Charitable giving has become a significant consideration in the tax and estate planning of individuals due to the substantial federal income and estate tax savings which charitable transfers can generate. Long-term family charitable projects can also provide intangible benefits to the family, which can be as important and rewarding as the tax benefits. The use of charitable trusts is an important consideration in any estate plan where the client is charitably inclined.
The Taxpayer Relief Act of 1997 (the "1997 Act") also made significant changes in certain rules concerning charitable transfers. The most significant of these rules will be discussed below, following our general discussion of charitable planning.
I. Charitable Planning In General
A. Income Tax Benefits
1. In General. Lifetime contributions to charitable organizations allow the donor to take an income tax deduction, subject to certain limitations. Also, the charitable organization receiving the contribution does not pay income tax on the property received or, with certain limited exceptions, on the income it generates.
Example: Donor, who is in the 40% income tax bracket, transfers publicly-traded stock with a value of $1,000,000 to a charitable organization. The stock cost the Donor $100,000 so that there would be a capital gain of $900,000 if Donor sold the stock ($1,000,000 - $100,000). The effect of this transfer is as follows:
(a) Donor takes a $1,000,000 income tax deduction and the potential capital gain of $900,000 is eliminated.
(b) Assuming a 40% tax bracket, and Donor's ability to use the deduction completely, the tax saved from the deduction is $400,000.
(c) The tax saved on the untaxed capital gain, assuming a 28% capital gains rate, is $252,000.
(d) The net cost of this $1,000,000 gift, therefore, is $348,000.
(e) The charity does not pay income tax on the $1,000,000 stock it received.
2. Percentage Limitations on the Income Tax Charitable Deduction. There are percentage limitations on the amount of the available charitable deduction for income tax purposes. These limitations are set forth in Internal Revenue Code ("IRC") Section 170(b). The limitations are dependent upon both the type of recipient and the type of property contributed.
(a) Generally, charitable gifts may be deducted in an amount up to 50% of adjusted gross income. The 50% limitation generally applies to contributions made to religious organizations, educational organizations, hospitals, the government, private operating foundations and publicly-supported corporations, trusts, community chests, funds or foundations organized and operated only for charitable, religious, educational, scientific or literary purposes. However, a special 30% limit applies to such gifts if they are gifts of capital gain property and the deduction is claimed at fair market value as opposed to basis.
(b) A 30% limitation applies to contributions of capital gain property and contributions "for the use of" any charitable organization. This limitation would therefore apply to contributions to the charitable trusts described below. Contributions to private foundations, other than operating foundations, are generally subject to a 30% limitation for contributions of cash and ordinary income property and to a 20% limitation for contributions of capital gain property. Contributions of capital gain property that could potentially be "for the use of" any charitable organization which is a private foundation are also subject to the 20% limitation. Again, this is a limitation that can apply in the case of contributions to the charitable trusts discussed below.
(c) Carryovers: The excess contribution over the percentage limitation may be carried forward for five subsequent taxable years.
3. Eligible Charitable Recipients. In order for the contribution to qualify for a charitable deduction, the gift must be made to or for the use of one (or more) of the following recipients (See IRC '170(c)):
(a) governmental entities (federal or state), provided that the gift is for public purposes.
(b) corporations, trusts, community chests, funds or foundations, if:
(i) created in the United States (or a possession), or under U.S. law or any state;
(ii) organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or for prevention of cruelty to children or animals;
(iii) no part of the earnings inures to the benefit of any private shareholder or individual; and
(iv) not disqualified for tax exemption by reason of attempting to influence legislation.
(c) a post or organization of war veterans.
(d) a domestic fraternal society, order or association operating under the lodge system, but only if the contribution is to be used exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals.
Examples: Religious organizations; most non-profit charitable organizations; public parks and recreational facilities; non-profit schools and hospitals. The following are not qualified organizations: sports clubs; chambers of commerce; lobby/political groups; dues/fees paid to country clubs or lodges or other similar groups; the value of your time and services contributed to qualified organizations.
B. Estate and Gift Tax Benefits
In General. The tax law allows a deduction (without limitation) for gift tax (IRC '2522) and estate tax (IRC '2055) purposes for transfers to qualifying recipients for public, charitable, religious, scientific, literary or other similar purposes.
Example: Decedent with a substantial estate dies with a surviving spouse but no children or close relatives. If Decedent transfers his property to a marital deduction trust/charitable remainder trust, no federal estate tax will be levied on this trust.
