Pointers in Selecting Assets to Fund Charitable Trusts

Pointers in Selecting Assets to Fund Charitable Trusts
Estate Planning Magazine

Charitable trusts will continue to be an important part of the thoughtful estate planner's repertoire in our new estate and gift tax environment. Charitable trusts also continue to offer significant income tax benefits. Thus, the planner needs to be well-versed in their design, creation, funding and operation.

nnThe basic charitable remainder trust or charitable lead trust document can be deceptively simple. The greater complexities arise in the design of the plan that drives the document. That design includes the selection of appropriate trust assets. We will consider a variety of possible assets and whether they do or do not have an appropriate place in certain types of charitable trusts.

Charitable Trusts - The Basics

Charitable Remainder Trusts. By way of background, there are two basic types of charitable remainder trusts ("CRTs"): the charitable remainder unitrust and the charitable remainder annuity trust1. These trusts initially make distributions to an individual beneficiary or beneficiaries. The remainder interest is payable to a charity.

In a charitable remainder unitrust ("CRUT"), the individual beneficiary receives a stated percentage (no less than 5%) of the fair market value of the trust assets at least annually2. This amount, which will fluctuate based upon the value of the CRUT's assets, is referred to as the "unitrust amount."

A popular type of CRUT, called the net income make-up unitrust ("NIMCRUT")3, provides for annual payments of the lesser of all trust income, or the unitrust amount. If income then exceeds the unitrust amount in future years, the excess income will be paid to the beneficiary to the extent that he or she did not receive the full unitrust amount in earlier years.4

A charitable remainder annuity trust ("CRAT") is similar to a CRUT, except that the individual beneficiary receives a fixed distribution (an "annuity amount") at least annually.5

The donor of an inter vivos CRT is entitled to a federal income tax charitable deduction equal to the present value of the remainder interest6. The donor is also entitled to a similar gift tax deduction7. A testamentary CRT will qualify for an estate tax deduction equal to the present value of the remainder interest at the donor's death.8

The CRT itself is generally exempt from tax9. Distributions from the CRT to its beneficiary do, however, pass out trust income to the beneficiary under a "tier" system whereby the trust is deemed to distribute out, in order, ordinary income, capital gains, tax-exempt income (taking into account all income and gains earned since the trust's inception) and, finally, return of corpus10. For example, a $150 distribution by a CRT that had $100 of undistributed ordinary income and $50 of undistributed tax-exempt income, carries out $100 of taxable ordinary income and $50 of tax-exempt income to the beneficiary.

Charitable Lead Trusts. There are similarly two types of charitable lead trusts ("CLTs"): the charitable lead unitrust and the charitable lead annuity trust. These trusts operate in the reverse of charitable remainder trusts in that the initial beneficiary (of either a unitrust or an annuity trust interest) is a charity and the remainder beneficiary is either the donor or other non-charitable beneficiaries11. nnA donor of an inter vivos CLT is only entitled to a federal income tax charitable deduction if the CLT is a grantor trust for federal income tax purposes12. The donor is, however, entitled to a gift tax deduction equal to the present value of the charitable lead interest, regardless of whether the CLT is a grantor trust13. A testamentary CLT will qualify for an estate tax deduction equal to the present value of the charitable lead interest at the donor's death14.nn

In contrast to the CRT, the CLT is taxed under the usual trust income tax rules of subchapter J of the Internal Revenue Code. The CLT is, however, entitled to an income tax charitable deduction, without limitation, for income paid to the charitable beneficiary15.

In the case of a grantor CLT, all trust tax attributes will be included on the grantor's annual income tax return16. Note that the grantor is not allowed an additional income tax charitable deduction (beyond the initial deduction for the present value of the lead interest) as annuity or unitrust payments are made to the charitable beneficiary17.

Funding Charitable Trusts

Retirement Benefits and Appreciated Assets. Because a CRT is generally tax exempt, two types of assets are especially favored for funding: income in respect of a decedent (IRD) items (in the case of the testamentary CRT) and highly appreciated capital gain property (in the case of the inter vivos CRT). Since the CRT is tax-exempt, the receipt of IRD by a testamentary CRT will not result in taxable income to the trust. Similarly, appreciated property can be sold by the CRT without a tax consequence to the trust.

