Too Many Irons in the Fire – Malpractice XIII – Vaughn W. Henry

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)