Ten Charitable
Planning Mistakes to Avoid
This article highlights specific areas of the
charitable planning process where mistakes seem to re-occur based on the
authors’ combined experiences as charitable planning consultants. Newcomers to the field of planned giving
aren’t the only ones making mistakes because as you read through the article,
you’ll see that all types of planners, from the seasoned professional to the
charitable planning novice, show up in the following examples. By sharing real-life situations, the authors
hope to provide practical experience and knowledge
from the trenches, not from the painful school of hard knocks, but via
the less painful old cliché, “learn from the mistakes of others.”
1. Not Putting the Donor’s Interests Ahead of All Others
As planners work together as a team to recommend a
charitable plan for clients, it is imperative to always put the client’s
interests ahead of the charity, the attorney, the CPA, and the agent. It seems like a statement of the obvious,
but sometimes a plan can seem so good, the planner doesn’t want to throw water
on the proposal by bringing up the possible downsides. Here’s a case where the planners went a step
further down the wrong path by intentionally omitting relevant information the
donors needed.
In the case of Martin v. Ohio State
University Foundation (Ohio App., 10th App. Distr., 2000), the
donors of a NIMCRUT sued their life insurance agent, the life insurance
company, and the charity that also acted as
their NIMCRUT’s trustee. An attorney
and an insurance agent proposed a charitable plan to a couple that included the
donation of $1.3 million of undeveloped farmland to a NIMCRUT. The donors would use income from the NIMCRUT
to purchase a $1,000,000 life insurance policy costing $40,000 per year for
wealth replacement for the donor’s children.
The donors
received several proposals over the course of a few months. Each and every proposal showed the NIMCRUT
paying the donors income immediately after the execution of the NIMCRUT. Since the donor’s annual income prior to the
transaction was only $24,000, the donor was counting on the trust income to pay
the insurance premiums.
The charity’s representative wrote a comment on the
last proposal shown to the donors that a net income
trust funded with non-income producing land can’t make any income
payments until after the land is sold.
When the insurance agent saw the comment on the proposal, he deleted it
before giving it to the donors. Unfortunately, the land was not sold until two
and one-half years later and no income was paid to the donors during that
time. In the meantime, the agent tried to loan the clients enough money
to pay the insurance premiums, but in the end, the policy lapsed. The donors sued for fraud, negligent misrepresentation, breach of
contract and breach of fiduciary duty asserting they had never been told the
truth about income not being payable from the NIMCRUT until after the land was
sold.
In the Martin case, the advisors failed to
give the donors accurate and complete information as to how the charitable gift
would work in their situation. They
intentionally deceived the clients for what appears to be their own financial
gain. At all times and in all aspects
of planning with clients, the goal must be to provide advice that is in the
clients’ best interests, not the planners. Clients deserve the best and
accurate advice from their planners even if it prevents the gift from
occurring.
2. Recommending a Charitable Gift Without a Full Understanding
of the Donor’s Financial Needs and Goals
A few planners tend to sell a charitable gift like a financial product. A charitable gift is not a product; it’s part of an integrated estate and charitable planning process. To illustrate, one planner wanted to set up a CRAT for an older client funded with farm-land. The planner had a fixed annuity he wanted to sell to the trustee using the proceeds from the land. The planner was under the impression the trust was required to purchase an annuity since it was a charitable remainder “annuity” trust. The planner was then counseled on how a well-balanced mutual fund might be a more suitable vehicle for the proceeds. Unfortunately, the planner responded he wasn’t licensed to sell mutual funds.
Upon further learning that the annuity would produce tier one ordinary income at the client’s marginal income tax bracket of 42%, the planner replied that since his client would be obtaining a large income tax deduction he could afford to pay more in income taxes.
Sadly, this situation represents a product-selling planner who isn’t mindful of the downside of recommending the CRT. The planner did not ascertain his client’s charitable interests, instead he recommended the concept as a means to avoid or even evade capital gains taxes when, in fact, it would potentially increase his client’s tax liabilities. The recommendations made for this plan weren’t in the client’s best interests and could be considered malpractice on the part of the planner.