The following examples illustrate these benefits:

Example 1 - Funding at death with IRA proceeds.

Paul has a large IRA. He wants his wife to continue to benefit from the IRA if she outlives him, but he's concerned about the estate and income taxes it will bear after they both die. Paul is charitably inclined. He names a CRUT, to be established under his will, as the secondary beneficiary of his IRA. His wife predeceases him. At his death, the IRA proceeds are paid to the CRUT. His children are the initial beneficiaries of the CRUT. Since the CRUT is tax-exempt, it will not pay income tax on the IRA proceeds, even though those proceeds are IRD. If the CRUT earns enough additional ordinary income to satisfy the annual unitrust payments, the current IRD will effectively never bear income tax under the tier system. Since no income tax is paid by the trust upon receipt of the IRD, the gross amount of the IRA is available to earn for the trust. In contrast, if the children were direct beneficiaries of the IRA, the income tax burden would reduce the earning power of the IRA. The estate tax savings combined with the greater earning power of the larger principal base may, in fact, compensate the children for the loss of the remainder interest that is ultimately distributed to charity.18

Example 2 - funding with appreciated assets

Helen's stock portfolio is disproportionately invested in a single, low-basis, publicly-traded stock that does not pay dividends. For some time, she's considered selling some of the stock, but she's concerned about the resulting capital gains tax. Helen is also charitably inclined. She decides to transfer the stock to a CRUT, reserving an 8% annual unitrust interest for her lifetime. Helen has also received a very large, one-time deferred compensation payment this year that will cause a considerable increase in her taxable income. She will receive an income tax deduction19 equal to the present value of the remainder interest. That deduction will offset much of the extraordinary income she has received this year. The CRUT may (and, in fact, should) sell the stock to diversify the holdings of the trust. The trust will not pay any tax on the capital gain. Further, if the unitrust payout rate is low enough, and the ordinary income thereafter earned by the trust is high enough, none of this capital gain will be deemed to be distributed to Helen under the tier system. Since it pays no income tax, the trust's entire value remains intact to generate its annual unitrust return for Helen. If Helen is fortunate enough to have the trust's assets continue to appreciate in value, that in turn will increase the dollar amount of the unitrust payout.

If Helen had instead established a CRAT, the benefits would be similar, except that her payout would be fixed, regardless of whether trust assets appreciated or depreciated in value.

If a CRT might eventually benefit a private foundation (other than an operating/supporting foundation, a distributing foundation, or a foundation maintaining a common fund)20, the income tax deduction for the contribution of capital gain property will be based on the property's basis, rather than its fair market value21, unless the property is publicly-traded.22 Thus, the CRT should either preclude any distributions to such a private foundation, or contributions of appreciated property should be limited to publicly-traded securities, if a deduction based on fair market value is desired23. Furthermore, contributions for the benefit of a private foundation (and this includes contributions through a charitable trust) are only deductible to the extent of 30% of adjusted gross income if those contributions are in cash and, at most, 20% of adjusted gross income if the contributions are in the form of appreciated property.24

It is also important to consider the payout rate requirements in a conventional inter vivos CRT or CLT if appreciated assets are contributed. The regular distributions to the beneficiaries (individuals in the case of the CRT, and charities in the case of the CLT) may generate capital gain either because the trust had to sell assets to generate cash for distributions or because it made distributions of assets in kind. Even in the case of the otherwise tax-exempt CRT, these income tax consequences may be carried out to the individual beneficiary under the tier system.

In the case of contributions made at death, most of the capital gains disadvantages discussed above are no longer an issue.26 Thus, non-publicly-traded capital gain property (such as closely-held stock or real estate) may be a fine way to fund a testamentary CRT or CLT. The estate tax deduction will be calculated based upon the property's fair market value (i.e., federal estate tax value) even if the charitable trust is permitted to make distributions to a private foundation.

