Design a CRT to Irritate Your Client-Donors
The Error of Our Ways
Why Some Charitable Trusts Make Donors Irrevocably Unhappy
Sometimes it’s important to learn when a charitable trust won’t work as planned. A CRT is not always a “magic bullet”. What should be a win-win-win estate planning scenario sometimes turns into a lose-lose-lose disaster. Don’t make the mistake of promoting or using them as solutions for all estate and financial planning problems. A prime example of this is a case study for Georgia Miller, a semi-retired business owner who wanted to set up a charitable remainder trust. Ms. Miller, a 61 year old widow with no heirs, was persuaded by a foundation officer at the local university to transfer appreciated business development property to her §664 trust. The original purpose of the CRT was to help her avoid paying capital gains tax and provide a better source of funding for her retirement. Already charitably inclined, it made good sense to Georgia who had a long history of supporting this university to create this trust. After all, this was a classic example of taking an under-performing appreciated asset, repositioning it for retirement income and providing some charitable support for the nonprofit institution.
The first of many problems started with the development officer and an inexperienced university attorney who were not quite as sophisticated as they should have been. As gift planners, they suggested a 5% charitable remainder annuity trust (CRAT) as the deferred giving vehicle of choice. They also used an IRS prototype document and named the school as both the trustee and irrevocable charitable remainder recipient. The donor, Ms. Miller, was named as the CRT’s sole income beneficiary. The errors compounded when her business property was deeded to the CRAT and the rental income dropped due to a “temporary” glut on the market. This over-supply of office space also negatively affected the marketability of the building. Faced with a lack of income, the trustee should have been thinking about solving problems, but failed to act appropriately. As trustee, the university was unwilling to sell the property below appraised value and take a loss. Why? If the trustees sold the property in a depressed market, it meant that the school would eventually receive less funding at the maturation of the trust and this was a concern. The trustee took the position that there was no income and convinced the donor to not expect any income distributions until the building could either be sold or start generating additional rental income. Ms. Miller became disillusioned with the performance of her charitable trust, originally marketed as a tax advantaged retirement supplement, and she sought guidance from another planning firm to review her options. A few of the many comments follow:
- While a CRAT is generally the easiest CRT to explain and administer, it may not be the best tool for a woman who is expected to live 20 or more years. A CRUT or uni-trust, which pays out a percentage of annually revalued trust assets, might be more suitable for someone concerned about inflation’s effect on a fixed annuity payment. Since a CRUT pays out a percentage annually, it depends on good investment results. So if the portfolio of CRT investments performs well, the income stream should increase every year.
- Georgia’s 5% CRAT generates a significant income tax deduction of 51.6% of the gift’s fair market value. Since a donation of appreciated property allows her to use her charitable deduction against 30% of her adjusted gross income (AGI), it will reduce her income taxes somewhat. Although she can carry forward the deduction for five additional years, her modest income tax liabilities will not allow her to make full use of the nearly $500,000 in tax deductions available from her gift. A higher payout CRUT would have provided both more initial income and the opportunity for a rising level of payments. This recommended change from a 5% CRAT to an 8% CRUT would also produce a lower and more useable charitable income tax deduction and address the concerns about inflation’s effect on her retirement income stream. The school, however, would not be expected to receive quite as large a remainder interest at her death, thus the school’s preference for a CRAT.
- Putting any “hard to value” real property into a CRAT is often an invitation to disaster. If the property can neither generate adequate income, nor be sold to provide the required payout, there is no option for the trustee except to distribute “in kind” assets back to the income beneficiary. The trustee has no ability to defer required payments, so the trustee was creating the potential for debt financed problems in the CRAT by not distributing income to Ms. Miller. On the other hand, in a CRUT, it’s possible for the donor to make additional contributions, which may then be paid back out as income distributions, to satisfy the required payments to the income beneficiary. In a more restrictive CRAT, additional contributions aren’t allowed and this means that pieces of the donated property must be deeded back to the income beneficiary. This creates an administrative nightmare. Not only is there an issue of new deeds and multiple interests in the property after an in-kind distribution, there may be adverse tax issues that crop up after this action. If hard to value real property must be used, then a better choice would have been a net income only (NICRUT) or net income with make-up charitable remainder unitrust NIMCRUT) or a recently approved FLIP trust. All of these uni-trust variations provide much more flexibility in dealing with unmarketable assets in a CRT.
- By acting as trustee, the school has positioned itself in a fiduciary role that exposes it to serious liability. It appears that the trust was established more for the benefit of the charity, and the donor did not have adequate counsel to explain and better plan the trust to meet her individual needs. It might have been more prudent to allow a third party act as trustee, or even have the donor to continue to act as her own trustee, as long as there was an independent party to handle the transaction and valuation issues of the real estate in trust.
- Some business assets inside a CRT generate unrelated business taxable income (UBTI), and this is a serious problem. While a nonprofit organization can accommodate the UBTI by paying tax on the pro-rata taxable earnings without affecting its nonprofit status, a CRT can not. UBTI means that the trust is entirely taxed in the year it earns this type of income, and so any unrealized capital gains would be recognized when sold inside the trust. Besides losing the charitable deduction and recognizing taxable gain, the asset is locked in an irrevocable trust and the donor is likely to be experiencing a world of frustration.
- IRS approved prototype documents are very restrictive and generally do not address all the concerns about removal of trustees, modifying the charitable remainder interests and managing trust assets for tax efficiency. A custom document will deal with the donor’s needs and provide more flexibility and control, this option might be a more useful approach in Ms. Miller’s case. Many charities do properly act as trustee and administer charitable trusts quite well, but non-profits doing so are taking another look at the liability issues and often back out of the responsibility. By naming the university as both trustee and irrevocable remainderman, the school’s foundation expected to maintain control of the trust and report the proceeds as available in their capital campaign. However, the development officer was concerned that if the donor fully understood that the charitable remainder could be both modified and the trust proceeds split among her favorite organizations, the university might not be the beneficiary of the entire trust corpus, and this was unacceptable to the university. Most donors prefer to retain some ability to modify their CRT beneficiary and reflect their changing lifestyles and interests, so that power should be reserved in the trust. These issues are a concern in any CRT, and anything affecting the independence of all parties in the transaction should be addressed before the CRT is implemented.
- There were other concerns, but the purpose of this article was more to discuss problems and how they might have been prevented. The CRT would have been an excellent tool in Ms. Miller’s financial and estate plan, if it had been properly designed and executed. Quality technical support and competent advisors are critical for success of a complex plan using a charitable remainder or lead trust, and planning partnerships among tax and legal specialists is a must.
Henry & Associates
22 Hyde Park Place – Springfield, Illinois 62703-5314
217.529.1958 – fax 217.529.1959 toll-free 800.879.2098