II. Charitable Trusts A. In addition to direct contributions of property to a charity, a donor may achieve income, gift and estate tax savings by transferring property to a "split-interest" charitable trust. These trusts are of two types: the charitable "remainder" trust and the charitable "lead" trust. These trusts are among the most creative and effective ways to reduce federal taxes. Charitable remainder trusts are generally described in IRC '664. Suggested forms of charitable remainder trusts are also contained in Rev. Proc. 89-20, 1989-1 C.B. 841 (inter vivos, one-life unitrust), Rev. Proc. 89-21, 1989-1 C.B. 842 (inter vivos, one-life annuity trust), Rev. Proc. 90-30, 1990-1 C.B. 539 (inter vivos and testamentary one- and two-life NIMCRUT), and Rev. Proc. 90-32, 1990-1 C.B. 546 (inter vivos and testamentary one- and two-life annuity trusts).
1. Charitable Remainder Trusts. There are two types of charitable remainder trusts: the charitable remainder unitrust ("CRUT"), and the charitable remainder annuity trust ("CRAT").
(a) CRUT. A CRUT is a trust which is required to pay a fixed sum of at least 5% of the net fair market value of the trust assets as valued annually. This minimum unitrust percentage must be distributed not less often than annually to the noncharitable lead beneficiary (i.e., a person). A CRUT may also have joint or successive noncharitable beneficiaries before its termination. The remainder interest must be distributed to or for the use of a qualified charity.
Example: Donor transfers $100,000 to the trustees of a trust. The terms of the trust agreement require the trustees to pay to Donor's spouse, for her lifetime and annually, 5% of the net fair market value of the trust property, and to pay the remainder to a qualified charity. The terms of the trust agreement also require the trust assets to be valued on De cember 31 of each year for purposes of determining the unitrust amount to be distributed to the noncharitable lead beneficiary.
Net Income Make-up Unitrust ("NIMCRUT"). A NIMCRUT is similar to an ordinary CRUT, with one significant difference: if the trust does not generate sufficient income in a given year to satisfy the unitrust amount, the trustee is only required to pay to the noncharitable beneficiary the net income that the trust actually earned in that year. This is accomplished by providing in the trust that the trustee will pay to the noncharitable beneficiary, each year, the lesser of the net income of the trust for the year or the fixed unitrust percentage. The trust may also have a "make-up" feature, which provides that if the net income of the trust in any given year exceeds the unitrust amount for that year, the excess income will be paid to the noncharitable beneficiary to pay down the deficiency for earlier years in which the payout was below the unitrust amount (however, although the trust allows the trustee to pay the lesser of the net income or the unitrust amount, the makeup feature is not required for the trust to qualify as a valid CRUT).
Example: A NIMCRUT is created which provides for the annual payment of the lesser of (a) the net income of the trust for the year or (b) 5% of the net fair market value of the trust assets, valued on December 31 of each year. On December 31, 1997, the trust assets are valued at $1,000,000. Therefore, the unitrust amount for 1997 equals $50,000 ($1,000,000 x 5%). The trust only earned $30,000 of net income in 1997. The trustee pays this $30,000 to the noncharitable beneficiary, leaving a $20,000 deficiency ($50,000 - $30,000). On December 31, 1998, the trust assets are again valued at $1,000,000. The unitrust amount for 1998 is therefore $50,000. However, the net income earned by the trust in 1998 is $60,000. The trustee will pay the entire $60,000 to the noncharitable beneficiary ($50,000 of this payout represents the lesser of the unitrust amount and the net income for the year, and the other $10,000 represents the excess net income for 1998 which will reduce the $20,000 deficiency from 1997, thus leaving a net deficiency of $10,000).
(b) CRAT. A CRAT is a trust which is required to pay a fixed sum of at least 5% of the initial net fair market value of the trust assets (i.e., at least 5% the net fair market value of the trust assets as valued when originally transferred to the trust). This fixed sum must be distributed not less often than annually to the noncharitable lead beneficiary. The remainder interest must be distributed to or for the use of a qualified charity.
Example: Donor transfers $100,000 to the trustees of a trust. The terms of the trust agreement require the trustees to pay to Donor's spouse, for her lifetime and annually, the sum of $5,000, and to pay the remainder to a qualified charity.
(c) Income Tax Deduction. The donor who contributes cash or property to a charitable remainder trust is entitled to a federal income tax charitable deduction for the present value of the remainder interest (i.e., the present actuarially discounted value of trust assets distributable to the charitable beneficiary at the termination of the trust).
