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Henry & Associates – Malpractice Issues II

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.

PhilanthroCalc for the WebCONTACT US FOR A FREE PRELIMINARY CASE STUDY FOR YOUR OWN CRT SCENARIO or try your own at Donor Direct. Please note — there’s more to estate and charitable planning than simply running calculations, but it does give you a chance to see how the calculations affect some of the design considerations. Which tools work best in which planning scenarios? Check with our office for solutions.