Blowing Up A Charitable Remainder Trust

I was helping a friend (and fellow CPA) with a split-interest trust this busy season.

Let’s review the tax jargon in this area.

A split-interest means that there are (at least) two beneficiaries to the trust, one of which is a charity.

There are two main types of split-interest trusts:

(1)  The charity gets use of the trust assets first, after which the assets go to the noncharitable beneficiaries.

This sounds a bit odd, but it can work with the right asset(s) funding the trust. Let’s use an example. Say that you own a modest suburban strip mall. You have a solid tenant or two, providing reliable cash flow. Then you have a theater which barely survived COVID, and that only with major rent concessions.

This might be an excellent asset for a charitable lead. Why? First, you have reliable cash flow to support the annuity to the charity. Second, you have an underperforming asset (the theater) which is likely to outperform (whether as a theater or as something else) during the term of the trust.

The tax calculations for a lead use IRS-published interest rates. If you can fund the lead using assets with greater earning power than the IRS interest rate, you can leverage the math to your advantage.

How? Let’s say that the IRS expects you to earn 4 percent. You are confident you can earn 8 percent. You design the lead so that the amount “expected” to remain after the charitable term is $100. Why even bother with it for $100? Because the IRS is running the numbers at 4%, but you know the numbers are closer to 8%. You are confident there will be assets there when the charitable term is done, even though the IRS formula says there won’t be.

Your gift tax on this? Whatever tax is on $100. What if there is a million dollars there when the charitable term is done? Again, the gift is $100. It is a wonky but effective way to transfer assets to beneficiaries while keeping down estate and gift taxes.

(2) There is another split-interest trust where the noncharitable beneficiary(ies) get use of the assets first, after which the remainder goes to charity.

Once again, the math uses IRS-provided interest rates.

If you think about it, however, you want this math to break in a different direction from a lead trust. In a lead, you want the leftover going to the noncharitable beneficiary(ies) to be as close to zero as possible.

With a remainder, you want the leftover to be as large as possible. Why? Because the larger the leftover, the larger the charitable deduction. The larger the charitable deduction the smaller the gift. The smaller the gift, the smaller the estate and gift tax.

You would correctly guess that advisors would lean to a lead or remainder depending on whether interest rates were rising or falling.  

What is a common context for a remainder? Say you are charitably inclined, but you do not have Bezos-level money. You want to hold on to your money as long as possible, but you also want to donate. You might reach out to your alma mater (say the University of Kentucky) and ask about a charitable remainder trust. You receive an annuity for a defined period. UK agrees because it knows it is getting a donation (that is, the remainder) sometime down the road.

Are there twists and quirks with these trusts? Of course. It is tax law, after all.

Here is one.

Melvine Atkinson (MA) died in 1993 at the age of 97. Two years prior, she had funded a charitable remainder trust with almost $4 million. The remainder was supposed to pay MA approximately $50 grand a quarter.

I wish I had those problems.

Problem: the remainder never paid MA anything.

Let’s see: 7 quarters at $50 grand each. The remainder failed to pay MA approximately $350 grand before she passed away.

There were secondary beneficiaries stepping-in after MA’s death but before the remainder went to charity. The trust document provided that the secondary beneficiaries were to reimburse the trust for their allocable share of federal estate taxes on MA’s estate.

Of course, someone refused to agree.

It got ugly.

The estate paid that someone $667 grand to go away.

The estate now did not have enough money to pay its administrative costs plus estate tax.     

The IRS was zero amused with this outcome.

It would be necessary to invade the charitable remainder to make up the shortfall.

But how would the IRS invade?

Simple.

(1)  The remainder failed to pay MA her annuity while she was alive.

(2)  A remainder is required to pay its annuity. The annuity literally drives the math to the thing.

(3)  This failure meant that the trust lost its “split interest” status. It was now just a regular trust.

a.    This also meant that any remainder donation to charity also went away.

MA’s remainder trust was just a trust. This just-a-trust provided the estate with funds to pay administrative expenses as well as estate taxes. Further, there was no need to reduce available cash by the pending donation to charity … because there was no donation to charity.

My friend was facing an operational failure with a split-interest trust he was working with this busy season. His issue with not with failure to make distributions, but rather with another technical requirement in the Code. I remember him asking: what is the worst possible outcome?