Closely-Held Business Interests

Notwithstanding some of the drawbacks discussed above, interests in closely-held businesses may nevertheless make good candidates for charitable trust funding, with the following caveats:


Generally, the only trusts allowed to hold stock in an S corporation are (i) grantor trusts, (ii) former grantor trusts receiving S corporation stock upon the death of the grantor (and then only for a maximum of two years following the grantor's death), (iii) a testamentary trust for a period of two years following the date on which the stock is transferred to it, (iv) qualified subchapter S trusts ("QSSTs"), and (v) electing small business trusts ("ESBTs").27

CRTs, therefore, should not be funded with S corporation stock. A CRT is not a grantor trust.28 A CRT cannot be a QSST,29 and a CRT cannot be an ESBT30.

Certain CLTs may, however, own S corporation stock. For example, a CLT that is also a grantor trust may be an S corporation shareholder31. Proposed Treasury Regulation 1.641(c) 1(k) Example (4) also allows a non-grantor CLT to elect to be treated as an ESBT, and thus be eligible to own S corporation stock.

Partnerships & Limited Liability Companies.

Reg. §1.664-1(c) provides that if a CRT has any UBTI in a given taxable year, it loses its tax-exempt status for that year. If a CRT owns an interest in an LLC or partnership, the LLC or partnership may pass through income items to the trust that constitute UBTI. In Leila G. Newall Unitrust v. Commissioner,32 a CRT held limited partnership interests in three publicly-traded limited partnerships. The Tax Court, citing I.R.C.§ 512(c)33, held that the pass-through of UBTI items to the trust from the partnerships caused all of the CRT's income in that year to be taxable34.

Special valuation requirements

Reg. §1.664-1(a)(7) requires that any required valuation of "unmarketable assets" in a charitable remainder trust must be done by either an independent trustee or determined by a qualified appraisal35. This requirement would therefore apply to a CRUT (which requires an annual valuation of its assets in order to determine the unitrust amount).

What can (or must) the trustee do with the contributed asset?

A trustee of a charitable trust largely funded with closely-held assets may be forced to (i) distribute assets in kind, or (ii) sell assets if the trust does not otherwise generate enough income to satisfy the annual annuity or unitrust payment obligation of the trust. Note that distribution in kind to the unitrust or annuity beneficiary will, in the case of the CRT, give rise to capital gains which may ultimately be passed through to the beneficiary under the tier system. Similarly, a distribution in kind to a charitable beneficiary of a lead trust will generate capital gains to the trust.

A CRT with closely-held assets may be best established as a NIMCRUT. As noted earlier, the trustee would only have to distribute the lesser of the trust income or the unitrust amount. The make-up provision of the NIMCRUT would allow the beneficiary to potentially "catch up" in later years. Unfortunately, there is no similar sort of mechanism allowed for lead trusts, since that could have the effect of decreasing the amount given to the charity (and increasing the amount given to the non-charitable remainderman).

Another solution would be to use a "flip unitrust." A flip unitrust can provide that upon certain triggering events, a NIMCRUT or NICRUT would convert to a conventional CRUT37. The trigger cannot be discretionary and/or within the control of the trustee or any other persons. Examples of permissible triggering events include marriage, divorce, death, birth of a child, or a sale of unmarketable assets38.

The prudent investor rule, now the law in most states, requires that "a trustee shall diversify the investments of the trust unless the trustee reasonably believes that, because of special circumstances, the purposes of the trust are better served without diversifying."39 Thus, a trustee may be obligated as a fiduciary to sell a portion of the trust's interest in the closely-held asset, in order to properly diversify the trust portfolio. Such a sale may not, however, be in the best interest of the closely-held business.

Private Foundation Excise Tax Problems.

Many of the private foundation excise tax rules apply to charitable trusts. Several of those rules (I.R.C. §§4941 and 4943 through 4945) limit trust investments and the types of transactions a trust may undertake.40

For example, I.R.C. §4943 imposes an excise tax on a charitable trust's "excess business holdings." A charitable trust would have "excess business holdings" if the charitable trust and all disqualified persons41 own in the aggregate more than 20% of the voting stock of an incorporated entity (or corresponding interests in non-incorporated business entities, i.e., profits interest in a partnership)42. Fortunately, this provision generally only affects lead trusts, since remainder trusts are exempted under I.R.C. §4947(b)(3)(B). Nevertheless, in the case of a lead trust, and even though the trust is given five years to dispose of the holdings before a tax is imposed43, the possible applicability of Section 4943 should be considered before an interest in a closely-held business is contributed.

