The FLIP CRUT Charitable Trusts with Flexibility – Vaughn Henry & Associates
The Flip CRUT
The IRS has “flipped out” with an unusual series of holiday decisions that have positive applications for clients with charitable trusts. In light of erratic market performance and declining fixed income investments, many donors with net income charitable remainder trusts have been disappointed with their beneficiary payments. Notably, the NIMCRUT or “spigot” trust (sometimes called a type 3 CRUT) is the most difficultยง664trust to manage because of the restriction on paying out only distributable net income (DNI). DNI in most states is defined as interest, rents, royalties and dividends offset by trust expenses. When charities, unsophisticated money managers at best, invest as trustees, most often bond type assets are used to generate income, but this prevents the trust from ever appreciating. The new regulations, TD 8791, released on December 10, 1998 now allow any net income unitrust, either NICRUT or NIMCRUT, to be reformed into a FLIP CRUT without challenge by the IRS. This is much more flexible than most commentators expected, as the proposed rules originally called for a triggering event to be included in the original trust document and a more rigid set of asset restrictions. This largesse by the IRS may result in a flurry of court filings before the June 8, 1999 deadline.
Flip Away
What’s a FLIP CRUT? It is a hybrid CRT that starts off as a NIMCRUT or NICRUT because the contributed asset is hard to value (see the new IRS definitions) and illiquid. For example, raw land contributed to a standard unitrust produces little, if any, income. However, when the required payout must be made, there’s no liquidity to make the payment. The only recourse is to distribute a portion of the land back to the income beneficiary since the CRT may neither postpone the payment nor borrow the funds. This tends to make the income beneficiary unhappy since the land was contributed as a way to avoid capital gains liability and reposition the assets into something capable of producing spendable income. The old solution was to use a net income trust that paid out the lesser of earned income or a fixed percentage of annually revalued trust assets. In this way, the trust would payout only what it could earn, but it wouldn’t compel the trustee to imprudently liquidate the assets at a loss just to make an income beneficiary’s distribution. Generally, this meant the beneficiary was in the same position as before the contribution, receiving only what income the land produced. However, after the trust sold the land, the beneficiary found out that the trust payout was still limited to what the trust “earned” in the way of net income. Many clients went along with the NIMCRUT concept expecting to receive a 7% or 8 % income stream once the property was sold, only to find out that they were still limited to receiving the lesser of net income for life. Additionally, in the real world of financial markets, there was little hope of ever invading the “make-up” account to offset lost ground. This called for sophisticated investment advice and many documents do not allow the use of these tools, as trusteesnever researched the use of non-typical trust investment products like specially designed deferred annuities and zero coupon bonds to control timing and income recognition.
The typical alternative of defining capital gains as “income” was a band-aid means of managing this choke point in a NIMCRUT. However, this strategy adversely affectsinvestment choices by requiring the trust to sell the best performing investments and keep the worst performers. This technique wrecks the long-term performance of the trust and isn’t recommended.
Triggering the Flip
Now it is possible to convert existing net income trusts into straight percentage unitrusts if the drafting attorney can identify a “triggering event or date” that is “outside the control of the trustee or any other person.” Examples of triggering events, in addition to sale of unmarketable assets include retirement at a specified age (not any arbitrary retirement date), marriage, divorce, death or birth of a child.
The trustee has a fiduciary duty to be even handed to both the income beneficiary and the remainder beneficiary. In a net income unitrust, greater equities favor the charitable remainderman since the portfolio appreciates. However, this investment choice produces little DNI and is often detrimental to the income beneficiary. On the other hand, greater fixed income securities initially favor the income beneficiary but limit future growth, and that damages both of the remaindermen. Equities often play a lesser role in a NICRUT than in a straight unitrust because of the difficulty of earning a 5% net income. Remember, this isn’t total return, since appreciation isn’t usually defined as income, so a diversified portfolio of equities and fixed income instruments wasn’t often used. Once the trust is flipped to a standard CRUT, then total return can be part of the investment philosophy and invasion of principal could occur during downturns in the market, something not allowed in a typical net income unitrust. Does this mean NIMCRUTs are out? No, the retirement planning unitrust still makes terrific use of the strategy, especially in light of a recent IRS Technical Advice Memorandum (TAM 9825001), and may well replace the traditional pension plan for high income earners with an estate tax liability. However, the FLIP-CRUT will likely become more prominent once planners understand the flexibility.
Divorce
On a slightly different note, clients occasionally ask about dividing charitable remainder trusts upon divorce.
The IRS issued two (identical) rulings authorizing such a split: Private Letter Rulings 9851006 and 9851007 (Sep. 11, 1998). Husband and wife had a single 5% net-income-with-makeup charitable remainder unitrust (NIMCRUT) that was to last for both of their lives. After the divorce, the IRS approved dividing the NIMCRUT into two separate 5% NIMCRUTs, with one NIMCRUT for each spouse. The assets were split 50-50.
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