Malpractice Coverage – VI

Don’t Leave Home Without It

(sixth in a series on design and implementation issues)                   

One problem encountered in setting up long term charitable trusts is the impatience of income and remainder beneficiaries.  All too often, there is an adversarial relationship among the various beneficiaries of split interest trusts, each perceiving their needs as more important than the other, forcing the trustee to weigh competing requests and desires.  The nature of a charitable lead or remainder trust often pits trustees interested in growth against those beneficiaries attracted to secure or tax-free income.  Just as often, there are trustees who are more concerned about preserving capital while beneficiaries may be adamant about increasing income by investing in more diversified growth assets.

One of the solutions is to spend more time conveying the concept and responsibilities of the parties involved, especially in testamentary plans.  In a court case described below, it’s apparent that the decedent didn’t do a very good job briefing his heirs about what he expected to accomplish with his estate plan.  A little prior planning would have avoided a lot of discord and the expense of taking the estate’s trustees to court.  It never hurts to have everyone rowing in the same direction when these trusts are put to work.

Estate of Rowe, 712 NYS 2^nd 662 (App. Div. 3^rd Dept., 8/10/2000).  Mr. Rowe created an 8% CLAT in 1989 by transferring 30,000 shares of IBM stock worth nearly $3.5 million designed to pay a fixed dollar annuity to charity for 15 years, and then pass the remaining balance to his nieces.  Unfortunately, the IBM stock took a hit in the market shortly after the trust was funded and the trust declined in value, but was still required to pay out the same annual charitable distribution.  Mr. Rowe’s bank, acting as trustee, decided to hold the stock with the expectation that it would recover its value.  The trustees counted on “Big Blue”, its history of paying dividends and consistent growth.  The bank argued in court that a sale in a down market would recognize a loss in value of the trust’s portfolio, while waiting until the stock recovered before it was sold would protect the trust better.  The nieces argued that a prudent trustee should have immediately diversified the trust (usually an obligation in a prudent investor state, but remember that a CLT is a tax-paying trust, so this has to be done carefully).  As a side note, appreciated stock sold by a CLT would trigger potential capital gains taxes and with the compression of federal trust tax rates, any ordinary income in excess of $8,650 is taxed at 39.6%. 

The court ruled in favor of the nieces and ordered the bank trustees to refund its commissions and pay $630,249 in damages.  The bank appealed, arguing that the trust still had ten years to operate and any “loss of value” was only a hypothetical paper loss and no damages could possibly be assessed until the trust terminated and remaining assets passed to the beneficiaries.  The trustees lost; although in hindsight, the IBM stock did rebound and the trust would have done quite well if it had been left alone. 

The goal of a non-grantor CLT is to fund charitable gifts and pass assets efficiently to heirs, so selecting solid growth assets is critical to success.   However, great strategic planning would give full consideration to any assets transferred into an irrevocable charitable trust, and diversification is critical to surviving market volatility. 

Good estate planning should address the potential disputes, map the responsibilities for all the parties in the process and avoid costly conflicts.  The secret to success is often good communication.

Henry & Associates

Malpractice Coverage – II,

Don’t Leave Home Without It

(second in a series on design and implementation issues)

The main problem of funding an irrevocable CRT is that so few commercial advisors regularly work with §664 trusts.  Too often, these structures get treated like tax paying entities, and they aren’t.  Advisors rarely disclose their mistakes, so I encourage planners to learn from the experiences of others.  Rather than swamp readers in IRC sections and the minutiae of legalese, this article will cover real world examples encountered in my consulting work.  The following avoidable design errors have pushed trust makers and trustees to replace or even sue their advisors, so it bears review of actions that poison client – advisor relationships.

Properly managed, the charitable remainder trust (CRT) is normally a tax-exempt entity.  Unfortunately, some advisors put the exempt nature of the trust in jeopardy.  Some risky actions are obvious, others less so, but the following examples are classics. 

Assets contributed to a CRT are generally placed into trust to sell, not hold.  Not that a well-diversified investment account couldn’t be contributed to a CRT, it can.  However, appreciated assets repositioned from pure growth to income, or stock that’s caused a portfolio to become unbalanced and now needs to be reallocated to reduce risk and volatility work best with the CRT. 

Where does risk enter into holding onto an asset inside a CRT?

The contribution of an operating farm or business inside a CRT may expose the trust to Unrelated Business Income (UBI) — unlike a typical charity that simply pays tax pro-rata on its taxable UBTI, any CRT that has UBTI loses its exempt status for the entire year.  If an advisor wants to avoid the wrath of an irritated client, it’s critical to avoid UBI in any year the trust has potential income, as both distributions and sale of appreciated assets are completely taxable.  That’s a first year mistake that generates significant malpractice exposure and seems obvious on its face, but there are other ways UBI sneaks into the equation. 

Where does UBI show up? 

·        Margin accounts are debt financed and UBI risks occasionally occur when a brokerage firm delays settlement on trades and charges the charitable trust interest. 

·        Sometimes real estate developers sell partnerships to investors, but the history of debt and the contribution of an active trade or business expose the CRT to UBI.  Even publicly traded partnerships are a risk, and inexperienced brokers who are pitching the “next great idea” to their trust clients often put the CRT into a situation where it turns into a tax-paying trust.  Passive activity income losses create risks that the trust administrator would rather avoid, so partnerships are rarely used inside a CRT.

·        Day trading trustees who try to outguess the market may expose the trust to self-dealing and UBI, as sometimes the IRS holds that operating a trading firm is in the same as trustees running a hotel, warehouse, trailer park or coin laundry; all are businesses and expose the CRT to tax liabilities.  

·        Contributing appreciating real estate to avoid the capital gains forces the CRT trustee to tread cautiously in order to avoid being characterized as a “developer”.  If the trustee contributes property and sells it outright, that’s an easy fix to the problem.  If the trust maker is a real estate professional, he or she might find the value of their tax deduction evaporating since inventory property is an ordinary income asset that generates a deduction hinged on “basis”, not FMV.  If the trust makers decide to develop the property themselves, then they may run afoul of UBI and turn the CRT into a taxable trust.

·        With the increasing popularity of the Family Limited Partnership (FLP), there are now more potential donors with these appreciating units in their basket of assets.  Can FLP units be contributed to a CRT?  Maybe, if the FLP is only a marketable securities partnership with no margin debt and it has been treated as a passive investment.  However, seek qualified counsel to make sure before you transfer these units to a CRT.  One of the problems with FLP units is getting a qualified appraisal (IRS Form 8283), which should take into account the minority and marketability discounts that made the FLP popular as a compression tool, but reduces the tax deductions.

Self-dealing issues crop up occasionally.  Sometimes the trustees try to loan CRT funds to finance family businesses, that’s an obvious no-no.  Once in awhile, I hear about a brokerage firm that inadvertently issues a debit or charge card to their clients to access money market funds as a benefit of doing business with that investment company.  That may be a great feature for a trust account, but it’s a terrible idea if a CRT is responsible for tracking those unauthorized withdrawals from trust principal.  One client treated it as free money and had a great time until the trust administrator caught up with the paperwork and had the trust repaid. 

Let’s be careful out there.