Another concern for the lead trust (again, remainder trusts are generally exempted) is I.R.C. §4944 which imposes an excise tax on a charitable trust that invests any of its assets in a manner that jeopardizes the trust's ability to carry out its exempt purposes. Reg. §53.4944-1(a)(2)(i) generally provides that a jeopardizing investment is an investment made by the foundation managers for which at the time of the investment, the foundation managers have failed to exercise ordinary business care and prudence in providing for the financial needs of the foundation to carry out its exempt purposes. For example, in P.L.R. 9205001, the IRS held that I.R.C. §4944 applied because of a lack of diversification where (i) all of the foundations assets were invested in the stock of a closely-held company, (ii) the risk of investing in the particular industry was not considered, (iii) there was no reasonable expectation of a return, and (iv) there was no diversification of investment. Thus, the trustee of a lead trust must carefully consider whether to invest in closely-held assets.

I.R.C. §4947(b)(3)(A) provides another more limited exception to the excess business holdings and the jeopardy investment provisions if (i) all of the income interest of the trust (and none of the remainder interest) is devoted exclusively to charitable purposes (i.e., some sort of lead trust), and (ii) the value of the charitable deduction for the lead interest does not exceed 60% of the total fair market value of the trust44. Thus, a donor may be able to fund certain CLTs with interests that otherwise violate these rules.

If the trustee decides to sell a contributed asset (or buy or sell new assets), the trustee must also consider I.R.C. §4941, which generally imposes an excise tax on the amount involved in any act of self-dealing between a disqualified person and the charitable trust. Acts of self-dealing include, among other things, the sale, exchange, or lease of property between a charitable trust and a disqualified person. Often, the best (and maybe only) market for a closely-held business interest will be the other owners of the business. Those individuals (or entities) will often be disqualified persons with respect to the trust. Note that there is no "full and adequate consideration" exception to the self-dealing rules45

In short, a donor of a closely-held interest needs to consider (i) whether the trust can even accept the contribution without generating excise taxes; (ii) if the trust can accept it, whether it must ultimately sell it in order to avoid an excise tax or to fund unitrust or annuity payments; and (iii) whether there will be an acceptable purchaser available if the interest needs to be sold.

Real Estate

Contributions of real estate present the same sort of problems as those discussed above in connection with contributions of closely-held business interests. Those problems are compounded if encumbered real estate is involved. As an initial matter, if a donor contributes encumbered property with indebtedness in excess of basis, the donor will recognize gain46.

Also, I.R.C. §681 disallows an income tax charitable deduction under I.R.C. §642(c) to a CLT, to the extent that distributions to a charity are allocable to the trust's UBTI for that year47. However, I.R.C. §512(b)(11) allows a CLT to take a charitable income tax deduction subject to the same limitations generally applicable to individual donors, even though all or part of the charitable distributions may be allocable to UBTI.

Rental income generally is not UBTI48. Nevertheless, a percentage of rental income attributable to acquisition indebtedness is UBTI49. The term "acquisition indebtedness" generally includes an already existing mortgage on property contributed to a charitable trust (regardless of whether the trust assumed the mortgage), as well as any debt incurred by a charitable trust to purchase or improve property.

One notable exception is that mortgaged property acquired by a charitable trust by bequest will not be treated as having acquisition debt for a period of ten years following the date of acquisition, unless the trust assumes the mortgage50. Another exception provides that (in the case of an inter vivos contribution) if (i) the mortgage was placed on the property more than five years before the gift, and (ii) the property was held by the donor more than five years before the gift, the debt is not acquisition debt for a period of ten years following the date of acquisition, unless the trust assumes the mortgage.