3. Serving As Trustee
Another misstep can occur during the charitable
planning process when the advisor serves as the trustee for either the client’s
life insurance or charitable trust.
Financial planners, brokers and insurance agents need to be careful when
asked by their clients to serve as the trustee. The best answer to give a client is “No, thank you.” Serving as
trustee can create a serious conflict of
interest if the trustee benefits by the transaction, not to mention SEC
problems if the agent or broker has a securities license.
If the life
insurance agent is selling the policy to the trustee when he also serves as
trustee, he is selling a product to himself for which
he earns a commission using someone’s else’s money. It’s a conflict of interest and it is best to leave the trustee's
duties to a trust professional.
Generally, non-legal advisors are not well trained in the duties imposed on the trustee as a fiduciary. Moreover, non-legal advisors are generally not trained to understand the language used in trust documents and what each paragraph means in layman’s terms. Moreover, most insurance companies will not allow their agents to act as trustees for trusts funded with their own insurance policies. Additionally, most E&O coverage does not cover acts by an insurance agent acting as a trustee.
For many reasons even attorneys are reluctant to serve as trustees because attorneys know all too well the complex duties involved when acting as a fiduciary and following the prudent investor rules. One trust officer, who found out too late what the trustee’s duties are, served as the trustee of a testamentary CRAT. He asked how long he could wait to begin making payments to the income beneficiaries as the land inside the CRAT hadn’t sold and there were no other assets inside the trust. Three years later, the income beneficiaries still hadn’t received their first income payment from a trust that has no legal recourse but to distribute income or assets annually, whether it’s liquid or not.
4. Donating Inappropriate Assets
A charitable planner can find himself in an uncomfortable position when he is unfamiliar with the consequences making gifts using various assets. The tax rules covering charitable deductions for different kinds of assets can be complex, so the best way to prevent these types of mistakes from happening is to know the rules for each type of asset.
To illustrate, one planner suggested a client donate
$3,000,000 of art to a CRUT using a 10% income payment. Even though the client properly executed the
CRUT, the client continued to display the artwork in his home. The planner mistakenly thought the charity
would advance the 10% income payment to the trust each year, and he did not
know the artwork couldn’t be kept indefinitely on display at the client’s
home. To make matters worse, the
charitable deduction was not based on the artwork’s
fair market value like the planner told the donor, but instead the deduction
for tangible personal property that has no "related use" to the trust
was based on the donor’s lower cost basis.
Another planner was working with a client whose only
other asset beyond $75,000 of mutual funds was a $350,000 IRA. The planner didn’t realize the entire IRA
would be subject to income taxes if the client donated it to charity in
exchange for a charitable gift annuity.
Adding to the misunderstanding was the offending charity’s IRA Donation
“proposal” which failed to adequately disclose the disadvantages of using an
IRA for a charitable gift under current tax laws. (Note: proposed
legislation, if enacted into law, may allow IRAs to be given to charities
during the donor’s lifetime without incurring a taxable event. See Senate Bill S-1924.)
A financial planner, who also wasn’t aware of the consequences of donating the specific asset he recommended, knew his client was coming into a large sum of money soon from the sale of his business. The planner recommended that his client quickly donate the business to a CRT to help his client avoid taxes. Upon discovery, however, the client had actually sold his entire business five years ago and this large sum of money was the final payment in a series of installment payments for the buyout.
Donating Various Types of Assets
These assets need extra special handling:
·
Encumbered
real estate
·
Closely
held "C" corporation stock
·
Restricted
(Rule 144) stock
·
Stock
with a tender offer in place
·
Sole
proprietorships, partnerships and on-going businesses
·
"S"
corporation stock
These assets should generally be avoided in
charitable gift planning:
·
Property
with an existing sales agreement
·
Installment
notes
·
Stock
options (both qualified Incentive Stock Options and nonqualified stock options)
·
Lifetime
transfers of IRAs and Qualified plan dollars
·
Lifetime
transfers of commercial deferred annuities
·
Lifetime
transfers of savings bonds
5. Reinvesting CRT Assets Improperly
Often times a charitable trust is put together by a financial advisor or insurance agent with the hopes that the donor, who generally serves as trustee, will look to the advisor or agent to reinvest the proceeds of the gifted asset once it’s sold. While there is nothing wrong with this plan, advisors need to be educated on the complexities associated with prudent investor rules, charitable trust accounting, tax deductions, etc., before they can fully understand the consequences of their recommendations.
