charitable split-interest trusts and form...

Charitable Split-Interest Trusts and Form 5227 Avoiding Compliance Pitfalls and Navigating Recent Regulatory Changes

THURSDAY, MAY 16, 2013, 1:00-2:50 pm Eastern

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Charitable Split-Interest Trusts and Form 5227

Rosemarie Steeb, Chiampou Travis Besaw & Kershner

[email protected]

May 16, 2013

Dawn D. Hallman, Hallman & Associates

[email protected]

Donna J. Jackson, CPA, JD, LLM

[email protected]

Today’s Program

Identifying Kinds of Split-Interest Trusts

[Dawn D. Hallman]

Tax Consequences and Recent Developments

[Rosemarie Steeb]

Financial Accounting Requirements

[Donna J. Jackson]

Avoiding Common Mistakes

[Panel Discussion]

Slide 7 – Slide 36




Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

IDENTIFYING KINDS OF SPLIT-INTEREST TRUSTS

Dawn D. Hallman, Hallman & Associates

UNDERSTAND WHY PEOPLE GIVE THE PLANNING PYRAMID

Tax

Plan

Wealth

Enhancement

Legacy Planning

Wealth & Value

Preservation

Family Planning

Education/ Bloodline/ Spendthrift

Personal Protection

Privacy/ Disability/ Retirement

Philanthropic Motivator

‘Better than the IRS’

Philanthropic Motivator

‘Pure Form’

8

CHARITABLE CONSIDERATIONS

• Annuity or Unitrust

• Fixed payment amount/ %

• Easy to zero out/ GST

• Kids or Grandkids

• Grantor/ Non Grantor

• Income Tax deduction?

• Totally out of estate

• Now or at Death

• Immediate benefits

• Estate Tax Wipeout

Market Performance

What are expected returns

AFR

What does the IRS say we will

earn

Asset Issues

Taxes due?

Liquid?

9

CHARITABLE REMAINDER TRUST (CRT)

• An agreement in which property or money is donated to a charitable organization

• The donor receives income from the investment during the

remainder of his or her lifetime

• After the donor’s death, the charitable organization receives

the principal of the donation to be used for a purpose specified by the donor.

10

CHARITABLE REMAINDER TRUST

(CRT)

• A CRT permits an estate owner to:

• Increase the income potential from a highly appreciated asset

• Obtain an income tax deduction and reduce estate taxes

• Benefit a charitable organization

• Change charities which will receive trust remainder

11

DONOR

Payments

for Term

Term Ends

(Death of Donor)

CHARITABLE

REMAINDER

TRUST

Remainder of

Assets in Trust

CHARITY


12


(CRT)

• Tax implications:

• Delay impact of capital gains tax, permitting full use of highly

appreciated asset(s) for investment

• Create a partial income tax deduction based upon IRS

formula

• Reduce estate or gift taxes because the remainder of the

trust is distributed to the charity

13

UNITRUST (CRUT)

• A form of a charitable remainder trust in which the donor donates property or money in return for a fixed percentage of

income, not less than 5% per statutory requirements, of the

trust’s net fair market value of its assets each year until the

death of the beneficiaries or other specified term.

14

CRUT

Key benefits:

• Delays impact of capital gains tax

• Permits full use of highly appreciated asset(s) for investment

• Increases potential net income to donor which may

keep pace with inflation

• Creates immediate income tax deduction

• Reduces estate taxes through charitable gift

15

CRUT

Other benefits:

• Allows control over investment choices

• May change investments without income tax on gains

• Trust can receive multiple gifts over time

• Provides long lasting value to charity of choice

16

Transfer

To CRUT

At end of

Distribution

Period

-- Income

Tax

Deduction

-- Full Use

of Asset

Fixed %

Distribution of

Trust Market

Value for

Certain Period

or Life

-- Possible Higher Realized

Income for Recipients

Charitable Organization

Receives Remainder

From CRUT

Asset

CRUT

Diversifies

Portfolio &

Produces

Annual

Distribution

-- Removes Asset from Estate

-- Leaves Legacy to Charity

Distribution

Recipients

17

CHARITABLE REMAINDER ANNUITY TRUST (CRAT)

• A form of charitable remainder trust in which the donor donates property or money in return for a fixed percentage of

the initial fair market value of its assets.

• Unlike the Unitrust, the payments to the beneficiaries are set at

the inception value and do not change.

18

CRAT

Key benefits:


• Permits full use of highly appreciated asset for investment

• Increases potential net income to donor



19

CRAT

Other benefits:

• Allows control over investment choices

• May change investments without income tax on gains

• Provides long-lasting value to charity of choice

• Provides certain fixed income payment to lifetime

beneficiaries

20

One-time

Transfer

To CRAT

At end of

Distribution

Period

-- Income

Tax

Deduction

-- Full Use

of Asset

Fixed Amount

Distribution of

Initial Trust

Value for

Certain Period

or Life

-- Possible Higher Realized

Income for Recipients


Receives Remainder

From CRAT

Asset

CRAT

Diversifies

Portfolio &

Produces

Annual

Distribution

-- Removes Asset from Estate

-- Leaves Legacy to Charity

Distribution

Recipients

21

NET INCOME UNITRUST (NIMCRUT)

• A form of charitable remainder trust in which the donor donates property or money and receives income for the

lifetime of the beneficiaries. The income payment is either the

specified percentage of the market value in that year or the

net income earned by the trust in that year.