Tax-Exempt Securities

At first blush, contributions of tax-exempt securities might seem to be an attractive alternative in order to generate tax-free liquidity for the trust. But it would not be prudent for the trustee to continue to hold a trust portfolio disproportionately invested in tax-exempt securities. Furthermore, the contribution of appreciated (or appreciating) tax-exempt securities gives rise to the possibility that liquidation to pay annuity or unitrust payments to the present beneficiaries would generate a capital gain. Finally, a charitable trust should not require the trustee to invest exclusively in tax- exempt securities51.nn

Assets to Avoid

Certain types of assets should be avoided when funding charitable trusts. Those assets include:


1The rules governing charitable remainder trusts are found in I.R.C. §664.

2Additional restrictions may affect the amount of this percentage. See I.R.C. §§664(d)(2)(A) and 664(d)(2)(D).

3Reg. §§1.664-3(a)(1)(i)(b)(1) and 1.664-3(a)(1)(i)(b)(2).nn4Another less popular type of CRUT is the net income charitable remainder unitrust ("NICRUT"). See Reg. §1.664-3(a)(1)(i)(b)(1). The NICRUT is similar to the NIMCRUT, except that there is no deficiency make-up provision.

5 The annuity must equal at least 5% of the initial trust value. I.R.C. §664(d)(1)(A). Additional restrictions may also apply. See I.R.C. §§664(d)(1)(A), 664(d)(1)(D) and Reg. §1.664-2(b).

6I.R.C. §170(f)(2)(A).

7See I.R.C. §2522(c)(2)(A). Note, however, that if someone other than the donor and charities are current or future beneficiaries of the CRT, a taxable gift of the present value of that person's interest will occur when the trust is created.

8See I.R.C. §2055(e)(2)(A).

9I.R.C. §664(c). This exemption is lost in any year in which the trust has any unrelated business taxable income ("UBTI"). Id.

10I.R.C. §664(b).

11Certain restrictions applicable to CRTs do not, however, apply to CLTs. For example, there is no 20-year limit on the duration of a fixed term CLT. Further, there is no requirement of a 5% minimum payment, no requirement of a minimum value for the remainder interest and no prohibition on future contributions to a CLT. See Reg. §§1.170A-6(c)(2)(i) and 1.170A-6(c)(2)(ii) for further rules governing CLTs.

12I.R.C. §170(f)(2)(B).

13See I.R.C. §2522(c)(2)(B). If someone other than the donor is a remainder beneficiary, there will generally be a taxable gift at the trust's creation equal to the present value of the remainder interest.

14See I.R.C. §2055(e)(2)(B).

15The usual income percentage limitations on charitable deductions are not applicable. I.R.C. §642(c).

16See I.R.C. §671.

17See I.R.C. § 170(f)(2)(c).

18Note that under current law, these advantages are not available for contributions of retirement benefits to an inter vivos CRT. In such a scenario, the donor would be deemed to have received a taxable distribution from the IRA or pension before he or she contributed those assets to the CRT.

19This deduction will be based upon the fair market value of the publicly-traded stock, despite its low basis.

20See I.R.C. §170(b)(1)(E).

21See I.R.C. § 170 (e)(1)(B).

22See I.R.C. §170(e)(5).

23Non-publicly-traded assets also give rise to special valuation requirements. If a donor contributes property (other than cash and certain publicly-traded securities) to any charity (including a charitable trust), and claims a charitable deduction in excess of $5,000, the donor must obtain a qualified appraisal, attach an appraisal summary to the tax return on which the deduction is claimed, and maintain records containing the information required by Reg. §1.170A-13(c). Reg. §1.170A-13(c). See Hewitt v. Commissioner; 109 T.C. 258 (1997) which disallowed a taxpayer's claimed charitable deduction of greater than $5,000 for a contribution of stock, where the taxpayer failed to comply literally or substantially with the requirements of Reg. §1.170A-13(c ). Reg. §1.664-1(a)(7) also requires that any valuation of "unmarketable assets" in a CRT must be done by either an independent trustee or determined by a qualified appraisal (as defined in Reg. §1.170A-13(c)). This requirement would, for example, apply to the annual unitrust payout valuation for a CRT. See later discussion in this article concerning the contribution of closely-held assets to charitable trusts.

24See I.R.C. §§170(b)(1)(B) and 170(b)(1)(D)(i).