An example of improperly invested CRT assets
occurred when a planner recommended his middle-aged donor establish a
CRAT. Inside the CRAT, the donor-trustee bought a “life-only” single
premium immediate annuity to “guarantee” the annuity income payable to the
income beneficiary. The flaw
underlining this transaction is that the charity’s remainder interest would be
left without any assets when the trust terminates,
as a single premium immediate annuity for “life only” will end upon the death
of the client with no principal balance leftover. This recommendation could
make the trust subject to oversight by the state's
Attorney General for imprudent investment and all its advisors are potentially liable to the charity. Remember, a CRT
is a split interest gift, and there are two beneficiary groups with a legal
interest in these tools, so the trustee often must wear two hats, one as an
income beneficiary and one looking out for the charity's well being.
To compound an already unpleasant situation, when
the planner was counseled regarding the flaw in his proposal, he and the lawyer
argued that the trustee’s purchase was valid because the trust “passed the 10%
test.” The planner and lawyer were then
counseled on the difference between the 10% test in terms of the charitable
deduction and subsequently investing CRT assets improperly.
Another planner, who also recommended a similar
plan, suggested his trustee purchase a life insurance policy to pay the charity
its portion when the immediate annuity payments end. However, this plan was similarly destined for failure, as the CRAT cannot accept ongoing contributions to
pay a lifetime of insurance premiums.
Improper investing
occurred with a stockbroker who chose to invest his client’s CRT funds with
several partnerships (creating UBTI) in the first year of the CRT's
existence. This choice created a
taxable CRT that does not avoid the capital gains liability when the
appreciated asset that funded the CRT was sold. In addition, there was no income tax deduction to offset the
reinvestment error, compounding the broker's poor advice. Other mishaps have occurred when the
trustees were given access to a charge card on a money market account held
inside a CRT. Trustees with charge
cards on CRT assets open up self-dealing and debt financed problems similar to
trading on margin accounts and charging the CRT interest on the loan when the
trades do not materialize as expected.
If a planner "sells a CRT" as a way to take assets
under management or sell wealth replacement, it isn’t unethical but it sure can
be short sighted. It’s also likely to
result in unhappy clients who find themselves stuck with an irrevocable plan
that doesn’t meet their needs. Agents
and planners who recommend charitable gifts must be knowledgeable of charitable
gift laws and be prepared to pull in a team of experts to implement a plan in
the donor’s best interests.
Learn from the mistake of an insurance
company that allowed a commercial deferred annuity to be removed from inside a
CRT. The CRT’s trustee was the owner
and beneficiary of the annuity and the husband was the annuitant. At the husband’s death, the death claim
papers were sent to the surviving spouse who checked the box on the claim form
allowing the surviving spouse to change the ownership of the annuity to her own
name as an individual. She then
withdrew all the interest earnings in the annuity. The error wasn’t caught until the spouse complained of the large
IRS Form 1099 she received the following January for the interest income she
received. This is often a problem in a NIMCRUT using a deferred annuity when
the insurance company incorrectly sends out a 1099 to the annuitant, instead of
to the tax-exempt CRT, while the CRT is properly issuing a K-1 for the same
income distributions, thus doubling the income tax exposure.
Understanding the four-tiered system of
accounting in a CRT can seem complex.
Often planners may not fully comprehend all the issues involved and this
leads to mistakes. For instance, one
attorney counseled his client to fund a CRT with farmland. He had the trustee purchase tax free
municipal bonds after the land sold to obtain tax-free income from the
CRT. However, what the professional
didn’t realize, is how the capital gain income from the sale of the real estate
is higher on the 4 tier accounting system than any new tax free income
generated by the municipal bonds.
Understandably, the client was quite unhappy when the income wasn’t
“tax-free.”