• It also may contain a “make-up” provision in which the donor

can elect to receive less income than the agreed upon

percentage of market value in return for receiving a higher

percentage in a subsequent year.

22

NIMCRUT

Key benefits:

• Permits income payment flexibility

• Creates an additional retirement income source with no limits on contributions, no early withdrawal penalties, and

no minimum distribution requirements

23

NIMCRUT

Other benefits:


• Permits full use of highly appreciated asset(s) for

investment

• Increases potential net income to donor which may

keep pace with inflation



24

STAGE 1

Net Income Trust

Holds Asset &

Produces

Annual

Income, if any


Receives Remainder

From CRUT

Transfer To

Net Income

Trust

After Distribution Period

Distribution

Recipients

STAGE 1 Income, if any, Up to Fixed

% of Trust Market Value

-- Allows time to convert

illiquid assets

-- Permits flexible income

planning for future needs

Asset

STAGE 2

CRUT Diversifies

Portfolio &

Produces

Annual

Distribution

STAGE 2

Fixed %

Distribution of

Trust Value for

Certain Period

or Life

After

Triggering

Event,

Converts

To CRUT

25

CHARITABLE LEAD TRUST (CLT)

• A CLT permits an estate owner to:

• Transfer assets to heirs and receive significant estate or gift

tax deductions

• Reduce exposure to income tax by providing income to a charitable organization

26

CLT

Donor:

• Makes a gift of property to irrevocable trust

• Charitable organization is income recipient and receives either an annual fixed % of the net fair market value of trust assets or an annual fixed amount for a certain period of time or the life of the donor or another individual.

• Receives either a gift tax charitable deduction or estate tax deduction depending upon whether or not trust is created during lifetime of donor.

27

CLT

Key benefits:

• Permits transfer of assets to heirs with significantly reduced

estate or gift taxes

• Can reduce income taxes

• Flexible planning tool to zero out estate tax

• Can create delayed inheritance/retirement benefit for

heirs

28

CLT

Other benefits:

• Allows excess return on investment within trust to go to

heirs tax free

• May make multiple gifts

• Provides long-lasting value to charity

29

Transfer

To CLT

At end of

Distribution

Period

-- Gift or

Estate

Tax

Deduction

Distribution for

Certain Period or

Life

-- Charity receives income

immediately

Asset

CLT

May Diversify

Portfolio &

Produces

Annual

Distribution

-- Reduced gift or estate taxes

on the transfer of the trust

assets

Beneficiaries

Receive

Remainder

From CLT

Charitable

Organization

30

Slide Intentionally Left Blank

ADVANTAGES OF A CRT

• By setting up a CRT, a donor can avoid currently paying tax on the disposition of appreciated assets

• Donor can invest the sale proceeds to generate a future income stream. The donor forms a CRT and contributes assets (such as appreciated stock) to it.

• The donor receives an income tax charitable deduction (as well as a gift or estate charitable deduction) when the CRT is created. The amount of the deduction is measured by the actuarial present value of the charity’s right to receive the corpus on termination of the noncharitable (remainder) interest.

• The CRT sells the stock but does not pay tax on the gain, because the CRT is generally a tax-exempt entity under IRC § 664(c).

32

ADVANTAGES OF CRT (CONT.)

• The CRT then invests the proceeds of the stock sale and pays the donor an income stream for a fixed term of years (or over the course of a life or lives), based either on the value of the assets at the time the trust is created (annuity trust) or a fixed percentage of asset value each year going forward (unitrust).

• Any gain is taxable to the income beneficiary only when it is distributed. On completion of the term, the CRT distributes the remaining assets to a charity, which can include a private foundation established by the donor.

• If the donor retains an interest in the trust for life, the assets remaining in the CRT at death are deductible for estate tax purposes.

• Another type of charitable trust is the charitable lead trust (CLT), which pays an income stream to the charity on the front end, with a remainder interest payable to noncharitable beneficiaries. CLTs are generally used to minimize gift and estate tax.

33

CRT REQUIREMENTS

• A CRT must make a minimum annual distribution of at least 5% of the fair market value (FMV) of the trust assets for either the lifetime of an individual or individuals or a term not to exceed 20 years.

• No distributions are permitted to any other individual, but a qualifying charity may in certain circumstances also receive income.

• Another individual or individuals can receive an interest for a term of years or for life following the first interest. However, state law may require that federal estate or state death taxes due upon the first beneficiary’s death be equitably apportioned among the interests in the estate.

• In such cases, in the absence of clear direction to the contrary in a decedent’s will, the secondary beneficiary will lose the life estate unless the secondary beneficiary pays any estate or death taxes for which the trustee may be liable on the first beneficiary’s death (Revenue Ruling 82-128, 1982-2 CB 71). After the term of years or on the death of the

measuring individual, the remainder interest (the present value of which must be at least 10% of the initial FMV of assets on funding) must pass to a qualifying charity. The trust must operate according to these rules from its inception. 34

TRUSTS AS A FINANCIAL TOOL

• As you can see, charitable trusts are useful to:

• Increase income from low-yielding assets

• Transfer assets to heirs on a tax effective basis

• Reduce exposure to income tax or create a deduction by

providing a gift to a charitable organization

There are many variations to meet the needs of your clients. You

should ensure your clients use a reputable estate planning attorney.