(d) Gift Tax Deduction. If a charitable remainder trust is established during the donor's lifetime, the donor is entitled not only to the income tax deduction noted above, but also to a gift tax deduction for the present value of the charitable interest. A noncharitable lead interest created for anyone other than the donor is, however, a taxable gift (although a marital deduction may be available for a spouse).
(e) Estate Tax Deduction. If a charitable remainder trust is created upon the donor's death (i.e., the trust is created under the donor's last will and testament or other testamentary instrument), then the donor's estate is entitled to an estate tax charitable deduction equal to the present value of the remainder interest at the date of the donor's death (or alternative valuation date, if elected).
2. Charitable Lead Trusts. A charitable lead trust, like the charitable remainder trust, is a trust created during the donor's lifetime or at death (by last will and testament or other testamentary instrument). In a charitable lead trust, however, the charity is the lead beneficiary which will receive the current annual annuity or unitrust payments for a term of years, and the remainder interest will either revert to the donor or pass to noncharitable beneficiaries. The charitable lead trust can therefore be thought of as the "reverse" of the charitable remainder trust.
Example of Charitable Lead Unitrust: Donor transfers $100,000 to the trustees of a trust. The terms of the trust agreement require the trustees to pay to a specific charitable organization, annually, 8% of the net fair market value of the trust property for 20 consecutive years, and to pay the remainder to Donor's descendants. The terms of the trust agreement also require the trust assets to be valued on December 31 of each year for purposes of determining the unitrust amount to be distributed to the charitable lead beneficiary.
Example of Charitable Lead Annuity Trust: Donor transfers $100,000 to the trustees of a trust. The terms of the trust agreement require the trustees to pay to a specific charitable organization, annually, the sum of $6,000 for 20 consecutive years, and to pay the remainder to the donor's descendants.
(a) Income Tax Deduction. The income tax charitable deduction is available only if the charitable lead trust is a "grantor trust." The grantor charitable lead trust enables the donor to obtain an income tax charitable deduction for the amount of the actuarial value of the charitable income interest on the date of the transfer but also requires the donor to report the trust's annual income.
(b) Gift Tax Deduction. Where a charitable lead trust is established during the donor's life, the donor is entitled to a federal gift tax charitable deduction for the present value of the charitable lead interest at the creation of the trust. The value of the remaining trust assets will be subject to gift tax at the creation of the trust if at the trust's termination they are to pass to a third party.
(c) Estate Tax Deduction. Where the trust is created by last will and testament, the donor's estate is entitled to an estate tax charitable deduction for the present value of the charitable lead interest at his or her death (or alternative valuation date, if elected).
No Minimum Required Payout. Unlike the charitable remainder trust, there is no minimum annual payout requirement or exhaustion requirement in determining the amount to be paid to the charity in a charitable lead trust.
3. Income Taxation of Charitable Trusts.
(a) Charitable Remainder Trust. These trusts are subject to the tier system set forth in IRC '664(b). The trust itself will not generally be subject to income tax, unless it has unrelated business taxable income ("UBTI"). However, amounts distributed to the unitrust noncharitable beneficiary will carry out tax consequences to the beneficiary based upon the nature of the trust's income receipts during its existence. These are grouped into categories: ordinary income, short-term capital gain, long-term capital gain, etc. Distributions first carry out ordinary income that the trust has earned since its inception. It is therefore possible for 100% of each distribution to be taxable to the beneficiary as ordinary income.
(b) Charitable Lead Trust. These trusts are taxed under the usual rules of subchapter J of the Internal Revenue Code, except that distributions to charitable beneficiaries are not subject to the percentage deductibility limitations discussed above. For example, if the trust earns $50,000 of income in a given year, but makes a $100,000 charitable distribution, it would have no tax liability in that year.
4. Remainder Trust or Lead Trust? Annuity or Unitrust? As the above case studies should indicate, neither the remainder trust nor the lead trust, as well as neither the annuity trust nor the unitrust, is inherently superior. The unitrust allows for the possibility of additional contributions in future years. The unitrust, because the actual dollar amount of the payout will vary each year based upon the overall performance of trust assets, may offer a return that more closely tracks economic changes, so it may be more attractive (in the remainder trust) if the objective is to provide a long-term benefit to the individual beneficiaries that can increase with inflation. The annuity trust offers a "surer thing" in terms of its payoff in the short-term, and may provide a better short-term hedge against disastrous trust performance for an individual beneficiary who has only a limited beneficial interest (e.g., a charitable remainder trust for a 90-year old). The lead trust offers fewer initial income tax advantages, but is an excellent way to leverage tax benefits such as the unified credit and (in the case of the charitable lead unitrust) the generation-skipping transfer tax exemption. Each of these trusts also has practical pros and cons depending upon the client's non-tax objectives in creating the trust.
