Charitable solutions can create a steady stream of payments for a donor. Professional advisors may provide guidance on retirement planning, investments, tax strategies and charitable giving. Clients are often concerned with maintaining their standard of living, minimizing tax recognition and supporting their favorite charitable organizations. Life income gifts are a great solution for clients who desire a steady source of income for the duration of their lives, while also providing a legacy for charity.
Part two of this article series will provide an explanation of payout methods, options for trustee and the four tier accounting rules. This article series will provide illustrations of the gift models and practical pointers for using a charitable remainder unitrust. The information should enable a donor to understand how a charitable remainder trust can fulfill his or her philanthropic goals.
Types of Unitrust Payouts
Payouts are among the most important areas for the advisor to communicate to the income recipient. With a charitable remainder unitrust, payouts are based on a unitrust percentage multiplied times the trust value. The distribution of unitrust amounts may be monthly, quarterly, semiannually or annually.
There are four major formulas for payment of unitrust amounts. An attorney drafting unitrust documents must understand clearly the four different methods, the appropriate language for each method and the correct use of each of the four options. The four options are commonly referred to as "Type I - Standard Unitrust (Reg. 1.664-3(a)(1)(i)(a)), Type II - Net Income Plus Makeup Trust or NIMCRUT, (Reg. 1.664-3(a)(1)(i)(b)(2)), Type III - Net Income Only Unitrust or NICRUT (Reg. 1.664-3(a)(1)(i)(b)(1)), and Type IV - FLIP Unitrust (Reg. 1.664-3(a)(1)(i)(c))."
Type I or Standard Unitrust
The Type I or Standard Unitrust is reasonably straightforward. In most cases, the valuation date for the trust is January 1 of each year. The annual amount is the selected unitrust percentage multiplied times the January 1 value of the trust. If the amount is paid semiannually, quarterly or monthly, the unitrust amount is divided by two, four or twelve to calculate the distributions.
This plan has several advantages. It is easy for the donor to understand, for the CPA or attorney to explain to the client and it is possible for a portion of the distribution to be capital gain. For these reasons, the standard unitrust is preferred by donors, trustees and the Internal Revenue Service. While the IRS does not publicly advocate specific trust types, the standard unitrust is preferable, since it increases the probability of compliance by trust administrators. The standard unitrust is commonly used when public stocks or other liquid assets are transferred to a CRT.
Type II or Net Plus Makeup Unitrust (NIMCRUT)
The Type II or Net Income Plus Makeup Trust pays the lesser of trust income or the unitrust percentage. A NIMCRUT was initially included in the 1969 legislation because donors often contribute real property to charitable trusts. The real property may not earn sufficient income to enable the trustee to make the required 5% or greater payment. Thus, the trust may pay the lesser of the unitrust amount or the actual income earned until the real property is sold. After the real property has been sold and the proceeds reinvested, the trust will pay the regular unitrust amount. If there are excess earnings over the unitrust amount, any shortfall or deficit in the initial years could be repaid. The latter amount is referred to as the "makeup" portion of the payout.
This method has become quite popular for those donors who desire an "income control" unitrust. Through careful selection of either growth or income assets, the trustee may allow growth for a period of time, such as prime earning years prior to retirement. After retirement, the trustee could shift from a growth to an income-producing investment and make distributions of both the regular unitrust amount plus the makeup amount.
Under Reg. 1.664-3(a)(1), income is defined under Sec. 643(b) and the applicable regulations. Reg. 1.643(b)-1 notes that income shall be defined under the "governing instrument and applicable local law." In states that have passed the Uniform Principal and Income Act, a trustee of most noncharitable trusts may be given the power to allocate capital gains to distributable income or to principal. However, under Reg. 1.664-3(a)(1)(i)(b)(3) a NIMCRUT is precluded from permitting the trustee to have a purely discretionary power to allocate capital gain. The unitrust drafter may allocate all recognized capital gain to income, no recognized capital gain to income or a fixed fractional part of gain to income. An alternative to permit discretionary distribution of capital gain is to place the unitrust assets in a partnership or single-member LLC. When a trust payout is desired, recognized capital gains are distributed from the partnership or LLC to the unitrust, and then to the income recipients. The NIMCRUT defines income as a cash distribution from the LLC or partnership and there is no obligation to make the trust income payments until receipt of the LLC or partnership distribution.