35

THANK YOU

Dawn D. Hallman

Hallman & Associates, P.C.

2230 McKown Drive

Norman, Oklahoma 73072

www.hallmanlawoffice.com

[email protected]

(405) 447-9455

http://www.hallmanlawoffice.com/

mailto:[email protected]

TAX CONSEQUENCES AND RECENT DEVELOPMENTS

Rosemarie Steeb, Chiampou Travis Besaw & Kershner

Topics Covered

• Income and transfer tax considerations:

― Charitable remainder trust (CRT)

― Charitable lead trust (CLT)

• Form 5227 presentation

― Compliance reminders

― Applicable Private foundation excise taxes

― Public inspection rules

• Unrelated business income (UBI)

― Hedge funds

― Debt financed income

• Advantages & planning

• 3.8% Medicare tax issues

38

Donor (Income Beneficiary)

Public

Charity (Remainder Beneficiary)

Transfer of highly-

appreciated assets

Donor receives an

immediate income tax

deduction for present

value of the remainder

interest (must be at least

10% of the value of the

assets originally

contributed)

At the donor’s death (or at

the end of the trust term),

the charity receives the

residual assets held in the

trust

Annual (or more

frequent) payments

for life (or a term of

years)

CRT

Charitable Remainder Trust (CRT)

39

Income Tax Consequences - CRT

Formation:

• A donor receives no charitable income tax deduction for a gift

of a remainder interest to charity unless the trust is a CRT

described in Section 664.

• Intervivos CRT - The grantor is entitled to an immediate

income tax deduction in the amount of the present value of

the remainder interest passing to charity.

• Testamentary CRT - The estate of the decedent whose will

created a CRT is entitled to an estate tax deduction for the

present value of the remainder interest passing to charity.

40

Charitable Contribution Deduction - CRT

• CRAT - At the time a CRAT is formed, the donor may deduct the fair

market value of the property placed in trust less the present value of the

annuity as a charitable contribution on his or her individual tax return

and for estate and gift taxes

• Additional contributions cannot be made to a CRAT because the

annuity amount is based on the value of the assets only valued as of

creation. The governing instrument of the CRAT must prohibit

additional contributions.

• CRUT - the deduction is the present value of the remainder interest

• Additional contributions can be made to a CRUT as long as the

governing instrument provides a formula upon which to base the

unitrust amount, which takes into account the additional

contribution.

41

Charitable Contribution Deduction

The value of the donor's federal income tax deduction is a

function of:

1. The type of charitable remainderman;

2. The kind of property contributed to the CRT; and

3. Whether, at the end of the non-charitable term, the assets

are:

a) Distributed outright to the charitable remainderman;

or

b) Held in trust for the benefit of the charitable

remainderman

42

Type Of Charitable Remainderman

• A public charity including churches, educational institutions,

hospitals and medical institutions

• University endowment funds, governmental units, publicly

supported organizations under Sections 170(c)(2) & 509(a)(2)

(i.e., museums, drama companies, ballet companies, etc.)

• Supporting organizations under Section 509(a)(3)

• Private operating foundations

• Two types of non-operating private foundations:

― Distributing foundations

― Foundations that maintain a common fund

43

Impact Of Kind Of Property Contributed - CRT

The donor gets a federal income tax deduction for the fair market value of

the remainder interest passing to charity subject to the following

percentage limitations.

• Gift of cash and non-appreciated property

― Passes outright to public charity at end of non-charitable term

― In the year of the gift, the donor's fair market value charitable

income tax deduction is limited to 50% of his/her adjusted gross

income (AGI) with a five-year carryforward.

― Held in trust for the benefit of public charity at end of non-

charitable term

― In the year of the gift, the donor's fair market value charitable

income tax deduction is limited to 30% of his/her AGI with a

five-year carryforward.

44

Impact Of Kind Of Property Contributed – CRT (Cont.)

• Gift of appreciated property

― Passes outright to public charity at end of non-charitable

term

― In the year of the gift, the donor's fair market value

charitable income tax deduction is limited to 30% of

his/her AGI with a five-year carryforward.

― Held in trust for the benefit of public charity at end of

non-charitable term

― In the year of the gift, the donor's fair market value

charitable income tax deduction is limited to 20% of

his/her AGI with a five-year carryforward

45

Income Tax Consequences - CRT

Annually – annuity recipient

• The distributions to the recipient of the annuity amount or unitrust

amount are includable in the recipient's gross income – reportable on

Schedule K-1

• Tiered structure - the highest-taxed items are deemed to be distributed

first in the following order:

― Ordinary income to the extent of the CRT's ordinary income for that

year and undistributed ordinary income from prior years

― Capital gains to the extent of the CRT's capital gains for that year

and undistributed capital gains from prior years (short term gains

first)

― Current and undistributed tax exempt income

― Corpus – non-taxable

46

Income Tax Consequences – CRT (Cont.)

