Summer 2019 Archive
Drafting and executing a charitable remainder trust that meets the requirements of Code §664 is the first step, but there are many other ways trusts can run afoul of the rules.
Failure to pay—A trust must meet the definition of and function exclusively as a charitable remainder trust from inception [Reg. §1.664-1(a)(4)]. One requirement is that payments be made at least annually [Code §§664(d)(1)(A), (d)(2)(A)], although there are special exceptions in the case of a unitrust.
UBTI concerns—Prior to 2007, a charitable remainder trust’s continued tax-exemption depended upon the trust having no unrelated business taxable income for the year. A trust with UBTI no longer loses its exempt status, but the income is subject to a 100% excise tax, to eliminate the unfair competitive advantage the trust would otherwise have over nonexempt commercial rivals [Reg. §1.513-1(b)].
Self-dealing cautions—Charitable remainder trusts are subject to the private foundation rules that prohibit acts of self-dealing [Code §4941(d)], excess business holdings [Code §4943(c)], jeopardizing investments [Code §4944] and taxable expenditures [Code §4945(d)]. Penalties for self-dealing can reach up to 200% of the amount involved for the disqualified person and 50% for the trust [Code §4941(e)(4)]. Self-dealing is a concern, especially, where an unsophisticated donor attempts to save on fees by acting as the trustee and subsequently has any financial transactions with the trust.
Many donors have discovered the tax advantages of contributing a remainder interest in a home or farm. Some have found it a way to accelerate a gift, generating an income tax charitable deduction, rather than an estate tax deduction that they might not need. Before making the gift, the donors and charity should discuss continuing responsibility for property taxes, insurance and maintenance of the property. But what happens if the donors eventually need to leave the property? There are several options:
- The donors can lease the home or farm and receive rental income for their lives.
- If the donors don’t need the income, a gift can be made to charity of the remaining life estate, entitling the donors to a second charitable deduction.
- The parties can jointly sell the property, with the donors and charity each receiving the actuarial value of their respective interests.
- Charity might wish to buy the donors’ life interest if the property is one the charity wants to keep.
Philanthropic clients increasingly seem interested in giving to specific projects or programs of a charity, rather than for the general use of the organization. Some donors also evidence a desire for continuing involvement and participation after a gift occurs, demanding a greater degree of accountability.
Gift restrictions clearly have practical implications for the donee organization, but tax issues may arise for the donor, as well. For example, suppose an individual contributes a farm to a university, with the restriction that the land always be used for agricultural research.
Assuming the donee agrees to the restriction, three issues arise: (1) Is the restriction so severe as to cause the gift to be one of a partial interest, for which no deduction may be allowed? (2) How will the restriction be enforced? (3) What is the measure of the donor’s contribution?
In the example of a gift of a farm, the restriction would not seem so great as to cause the gift to be considered a gift of a partial interest, assuming the university has an agricultural program. But other restrictions may have a different effect. For example, where an individual contributed a rare book collection to a university under an agreement that permitted him to use the collection during his life, and also allowed him to deny permission for others to use the collection, he was held to have contributed a nondeductible future interest (Rev. Rul. 77-225).
There are several ways a restriction might be enforced. The deed of gift for the farm could provide that if the land is ever contemplated for use other than as an agricultural research area, the university shall petition a court for instructions regarding the future use of the land. Or the donor could provide that if the restriction is ever violated, the donor or heirs shall regain ownership of the land automatically (i.e., by making the gift one of a fee simple determinable) or shall have the right to reenter the property (i.e., by making the gift one of a fee simple subject to a condition subsequent). Finally, the donor might provide that if the restriction is ever violated, some other charitable organization shall take ownership of the property or have the right to enter it.
Lifetime gifts involving restrictions typically occur in the context of consultation and negotiation with the donee charity. Restricted bequests, however, are frequently made without charity’s input, sometimes with unfortunate results. Clients should be encouraged to consult with charities before attaching restrictions to testamentary transfers.
Planning charitable bequests involves more than just determining a charity’s correct legal name and its status as a qualified organization. The testator must consider whether the bequest should be outright or in the form of a testamentary trust and which assets would best be given to charity.
Outright or in trust?—Outright bequests can be a specific dollar amount, a specific asset, a percentage of the net value of the estate or all or a portion of the residue of the estate. Bequests in trust, also known as deferred bequests or split-interest bequests, offer flexibility and possible estate tax savings. An outright bequest to charity produces a larger charitable deduction than a bequest in trust because charity receives the money immediately. However, some testators may need to provide continuing financial support for dependents.
Split-interest bequests come in many forms: charitable remainder annuity trusts, charitable remainder unitrusts, QTIP trusts, charitable gift annuities, charitable lead unitrusts, charitable lead annuity trusts, remainder interests in farms or personal residences. Whatever the form, it is important that the transfer follows the requirements set out in Code §2055(e)(2).
Which assets are best?—Property that would cause problems if given during the donor’s life often makes the best bequest. One example is ordinary income property. The charitable deduction for an inter vivos gift of ordinary income property, such as a painting in the hands of the artist, is limited to the donor’s cost basis under Code §170(e)(1)(A). In contrast, a bequest of a painting by the artist produces an estate tax charitable deduction equal to the fair market value of the artwork. Keep in mind, however, that a reduced income tax deduction may be more valuable to a donor whose estate will not be subject to estate tax.
Tangible personal property at risk of being put to an unrelated use by the charity is also more valuable as a bequest. Consider for example the contribution of an antique car to a college. If given during the donor’s life, the income tax charitable deduction likely would be reduced by 100% of any long-term capital gain [Reg. §1.170A-4(b)(3)(i)]. The same car bequeathed to the college produces an estate tax charitable deduction equal to fair market value for an estate subject to tax.
Testators may be wise to make charitable bequests of income in respect of a decedent (IRD), creating both an income tax and an estate tax charitable deduction [Code §642(c)(1)]. Items of IRD include interest on U.S. savings bonds, accounts receivable of a cash-basis individual, renewal commissions of insurance agents, deferred compensation, last salary checks, bonuses and distributions from employee benefit plans, accrued royalties under a patent license, a deceased partner’s distributive share of partnership income up to the date of death and payments on installment obligations.
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