B. Types of Property Which Can Be Contributed. The greatest benefit of a charitable remainder or lead trust as an estate planning tool is the ability to dispose of appreciated or appreciating assets in a tax advantageous manner. The funding of a charitable remainder trust with low basis or substantially appreciated property will generally not result in recognition of gain by the donor (although gain recognition would result if the donor received property other than a guaranteed annuity or unitrust amount in exchange for the contribution or if indebtedness on the property exceeds the basis of the property). The nonrecognition of gain, together with the income tax charitable deduction, effectively increases the return on investment assets for the donor or other noncharitable recipient. The ideal property to contribute to a charitable lead trust is property appreciating at or above prevailing rates of return (so as to maximize the "leveraged" use of the unified credit). The future appreciation on the property will be removed from the donor's estate and the property will be preserved for the future enjoyment of the noncharitable beneficiaries.
Some specific types of property which may be contributed to a charitable lead or remainder trust are as follows:
1. Income-Producing Property. When income-producing property is contributed to a charitable lead or remainder trust, the income earned by the assets will serve as a source to satisfy the annual unitrust or annuity payout requirement.
2. Mortgaged Property and Real Estate. Generally, a donor may transfer property to a charitable lead or remainder trust although the property is subject to a mortgage. Two caveats are relevant here: First, if the mortgage was acquired immediately before the property was transferred to the trust, unrelated business taxable income may result under IRC '512. Second, if the property transferred to the trust is subject to indebtedness which exceeds the donor's basis in the property, the donor will recognize gain on the transfer under IRC '1001 & Treas. Reg. '1.1001-2.
3. Tax-Exempt Securities. The donor may transfer tax-exempt securities to a charitable lead or remainder trust. A significant consideration should be noted, however, if an express or implied obligation is imposed on the trustee to invest the corpus of a charitable remainder trust in tax-exempt assets. In the case of a charitable remainder trust, a restriction on the trustee's ability t o invest the corpus of the trust in a manner which can generate a reasonable return would result in disallowance of the donor's income, estate and gift tax deductions See Treas. Reg. '1.664-1(a)(3). No such obligation to produce a reasonable return exists in the case of a charitable lead trust. However, the IRS may attempt to challenge the sale of appreciated property followed by a reinvestment in tax-exempt securities.
4. Non-Income Producing Property. Contribution of non-income producing property to a charitable lead or remainder trust may entail both advantages and disadvantages for the donor. Such property may be "easier" to give away since the donor is not relying on it for his or her income needs. However, if such property is contributed to the trust and the trust's principal fails to produce sufficient income to satisfy the annuity or unitrust payment requirements, the trustee will be forced to borrow on behalf of the trust, sell a portion of the principal or make distributions of principal in order to satisfy the required annual payments. If a lead trust contains appreciated property which was transferred to the trust with the purposes of removing future appreciation from the donor's estate while preserving the property for future enjoyment by the noncharitable remaindermen, a forced sale would thwart the purposes of the donor. A distribution of principal to the charity to satisfy the payout obligation would have the same consequences, since such a distribution would be treated as a sale. Borrowing by the trust could result in less liquidity because the loan, with interest, must be repaid.
5. Income in Respect of a Decedent Items. Income in respect of a decedent ("IRD") is taxable income to which the decedent was entitled at death but which was (properly) not includible in his or her final income tax return. IRD items include almost all types of deferred compensation (such as IRAs and qualified retirement plans), accrued interest on bonds, unpaid salary, and certain other property interests. One or more of these items will be included in the estate of most taxpayers, and these assets are denied a tax-free step-up in basis. Depending on the circumstances of the particular client, a bequest of these assets to a charitable remainder trust may be advisable. The value of the interest of the noncharitable beneficiaries of such a trust may not be significantly less than the value that the beneficiaries would have received, net of taxes, if the IRD was instead given to them directly. This result obtains because the IRD may never actually be distributed (and therefore may never be subjected to income tax) under the tier system described above. Thus the trust corpus on which the unitrust amount is calculated will be larger than the net amount that the beneficiaries would have had, after taxes, if they had received the IRD directly. The IRS has indicated in private letter rulings that proceeds of an IRA payable to a charitable remainder trust would not be subject to income tax in the trust. See, e.g., PLR 9237020. Note that under present law, these favorable features will not be available in the case of the transfer of retirement benefits to an inter vivos charitable trust. In that case, the donor would be deemed to have first received a taxable distribution from the IRA or pension before contributing those assets to the charitable trust.