Annually – annuity recipient (Cont):

Net income make-up charitable remainder unitrust (NIMCRUT)

• The unitrust payment from a NIMCRUT is based on a fixed

percentage of the value of the trust assets at the beginning of

the year, but is limited to the trust's annual income.

• If the trust income is less than the payment based on the fair

market value of trust assets, the trust may increase payments

to the beneficiary in subsequent years to compensate for a

prior deficiency.

• Tiered distribution rules still apply

47



CRAT and the fixed-percentage CRUT:

• The trustee may be forced to make a distribution in kind if the income is

insufficient to satisfy the annuity amount of the CRAT or the unitrust amount

of the fixed percentage CRUT

• A distribution in kind is deemed to be a sale of the property so distributed

causing the recipient to recognize capital gain on the property in kind

distributed.

― For example, if a donor funds a fixed percentage CRUT with closely held

C stock and then the stock cannot be sold after such funding, the trustee

will be obligated to distribute enough stock to the donor to meet the

annual fixed percentage and the CRUT will realize the capital gain on

that stock even though it was not sold; that capital gain will be passed

through to the recipient under the income tax characterization rules

above causing the recipient to recognize gain.

48



CRAT and the fixed-percentage CRUT:

• If NIMCRUT, the trustee will not be forced to make a

distribution in kind. Rather, the trustee can satisfy the unitrust

amount based on the income earned by the CRUT. Obviously, if

a non-income earning asset, such as real estate, is used to

fund a CRT, it is best to choose a CRUT with the lesser of

income feature.

49


Annually – trust:

• A CRT is a tax exempt entity; therefore, the CRT pays no

income tax on its income unless it has unrelated business

taxable income (UBTI).

• A CRT is not taxed on any retained gain it realizes upon selling

appreciated property, whether donated by the grantor or

appreciation occurring after the donation.

50

Transfer Tax Consequences - CRT

The retention of a right to revoke by the donor results in the CRT assets

being includable in the donor's estate at his/her death

The gift tax consequences is based on the recipient of the annuity amount

or unitrust amount:

― Just the donor: The donor gets a charitable gift tax deduction for

the value of the remainder interest passing to charity.

― The donor and spouse only: The donor has made a gift to his/her

spouse of the value of the annuity amount or unitrust amount

going to his/her spouse but such gift is shielded by the marital

deduction. The donor also gets a charitable gift tax deduction for

the value of the remainder interest passing to charity

51

Transfer Tax Consequences – CRT (Cont.)

The gift tax consequences is based on the recipient of the annuity amount

or unitrust amount (Cont):

• Spouse and others (e.g. the donor, then spouse and then children) -

The donor has made a gift to his/her spouse that does not qualify for

the marital deduction. Further, the donor has made a gift to his/her

children. However, the donor can retain the right to revoke by will

his/her spouse and children's rights to the annuity amount or unitrust

amount without disqualifying the trust as a CRT and if so, the gifts are

incomplete.

• Someone other than the donor's spouse: The donor has made a gift

to that person in the amount of the present value of the annuity

amount or unitrust amount unless the donor retains the right to revoke

by will that person's right to the annuity amount or unitrust amount.

52

53

Donor (Income Beneficiary)

Public

Charity (Income Beneficiary)

Transfer of cash, stock

and/or other assets

At the donor’s death (or at

the end of the trust term),

the remainder beneficiaries

receive the residual assets

held in the trust

Annual (or more

frequent) payments for

life (or a term of years) CLT

Donor’s Children (Remainder Beneficiary)

Charitable Lead Trust (CLT)

53

Types Of CLTs

• Grantor or non-grantor trust depending on whether the grantor

retains the power to control beneficial enjoyment, the power

to revoke the trust, or any of the attributes described in IRC

sections 672–677.

• A retained reversionary interest triggers grantor trust treatment

if the reversion is valued at more than 5% of the trust property's

fair market value at the time the trust is formed

54

Income And Transfer Tax Consequences - CLT

Grantor Nongrantor

Income tax:

Formation Grantor can deduct the present value of the income interest, subject to charitable contribution limits

No deduction

Annually Grantor will include trust income on individual income tax return, but no deduction for charitable contributions made by the trust

Trust recognizes income offset by the annuity or unitrust payment each year, but cannot deduct any excess contribution

Transfer tax:

Inter Vivos - Gift tax Grantor deducts the present value of the income interest at the time of formation. No deduction is allowed as the payments are made to the charity by the trust.

Grantor deducts the present value of the income interest at the time of formation. No deduction is allowed as the payments are made to the charity by the trust.

Testamentary - Estate

Not applicable Estate deducts the present value of the income interest at the time of formation. The trust cannot deduct charitable contributions as they are made.

