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Lisa Newfield, White Plains lawyer, Using Charitable Trusts & Private Foundations in Estate Planning




Monday, September 24, 2007

Wachovia Bank

White Plains, New York


McCarthy Fingar LLP

White Plains, New York

1. Case Study - - Let's whet your appetites. An extremely simplified example of the horrific estate tax on the death of a surviving spouse (or, for that matter, a single person).

H has $5,000,000 estate. His wife W has a $5,000,000 estate of her own. H gives an amount equal to the equivalent exemption to his children and the balance of his estate is set up in such a way as to obtain the unlimited marital deduction. H dies in February 2007; his wife then dies later in 2007, leaving her entire estate to their children. Here is what the estate tax computations would look like:

H’s Estate

Gross estate $5,000,000

Less: Estimated

expenses -- at 5% $ 250,000

Marital deduction --

balance of estate less

$2,000,000 federal

exemption amount $2,750,000 $3,000,000

Taxable estate $2,000,000

Tentative federal estate tax $ 780,800

Less: Applicable credit amount $ 780,800

Federal estate tax -0-

W’s Estate

Her separate assets $5,000,000

Marital share from H $2,750,000

Gross Estate $7,750,000

Less: Estimated expenses -- at 5% $ 387,500

Taxable estate $7,362,500

Tentative federal estate tax $3,247,550

Less: Applicable credit amount $ 780,800

*No state death tax credit available as of 2005 _________

Federal estate tax $2,466,750

2. Integrating Split-Interest Charitable Gifts Into the Estate Plan to Save Estate Tax

Assume that W is charitably inclined. Her Will divides her estate into two parts. With the first part, she creates a 6% charitable remainder unitrust (furnishing a potential hedge against inflation) providing payments to her children in equal shares for a term of 20 years after her death. The other half is placed in a charitable lead trust providing for payment of 8.2% of the initial value of the assets (a guaranteed annuity) to charity for a term of 20 years with the remainder payable to children (or grandchildren) at the end of the 20 year term. Here is what the estate tax calculation in W’s estate would look like using a discount rate of 5.4%:

Gross estate $7,750,000

Less: Estimated

expenses -- at 5% $ 387,500

Gross charitable deduction computation:

Gross principal into unitrust

of $3,681,250 x 30.228% factor $1,112,768

into lead annuity trust of

$3,681,250 x 100% factor $3,681,250


Less: Estate tax payable* $ 262,949

Net charitable deduction $4,531,069

Total deductions: $4,918,569

Taxable estate: $2,831,431

Tentative federal estate tax $1,163,258

Less: Applicable credit amount $ 780,800

Federal estate tax $ 382,458

The estate tax savings is $2,084,292

*Tax attributable to non-charitable portion of unitrust. Gross principal of each trust is reduced by ½ of estate tax, thereby reducing charitable deduction for each trust. Estate tax is determined by interrelated calculation.

3. Overview of Various Life Income Arrangements

A. Unitrust agreements.

(1) Standard unitrust -- pays stated percentage (at least 5% and no more than 50%) of net fair market value of trust assets, revalued at least annually, out of income and, if income is insufficient, out of principal. Excess income is retained in trust.

(2) Net income with makeup unitrust (the NIMCRUT) -- pays lesser of (i) stated percentage of annual net fair market value and (ii) actual trust income. Deficiencies in distributions from an earlier year are made up in any later year in which trust income exceeds stated percentage. Then excess income retained in trust.

(3) Net income without makeup unitrust -- pays lesser of (i) stated percentage of annual net fair market value and (ii) actual trust income. Deficiencies in distributions from an earlier year are not made up. Excess income is retained in trust.

(4) In net income unitrust, agreement can provide that realized capital gain -- but only that portion representing post-gift appreciation – can be treated as income for purposes of distribution. 

(5) Hybrid agreement (the “Flip” unitrust). Net income unitrust becomes standard unitrust on sale of, i.e., closely held corporate stock. First, unpublished PLR said O.K. Then, IRS said it doesn’t work. PLRs 9506015 and 9516040. Then proposed §664 Regs again said O.K. Final Regs confirmed viability of Flip - - but significantly broadened events that trigger flip.

(6) Why the Flip?