C. Case Studies
1. Case Study #1 - Disposition of Appreciated Assets through a Charitable Remainder Trust. Taxpayer has accumulated options to purchase stock which were granted to him by his employer throughout his career. Taxpayer exercised some of these options years ago, and the value of the underlying stock which he now owns has appreciated significantly since the time of exercise. Therefore, if taxpayer were to sell the stock, he would face recognition of a large capital gain. Taxpayer is charitably-inclined. Taxpayer transfers the stock to a charit able remainder unitrust. He recognizes no gain on the transfer and receives an income tax charitable deduction and gift tax charitable deduction in the amount of the present value of the remainder interest. In the process, he has also provided for a stream of income for himself and his spouse from the required unitrust payout (which pays for their joint lives). Furthermore, the trustees can sell the stock and diversify the holdings of the trust, without an income tax consequence to the trust. Given the payout rate of this unitrust (5%), it is likely that a substantial portion of this gain will be "trapped" in the trust and never subjected to income tax.
2. Case Study #2 - Funding a Remainder Trust with Retirement Benefits at Death. Taxpayer has significant wealth in his IRA. Taxpayer is married. The primary beneficiary of taxpayer's IRA is his wife; his secondary beneficiary is a charitable remainder unitrust provided for in his will. In the event he survives his wife, all of his IRA will be paid to the trust. Since the trust itself is not subject to income tax, the trust will not pay any tax as a result of its receipt of the IRA, despite the fact that it is IRD. The IRA will, however, be ordinary income on the trust's books for purposes of the tier system method of taxation, and will be income to the trust's unitrust beneficiaries (his children) in the event that income ever becomes distributable to them under the tier rules. However, if the trust annually earns ordinary income equal to or greater than the unitrust payout, then the IRA/IRD will remain "trapped" in the trust, and will never be subject to income taxation. Furthermore, since there is no immediate income tax to be paid on the IRA, the gross amount of the IRA, at least initially, is available to "earn" for the trust. In contrast, a lump sum distribution, or even annual distributions from the IRA directly to the children each year under the minimum distribution rules, would deplete principal, i.e., the earning power, of the IRA monies. The potential saving of the income tax, along with the increased earning power of the larger principal base, makes the economic "loss" to the children of the IRA monies at the end of the trust term (when the trust is distributed to charity) much less, and perhaps nearly neglible. This therefore may be one of the best ways for this client, who is charitably inclined, to provide for charities in a way that "costs" his family relatively little, and certainly less than a similarly-sized disposition to a charitable trust of non-IRD assets.
3. Case Study #3 - Using a Lead Trust to Maximize Gift Tax and Generation-Skipping Tax Benefits. Taxpayer, a childless widow, has a significant estate, and desires to leave a substantial portion of it to grandnieces and grandnephews. Her estate consists largely of appreciated marketable securities. She is charitably inclined. She thinks it would be beneficial for the grandnieces and grandnephews to become "involved" with philanthropy, and she'd also like to see them demonstrate a greater level of maturity before they receive her wealth. She has already made substantial provision for their parents (her niece and nephew), and would like to take advantage of her generation-skipping exemption. She therefore creates a relatively long-term charitable lead trust, naming the niece, nephew, and certain of the grandnieces and grandnephews as trustees. She does not name specific charitable organizations as lead beneficiaries, but instead describes in her trust the parameters within which the trustees should select appropriate charitable beneficiaries. The trust is constructed as a lead trust, so that her generation-skipping exemption can be allocated to it today based upon the present value of the remainder interest. She understands that the trust will not result in any income tax deduction for her, and that she will be making a present taxable gift to her grandnieces and grandnephews. Given her expectations concerning the performance of the trust portfolio, she feels that this is a very effective way to leverage her estate and gift tax credit and her generation-skipping exemption, while at the same time giving the beneficiaries some experience in philanthropy and the management of wealth. It also allows them to ultimately receive that wealth at a time when they are sufficiently mature, yet young enough to enjoy it and make good use of it.