There also is a limit on recognized capital gain allocated to income with a NIMCRUT. Under Reg. 1.664-3(a)(1)(i)(b)(3), the pre-gift gain must be allocated to corpus. Only post-gift capital gain may be allocated to income and distributed to income recipients.
Type III or Net Income Only Unitrust
The Type III or net income only trust is very similar to the Type II trust, except there is no makeup provision. Once again, the trust pays the lesser of the income or the unitrust percentage. This formula is used infrequently. Generally, it is helpful for individuals who desire income, but want to ensure a substantial remainder to the charity.
Type IV or FLIP Unitrust
The Type IV or FLIP unitrust was created by regulations and usually combines a NIMCRUT and a standard unitrust. In Reg. 1.664-3(a)(1)(i)(c), the Service permits a trust to function initially as a Type II or Type III trust. After a "trigger event," the trust will change the following January 1 to a Type I or standard unitrust. The triggering event may be a sale of nonmarketable assets, marriage, divorce, death, birth or fixed date in the future. It is possible to use a combination trigger event by selecting the first or last of two factors.
While the trigger event may not be a discretionary power of the trustee, a trustee may have some control over the trigger event if there is a readily salable parcel of real estate as the nonmarketable asset. In that case, the trustee may elect to sell the real estate and trigger the FLIP.
With a FLIP, any existing deficit is forfeited when the trust changes to a Type I unitrust on the January 1 after the trigger event. If there has been appreciation of the assets prior to the trigger event, then an initial NIMCRUT formula with recognized capital gain allocated to income could permit repayment of part or all of the makeup account. However, in most cases it may be preferable to retain the gain tax-free in the trust and benefit from added income for life, rather than distributing the makeup in one year and paying a large tax at that time.
Generally, the FLIP unitrust is used for sale of nonmarketable assets. Nearly all unitrust drafters now use a FLIP unitrust rather than a NIMCRUT for real property. The real property is transferred into the FLIP unitrust, usually sold during the first year and the following January 1 the trust FLIPs to a straight unitrust.
Generally, there are three options for the trustee of a charitable remainder trust. These are a corporate trustee, a charity serving as trustee or a private individual trustee. Before the trust is funded, the donor should understand the three options sufficiently well to make a reasoned decision. There are benefits with each of the three options, and circumstances in which one of the three is preferred over the others. Advisors need to explain these options and benefits to donors so they can make a proper choice.
Corporate trustees include banks, trust companies and the trust departments of major financial firms. All three share the following advantages.
First, the corporate trustee is objective. If there are significant trust assets, there may be several family members who are income recipients. There may also be some family members who are not income recipients but who are discretionary income recipients. Finally, there could be several charities that are remainder recipients.
The objective nature of a corporate trustee makes this choice very desirable for large trusts, particularly where there may be contentious family members. The corporate trustee has no vested interest in the income or remainder of the trust and being objective is a significant advantage in balancing interests of the various parties.
Corporate trustees also have expertise in taxation, investments and charitable trusts. Competition in financial services has resulted in lower costs and improved services. Corporate trustees also have a standard structure for sharing information with trust recipients.
Is there a cost for corporate trust services? All trusts have a cost for both management and investments. Many corporate trustees charge from 1% to 1.5% per year for their management, tax and investment services. For very large trusts, these rates may be negotiated to lower levels with some trustees. Given the cost structure of a corporate trustee, the minimum funding amount for trusts is perhaps $1 million and trust administration fees become more sustainable with a trust corpus of $2 million or more.
Charity as Trustee
Why would a charity desire to serve as trustee? When a charitable organization serves as trustee, there is always potential liability. In addition, the charity has an obvious conflict of interest. The family will receive the income payments, while the charity will receive the remainder interest.
Charities who serve as trustee typically do so because they desire an opportunity to build a relationship with the donors and they will receive part or all of the trust remainder. If the charity is a good manager of the trust, the donors will be pleased with the result and have regular and periodic contact with the charity.