(a) In NIMCRUT, once non-income producing asset is sold, there is expectation that Trustee will invest so as to achieve ordinary income at the stated percentage payout rate. Not easy to do.

(b) Once crut flips and becomes standard crut, can invest for total return. Easier to achieve payout percentage and some reasonable growth in trust assets.

(c) Can use flip to defer income.

(7) Some Specific Items Regarding Nimcruts.

(a) Excess income in earlier year cannot be used to make up deficiency in later year.

(b) What is income? Generally state law governs. Be careful of specific unique situations; i.e., assets such as timber; assets that have periodic large amounts of income. Defining income to include realized gain attributable to post-gift appreciation.

(c) Net income provision does not change calculation of charitable deduction for income, gift or estate tax purposes.

B. Annuity trusts.

(1) Annuity amount couched in terms of stated dollars; trustee directed to pay X dollars a year out of income and, if income is insufficient, out of principal. Any excess income is retained in trust.

(2) Annuity amount couched in terms of a percentage of initial fair market value of assets transferred to trust. Once amount determined, stays constant for trust term.

(3) In either case annuity amount must be at least 5% (but no more than

50%) of initial value of assets transferred to trust.

C. Pooled income fund.

Donor irrevocably transfers money, long-term marketable securities or both to qualified charity's separately maintained pooled income fund, where it is invested together with transfers of others who make similar life income gifts. Donor (or other designated beneficiary) receives his share of pooled income fund earnings each year. On donor's death (or death of other designated beneficiary) payments terminate and charity removes donor's gift from pooled fund and uses for charitable purposes.

D. Charitable gift annuities.

(1) Immediate payment. Donor transfers money or property to charity in exchange for promise to pay fixed amount annually to donor (and survivor, if desired) for life. Transfer is part gift and part purchase of annuity. Annual income (rate of return) paid by charity depends upon beneficiary's (annuitant's) age at time of gift. Annual rate of return remains constant for life. 

(2) Deferred payment. Donor makes gift to charitable institution in exchange for charity's promise to pay him guaranteed life income starting at retirement (or any other date specified).

(3) Regulation in New York by Insurance Department.

(4) Some recent changes regarding annuities:

(a) Investment of reserve account

(b) Acceptance of broader range of assets for annuity.

E. Charitable lead trusts.

(1) Donor can avoid tax on income paid to charity, but the trust must not provide reversion for donor or spouse. Trust should be lead unitrust or lead annuity trust. Otherwise, value of charity's income interest will be subject to Federal gift tax. And, if donor dies before property reverts to him, there will be no estate tax charitable deduction.

(2) Main drawback of law is that donor cannot get income tax charitable deduction unless trust so drawn that he is taxed on income paid to charity -- a grantor trust. Thus, except for very wealthy individuals, charitable lead trust created during lifetime is generally not advantageous. Some create trust with tax-exempt bonds so that income is not taxable.

(3) Lead trusts paying income to charity are advantageous when created by donor's will. Estate tax charitable deduction allowed for value of income stream paid to charity under lead trust created by donor's will. To get estate tax deduction, income interest must be guaranteed annuity (annuity trust) or fixed percent of net fair market value of trust assets, determined yearly (unitrust). 

4. Basic Tax Implications

A. Income tax.

(1) charitable contribution deduction allowed for charitable remainder interest or other gift element. In order to qualify, value of remainder must be at least 10%.

(2) Capital gain avoidance; the problem of prearranged sales.

-- The Palmer case still lives. 

-- What about Blake? 

B. Gift tax charitable deduction (unlimited) allowed for remainder interest.

C. Estate tax charitable deduction (unlimited) allowed for charitable remainder interest.

D. Taxation of income beneficiary -- four-tier system - - WIFO basis.

(1) Ordinary income.

(2) Capital gain income; first short-term, then long-term.

(3) Other income, including tax-exempt interest.

(4) Return of principal.

5. Funding the CRT.

A. Use of securities.

(1) Highly appreciated, but low-income stock to fund "net income with makeup" unitrust.

(a) Provide low percentage payout -- but, at least 5% -- to increase charitable deduction.

(b) By retaining securities with high apprecia­tion potential but low income, reduce income paid to donor when in higher income bracket and less need for income.

