Month: June 2003

Paving over Farmland – Malpractice XII

Keep those tax notes updated.

John and Julia Ramirez have a citrus grove in what is turning into a rapidly growing neighborhood.  They have drawn the unwanted attention of a number of buyers seeking large tracts of agricultural land for its commercial and residential potential.  Additionally, because they possess senior water rights, a nearby city has been pressuring them to sell the rights to develop wells and add capacity to the city’s water system.  Rising property tax rates and increased suburbanization have added further pressure to sell out and move on, especially when they routinely find youngsters prowling around their equipment and getting into mischief.  These liability concerns have forced them reluctantly to accept the inevitable and sell out to commercial developers, and one of their advisors has suggested a charitable remainder annuity trust and a private foundation to minimize the tax hit on the transaction.

Generally, a CRT is a good idea to defer capital gains recognition, especially if the family has charitable inclinations.  However, a CRAT is a poor choice for most real estate sales because of its limitations and rigidity.  A better choice would be a custom drafted unitrust (CRUT) because it offers more flexibility.  Whether they choose a standard CRUT, “FLIP-CRUT”, or a NIMCRUT depends more on the family’s need for control, flexibility and a predictable income stream, as the income tax benefits and basic structure is the same for all three variations of the CRUT. 

Besides recommending the wrong charitable trust, their advisor’s assumptions about using a private foundation as a remainder charity are probably incorrect as well.  Although private foundations previously offered a fair market value income tax deduction for gifts of appreciated assets, after 1998, the rules changed and the more favorable tax treatment is now limited to just cash and appreciated qualified (publicly traded) securities.  If land is used, the income tax deduction is restricted to basis or cost when private foundations are the eventual recipients.  A better choice for tax efficient gifts with hard to value assets like farms, commercial real estate, or residential property would be a CRT with a public charity or, if ongoing family influence is desirable, a donor advised fund inside a community foundation is used instead. 

Why would a donor advised fund be a better choice?  It is simple, easy, and less hassle.  The umbrella charity provides oversight and compliance, spreads the cost of operation over many funds, offers economical management, and still provides for a donor to make recommendations in support of his or her charitable interests.  Many legal and tax commentators routinely suggest the use of a private foundation when contributions exceed $5 million, others suggest that $10 million is more appropriate when families seek to create legacies and provide for ongoing family management.  However, when transferred assets are more modestly valued, then the donor advised fund offers the same immediate tax treatment as that of a public charity with some of the advantages and donor continuity of a private foundation.  Remember to consider all of your options; charitable planning involves irrevocable tools and for this planning to work, articulate specific philanthropic goals.  Too many planners and families allow tax deductions to drive the process instead of treating it as an ancillary benefit.

* closely held stock, commercial real estate, farms or ranches, life insurance policies with cash value, patents, personal residences and vacation homes, retirement plan assets (via beneficiary designation), securities, unimproved property

** art, collectibles or other tangible personal property, equipment or inventory, royalties, copyrights, ordinary income assets

*** Electing “step-down”, uses basis against AGI instead of FMV with 3% itemized deduction reduction rule.

©2003 — Vaughn W. Henry

Vaughn W. Henry

Henry & Associates

CONTACT US FOR A FREE PRELIMINARY CASE STUDY FOR YOUR OWN CRT SCENARIO or try your own at Donor Direct Please note — there’s much more to estate and charitable planning than simply running software calculations, but it does give you a chance to see how the calculations affect some of the design considerations. This is not “do it yourself brain surgery”. When is a CRUT superior to a CRAT? Which type of CRT is best used with which assets? Although it may be counter-intuitive, sometimes a lower payout CRUT makes more sense and pays more total income to beneficiaries. Why? When to use a CLUT vs. CLAT and the traps in each lead trust. Which tools work best in which planning scenarios? Check with our office for solutions to this alphabet soup of planned giving tools.

Too Many Irons in the Fire – Malpractice XIII

Trustees should be independent and remember their fiduciary duties.

Tim and Julia Brennan, both 66 years old, created a standard charitable unitrust and sold some highly appreciated bank shares through it three years ago.  It made great sense as a way to minimize their capital gains liabilities, and passing the remainder to a charity was an acceptable cost, even though neither was particularly charitably oriented.  Their financial advisor on the transaction convinced them that the “perfect investment” tool inside their CRT should be a deferred variable annuity.  While using a deferred annuity is frequently a legitimate planning tactic inside a NIMCRUT that operates as a “spigot” trust, it is generally not the best tool inside a traditional CRUT. Why not?  Because there is no need for the trustee to accept the compromise of highly taxed ordinary income payments instead of more tax efficient tier two capital gains.  Using a deferred annuity turns a capital asset into an ordinary income stream, and since the top rate for tax on ordinary income is nearly twice that of capital gains, there is an unacceptable penalty for the use of this product.  If this was a net income trust there would be a need to control distributable net income, but a commercial deferred annuity usually does not work that way inside a SCRUT or CRAT.  While there may be reasonable differences of opinion about the best funding mechanisms, in the Brennan case, their financial advisor seemed to have motives that put his needs ahead of his clients’

Where did this train wreck fall off the rails?  Prior to helping the Brennans set up their charitable remainder trust, the life insurance agent had no experience with CRT management issues or the obscure rules associated with §664 trusts, but he knew there were opportunities to provide wealth replacement in the form of a life insurance contract.  The agent attended an advanced marketing program and learned that in addition to the insurance, a variable annuity was touted as the “perfect investment” inside a CRT.  Unfortunately, the marketing staff was more interested in pushing product instead of solving problems, and they neglected to disclose the down side of using an annuity inside the charitable remainder trust. 

What down side?

The first problem that popped up was that this annuity contract had a limit on the number of distributions and the value of penalty free withdrawals.  Where this developed into a serious problem was when the equity market free-fall in 2000 through 2002 dropped the annuity value to a level that restricted the required quarterly unitrust distributions.  Once the annuity dropped in market value by over 50 percent, then the required payments triggered the insurance company’s penalty.  Because the annuity company had no experience with charitable trusts, it was issuing a 1099-R for all of the payments made to the income beneficiary, but that causes a problem because income beneficiaries should receive a K-1 from the CRT, not a 1099 from the carrier.  The second problem was that the agent who sold annuity had himself named trustee, and he convinced the Brennans that because the annuity was not liquid enough to make the required distributions, the trust would not be able to meet its obligations.  The third problem is that the trustee neglected his fiduciary responsibilities, i.e., the duty to look out for both the income beneficiary and the charitable remainder beneficiary.  By keeping the charitable trust invested in an underperforming annuity, he harmed both beneficial interests.  The trustee, as an insurance producer, knew that if the trust terminated the contract he might be required to refund the sales commission on the initial purchase and lose the ongoing trail commission, so there was an existing conflict of interest that may have influenced his decision to do nothing about dumping the annuity.  This is one reason why insurance carriers and the National Association of Securities Dealers (NASD) prohibit a registered representative from acting as a trustee for a client’s trust.

Even if the CRT is a properly drafted irrevocable trust, as long as it does not operate as a CRT it is not going to qualify as a tax-exempt charitable remainder trust.  It is important to understand that standard unitrusts and annuity trusts do not have discretionary authority to pay less than the appropriate amount as stipulated by the trust document.  Occasionally trustees make errors, and make incomplete distributions, but an ongoing pattern of missed or improper payments exposes the trust to grantor status and loss of its charitable remainder trust protections *

* Atkinson v. Commissioner, No 01-16536 (11th Cir.,Oct. 16, 2002), Atkinson v. Commissioner, 115 T.C. 26 (2000)