6. Not Monitoring the Wealth Replacement Sale
A charitable planning case can be effectively
implemented with the appropriate professionals including the client’s attorney,
CPA, planned giving officer, and the life insurance agent. However, in charitable plans where life
insurance is a part of the overall plan, the purchase of life insurance inside
an irrevocable life insurance trust (ILIT) should be monitored by the donor’s
estate planning attorney. Attorneys
should direct the process and clearly indicate to the donor, the trustee, and
the life insurance agent how the process should work and in what order each
step should occur. Otherwise, what can
happen is the insurance sale can be implemented in a way that undermines the
donor’s estate plan. The following are life insurance missteps that can cost
clients hundreds of thousands of dollars in estate or gifts taxes.
1)
The insurance policy is issued prior to the life insurance trust’s
implementation. This occurs when the insurance
agent issues the policy before the irrevocable trust is executed and
funded. If the policy is applied for
before the trust is executed, it is commonly applied with the insured as the
policy owner. If the ownership is
thereafter transferred to the irrevocable trust, the three-year in contemplation of death rule occurs causing
the policy to be pulled back into insured’s estate if he dies within three
years of the transfer.
It’s a preferred practice to
have the donor’s insurability determined using “trial” applications, but once
insurability is approved, the policy should not be issued until the ILIT is
executed, funded, and withdrawal power letter have been sent to trust
beneficiaries and the Crummey powers lapse. At that point,
the agent submits completely new applications with the trustee as the owner and
beneficiary. The trustee then pays the premium to the agent and the policy is
then officially issued.
2)
The insurance agent accepts the premiums directly from the insured and
applies those premiums to the policy owned by the ILIT. The proper procedure requires that the agent obtain the premium
check from the trustee’s funds, not
from the insured’s personal funds, when the trust beneficiaries have withdrawal
powers. The goal is to have the trust
funded and the withdrawal beneficiaries notified and their right to those annual exclusion gifts lapse prior to
the trustee paying the premium.
If, on the other hand, the agent obtains a premium
check directly from the donor’s personal funds, the premium amount is not
considered a gift of present interest since the trustee never had the funds,
nor have the beneficiaries been notified of their withdrawal rights and
therefore, their gifts cannot fall within the annual exclusion gift amount. The insured must file a gift tax return for
these gifts and use part of his estate tax exemption equivalent of the unified
credit (currently $1,000,000) to cover the premiums.
7. Selling the Numbers on a Charitable Illustration.
The various illustrations from charitable planning
software vendors are generally provided to prospective donors to give them
diagrams or flowcharts to describe the type of charitable gift being
presented. The mistakes made when
presenting these illustrations arise from a misunderstanding of the variables
behind the illustration. For example, a common
mistake is to create a CRT with a non-spouse as an income beneficiary, e.g.,
mom, dad and child, and the illustrations are cranked out without any
cautionary words about the loss of the unlimited marital deduction and the
effect of taxable gifts with a CRT being included in the trustmaker's
estate. The software produces the
correct "income tax deduction," but does not address the more complex
gift or estate tax issues.
The charitable planner must know the variables that
produced these calculations and numbers.
The planner must know and understand the footnotes and assumption behind
every proposal. With a charitable
remainder trust, for example, the planner needs to know what interest rate is
being used to assume the future growth of the CRT assets. In addition, the interest rate must be a
reasonable number. In turn, the planner must inform the client of the variables
used in the illustration. The client
must know what numbers he can rely on and those he cannot. It’s simply an education process, and the
more the client knows and understands, the better and happier the client will
be.
8. Selling Charitable Gift Annuities
Planners new to the field of charitable giving
frequently have a misconception surrounding a charitable gift annuity. Since planners may sell commercial annuities
to clients for commissions, they sometimes assume that a charitable gift
annuity is an annuity offered for sale to the public from their insurance company.
However, a charitable gift annuity is not a
commercial annuity offered by a life insurance company. It can only be offered by a charity and is
an agreement between a donor and a charity in which the donor gifts an asset to
a charity in exchange for lifetime income for the donor. The income provided to the donor from the
charitable gift annuity is always paid by the charity.