55


56

Form 5227 – Compliance Reminders

• Due date April 15 – extended with Form 8868 (not 7004) for up to six

months – three months at a time (i.e. until July 15 and then October 15)

• All filed with IRS Center in Ogden, UT

• Copy of trust instrument must be attached to initial return

• Balance sheet (Part IV) – all trusts must complete columns a and b based

on the accounting method the trust uses in keeping its books and records

― Column c only applies to CRUTs and should be completed as of the

valuation date – valuation date and method must be used each year

• Short tax years – the annuity or unitrust amount for short tax year is

computed by multiplying the full year annuity or unitrust amount by the

number of days in the trust’s tax year divided by 365 or 366 for leap

years

57

Applicable Private Foundation Excise Taxes

• Since some but not all of the unexpired interest are charitable

the following private foundation excise taxes also apply to

CRTs and CLTs:

― Self-dealing (Section 4941)

― Excess business holdings (Section 4943)

― Investments that jeopardize charitable purposes (Section

4944)

― Taxable expenditures (Section 4945) and political

expenditures (Section 4955)

58

Self-Dealing

• The trust must not be involved in self-dealing. This includes any of the

following direct or indirect transactions between the trusts and a disqualified

person:

― Sale, exchange, or leasing of property;

― Lending of money or extension of credit;

― Furnishing of goods, services, or facilities, unless such goods, services, or

facilities are made available to the general public on at least as favorable

a basis as they are made to the disqualified person,

― Payment of compensation (or payment or reimbursement of expenses),

unless it is for personal services and such compensation is reasonable and

necessary to carry out the exempt purpose and is not excessive;

― Transfer to, or use by or for the benefit of, a disqualified person of the

income or assets of the trust

59

Disqualified Person

• A disqualified person is:

― A substantial contributor to the trust,

― A family member of a substantial contributor (i.e. spouse,

descendants, and spouses of descendants), or

― Persons owning more than 20% of an entity that is a

substantial contributor to the trust

• A substantial contributor is an individual, trust, estate,

corporation, or partnership who contributes an aggregate

amount in excess of $5,000 to the trust, if his or her total

contributions are more than 2% of the total contributions

received

60

Example Of Potential Self-Dealing

Reimbursement to disqualified persons for travel expenses

• Could cause the trust and the disqualified person' to be potentially liable for

penalty taxes for self-dealing, for making non-charitable expenditures, or

possibly both.

• Such reimbursement of expenses will not be subject to the excise tax if the

expenses are reasonable and necessary to carrying out the exempt purposes of

the trust and are not excessive.

• The Code does not explain what is "reasonable and necessary” – follow guidance

under business expense deductions rules include travel fares, meals, lodging,

and expenses incident to travel. Travel expenses are not reasonable and

necessary if the trip is primarily personal in nature.

• An amount spent on director's services will not be deemed "excessive" if it is

only such as would be paid "for like services by like enterprises under like

circumstances.

61

Example Of Potential Self-Dealing (Cont.)

Attendance by grantor/trustee at fundraising event for one of

trust’s charitable beneficiaries where donor benefits are

received.

• The grantor/trustee who participated in the event should

reimburse the trust for the value assigned to the benefits

received so as to minimize appearance of self dealing. If the

trustee reimbursement comes after year end then reflect as an

accounts receivable on the balance sheet

62

Consequences To Self-Dealing

• Any disqualified person who engages in an act of self-dealing is

assessed an excise tax of 5% of that amount involved in the transaction

for each year that the transaction is uncorrected.

• A trustee who knows that the act is prohibited but approves it may

also be subject to a tax of 2.5% of the amount involved (up to $10,000

for each such act) for each year that the transaction is uncorrected.

• If the transaction is not timely corrected and the 5% was initially

assessed, the disqualified person is subject to being assessed an

additional tax of 200% of the amount involved.

• Any trustee who does not correct the transaction may also be subject

to an additional assessment of 50% of the amount involved (up to

$10,000 for each such act.)

63

Excess Business Holdings – Section 4943

• Section 4943 imposes an excise tax on the value of the "excess

business holdings" of the trust.

• A trust created after May 26, 1969 has excess business holdings

to the extent that it, together with all disqualified persons,

owns in the aggregate more than 20% of the voting stock of an

incorporated business enterprise (or corresponding interests in

non-incorporated business enterprises).

• In general, where a trust acquires excess business holdings by

gift or bequest, the trust has five years from the date it

acquires such holdings to dispose of them

64

Jeopardizing Investments – Section 4944

• Section 4944 imposes an excise tax on a trust (and under some

circumstances trustees) for investing any amount in such a

manner as to jeopardize the carrying out of its exempt

purposes.

• The imposition of an excise tax on "jeopardy" investments is

intended to assure that the trustees adopt a "prudent person"

approach toward the investment of trust assets.

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Exceptions To Sections 4943 And 4944

• The excess business holdings provisions of Section 4943 and the

"jeopardy investment" provisions of Section 4944 do not apply to a

split-interest trust if either:

― All of the income interests (and none of the remainder interests)

of the trust are devoted solely to charitable purposes and all

amounts in trust for which a charitable deduction was allowed

have an aggregate value of not more than 60% of the aggregate

fair market value of all amounts in trust; or

― A charitable deduction was allowed for amounts payable under the

terms of the trust to every remainder beneficiary, but not to any

income beneficiary, as is the case with the majority of charitable

remainder trusts.