(c) Trust sells later when securities appreciated and invests proceeds in high yield securities paying stated percentage of increased value plus make-up of deficiencies from earlier years; donor now possibly in lower tax bracket (say, at retirement) or needs greater income.

(2) Transfer of closely held corporate stock (charitable stock bailout) to charity.

(a) Donor transfers stock of close corporation to charity generating deduction for fair market value with no tax on appreciation.

(b) Corporation, although not legally obligated to do, redeems stock from charity. Palmer; Rev. Rul. 78-197; but see Blake.

(c) Transfer to charitable remainder trust.

(i) Generally not good idea unless trust can sell without violating self-dealing prohibitions.

(ii) A way out: Offer to redeem all stock is made. 

(iii) Query: Is close corporation stock a "prudent" trust investment?

B. Funding Charitable Remainder Trust With Individual Retirement Account (IRA).

(1) The general rules on "income in respect of a decedent."

(2) Other tax problems on IRAs and like plans.

(3) IRS Private Letter Ruling. 

(a) D has Individual Retirement Account. She plans to create testamentary CRUT for son's benefit. To fund trust, D will name CRUT as beneficiary of her IRA.

(b) IRS rules. Trust will qualify and entitle D's estate to estate tax charitable deduction for value of remainder interest. Any IRD received by CRUT will have same character in its hands as it would have had in D's hands, had she lived and received it.

(c) IRS also said that trust won't be taxable on its income unless it has unrelated business income. This, CRUT won't be taxable on IRD; instead, that income will be taxed to son piecemeal as it's paid to him in satisfaction of annual unitrust amounts under four-tier provisions of Code.

(d) Generous individuals often disappointed to learn that IRAs and other pension plans can't be "rolled over" tax-free into charitable remainder trusts during lifetime. Resulting income is taxed to donor in year of transfer, reducing funds available for trust. However, by funding testamentary unitrust with her IRA, D has avoided up-front income tax. And unitrust payments based on a percentage of assets in CRUT, as revalued each year. Thus, the more (untaxed) assets pass to trust, higher payments will be - and more pre-tax funds will be available for reinvestment.

(4) Current ruling. IRS confirmed its holding in above ruling, but made it clear that income tax deduction for estate tax attributable to IRD belongs to CRT not its beneficiaries. Extent of adverse impact?

C. Wealth Replacement.

(1) Create CRT

(2) Use tax savings and/or increased income stream to purchase life insurance to replace amount transferred to CRT. Perhaps use life insurance trust to hold insurance.

6. Some Potential Pitfalls

A. Transfer of mortgaged property to remainder trust.

(1) Don't do it. 

(2) Some possible outs.

(a) Pay off mortgage or get lien released.

(b) Sale to charity of undivided interest. Donor uses proceeds to pay debt and transfers balance of his interest to CRT. Caveat: The undivided interest problem and self-dealing.

B. Installment obligations.

(1) Transfer triggers unreported gain.

(2) Better to use testamentary gifts.

C. S Corporation stock.

7. Planning Considerations.

A. Trust Measuring Terms.

(1) Life Only. The Trust makes payments to one or more persons as long as one individual is alive.

(2) Term of Years. The Trust makes payments to one or more persons for a period not to exceed 20 years.

(3) Life and Concurrent Term of Years (the longer of). The Trust makes payments for a guarantee term of years (not to exceed 20) that is concurrent with the lives of one or more individuals. For example, the trust could make payment to an individual as long as the individual is alive, or for a period of 20 years, which ever is longer. If the individual dies within the first 20 years, the payments can be made to named individuals or a named class of individuals for the balance of the 20 year period.

(4) Life and Concurrent Term of Years (the shorter of). The Trust makes payments for the shorter of a term of years (not to exceed 20) or the life (or lives) of the measuring life. For example, the Trust could pay income to an individual for a period of 20 years. If the individual dies within the 20 years, all payments stop and the remainder passes to the charitable beneficiary.

(5) Life and Consecutive Term of Years (measured by other lives). The Trust makes payments to named recipients for the balance of their lives. At their deaths, the trust continues to make payments to a new group of recipients whose income term is measured by the shorter of their lives or a term of years (not to exceed 20), which begins at the death(s) of the primary life recipients. If the second class of recipients dies within the stated term of years, the trust terminates. 