III. Retaining Ongoing Donor Control of Charitable Gifts: Charitable Trusts as Private Foundations
A. Private Foundations in General. In general, private foundations are charitable organizations organized and operated exclusively for certain purposes, including charitable, religious, scientific, literary or educational purposes, but which are not publicly-supported. Private foundations have been characterized as a "unique breed" of tax-exempt organization. What is unique is that they are qualified organizations (charitable recipients) but typically are controlled and supported by a single source, such as one donor, a family or a company.
A major advantage of a private foundation is the ability of the donor to retain maximum control over the use of charitable dollars. For example, the donor may establish guidelines for purposes of determining who will be an eligible recipient of the funds, such as a foundation established to provide academic scholarships. Private foundations also provide public recognition for the donor (both during life and after the donor's death), linking the donor's name to philanthropy and involvement in the community.
The private foundation may be organized under applicable state non-profit corporation statutes. It may also be organized as a trust pursuant to a trust agreement. Careful drafting of the organizational documents is essential if tax-exempt status is to be achieved. There must be provisions with respect to the timing and manner of distributions, prohibitions against engaging in self-dealing, prohibitions against retention of excess business holdings, prohibitions against jeopardizing investments and the making of taxable expenditures. See IRC '4940-4948 for rules applicable to private foundations.
B. The Private Foundation Trust. A quick and relatively easy way to create a private foundation (and time can often be of the essence with charitable giving) is to create a private foundation by way of a trust agreement. This trust is subject to the governing instrument requirements mentioned above, but its dispositive terms simply provide for distributions to qualified charities. Those charities may or may not be named in the trust, so long as trust assets cannot be diverted to noncharitable beneficiaries. The foundation trust may be simpler to operate since it is not subject to the same corporate housekeeping requirements of non-profit corporations. Nevertheless, in many instances, a corporate umbrella will ultimately be desirable, so the foundation trust should always allow for its conversion to a non-profit corporation.
IV. The 1997 Act and Charitable Contributions
A. Extension of Period For Full Deduction For Contributions of Qualified Appreciated Stock To Private Foundations.
1. Limitation on Deduction. As a general rule, the deduction allowed to a donor who contributes appreciated property to a private foundation is limited to the donor's adjusted basis in the property contributed. The donor may not take a deduction for the full fair market value of the property contributed. This limitation results from the tax law's requirement that the deduction be reduced by all of the capital gain which the donor would have recognized had the property been sold at its fair market value rather than donated to the private foundation.
Example: Donor contributes to a private foundation property with a fair market of $1,000,000. Donor's adjusted basis in the property is $100,000. If Donor had sold this property, he would have r ecognized $900,000 capital gain ($1,000,000 fair market value - $100,000 adjusted basis). Therefore, rather than taking a charitable deduction of $1,000,000, Donor must reduce this amount by $900,000, resulting in an allowable deduction of $100,000 (which is Donor's adjusted basis).
2. Exception. The tax law provides an exception to this limitation for contributions of "qualified appreciated stock" (i.e., stock which is traded on an established securities market), which allows a deduction equal to the full fair market value of the contributed stock. However, prior to the 1997 Act, this exception did not apply to contributions made after May 31, 1997.
3. Effect of 1997 Act. The 1997 Act extends the termination date for this exception from May 31, 1997, to June 30, 1998. Thus, until June 30, 1998, donors may make contributions of qualified appreciated stock to private foundations and take a full fair market value deduction.
B. Charitable Remainder Trust Eligibility: Effect of 1997 Act. Prior to the 1997 Act, the tax law did not impose a maximum limit on the amount that could be distributed annually to the noncharitable beneficiary, and did not impose a minimum on the remainder interest to pass to charity.
The 1997 Act, however, disqualifies a CRAT or CRUT from favorable charitable tax treatment if the annuity or unitrust amount to be paid to the noncharitable lead beneficiary exceeds the maximum amount set forth in the 1997 Act, or if the remainder interest to be paid to charity is less then the minimum amount required to pass to charity set forth in the 1997 Act.
50% Maximum Payout Test. A trust does not qualify as a CRAT if the required annuity payout is in excess of 50% of the initial net fair market value of the trust assets. A trust does not qualify as a CRUT if the required unitrust payout is in excess of 50% of the annual value of the trust assets.