66

Public Inspection Requirements

• Form 5227 be open to public inspection, except for

information related to non-charitable trust beneficiaries,

which is disclosed on Schedule A that is not open to public

inspection.

• To inspect a return, the petitioner must submit a written

request to the IRS that must include the name of the trust,

the trustee’s address, the type of return and the year for

which the return was filed.

67

Unrelated Business Income (UBI) Prior To 2006

• The CRTs tax exempt status would be suspended for any year

that the CRT generated UBTI forcing the trust to pay tax on the

entire amount of income for that year.

• The CRT would be taxed as a complex trust with an allowable

deduction for amounts required to be distributed to the

beneficiary.

• Any remaining income would be subject to income tax at the

appropriate trust tax rates.

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UBI After 2006

• The Tax Relief and Health Care Act of 2006 (the “2006 Act”) changed

the income tax rules on CRTs for any year in which the CRT incurs

UBTI. No longer is the entire trust income subject to tax. Rather, an

excise tax is imposes equal to 100% of the amount of the UBTI incurred

by the CRT.

• The UBTI is considered income of the trust for purposes of determining

the character of the distributions made to CRT beneficiaries, without a

reduction of such income for the excise taxes paid by the CRT.

• Example: CRT with $4.5M of stocks & bonds and $500K in hedge funds.

The investment return after deduction for the amounts paid to the

beneficiary is a total of $240,000 of which $5,000 is UBTI. he CRT

owes an excise tax of $5,000. Prior to 2006, the CRT tax obligation

could have been as high as $84K.

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Are Hedge Funds Appropriate For CRTs?

• A prudent fiduciary of a CRT should consider the following factors before adding

hedge funds to the trust’s investment portfolio:

― How much UBTI is present?

― Percentage of hedge fund return generated in the form of ordinary income

– an investment mix that promises to distribute a heavy annual dose of

ordinary income or short term capital gain become less attractive than

one which promises a lower tax cost to the non-charitable recipient

― Other investment considerations:

― Liquidity needs

― Risk of downside volatility

― Tolerance for fees and expenses

― Offshore fund reporting requirements

70

UBI – Debt-Financed Income

• Unrelated business taxable income includes income from debt-financed

property.

• A trust has debt-financed income it acquires realty subject to a mortgage.

• The trust will not have unrelated business taxable income if for a period of 10

years following the gift:

― The trust does not assume the debt or

― Meets all the following requirements:

1. The debt was placed on the property more than five years before the

date of the gift;

2. The property was held by the donor for more than five years before

making the gift; and

3. The CRT does not assume the debt. See PLR 9533014 PLR 9015049.

•

71

Advantages Of A CRT

Non-recognition of capital gains

• A donor can contribute highly appreciated property to a CRT and benefit

from the appreciated value of the asset because the donor's unitrust

amount from a CRUT will be greater due to such assets high value not

reduced by income tax on the appreciation.

• The donor benefits from the appreciation and at the same time the donor

avoids immediate payment of the tax from the appreciation.

• The key is to make sure that as of the date of the funding (not just

creation) of the CRT that there is no legal obligation to sell such asset. If,

when the trust receives the asset, the trustee is subject to an obligation to

sell, the IRS will ignore the gift to the CRT and treat the transaction as if

the donor sold the asset. The donor then gets the worst of both worlds-

payment of tax and loss of the asset.

72

Advantages Of A CRT (Cont.)

Growth of assets in a tax-exempt entity:

• Since a CRT is a tax-exempt entity, the value of the assets in the CRT

can grow at a faster rate because gain realized on the sale of assets of

the CRT is not recognized for income tax purposes in the CRT.

• The recipient of the unitrust amount from a CRUT gets the benefit

from such growth since the fixed percentage is applied to a larger

capital base.

• If family members are concerned that their inheritance will be

reduced, the donor may use the tax savings created by the charitable

contribution deduction to buy life insurance. This plan reduces the

client's taxable estate and provides a liquid inheritance for heirs.

73

Advantages Of A CLT

• CLTs are attractive for clients with ample income seeking to transfer

assets at minimal estate and gift taxes. By prolonging the payment

period to the charitable beneficiary, the present value of the

remainder interest is decreased and the value of the gift is reduced.

• In deciding whether to use a CLAT or CLUT, consider the donor's goals.

If the donor seeks to maximize the payment that the non-charitable

beneficiary will receive at the trust termination, a CLAT is preferable

if the trust assets are expected to significantly appreciate in value.

• A CLAT also favors the remainderman if the amount paid to the

charitable beneficiary is less than the trust's annual income, since the

excess accumulates for the benefit of the non-charitable beneficiary.

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Advantages Of A CLT (Cont.)

• A CLAT provides a fixed distribution, or annuity, to one or more charities in

each year of the trust.

• Distributions can be the same each year or can increase annually at a rate

established when the trust is put in place.

• Starting with a small annual payment but increasing the amount over the

course of the trust may result in assets of greater value passing to the non-

charitable beneficiary.

• For instance, a $1 million CLAT providing steady payments of $108,000 to

charity for 10 years would result in $369,000 passing to the non-charitable

beneficiary if it earned 6% per year. If, however, that $1 million CLAT

started with an initial payment of $33,000, increasing by 25% each year for

10 years, $476,000 would pass to the non-charitable beneficiary. In both

cases, the taxable value of the gift to the non-charitable beneficiary would

be zero.