The young planner who was asked to work with a particular charity's donors to conduct seminars and help establish charitable gift annuities best illustrates this misconception. The planner thought the insurance company had an annuity for him to sell at the seminar and that he would be earning a commission on each charitable gift annuity “sold.” The agent asked if these donors would be bringing their checkbooks to the seminar and if these gift annuities are mostly “one-interview sales.”
To make the confusion even worse, a few charities are under IRS scrutiny for their practice
of paying advisors a “finder’s fee” for bringing clients to establish a
charitable gift annuity with them. Not only are these practices considered highly unethical by
some professional advisors, but also it may be a violation of the Philanthropy
Protection Act of 1995. An advisor cannot help fulfill the donor’s
charitable mission and values by giving donations to causes in which the client
feels strongly if the advisor steers all potential donors to only one charity –
the one that will pay him a finder’s fee.
9. Unknowingly Practicing Law Without A License
The unauthorized practice law is generally thought
to be committed by a non-lawyer when that person provides legal advice to
another either verbally or through the drafting of legal documents. The unauthorized practice of law can occur
in charitable and estate planning through the misuse of computerized legal
documents also known as “specimen” documents.
The reason for providing specimen documents is so
the planner can bring something to the planning process as a “value added
service” for the client’s attorney. These sample documents are intended for use
by the client’s attorney when that attorney may not be an expert in the field
and could use a “starting point” in drafting.
It’s a way for the agent to be professional and helpful in the planning
process.
Unfortunately, the planner or the client can misuse
these specimen documents. Some
non-lawyers have asked if they can “just fill in these blanks” because their
client doesn’t want to pay an attorney. Whether it is a specimen life insurance
trust or a charitable remainder trust, many costly errors have been made when a
non-lawyer or donor takes the position that one document fits all and fills in
the blanks of a specimen document. Further, many of these specimen trust agreements are
ineffective as they are based on IRS prototype documents that are too rigid and
don't provide donors with the flexibility to create a legitimate planning tool
that meets their unique needs.
Form books
can also get a professional in trouble.
One attorney who hurriedly drafted a trust for his client found this out
the hard way after inserting boilerplate language from a forms book. The language gave the trustee of the CRT the
power to pledge trust assets and to borrow funds;
those powers put the exempt status of the CRT at risk.
Charitable gifts are complex and the laws with
respect to charitable giving as well as property law can and will vary by the
donor’s particular state law. Specimen
documents do not take into account any state law nuances. In fact, for this very reason, the practice
of providing specimen documents to planners has caused enough litigation to
stop some insurance companies from supplying these documents.
10. Recommending Aggressive Charitable Techniques
Planners could scuff their professional reputations
when they are involved in aggressive planning techniques and later the IRS or
the courts condemn the plan they once recommended. One of the most recently promoted
aggressive charitable planning arrangements was charitable split or reverse split
dollar. This was an idea whereby the
donor purchased a policy and had the death benefit split between the charity
and the donor’s family. However, the
donor took a charitable deduction for the entire premium knowing that the
donor’s family would personally benefit from this transaction. Sure enough, in
1999 charitable reverse split dollar arrangements were shot down by Congress
[H.R. 1180, the Tax Relief Extension Act of 1999] and the IRS handed down some
severe penalties in IRS Notice 99-36, 1999-26 I.R.B. 1.
Some life insurance companies refused to accept or
underwrite business from their agents if this concept was behind the life
insurance sale. Other companies
accepted the life insurance premiums without passing judgment on how that
business came to the insurance company or how the agent advised their clients
on tax deductibility.
Even though Congress has passed legislation stopping
this charitable tax technique, its promoters are still using this concept. The latest version of the technique uses a
charitable remainder trust that owns life
insurance under the disguise that the donor-income beneficiary is an “employee”
of the charitable remainder trust. The
trust is employing the donor-income beneficiary and hence the charitable plan
now falls within the “employment” context of split dollar funded life insurance
and thus, outside of the prohibiting legislation. However,
this plan may raise self-dealing issues that will be sure to capture the
attention of the IRS.
The above article demonstrates the pitfalls that planners want to stay clear of as they work to help clients in the area of charitable planning. Take this as a great opportunity to learn from the mistakes made by others and avoid the pitfalls in your practice.