10% Minimum Charitable Remainder Test. A trust does not qualify as a CRAT unless the value of the remainder interest which will pass to charity is at least 10% of the initial net fair market value of all of the trust assets. A trust does not qualify as a CRUT unless, with respect to each transfer of property to the trust, the value of the remainder interest in that property is at least 10% of the net fair market value of that property as of the date the property is transferred to the trust.
Result of Failure to Satisfy 50% Test. If a trust fails to satisfy the 50% test, it will fail to qualify as a charitable remainder trust. Rather, the trust will be treated as a "complex trust", i.e., all of the income received by the trust will be taxed to the beneficiaries or to the trust.
Result of Failure to Satisfy 10% Test. If a charitable remainder trust fails to satisfy the 10% test, the trust may be either (1) declared void from its inception, or (2) changed by reformation, amendment or otherwise to satisfy the 10% test by reducing the payout rate or the duration (or both) of any noncharitable beneficiary's interest to the extent necessary to satisfy the 10% test.
- The reformation pro-ceeding must be commenced no later than (1) the 90th day after the last date (including extensions) that an estate tax return is required to be filed, or (2) if no estate tax return is required to be filed, the last date (including extensions) for filing the income tax return for the first tax year of the charitable remainder trust.
- If the trust is declared void, no deduction is allowed for income, estate or gift tax purposes for transfers to the trust and any transactions entered into by the trust prior to being declared void will be treated as entered into by the transferor. Thus, any income earned on the assets transferred to the trust and capital gains resulting from sales of the property transferred would be treated as income and capital gain of the transferor (or his estate in the case of a testamentary trust), and the transferor (or his estate) would not be allowed a charitable deduction for the transfer.
Effective Dates. The 50% maximum payout test applies to transfers to a trust made after June 18, 1997. The 10% minimum charitable remainder test applies to transfers to a trust made after July 28, 1997. However, the 10% test does not apply to transfers to a charitable remainder trust created by will (or other testamentary instrument) executed on or before July 28, 1997, if the decedent either (1) dies before January 1, 1999, without having republished the will (or amended the testamentary instrument) by codicil or otherwise, or (2) was under a mental disability on July 28, 1997, making him unable to change the disposition of his property and did not regain his competence to dispose of the property before the date of his death.
C. Qualified Retirement Plans: Repeal of Excise Tax on Excess Distributions and Excess Accumulations.
1. In General. Prior to the 1997 Act, the law provided for a 15% excise tax on excess distributions from qualified retirement plans and IRAs and on excess accumulations in a decedent's qualified plans and IRAs. These taxes would have to be paid regardless of the purpose for which the funds were used, including charitable contributions.
2. Effect of 1997 Act. The 1997 Act repealed both the excess distributions tax and the excess accumulations tax. Congress decided that the tax deferrals can be limited by other existing rules which restrict contributions and benefits. Therefore, use of qualified retirement plans and IRAs to fund charitable bequests and contributions has become more attractive (since under prior law these additional taxes would have been paid by the charitable recipients).
Effective Date. The excess distributions tax is repealed for excess distributions received after December 31, 1996. The excess accumulations tax is repealed for estates of decedents dying after December 31, 1996.
D. Charitable Contributions No Longer Reported on Gift Tax Return.
1. In General. The tax law provides a $10,000 annual exclusion from gift tax. Generally, if the total amount of gifts made to any one donee in the same calendar year exceed $10,000, then the donor must file a gift tax return for that year reporting the gifts, and pay gift tax on the excess of the amount of the gifts made to that donee over $10,000. Many charitable gifts qualify for the gift tax charitable deduction, which completely exempts the gifts from gift tax (generally, this gift tax charitable deduction is available for outright gifts to charity as well as gifts of certain partial interests in property, as discussed above in the case of charitable trusts). Nonetheless, prior to the 1997 Act, these charitable gifts had to be reported on a gift tax return like any other gifts in excess of $10,000.
2. Effect of 1997 Act. The 1997 Act eliminates the requirement that the donor report outright gifts to charity on a gift tax return, so long as the entire value of the transferred property qualifies for the gift tax charitable deduction.
Effective Date. The elimination of the gift tax reporting requirements for charitable gifts qualifying for the charitable deduction is effective for gifts made after the date of enactment.