Many larger charities serve as trustee. They have sufficient staff to provide sound investment and tax services. The trustee-charity perceives it to be beneficial to manage the trust well and produce growth in the trust. This growth increases the income of the recipients and potentially provides larger corpus for future distribution to the charitable remaindermen.
Many charities provide trust services at low cost. In addition, some charities that are irrevocably vested with 50% or more of the trust corpus provide trust services at no cost. There will be investment costs even though the charity waives the administration fees.
A new or small charity should exercise great care before accepting the responsibilities of trusteeship. Most charities that are new to the gift planning field find that their resources are much more productively used in marketing, rather than trust administration. In addition, accepting the role of trustee is a major responsibility, with significant potential liability risk. A charity should not serve as trustee until the Board of Directors of the charity is committed to providing ample resources to fulfill all trustee functions and responsibilities.
The private trustee has historically been the least frequently used method, but it is growing in popularity. A private trustee permits the donor to have a great deal of flexibility and control over the administration and investments of the trust. However, it also involves a significant level of responsibility for the donors or other persons serving as trustee of the trust. As noted below, there are significant risks and penalties if the trust is not administered appropriately.
Private trustees must have good counsel from their attorney, CPA and investment advisor. The private trustee needs to understand all the rules that apply to charitable trusts. For example, charitable trusts are subject to Self-Dealing rules under Sec. 4941. This means that the donor, children, grandchildren and spouses cannot buy, sell, lease or otherwise transact business with the trust.
The trust should not make any investments under Sec. 4944 that jeopardize the charitable remainder. A portfolio of high-quality stocks and bonds is a good solution and complies with Sec. 4944. However, some investment advisors have suggested options, puts, calls, working interests in oil and gas, limited partnerships and other types of investments. With the exception of the covered call used with high quality stock, most of these other options involve major risk and should be avoided.
The trust CPA should make certain that the Form 5227, Trust Information Tax Return, is filed by April 15th after the close of each trust year. Hopefully, there will be no unrelated business taxable income (UBTI) and IRS Form 4970 will not be required.
The accounting for a charitable remainder trust and management of investments is a challenging task. While many individuals are now undertaking this responsibility with the advice of qualified counselors, there are several options that are also growing in popularity with private trustees. Yellowstone Trust (800-572-6394, www.yellowstoneta.com), Cornerstone Management (770-449-7799, www.cornerstonemgt.net), CRTPro LLC (800-422-3316, www.crtpro.com) and Renaissance Trust (317-757-3453, www.reninc.com) all provide trust accounting services (not trustee services). Your publisher does not endorse the above organizations and offers this information as a public service.
As a general rule, private trustees should select an independent company to do the trust accounting. The individual may control the trust and select the trust investment advisor, but the outside accounting firm will handle the four-tier accounting, IRS Form 5227 and other administrative actions. This solution is much more likely to comply with applicable Internal Revenue Code provisions.
Trustee Fiduciary Responsibilities - The Atkinson Case
In Estate of Melvine B. Atkinson v. Commissioner
, 115 TC., No. 20968-97 (July 26, 2000), the Tax Court held that an estate tax deduction would be denied for an annuity trust that never made payments. The annuity trust was funded with $3,999,974 by Melvine B. Atkinson in 1991. She passed away approximately two years later in 1993. The Tax Court noted that a charitable annuity trust under Sec. 664(d)(1) must pay out at least 5% of the initial net fair market value of trust assets. The requirement for the payout was deliberately created by Congress to minimize the risk that donors would use a charitable remainder trust as a substitute for a private foundation. See S. Rept. 91-552 (1969), 1969 3 C.B. 423, 481. Thus, the Tax Court determined that an annuity trust that made no payments failed to qualify under Sec. 664 requirements. A second status for disqualification was the invasion of the trust to pay estate taxes. Under Rev. Rul. 82-128, 1982-2 C.B. 71, charitable remainder trusts are not permitted to pay estate tax out of the trust. The beneficiaries must make tax payments out of other assets or out of the residue of the estate. Since no trust payments were made and since the trust corpus was invaded for payment of estate taxes, the trust was not qualified as an annuity trust.