25The position of the IRS is that the I.R.C. Section 1011 bargain sale rules apply. See Reg. 1.1011-2.

26However, the Economic Growth and Tax Relief Recognition Act of 2001 provides that a modified carryover basis rule will apply in 2010 (there is a special rule, however, allowing an estate to add $1.3 million of basis to assets held at death). Thus generally, assets contributed at death to a charitable trust will generally have a carryover basis. Therefore, if the charitable trust has to sell the contributed assets or, distribute them in kind, there will be a potential capital gain.

27I.R.C. §§1361(c)(2), 1361(d) and 1361(e).

28Reg. §1.671-1(d).

29Rev. Rul. 92-48, 1992-1 C.B. 301.

30I.R.C. §1361(e)(1)(B)(iii). This is the case even where the CRT is nonexempt because it has UBTI. Joint Comm. Staff, Gen. Expln. of 104 Cong. Tax Legis., 12/18/96, p.114.

31See P.L.R. 199936031. P.L.R. 199908002 provides that in such a situation, upon the death of the grantor, the CLT may make an election to be treated as an ESBT.

32104 T.C. 236 (1995), aff'd, 105 F.3d 482 (9th Cir. 1997).

33I.R.C. §512(c)(1) provides, " If a trade or business regularly carried on by a partnership of which an organization is a member is an unrelated trade or business with respect to such organization, such organization in computing its unrelated business taxable income shall, subject to the exceptions, additions, and limitations contained in subsection (b), include its share (whether or not distributed) of the gross income of the partnership from such unrelated trade or business and its share of the partnership deductions directly connected with such gross income."

34It should be noted that CRTs and CLTs may otherwise hold an interest in a partnership. See P.L.R. 9533014 and 200124029.

35See footnote 23. The term "unmarketable assets" is defined as "¦assets that are not cash, cash equivalents, or other assets that can be readily sold or exchanged for cash or cash equivalents. For example, unmarketable assets include real property, closely-held stock, and an unregistered security for which there is no available exemption permitting public sale." Reg. §1.664-1(a)(7)(ii). One may reasonably conclude that this definition describes most interests held in a closely-held partnership, LLC, or corporation.

36See P.L.R. 7918102.

37Reg. §1.664- 3(a)(1)(i)(c).

38Reg. §1.664-3(a)(1)(i)(d).

39Uniform Prudent Investor Act §3.

40I.R.C. §508 also requires that the governing instrument of the charitable trust explicitly contain many of these private foundation excise tax prohibitions.

41I.R.C. §4946 defines a disqualified person to include the donor, the trustees, and certain family members, affiliates, etc., of the donor or the trustees.

42I.R.C. §4943(c).

43See I.R.C. §4943(c)(b).

44The typical charitable lead trust requires that the income be paid to charity to the extent of the amount of the unitrust or annuity payment. It is not clear whether this exception would apply if income exceeded the unitrust or annuity payment amount. But see Rev. Rul. 88-82, 1988-2 C.B. 336.

45See Reg. §53.4941(d)-2(a)(1).

46Reg. §1.1001-2; and see Reg. §1.011-2.

47Reg. §1.681(a)-2. A CLT's UBTI would be the amount which would be computed under I.R.C. §512 (code section defining UBTI) and the regulations thereunder if the CLT was an I.R.C. §501(c)(3) organization.

48I.R.C. §512(b)(3)

49I.R.C. §514. This percentage is computed by multiplying the gross income from the property by a fraction, with the numerator being the acquisition indebtedness of the property and the denominator being the adjusted basis of the property.

50I.R.C. §514(c)(2)(B).

51Reg. §1.664-1(a)(3) provides that a trust will not qualify as a CRT if the provisions of the governing instrument restrict the trustee's ability to invest the trust assets in a way which could result in the annual realization of a reasonable amount of income or gain. See also P.L.R. 7802037, which stated that a requirement that the trustee only invest the assets of a CRT in tax-exempt securities during the lifetime of the grantor/beneficiary disqualified the trust.

521960-2 C.B. 103.

53P.L.R. 7802016 determined that this requirement would be violated if the grantor lived rent-free on the real estate contributed to the CRT.