75

Advantages Of The Unitrust

• Appreciation in the value of trust assets causes unitrust payments to

increase, maximizing the payment to the charity in a CLUT or to the

non-charitable beneficiary in a CRUT.

• Alternatively, if trust assets in a unitrust decline in value, the non-

charitable life tenant will receive a reduced annuity payment. The IRS

has allowed early termination of CRUTs when the donor is dissatisfied

with the annual return or needs access to the corpus. To avoid

repayment of the tax benefits from the initial charitable contribution,

the charity must receive the present value of its proportionate

interest. Distributions made to the non-charitable beneficiary are

taxed as long-term capital gains.

• NOTE: The annual valuation requirements for unitrusts increase

administrative costs over annuities.

76

Recent Increase In Use Of CLTs

• The IRS discount rate is used to determine the assumed rate of return for

assets contributed to a CLAT and affects the calculation of the lead payments

(that is, how much must be paid to charities in order to “zero out” or eliminate

the taxable gift component).

• When the discount rate is low, the annual payout to charity can be reduced.

• A trust funded with $1 million when the discount rate is 6% would need to pay

the charitable recipient almost $136,000 per year for 10 years in order to have

that stream of payments have a present value of $1 million. If, however, the

discount rate is 1.4% (as it was in March 2012), the charitable recipient would

need to be paid only $108,000 per year for the same result. That means that in

today’s environment, if this trust had an annualized return in excess of only

1.4%, it would not only be able to satisfy the annuity payment to charity but

also would have funds remaining at the end of 10 years for the non-charitable

beneficiaries.

77

Recent Increase In Use Of CLTs (Cont.)

• Low initial asset values might grow at a higher than expected

rate, delivering more to your beneficiaries without increasing

potential tax liability

• There is an expectation that the values of assets used to fund a

CLT may be only temporarily depressed and that over an

extended investment cycle, values will normalize and perhaps

appreciate.

78

Preferable Assets To Fund CRT • Low basis, highly appreciated, marketable securities - The sale proceeds can

then be invested to produce payments to the recipient who benefits from the

appreciation of his/her securities via the annuity amount or unitrust amount,

but has no taxable recognition of the gain from the sale of the securities while

the proceeds or those in that they are invested are held by the CRT.

• Investment by the CRT in tax free securities may not be wise if the CRT has

accumulated undistributed ordinary or capital gains since the recipient still has

to recognize the income therefrom under the tier approach applicable to

distributions to recipients.

• It is not a good idea to transfer a donor's personal residence to a CRT, whether

unencumbered or encumbered, because the donor cannot live in the residence

without committing a prohibited act of self-dealing. Also using encumbered real

estate caused unrelated business taxable income

• A CRT is not a qualified subchapter S shareholder, and therefore, a donor

cannot use subchapter S stock to fund a CRT.

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3.8% Medicare Tax Issues

• Use a CRT to harbor “net investment income” in a tax-exempt environment

while at the same time leveling income over a longer period of time to keep

modified adjusted gross income for the beneficiary below the “threshold

amount”.

• Use a non-grantor CLT to offset “net investment income” against charitable

deductions dollar-for-dollar in a tax-efficient manner.

• While a CRT itself is not subject to the 3.8% Medicare surtax on net investment

income, distributions from the CRT to non-charitable beneficiaries will be

potentially subject to the tax as the income is distributed.

• To avoid "unfairly" causing Medicare taxes to beneficiaries that receive income

in 2013 or beyond that was actually created prior to the Medicare tax (and just

not yet distributed), the new rules stipulate that only income in the trust that

was created in 2013 or later will be treated as net investment income.

80

FINANCIAL ACCOUNTING REQUIREMENTS

Donna J. Jackson, CPA, JD, LLM

FINANCIAL ACCOUNTING

REQUIREMENTS

Donna Jackson, CPA, JD, LLM

10400 Vineyard Blvd, Suite C

Oklahoma City, OK 73120

(405) 840-1874


84

A charitable remainder trust should not pay the estate tax or

gift tax of the donor.

The creation of an income interest for a person other than the

donor creates a gift equal to the value of the property

transferred less the APVRI.

If the donor’s spouse is the only person other than the donor

to receive an income interest, then the gift tax marital

deduction (IRC § 2523(g)) eliminates most gift tax concerns.

Define Principal And Income

85

The definition of trust accounting income is a function of the

language of the trust’s governing instrument and the principal and

income statute of the applicable state.

Where one or more provisions of the trust’s governing instrument

are in conflict with the principal and income statute, the trust’s

governing instrument takes precedence.

Trust Provisions

86

A number of desirable optional provisions exist that can increase

the utility and flexibility of a CRT.

For example, the donor may:

Retain the power to change the charitable remainder beneficiary.

Provide the trustee with the ability to accelerate the distribution of

principal to the charity

Spendthrift clause designed to restrict the income beneficiary’s

ability to alienate his or her interest

Give the income beneficiary the flexibility to make a charitable

gift of his or her income interest

Proper Payments

87

Several potential traps exist regarding the proper amount to pay the

income beneficiary.

