Vaughn W. Henry
Susan Barry, a 66-year-old widow, has 320 acres of productive farmland on the edge of town. She and her late husband resided there for most of their 35-year marriage, but when he passed away two years ago, she turned the management duties over to her tenant farmer who now rents her ground. The past two years have been dismal for farm income, and real estate developers frequently solicit her. Her children aren’t interested in farming and the land is the principal asset in her estate, since Mr. Barry never got around to starting a retirement plan and didn’t believe in using life insurance. Mrs. Barry has been active in the local hospital’s auxiliary and was advised by one of the development staff to consider a §664 charitable remainder annuity trust (CRAT). The gift planner, Sally Singleton, had a persuasive set of reasons for her recommendations that included:
a) A CRAT avoids capital gains on the appreciated property.
b) A CRAT produces a steady, secure income stream to finance her retirement. Gift planners know that older donors like safety and security, hallmarks of the CRAT.
c) The land was appraised at $1.5 million, so the CRAT income stream of $75,000 would be greater than the farm’s current rental income of $125 per acre.
d) The use of a 1 life 5% CRAT paid annually would provide Mrs. Barry with an income tax deduction of $853,837.
e) The use of an IRS prototype CRAT document would reduce legal costs.
f) The hospital could act as trustee and manage the investment account along with its other endowment funds.
g) Mrs. Barry might continue to reside in the farm home until the land was sold at the end of the farming season to the developer.
From the hospital’s perspective, this is a classic CRT plan and fits the guidelines nearly perfectly. When Mrs. Barry called the development officer, Ms. Singleton, and declined her CRT solution, Sally was surprised. After all, it was a pretty good plan, what was the problem with the scenario? Where did it go wrong?
First things first
Who’s the client? Who benefits? In this case, the hospital probably would benefit to the detriment of the income beneficiary. While Mrs. Barry is charitably inclined, her modest estate doesn’t require that 100% of her farmland be contributed to a CRT to avoid an estate tax. Remember, she has some “step-up in basis” on half the jointly owned property, so the capital gains liability, while significant, isn’t the only reason to act. In this case, it makes more sense to contribute only half of the land to a CRT, and use the tax deductions to offset some of the gain from a taxable sale of the portion she retains. This equity will provide her with the capital needed to relocate and still have a comfortable cushion. Additionally, even though her children weren’t interested in the farm, Mrs. Barry didn’t want to completely disinherit them. By splitting the land into two parcels, she’ll be able to use her exclusions to pass her heirs some assets and value free of tax. The strategy of skimming the top off of her taxable estate and dropping it into a CRT and aggressively gifting to heirs works well to solve current estate tax liabilities.
While it’s often true that older client/donors don’t like risk, and a CRAT is often a tool to avoid unnecessary risk, in this case, the CRAT is the wrong tool. If the development deal falls through, and the rental income is inadequate, a CRAT must distribute either cash or land back to Mrs. Barry. A delayed sale means the CRAT might not have the liquidity to meet trust obligations, and since she can’t contribute extra cash to meet the required payout, a CRAT presents big hurdles.
The CRAT’s income tax deduction, while available over a total of six years, is limited to 30% of Mrs. Barry’s AGI. Since she’s not likely to make the nearly $500,000/year it would take to use the deductions, most of the income tax savings are a fiction. It would be better to increase the income payout to 7% or 8%, and change to a quarterly payout unitrust (CRUT) that allows additional contributions of cash just in case the sale doesn’t go through. Better yet, Mrs. Barry should make use of a FLIP CRUT to avoid the problems of contributing an illiquid asset. Also, a 66 year old has a 50% chance of living longer than 16 years. This longer time frame might make the unitrust more suitable as a way to offset modest inflation that would nearly halve the buying power of a CRAT payment over time. For a 7% unitrust to function well, the trust investments need growth/income potential of 8 – 12%, so a well-diversified equity portfolio is required.
The use of a prototype legal document without outside counsel is a poor idea, as is providing complicated advice without getting the donor’s accountant, attorney and financial advisor into the loop. If Ms. Singleton had briefed all of the donor’s advisors and asked for input, she might have been able to present a plan that everyone could support and understand. IRS prototype documents aren’t designed for one size fits all cases, especially if there’s a hard to value asset involved. Also, the charity takes on a potentially adversarial role by acting as trustee, and lately more legal liability and increased scrutiny is added to the mix. While the charitable remainderman wants to preserve corpus, often by investing in bonds and preferred stocks, the income beneficiary of a CRT (especially a CRUT) would like growth. Better yet, assets should produce capital gains instead of the higher taxed ordinary income generated from interest and dividends. Additionally, the trustee must be very careful about commingling funds with other endowment accounts, as the CRT must track income earned and paid out under the trust’s four tier accounting system.
As for Mrs. Barry residing in her home after contributing it to the CRT, she’s a disqualified person and such actions might be considered self-dealing under §4941. This provides more reason to split the real estate into two parcels, contributing one portion to the CRT and retaining the other portion with the home, and then jointly listing them for sale to the developer.