Analysis of Compliance
In the Atkinson case, there was essentially no compliance. The trustee did not make the trust payments, did not file the trust returns and for all intents and purposes acted as if the trust did not exist. Therefore, the Tax Court had ample grounds to disqualify or disregard the existence of the trust.
In Reg. 1.664-3(a)(1)(i)(g), the Service notes that there is a safe harbor created if the CRT complies with the payment requirements. The regulations also make explicit provision for overpayments and underpayments. See Reg. 1.664-3(a)(2).
While in Atkinson there was essentially no compliance, most trusts will have a high level of compliance with the IRC and regulations. Since there is explicit authorization in Reg. 1.664-3(a) for correction of overpayments and underpayments, a trustee that takes action within a reasonable time to correct those payments should not be subject to penalties. While payments would normally be made by April 15th of the following years under Reg. 1.664-3(a)(1)(i)(h), the Code does not explicitly require payments within that time. Thus, a number of trustees faced with errors in payments have adjusted payments over 12, 24 or even 36 months. There is no explicit permission or prohibition for this practice.
For most trustees, the Atkinson decision should be cautionary, but will not dramatically change existing trust practices. Most unitrusts are in substantial compliance. Corporate trustees normally invest in high quality stocks and bonds and have a high level of compliance with all requirements. While larger charities approach the corporate standards in compliance; smaller charities tend to have greater diversity and more often make incorrect payments, fail to calculate makeup amounts correctly and may neglect to file Form 5227 returns. Private trustees have the lowest levels of quality control, the greatest diversity and the least experience in this area. Thus, private trustees are more likely to be in violation of the various rules.
While all private trustees and smaller charities should take the Atkinson decision seriously, it does not fundamentally change any law. The Atkinson case was very different from normal trust administration. Historically, there have been numerous trustees who make errors in calculation of payments, but these nearly always come squarely within the explicit provision within the regulations and revenue rulings for corrective payments. So long as corrective payments are promptly made, there should be no disqualification of the unitrust or penalties assessed.
Taxation of CRT Payouts
Unitrust payouts are one of the most important areas for the advisor to communicate to the recipient. With a charitable remainder trust, the basic payout rule is that the unitrust percentage is multiplied times the trust value and that amount is then distributed. The distribution may be monthly, quarterly, semiannually or annually.
This distribution sounds simple. However, the options and accounting can be complex. The challenge for the advisor is to explain these rather complex concepts in simple terms to donors and clients.
A majority of future CRTs will be standard unitrusts or FLIP unitrusts. After the FLIP trigger event, the following January 1 the CRT becomes a standard unitrust. The standard unitrusts are simple to understand, reasonably easy to administer and often enable donors to receive partly capital gain payouts.
Unitrust distribution rules are set forth in Reg. 1.664-1(b). Distributions from unitrusts are first ordinary income, then capital gain, then tax-free income and finally trust corpus. The distribution method is commonly described as the "Four-Tier" structure. In truth, the distribution rules have been made more complex by the different capital gains rules. The capital gain tier is further subdivided into the four levels for capital gain. The actual final structure is as follows:
| Capital Gain
|Tangible Personalty Gain
|SL Depreciation Gain
|Return of Principal
The trust accountant must also track post-2012 Sec. 1411 passive income. While the CRT is exempt if there is no unrelated business income (UBI), the distributions to the income recipients must track the four-tier amounts and the Sec. 1411 amounts. There is a 3.8% federal tax on the Sec. 1411 amounts.
The unitrust four-tier accounting can be complex, but the concept is simple. The distribution to the recipient will require payment of tax at the highest possible rate. Thus, all ordinary income earned by the trust must be distributed before any capital gain is paid out.
Since the goal for many unitrusts is to distribute partly capital gain payouts, the trust investments are carefully selected to minimize production of ordinary income and maximize recognized capital gain. Of course, creation of capital gain return involves inherent risk-return issues that will be addressed in subsequent chapters.
Charitable giving can be crafted to meet the goals of the particular client, whether those goals are financial, familial, philanthropic or a combination of all three. By creating a charitable remainder unitrust, donors will be satisfied that they have created income for life and will enjoy knowing they have made a positive impact through their charitable gifts.