E. Charities Permissible Share-holders of S Corporations. Although not part of the 1997 Act, it is worth noting that the Small Business Job Protection Act of 1996 (the "1996 Act") provides that a charitable organization is an eligible shareholder of an S corporation and will count as one shareholder for purposes of determining the number of shareholders in an S corporation. Prior to the 1996 Act (and until the effective date of this provision), a charity could not hold stock in an S corporation. The corporation would cease to be an S corporation if stock was transferred to a charity.
Effective Date. The provi-sion permitti ng charities to own S corporation stock applies to taxable years beginning after December 31, 1997.
F. Pending Regulations. Pending regulations would create another type of CRUT which would begin as a net income unitrust (discussed above) but change to a standard unitrust upon the happening of a certain event. These trusts may be indicated if the trust initially holds non-income producing assets. These regulations would also require charitable remainder trusts to pay their annuity or unitrust payout for a particular year before the end of the year (present regulations allow for payout within a reasonable time after the close of the year). The pending regulations also contain provisions related to appraisals and other provisions to preclude presumed NIMCRUT abuses. See Prop. Reg. 209823-96.
V. Commonly Overlooked Points; Potential Problem Areas
A. Required Tax Returns. Gifts to charitable trusts (unlike outright charitable gifts) need to be reported on a federal gift tax return (Form 709).
1. Charitable Remainder Trusts. The trustee of a charitable remainder trust must annually file a Form 1041-A and Form 5227 (the instructions to Form 5227 require charitable remainder trusts to distribute a Form 1041, Schedule K-1 to the recipient of the unitrust or annuity trust amount reporting the income and deductions reflected on the Form 5227). A charitable remainder trust is not required to file a Form 1041 unless the trust has unrelated business taxable income (described below).
2. Charitable Lead Trusts. The trustee of a charitable lead trust must annually file a Form 1041 and prepare a Schedule K-1 indicating the beneficiary's share of all items of income, deductions and credits. If any part of the trust's income is taxable under the "grantor trust" rules of IRC '671-679 (which describe situations where the trust will be ignored and the trust's income, deductions and credits will be reported on the donor's individual income tax return), then such income is not listed on the Form 1041 but is rather shown on a separate statement, along with applicable identifying information. This statement is then attached to and filed with the Form 1041.
3. Deadline for Filing. All forms must be filed on or before the 15th day of the fourth month following the close of the trust's taxable year. In the case of charitable remainder trusts, which are required to adopt a calendar year, the forms must be filed by April 15.
B. Income Taxation of Charitable Remainder Trusts. Income earned within a charitable remainder trust is passed through to noncharitable beneficiaries based upon the unique "tiered" method discussed above. Because the tier method applies, tax records generally must be retained from the inception of the trust. The trust's accountants need to have a thorough understanding of this unique method in order to properly account to the trust beneficiaries with respect to their tax consequences when they receive distributions.
C. Marital Deduction. Care must be taken to assure that spousal interests in charitable trusts qualify for the gift or estate tax marital deduction. For example, a testamentary charitable remainder trust that has a noncharitable beneficiary in addition to the spouse will not qualify for the estate tax marital deduction.
D. Unrelated Business Taxable Income ("UBTI"). $1 of this in a given year can destroy the tax-exempt status of a charitable remainder trust in that particular year. If a charitable trust might derive any income from a business activity (including any such income derived through a partnership or a limited liability company in which the trust has an interest), careful advance planning is in order. If income is UBTI, it is subject to tax even though it is earned by a charitable trust, or by a charity itself.
E. Propriety of Investments. Charitable trust investments are now (in many states) governed by the "prudent investor rule" embraced by the Prudent Investor Act (adopted in New Jersey as N.J.S.A. 3B:20-11.1 et. seq., and in New York as N.Y. E.P.T.L. '11-2.3). Under the prudent investor rule, a fiduciary is required to adopt an investment plan which is designed to accomplish the objectives of the trust. No investment is inherently imprudent, and the propriety of a particular investment is determined by examining the investment in the context of the entire portfolio and the trust's objectives, rather than evaluating the investment in isolation. However, the investments must comport with the trust's overall objectives. Delegation of investment decisions by non-professional trustees to professional investment advisors is encouraged under this law. The named charitable beneficiaries, as well at the attorney general of the state (who is an interested party in any charitable trust), can take the trustees to task if the trust is not properly invested.
F. State Income Tax Consequences. Charitable trust income may not be treated the same way for state tax purposes as it is for federal tax purposes. For example, the State of New Jersey does not recognize the tax-exempt status of charitable remainder trusts.