Note: The income interest of a surviving spouse under a CRT where children as successor income recipients will not qualify for the marital deduction for estate taxes.

Note: Changing recipient order, even with consent of all parties, will disqualify the CRT.

B. Permissible Income Recipients.

(1) The annuity or unitrust amount must be payable to or for the use of a person or persons, at least one of which is not an organization described in IRC Section 170(c). The term person includes: 

An individual

Trust or estate



Company or


(2) If the annuity or unitrust amount is to be paid to an individual(s) for their lifetime, they must be living at the time of the creation of the trust. A named person or persons may include members of a named class provided that, in the case of a class which includes any individual, all such individuals must be living and ascertainable at the time of the creation of the trust unless the annuity or unitrust amount is to be paid to such a class for a term of years. 

(3) The annuity or unitrust amount can be sprinkled among the members of a class, however, the trustee with such powers must be “independent” to avoid treatment as a Grantor Trust.

C. Terminating an Income Recipient’s Interest.

Testamentary power to revoke. Grantor can retain power to revoke a (non-grantor) successor beneficiary’s interest. The power must be included in the Trust and is exercisable only by the Grantor’s Will. 

D. Testamentary Charitable Trusts.

The CRT is deemed created as date of death of the decedent, even though the trust is not funded until the end of a reasonable period of administration or settlement. The obligation to pay the annuity or unitrust amount must commence with the date of death. However, if permitted by local law or the provisions of the governing instrument, payments may be deferred from the date of death until the end of the taxable year of the trust in which complete funding of the trust occurs. 

E. Permissible Charitable Remaindermen.

The remainder interest must be transferred to, or for the use of, an organization described in IRC Section 170(c). 

Consider the affect on the Grantor’s charitable contribution income tax deduction when selecting a remainderman that is not a public charity. 

The Trust must contain a provision that, in the event a named charity does not exist or is not qualified at the time of distribution, the Grantor or Trustee has the authority to select an alternate qualified charity(ies). 

Grantor can retain inter-vivos or testamentary power to substitute the charitable remainderman.

F. Payment of Estate Tax. 

There can be no invasion of the trust’s assets to pay estate taxes upon the grantor’s death.

8. Sample Forms.

A. Charitable Remainder Unitrusts.

(1) Inter-vivos – one measuring life (Rev. Proc. 2005-52). 

(2) Inter-vivos – term of years (Rev. Proc. 2005-53). 

(3) Inter-vivos – consecutive interests for two measuring lives (Rev. Proc. 2005-54). 

(4) Inter-vivos – concurrent and consecutive interests for two measuring lives (Rev. Proc. 2005-55).

(5) Testamentary – one measuring life (Rev. Proc. 2005-56).

(6) Testamentary - term of years (Rev. Proc. 2005-57).

(7) Testamentary - consecutive interests for two measuring lives (Rev. Proc. 2005-58).

(8) Testamentary - concurrent and consecutive interests for two measuring lives (Rev. Proc. 2005-59).

B. Charitable Remainder Annuity Trusts.

(1) Inter-vivos – one measuring life (Rev. Proc. 2003-53).

(2) Inter-vivos – term of years (Rev. Proc. 2003-54).

(3) Inter-vivos – consecutive interests for two measuring lives (Rev. Proc. 2003-55).

(4) Inter-vivos – concurrent and consecutive interests for two measuring lives (Rev. Proc. 2003-56).

(5) Testamentary – one measuring life (Rev. Proc. 2003-57).

(6) Testamentary - term of years (Rev. Proc. 2003-58).

(7) Testamentary - consecutive interests for two measuring lives (Rev. Proc. 2003-59).

(8) Testamentary - concurrent and consecutive interests for two measuring lives (Rev. Proc. 2003-60).

C. Charitable Lead Annuity Trusts.

(1) Inter-vivos non-grantor (Rev Proc 2007-45).

(2) Testamentary (Rev Proc 2007-46).

Contact Me

If you think you may require the assistance of Lisa Newfield in any matter, email (lnewfield@mccarthyfingar.com) or phone her (914-385-1032) with any question you may have.