Avoid Trustees Who Don’t Understand the Rules or Risks

Crash and burn management of a CRT injures clients.

Charitable remainder trusts are powerful tools for charitably inclined donors who find themselves asset rich, but income poor. Because of the complexity, trust-makers and trustees occasionally make mistakes that threaten the tax-exempt nature of a charitable trust, but sometimes they do dumb things and damage beneficiaries too.

Often marketed by sales professionals, a CRT is first and foremost a philanthropic gift; it is neither a tax dodge nor a means to evade capital gains taxes. While there are legitimate tax advantages with the use of a CRT, the tax tail should not wag the dog. Instead, income tax deductions should be viewed as an additional benefit, not the principal reason for creating a CRT. Too often, sales representatives, trained by someone who attended a three hour course on advanced planning, tout the benefits of the charitable remainder trust and try to sell it as a product. This lack of understanding leads clients, charities, and (eventually) their advisors into disenchantment (and liability exposure) with the CRT because it was used for the wrong reasons, and/or was improperly designed.

John Andrews had a successful family lumberyard, operated as an S corporation, and was being solicited by a broker to sell his business for its prime real estate location. John entered into a contract for the sale of his business, and was visiting with one of his neighbors about the disadvantages of selling high priced land. Overhearing the conversation, John’s long-time insurance agent, Fred Friendly, suggested a charitable remainder annuity trust would be the perfect vehicle to avoid the unrealized taxable gain on the sale, and offered to help John set up the transaction.

John appointed Fred as trustee to avoid the potential self-dealing problems that sometimes occur when a donor has too much influence over the affairs of the trust. Trustees should be wary of transactions that might create some personal financial benefits, and often a third-party trustee is used to put some distance between the donor and the sales process. Because Fred was the local, self-proclaimed “expert”; John willingly went along since he had plenty on his agenda with all of the business transitions that were already taking up too much time. In the meantime, Fred had John transfer the S Corporation shares into the trust’s ownership. Fred, as newly appointed trustee, consummated the transfer of the shares with the sales agreement that was already in place, and then went looking for a product to invest the $5 million proceeds of the sale. As an insurance agent with no securities license, Fred’s own offerings were limited to fixed and equity indexed annuities, so he decided those were the ideal investment for a CRAT. Once Fred collected his remarkable commissions, he decided that this was such a great opportunity, he went down to the bank and borrowed money in the trust’s name, pledging its new annuity contracts as collateral, and went out and purchased additional annuity products through his insurance agency with the borrowed funds and received another set of commissions.

Six months into the operation of the trust, John’s accountant asked about this “CRT thing” and gathered up some information about the transaction and planning so he could complete John’s tax return. Without any specialized training in charitable trusts or fiduciary accounting, he consulted with a firm that specialized in design and management of these IRC §664 charitable trusts and he learned the following ten problems were very real and potentially catastrophic.

1. A CRT is not a Qualified Subchapter S Trust. As an entity that can not own S corporation stock and maintain its S election, the CRT converts the corporation to a regular corporation and this involuntary conversion may trigger income tax liabilities.
2. Naming a friend or trusted advisor as trustee is a perfectly acceptable procedure, but there should be provisions in place to use a trust protector to remove an inept or uncooperative trustee or a means of replacing the trustee should he/she become unable to manage the affairs of the trust.
3. The trustee sold the business through an existing sales agreement. Once the sales contract was signed, and a commitment made to sell the business, it was too late to introduce a CRT into the transaction. A CRT does not avoid favorable capital gains treatment if there is an assignment of income or a pre-existing agreement is already in place. The IRS looks at step-transactions and may impose taxes and penalties for improper management of the trust when the sale has gone too far down the path and both parties are obligated to act.
4. Placing all of the clients’ assets into an irrevocable trust may not be the most prudent approach in the planning process. Advisors should not put clients into inflexible arrangements without full disclosure and a complete understanding of the risks.
5. Since it was an S corporation that actually owned the valuable real estate, the corporation itself might have been the better trustmaker, rather than John. By contributing the land to a term of years trust (not to exceed 20), the corporation could have taken advantage of a more flexible tax planning situation and passed the resulting trust income pro-rata out to the shareholders.
6. A trustee has a fiduciary responsibility to properly invest the funds of the trust. In many states, the Prudent Investor statutes stipulate the parameters of appropriate assets, allocation, and management considerations. The IRS also has private foundation regulations and laws, under which charitable trusts operate (see §4944), that restrict trustees from imprudently managing assets or acquiring assets that jeopardize the trust’s security and tax-exempt status.
7. A CRT trustee should not borrow funds. Assets with debt or a mortgage may create debt-financed income and trigger unrelated business taxable income (UBTI). The presence of UBTI means the CRT loses its income tax-exempt status, and to do that the first year of the trust’s operation, when a major sale of appreciated assets occurs, means the capital gains tax is not avoided.
8. Third party trustees should not be selling product to a CRT over which they have management responsibilities; there are too many opportunities for self-dealing and conflict of interest problems.
9. Borrowing funds to buy investment products is unwise for a trust, and purchasing only fixed and indexed annuities for either a standard CRUT or a CRAT is inappropriate. These products do not offer tax-advantages inside an already tax-exempt trust unless there is a “net-income” feature to the CRUT and the income beneficiaries desire some deferral. Even with both of these conditions in a unitrust design, proper diversification should still be the hallmark of a prudent investor. Additionally, the income beneficiary of a NICRUT OR NIMCRUT has to agree to defer income for at least seven to ten years in order to be comfortable with the performance of these contracts inside an already complicated trust structure. Neither a CRAT nor standard CRUT offers income deferral features, and this needs to be understood from the outset.
10. Contributing an active trade or business to a CRT has to be carefully considered because of the potential for UBTI. Normally, contributing stock of a C corporation, even of a closely-held corporation, works if the rules are followed, but trust makers must be very careful with other entities or sole proprietorships.

Advanced estate planning tools are often seen as a terrific way to preserve assets, protect dignity, and control the distribution and timing of assets acquired over a lifetime of hard work. For that reason, seek competent legal and tax counsel from advisors truly experienced in the tools of the trade. Learn about the choices offered and understand the costs, benefits, and risks associated with each of the tools proposed in any financial or estate plan.

Vaughn W. Henry
Henry & Associates
Gift and Estate Planning Resources
22 Hyde Park
Springfield, IL 62703 USA
Phone: (217) 529-1958 ~ Fax: (217) 529-1959

© Henry & Associates 2006