Yep, becoming just-a-trust.

Our case this time was Estate of Melvine B Atkinson v Commissioner, 115 T.C. No. 3.

Grantor Retained Annuity Trusts In 2020

I was glancing over selected IRS interest rates and one caught my attention.

The Section 7520 rate for June, 2020 is 0.6%.

There are certain tax tools that work well in times of low interest rates. One is a grantor retained annuity trust, commonly referred to as a “GRAT.” One associates them with the fancy-pants rich, but I am thinking they can have broader appeal when the triggering interest rate is 0.6%.

Let’s talk about it. We will keep the discussion general as otherwise we would be going into a math class. Our purpose today is to understand what makes this tax tool work and why 2020 – with low interest rates and declining stock prices – are a perfect setup for a GRAT.

First, a GRAT is an irrevocable trust. Irrevocable means no take-backs.

A trust generally has three main players:

(a)  The settlor; that is, the moneybags who funds the trust. Let’s say that is me (CTG)

(b)  The trustee. That will be you.

(c)  The beneficiaries., There are two types:

a.    Income. For now, that will be me (CTG) as I receive the annuity.

b.    Remainder. That will be my grandkids (mini-CTGs), because they receive what is left over.

This trust will be taxed to me personally rather than pay taxes on its own. The nerd term for this is “grantor’ trust.

I fund the trust. Say that I put in $50 grand.

The trust will then pay me a certain amount of money for a period of time. Let’s say the amount is $10,000, and the trust will pay me for two years. I am retaining an annuity from the trust.

COMMENT: Truthfully, I think it would take at least 2 years to even qualify as an “annuity.” One payment does not an annuity make.

When the trust runs its course (two years in our example), whatever is left in the trust goes to the mini-CTGs.

If you sweep aside the details, you can see that I am making a gift to my grandkids. The GRAT is just a vehicle to get there.

Why bother?

Say that I just give $50 grand to my grandkids or to a trust on their behalf.

I made a gift.

Granted, I am not worried about gift tax on $50 grand given the current lifetime gift tax exemption of $11.5 million, but if someone moves enough money there can be gift tax.

Let’s say you can move enough money.

Congrats, by the way.

Is there a way for you to gift and also minimize the amount of gift tax?

Yep. One way is the GRAT.

Here is how the magic happens:

(1)  The tax Code backs into the amount of the gift. It does this by placing a value on the annuity. It then subtracts that value from the amount transferred into the trust ($50 grand in our example). The difference is the gift.

(2)  How can I maximize the value of the annuity?

a.    I want $10 grand. If I could get 5% interest, I would need $200,000 grand to generate that $10 grand.

b.    But I cannot get 5% in today’s economy. I might get lucky and get 1.5%. To get $10 grand, I would have to put in $666,667, which is a whole lot more than $200,000.

c.    This example is far from perfect, as I what I am describing is closer to an endowment than to an annuity. The takeaway however is valid: I have to put more money into an annuity as interest rates go down if I want to keep the payment steady.  

(3)  How does this affect the gift?

a.    Had I created the GRAT in June, 2018, I would have used a Section 7520 rate of 3.4%.

b.    It would require less money in 2018 to fund a $10,000 payment, as the money would be earning 3.4% rather than 0.6%.

c.    Flipping (b), it would require more money in 2020 to fund a $10,000 payment at 0.6% rather than 3.4%.

d.    As the value of the annuity goes up, the value of the gift goes down.

Let’s express this as a formula:

Gift = initial funding – value of annuity

e.    As the value of the annuity increased in 2020, the gift correspondingly decreased.

f.     That is how low interest rates power the GRAT as a gifting technique.

How do declining stock prices play into this?

Let’s look at Boeing stock.

Around March 1^st Boeing was trading at approximately $275.

As I write this Boeing trades around $120.

Now, I do not want to get into Boeing’s story, other than this: let’s say you believe that Boeing will bounce back and bounce much sooner than eternity. If you believe that, you could fund the GRAT with Boeing stock. The mathematics will be driven-off that $120 stock price and Section 7520 rate of 0.6%.

What happens if you are right and the stock returns to $275?

