.
1.
What is personal residence? Any property used by donor as personal
residence even though not principal residence. For example, donor's
vacation home may be personal residence. Term personal residence also
includes stock owned by donor as tenant-stockholder in cooperative housing
corporation if dwelling he is entitled to occupy as stockholder used by him as
personal residence.
2.
What is a farm? Any land used by donor or his tenant for
production of crops, fruit or other agricultural products - or for sustenance
of livestock.
B.
Estate may be retained for one or more lives. Estate may also be retained
for term of years.
C.
Valuing the remainder interest:
1.
For income tax charitable deduction, in determining value of remainder
interest, depreciation (computed on straight line method) and depletion must be
taken into account. Depreciation on structure only, not land. Those
values are, under current law, discounted at a rate of 10% per annum.
2.
For gift and estate tax purposes, Code does not specify that
depreciation (or depletion) must be taken into account in valuing remainder
interest. Nor do Treasury regulations require that depreciation (or
depletion) be taken into account in computing gift and estate tax charitable
deductions. IRS, in private letter ruling issued to a mid-western college,
stated that for gift and estate tax charitable deductions, depreciation (or
depletion) need not be taken into account.
3.
Computing charitable deduction for remainder interest in personal residence or
farm not simple. Easier part is purely mechanical computation using IRS
tables and formulas. Difficult part is determination of hard fact
questions:
(a)
Fair market value of the property - with fair market value allocated between
land and structures.
(b) "Estimated useful life"
of structure (longer the estimated useful
life, larger the charitable deduction).
(c)
Value of structure at end of estimated useful life ("salvage value").
The greater the value at end of estimated useful life, larger the charitable
deduction.
D. Gift
of Undivided Interest in Real Property. Income, gift and estate tax
charitable deductions allowed for undivided portion of donor's entire
interest in real property whether or not a personal residence or farm.
IX.
LIFE INSURANCE GIFTS: BENEFITS, PITFALLS AND PRATFALLS
A. Basics.
1.
Donor gets income tax charitable deduction when donates insurance policy.
Donor makes public charity irrevocable beneficiary and assigns all incidents of
policy ownership to charity. Retention of just about any control over
policy -- including power to change beneficiary or to borrow against policy --
precludes deduction.
2.
Insurable interest ruling. LTR 9110016.
(a)
Rule differs from state to state. Which law governs?
(b)
The New York experience.
(c)
Assume there is no problem in Pennsylvania where policy is assigned by the
insured who obtained the insurance policy.
3.
Amount of deduction depends on type of policy contributed.
(a)
Gift of policy on which premiums remain to be paid. Amount of
income tax charitable deduction is policy's interpolated terminal reserve at
date of gift, plus proportionate part of gross premium last paid before gift
that covers the period extending beyond date of donation. Translated into
English: Generally slightly above cash surrender value. However, if
"interpolated terminal reserve," etc., exceeds cost basis of policy
(the premiums paid minus dividends received), deduction is limited to policy's
cost basis.
Gift qualifies for 50% of adjusted gross income deductibility ceiling, with a
five-year carryover for any "excess."
(b)
Payment of premiums. Donor not obligated to continue paying
premiums after contributes policy. If donor stops making payments,
charity may (1) continue to pay premiums so as to eventually receive full face
amount, (2) elect to receive paid-up policy in reduced face amount on which no
further premiums payable or (3) surrender policy for cash value.
If donor continues paying premiums
directly to insurance company, gets income tax charitable deduction each year
for premiums paid during year. Those payments are considered gifts
"to" charity, qualifying for 50% ceiling and five-year carryover.
(c) Gift of fully paid-up life
insurance policy. Income tax charitable deduction is allowed for
policy's replacement cost. However, if replacement cost exceeds policy's
cost basis (premiums paid minus dividends received), deduction is limited to
cost basis. Gift qualifies for 50% ceiling, with five-year carryover for
any "excess."
B. Estate
Tax Benefits From Lifetime Charitable Gifts of Life Insurance.
1.
In addition to income tax savings, donor can save estate taxes -- if estate
would otherwise be subject to tax -- by giving life insurance policy to
charitable institution. Proceeds received by charity are immune from
federal estate tax. Because policy contributed during lifetime, proceeds
are not includable in donor's gross estate. If gift made within three
years of death, proceeds will be includable in gross estate, but will be
deductible as estate tax charitable deduction -- resulting in washout.
2.
Retaining incident of ownership to increase size of estate tax marital
deduction. Now that marital deduction is unlimited, there's no point in
keeping scintilla of ownership. Donor who has retained interest in
policies contributed to charity should review those policies and transfer all
retained rights to charity. Although any amount included in gross estate
(due to retained rights) will be deductible as a charitable deduction, amounts
includable in gross estate (and hence adjusted gross estate) may result in
distortions that disqualify estate for IRC Sec. 2032A special use valuation,
redemptions under IRC Sec. 303 and the IRC Sec. 6166 installment payment of tax
when the estate has an interest in a closely held business.
C. Pitfalls.
1.
Charitable gift of maturing endowment policy. Income tax
charitable deduction is value of policy, minus amount that would be taxed as
ordinary income on sale. However, deduction need not be reduced by
ordinary income element if policy matures in year of gift.
Caveat. Donor who
contributes endowment policy will have to report (as ordinary income) difference
between cost basis of policy and maturity value in year policy matures -- that
is so even though charity (not donor) receives proceeds.
2.
Charitable gift of annuity contract linked to purchase of term insurance at
discount rates. No income tax charitable deduction allowable for
charitable gift of annuity contract under those circumstances.
3. Split-dollar plan
involving charitable gift. Under charitable split-dollar plan, donor
gives cash value portion of paid-up policy (or ordinary life policy on which
premiums continue to be paid) to charity, retaining right to designate
beneficiary of insurance proceeds that exceed cash value.
In 1973 private letter ruling, IRS
held that charitable split-dollar arrangement is "partial interest"
gift that does not entitle donor to income tax charitable deduction.
4. &nbs