A CRT must use the calendar year as its tax year. As a result, it will

have a short tax year in the first and last year of the trust.

For any short year, prorate the annuity or unitrust payment. The

proration is done on a daily basis.

Considerations for Leap-Year

Payment Traps

88

Assuming that the current year’s unitrust payment will be the same

as the prior year’s unitrust payment

Paying the income beneficiary of a NIMCRUT or a Flip-CRUT (pre-

flip) the full fixed percentage amount without regard to the trust’s

accounting income.

Valuation Issues

89

Unmarketable assets provide the greatest challenge. A CRT trustee

will need to know the value of the trust’s assets.

For example:

• Valuing the initial contribution to the trust;

• Determining the annual valuation of the trust’s assets and liabilities

required to compute the unitrust amount;

• Valuing additional contributions for the incremental change in the

unitrust amount; and

• Computing how much of an asset to transfer to make an in-kind

distribution

Treas. Reg. §1.664-1(a)(7)

90

Two alternative methods for securing the value of a CRT’s

unmarketable assets.

First, the valuation can be performed exclusively by an

independent trustee.

Second, the value can be determined by a current qualified

appraisal.

Compliance

91

Ensure continued qualification of CRT

Be familiar with the laws and regulations governing CRTs

Be familiar with terms of the trust

Monitor the activity of the trust for compliance

Areas Of Concern

93

Trustee powers

Principal and income allocations

Prohibited investments

Self-dealing transactions

Transactions that could produce UBTI

Annual Reporting

94

In some states, the trustee is required to make a periodic statement

or accounting to the income beneficiaries, remainder beneficiaries,

and/or a court.

Charities that prepare financial statements in accordance with

GAAP are required to include certain information about charitable

remainder trusts.

The type of information to be included depends on whether the

charity serves as trustee (or not) and whether the charity’s interest

is revocable or irrevocable.

Recording Balance Sheet

97

Limitations

Assets recorded at historical cost (does not show true value of

asset)

Use of cost estimates (not true financial position)

Omission of valuable non-monetary assets

Reporting

98

Financial statements

Tax return presentation

More requirements than fiduciary accounting to court

Reporting (Cont.)

99

A fiduciary accounting shall contain sufficient information to put the

interested parties on notice as to all significant transactions

affecting administration during the accounting period.


100

The presentation of the information in an account shall allow an

interested party to follow the progress of the fiduciary’s

administration of assets during the accounting period without

reference to an inventory or earlier accounting that is not included in

the current account.

An account is not complete if it does not itemize assets on hand at

the beginning of the accounting period.

Reporting (Cont.)

101

The first account for a decedent’s estate or a trust should detail the

items received by the fiduciary and for which he is responsible. It

should not simply refer to the total amount of an inventory filed

elsewhere or assets described in a schedule attached to a deed of

trust.

In later accounts for an estate or trust, the opening balance should

not simply refer to the total value of principal on hand as shown in

detail in the prior account, but should list each item separately.

Reporting (Cont.)

102

Instead of retyping the complete list of assets in the opening balance, the accountant may prefer to attach as an exhibit a copy of the inventory, closing balance from last account, etc.

Transactions shall be described in sufficient detail to give interested parties notice of their purpose and effect.

Too much detail may be counterproductive to making the account understandable.

In accounts covering long periods or dealing with extensive assets, consolidate information.

Ie: securities being accounted for over a long period of time, a statement of the total dividends received on each security with appropriate indication of changes in the number of shares held will be more readily understandable and easier to check for completeness than a chronological listing of all dividends received.

Although detail should generally be avoided for routine transactions, it will often be necessary to a proper understanding of an event that is somewhat out of the ordinary.

Reporting (Cont.)

103

Separately show and explain the following:

Extraordinary appraisal costs

Interest and penalties in connection with later filing of tax returns

An extraordinary allocation between principal and income

Computation of a formula marital deduction gift involving non-

probate assets

Carrying Values

104

Carrying values based on date of death may be adjusted to reflect changes on audit of estate or inheritance tax returns.

Where appropriate under applicable local law, a successor fiduciary may adjust the carrying value of assets to reflect values at the start of his administration.

Assets received in kind in satisfaction of a pecuniary legacy should be carried at the value used for purposes of distribution.

Though essential for accounting purposes, carrying values are commonly misunderstood by laymen as being a representation of actual values. To avoid this, the account should include both current values and carrying values.

Other Accounting Considerations

105

Gains and losses incurred during the accounting period shall be

shown separately in the same schedule

The account shall show significant transactions that do not affect

the amount for which the fiduciary is accountable.

Thank You

106

Donna Jackson, CPA, JD, LLM

10400 Vineyard Blvd, Suite C

Oklahoma City, OK 73120

(405) 840-1874

AVOIDING COMMON MISTAKES

Panel Discussion

Avoiding Common Mistakes

108

No/limited experience

Failure to maintain proper documentation

Lack of expertise of trustee

Choosing trustee

Trust terms are incomplete

Non-liquid assets in trust (5% annual requirement cannot be met)

charitable split-interest trusts and form...

Documents