Henry & Associates – Malpractice Issues I

Malpractice Coverage,

Don’t Leave Home Without It

This is the first in a series of articles on design and implementation problems inside charitable trusts.  I won’t spend a lot of time on drafting errors by attorneys, except to caution those lawyers who like to use boilerplate language from a forms book.  Do not copy the language of a net income with make-up charitable remainder unitrust and strip out the text dealing with make up accounts. If you think the resulting trust is a standard unitrust; all too often it’s been converted to a NICRUT or income only CRT and that’s often much worse for clients.

This discussion will instead concentrate on the financial professionals.  Stock brokers, insurance agents and financial planners, who, for one reason or another, had to know something about a CRT to pass some exam, and then never got past the basics to actually research the traps and nuances need to pay attention.  These gatekeepers to personal wealth often try to bluff their way past the client by claiming to know more about the charitable planning process than they really do.  Whether this is to prevent some other advisor from poaching their client or a misplaced sense of bravado that makes them seem more experienced than they really are, it’s a potential liability problem as unhappy donors turn on their advisors for bad advice on something that’s usually an irrevocable decision.

One of the biggest problems with inexperienced commercial advisors is that they try to sell a charitable trust like a financial product.  It’s not a product; it’s part of an integrated financial and estate planning process.  Many advisors have been issued financial “hammers” and everything begins to look like nails, and a CRT can’t be pigeonholed in that way.  Quite a few insurance and mutual fund companies heavily promoted the CRT as a way to sell wealth replacement life insurance and as a way to take illiquid assets and swap them for proprietary investments.  That turned out to be a short-term solution to a marketing problem and created a lot of unhappy clients in the meantime.

In pitching the advantages of a CRT, many advisors stress capital gains avoidance.  In reality, it’s capital gains deferral, and that depends as much on the investments held by the CRT after it’s funded as to those that were initially placed in trust.  Tax efficiency inside a CRT isn’t widely understood, and improperly managed, the CRT becomes an ordinary income pump instead of a more tax efficient means to distribute realized capital gains in an orderly way.  If the client isn’t under some pressure to liquidate their entire portfolio of appreciated assets via the CRT, maybe they’d be better off selling a few shares every year for income and paying the tax on those annual conversions.  The distributions from the CRT are likely to be taxed anyway under the four tier fiduciary accounting system, so there’s no free lunch with a CRT.

Misconceptions abound.  For example, I was asked about setting up a CRAT for an older client; his broker wanted to fund the trust with appreciated land and wanted to use a charitable annuity trust.  Now the client was old enough that a CRAT with its fixed dollar payments seemed suitable, but I cautioned the broker about the inflexibility of funding a CRAT with land.  The restriction on single contributions and a requirement for distributions whether the land sold or not seemed to make the CRAT unattractive.  The reason the broker preferred the CRAT was that he had a fixed annuity he wanted to sell to the client and that’s what he thought a CRAT had to be invested in after the land was sold.  I suggested that a well-balanced mutual fund with equities might be more suitable, but the broker wasn’t licensed to sell registered products.  I then told the broker that all income distributions from the annuity were going to produce tier one ordinary income, taxed at the client’s 42% marginal rate, and the broker asked if the use of a charitable trust wouldn’t generate an income tax deduction.  When I responded that there would indeed be a tax deduction, the broker said, “then the client can afford to pay more in tax”.  Now this is a classic product selling commercial advisor who hasn’t thought through the downside of selling his client on a charitable trust. 

The errors started when the broker wanted the highest legal payout, was restricting his investments to a 6% fixed income product that would cause the CRAT to implode in a few years, and ultimately this CRT would produce nothing for charity.  If the land didn’t quickly sell from the CRAT, the client would have no choice but to accept in kind distributions of illiquid land back and pay tax on the parcels received from the trust as income.  The broker did not ascertain his client’s charitable interests, instead he’d pitched the concept as a scheme to evade tax, when in fact, it would potentially increase his client’s tax liabilities.  Short-term perspectives during this planning weren’t in the client’s best interests, and probably constitute malpractice on the part of the advisor.