WESTCHESTER COUNTY BAR ASSOCIATION
SECTION ON TAXATION
Tuesday, May 7, 2002
Trinity Restaurant
Harrison, New York
PHILIP T. TEMPLE, ESQ.
McCarthy, Fingar, Donovan, Drazen & Smith, L.L.P.
White Plains, New York
1. Overview of Certain Planned Giving Vehicles.
So that you have an appropriate background for the discussion to follow, here is a summary of how certain planned giving instruments work and their basic tax implications.
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 and not taxed.
(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 tax-free.
(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 and not taxed.
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.
(4) 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 First, unpublished PLR said O.K. Then, IRS says it doesn’t work.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. Reg §1.664-3(a)(1)(i)(c).
(5) Why the Flip?
(a) In net income unitrusts, 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, Trustee can invest for total return. Easier to achieve payout percentage and some reasonable growth in trust assets. Thus, unitrust can furnish
potential hedge against inflation--and charitable remainder interest is increased.
(6) 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 fixed amount of X dollars a year out of income and, if income is insufficient, out of principal. Any excess income is retained in trust and not taxed.
(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.
(4) Therefore, annuity trust furnishes no hedge against inflation.
2. 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%. Same ceiling limitations as for outright gifts will apply.
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.
3. Gifts of Real Estate
A. Real estate represents approximately 50% of total individual wealth; important that charities tap potential of real estate gifts.
B. Many kinds of real estate interests; know the names and rules, for example: whole fee interests; partial interests (undivided interests, life estate and remainder; joint tenancy; tenancy in common).
C. Income tax charitable contribution deduction.
(1) Limit on charitable deduction for appreciated real estate gifts is 30% of adjusted gross income with five year carryover for any “excess” contribution - - up to 30% of adjusted gross income in each carryover year until exhausted.
(2) If you can’t use entire gift, consider contributing partial or undivided interest over a period of years or making the election to reduce the amount of the gift by the appreciation so that the ceiling increases to 50% of adjusted gross income.
D. Transfer of Encumbered Property to Remainder Trusts and as Outright Gift.
(1) Mere transfer of mortgaged property is deemed bargain sale. Reg. '1.1011-2(a)(3).
(a) IRS has said Reg. '1.1011-2(a)(3) applies to CRT. Rev. Rul. 81-163, 1981-1 C.B. 433.
(b) Gain is for difference between amount of debt and allocated adjusted basis; not limited by property's fair market value.
(2) LTR 9015049. CRT disqualified if funded with mortgaged property.
(a) Facts. D planned to fund charitable remainder unitrust with income-producing real estate. Trustee would make regularly scheduled payments on mortgage, but D would remain personally liable for the debt.
(b) IRS rules. Trust won't qualify. Charitable remainder trust must function exclusively as one from its creation. It isn't charitable remainder trust - indeed, it isn't even deemed "created" - as long as donor treated as owner of entire trust under the grantor-trust rules. Reg. '1.677(a)-1(d) provides that donor is treated as owner of trust whose income is or may be applied in discharge of donor's legal obligation. Because D would be treated as owner of entire trust, it wouldn't be deemed "created," and thus wouldn't qualify as charitable remainder unitrust.
(c) Earlier rulings (i.e. LTR 8931023).
(3) Possible ways to avoid issue:
(a) If outstanding mortgage is small, donor may be willing to satisfy it before transferring property to trust.
(b) Sometimes lender may be willing to release mortgage if donor can substitute other security for indebtedness.
(c) Donor could sell undivided interest in property to charity (reporting capital gain on any appreciation attributable to that interest). Then donor could use sale proceeds to satisfy mortgage, and transfer unencumbered property to charitable remainder trust. Charity would have to take care not to pay more than fair market value for undivided interest - and fractional interests in property may have to be discounted to reflect the unwieldiness of a co-tenancy arrangement. Naturally, charity would first have to be sure charitable remainder is large enough to make it all worthwhile.
E. Funding Charitable Remainder Trusts with real estate, consider the following types of unitrusts:
(1) Net Income With Makeup Unitrust.
(2) Net Income, No Makeup Unitrust.
(3) Hybrid agreement (the “Flip” unitrust).
4. Valuation and Substantiation Rules
A. Basics. If a charitable contribution is made in property other than money, the amount of the contribution is the fair market value of the property at the time of the contribution... fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.
B. Comparable sales.
(1) Comparable sales technique (also known as "market data method") most useful when donated property similar to other property available on open market.
(2) Appraiser locates several similar items -- called "comparables" -- that were sold or available for purchase near time of donation.
(3) That gives ballpark figure. Then value increased or decreased, depending on how donated property stacks up against comparables.
C. Capitalization of income.
(1) If asset generates income, value can sometimes be appraised by estimating how much income it can be anticipated to earn.
(2) Then match to market rates.
D. Replacement cost.
(1) This method most often used when property to be valued is unique and isn't expected to generate income.
(2) Because replacement cost represents value of brand-new asset, adjustments may be made to reflect depreciation on property before its donation.
E. Subsequent sales.
(1) Often, charities that have no immediate use for donated property sell property and use sales proceeds for charitable endeavors. Although sale price of donated asset is not conclusive evidence of fair market value, IRS and the courts generally find it very persuasive.
(2) Indeed, new reporting requirements for certain contributed property sold within two years of gift show how probative Congress finds that information.
5. Form 8283: Appraisal summary.
6. Form 8282: The "tattle tale" form.
7. Appraisals.
A. What must be appraised?
(1) Property gifts (other than money and publicly traded securities) if claimed or reported value of property exceeds $5,000. To determine whether $5,000 threshold crossed, only part of gift claimed as charitable deduction counts. Thus, if land worth $25,000 is placed in charitable remainder unitrust, appraisal requirements apply only if charity's remainder interest more than $5,000 and donor claims income tax charitable deduction.
(2) What is "qualified appraisal"?
(a) Qualified appraisal can be done any time from 60 days before donation up until due date (including extensions) for return on which donor reports or claims gift; post-donation appraisals are okay.
(b) Regulations require qualified appraisal to give following information:
(i) Description of property in sufficient detail for person who is not generally familiar with type of property to ascertain that appraised item is property contributed.
(ii) In case of tangible property, its physical condition.
(iii) Date (or expected date) of contribution to donee-charity.
(iv) Terms of any agreement or understanding entered into (or expected to be entered into) by or on behalf of donor (or donee) that relates to use, sale or other disposition of contributed property; includes, for example, terms of any agreement or understanding that –
(A) Restricts (temporarily or permanently) donee-charity's right to use or dispose of donated property;
(B) Reserves to, or confers upon, anyone (other than charity or organization participating with charity in cooperative fund-raising) any right to income from donated property or possession of property - including right to vote donated securities, to acquire property by purchase or otherwise, or to designate person having income, possession, or right to acquire; or
(C) Earmarks donated property for particular use.
(v) Name, address and TIN of qualified appraiser (or appraisers) and - if qualified appraiser is a partner in partnership, employee of any person (whether individual, corporation, or partnership or independent contractor engaged by person other than donor - name, address and TIN of partnership or person who employs or engages qualified appraiser.
(vi) Qualifications of appraiser who signs appraisal, including appraiser's background, experience, education, and membership, if any, in professional appraisal associations.
(vii) Statement that appraisal was prepared for income tax purposes.