Clients need complete disclosure of the advantages
and disadvantages of the plan being proposed.
Well-informed clients tend to be
appreciative of the extra effort and it is an important factor in client
satisfaction surveys. Take the extra
time and make sure the clients’ charitable plan is
proposed with the client’s best interests
first.
Vaughn Henry’s
consultancy, Henry & Associates, specializes in gift and estate planning
services, wealth conservation and multi-generational family entities. Vaughn
also owns http://www.gift-estate.com/, a frequently updated
wealth planning resource Web site, and resides in Springfield, IL.
Johni Hays is
the Director of Advanced Markets for AmerUs Life Insurance Company in Des
Moines, Iowa. She is also the co-author
of the book The Tools and Techniques of Charitable Giving, published by
The National Underwriter Company. She can be reached at JohniJD@aol.com.
Vaughn Henry provides training and consulting services on the charitable estate planning process. As an independent advisor to charitable organizations on planned giving, Vaughn's clients include some of the Forbes 400 and large U.S. corporations. His consultancy, Henry & Associates, specializes in gift and estate planning services, wealth conservation, and domestic and international financial services.
Since 1977, Vaughn has been a widely recognized and popular presenter to charitable groups, business owners, accountants, attorneys and financial services providers. He specializes in deferred gifting and the Economic Citizenship concept, and creative gifting for the Reluctant Donor. He helps charities learn how to develop larger gifts from difficult prospects and to work more cooperatively with donor advisors.
Vaughn received his BS in Agricultural Science and MS in Animal Science from the University of Illinois and is completing work toward a Ph.D. in management. Prior to consulting, he taught at the college level where he generated entrepreneurial funding for college programs. He continues to consult farm, ranch and closely held family businesses in operational and management techniques, specializing in small business communication technology, human resources training, operations, management and multi-generational estate planning. He is a licensed insurance and securities practitioner. Vaughn owns www.gift-estate.com, a frequently updated wealth planning resource Web site, and resides in Springfield, IL.
In addition to serving on the board of the National Association of Philanthropic Planners, Vaughn's affiliations include the Sangamon Valley Estate Planning Council, Central Illinois Planned Giving Council (NCPG) and numerous trade and professional financial services organizations. He has been featured in many professional publications, including The Wall Street Journal, Worth, Forbes, Investors Business Daily, Journal of Practical Estate Planning, Planned Giving Design Center, Leimberg Services Newsletters, Planned Gifts Counselor, and Planned Giving Today.
Johni Hays is Director of Advanced Markets for a
Midwest life insurance company.
Johni has extensive experience in estate and
business planning, life insurance planning, charitable giving, retirement
planning, annuities, and federal taxation.
She has lectured extensively on estate, business and retirement planning
in addition to publishing articles nationally on charitable giving. Johni is a co-author of the book The
Tools and Techniques of Charitable Giving, published by The National
Underwriter Company and is the charitable giving commentator for Steve
Leimberg’s electronic newsletter service, Leimberg Information Services, Inc.,
(LISI).
Johni was previously Advanced Markets Counsel for
ManuLife Financial in their U.S. headquarters in Boston. In addition, Johni served as an estate
planning attorney with Myers Krause & Stevens, Chartered law firm in
Naples, Florida, where she specialized in life insurance as a part of the
overall estate plan. She also was with
Principal Mutual Life Insurance Company for nine years as a marketing
consultant in the Mature Market Center in Des Moines.
Johni graduated cum laude with a Juris Doctor degree from Drake University in Des Moines, Iowa in 1993. She also holds a Bachelor of Science degree in Business Administration from Drake University where she majored in insurance, and graduated magna cum laude in 1988.
Johni is a member of the National
Council on Planned Giving, the Mid-Iowa Planned Giving Council, the Mid-Iowa
Estate & Financial Planners Council, and the State Education Council for
“Leave a Legacy - Iowa.” Johni is a
Chartered Life Underwriter (CLU) and a Fellow of the Life Management Institute
(FLMI), and she has been a member of both the Iowa Bar and the Florida Bar
since 1993. She can be reached at JohniJD@aol.com.