Your annuity is unchanged, your gift is unchanged, but the value of Boeing stock just skyrocketed. Your beneficiaries will do very well, and there was ZERO added gift tax to you.

Another way to say this is that you want to fund that GRAT with assets appreciating at more than 0.6%.

Folks, that is a low bar.

There however be dragons in this area.

You could fund the trust and the assets could go down in value. It happens.

Or you could die when the trust is still in existence. That would pull the trust back into your estate.

Or the trust becomes illiquid and you start pulling back assets rather than cash. That is a problem, as the assets appreciating is part of what powers this thing.

Then there are variations on the payment. One could specify a percentage rather than a dollar amount, that way the dollar amount of the annuity would increase as the assets in the trust increase.

There is a technique where one uses the annuity to fund yet another GRAT. It is called a “rolling” GRAT, and it worked when interest rates were much higher.

BTW, there is a twist on a GRAT, and it involves working the math so that the gift comes out to exactly zero. One might want to do this if one has run out of lifetime exemption, for example. The tax nerds refer to it as a “Walton” GRAT, in honor of Audrey Walton, wife of Wal-Mart cofounder Bud Walton. It took a court case to get there, but the technique has thereafter assumed the family name.

The Kiddie Tax Problem

You may have heard that there are issues with the new kiddie tax.

There are.

The kiddie tax has been around for decades.

Standard tax planning includes carving out highly-taxed parental or grandparental income and dropping it down to a child/young adult. The income of choice is investment income: interest, dividends, royalties and the like. The child starts his/her own tax bracket climb, providing tax savings because the parents or grandparents had presumably maxed out their own brackets.

Congress thought this was an imminent threat to the Union.

Which beggars the question of how many trust fund babies are out there anyway. I have met a few over the decades – not enough to create a tax just for them, mind you - but I am only a tax CPA. It is not like I would run into them at work or anything.

The rules used to be relatively straightforward but hard to work with in practice.

(1)  The rules would apply to unearned income. They did not apply if your child starred in a Hollywood movie. It would apply to the stocks and bonds that you purchased for the child with the paycheck from that movie.

(2)  The rules applied to a dependent child under 19.

(3)  The rules applied to dependents age 19 to 23 if they were in college.

(4)  The child’s first $1,050 of taxable unearned income was tax-free.

(5)  The child’s next $1,050 of taxable unearned income was taxed at the child’s tax rate.

(6)  Unearned income above that threshold was taxed at the parent’s tax rate.

It was a pain for practitioners because it required one to have all the returns prepared except for the tax because of the interdependency of the calculation.

For example, let’s say that you combined the parents and child’s income, resulting in $185,000 of combined taxable income. The child had $3,500 of taxable interest. The joint marginal tax rate (let’s assume the parents were married) at $185,000 was 28%. The $3,500 interest income times 28% tax rate meant the child owed $980.

Not as good as the child having his/her own tax rates, but there was some rationale. As a family unit, little had been accomplished by shifting the investment income to the child or children.

Then Congress decided that the kiddie tax would stop using this piggy-back arithmetic and use trust tax rates instead.

Problem: have you seen the trust tax rates? 

Here they are for 2018:

          Taxable Income                         The Tax Is

Not over $2,550                         10%

$2,551 to $9,150         $ 255 plus 24% of excess

$9,151 to $12,500       $1,839 plus 35% of excess

Over $12,500              $3,011.50 plus 37% of excess

Egad.

Ahh, but it is just rich kids, right?

Not quite.

How much of a college scholarship is taxable, as an example?

None of it, you say.

Wrong, padawan. To the extent not used for tuition, fees and books, that scholarship is taxable.

So you have a kid from a limited-means background who gets a full ride to a school. To the extent the ride includes room and board, Congress thinks that they should pay tax. At trust tax rates.

Where is that kid supposed to come up with the money?

What about a child receiving benefits because he/she lost a parent serving in the military? These are the “Gold Star” kids, and the issue arises because the surviving parent cannot receive both Department of Defense and Department of Veteran Affairs benefits. It is common to assign one to the child or children.

Bam! Trust tax rates.

Can Congress fix this?

Sure. They caused the problem.

What sets up the kiddie tax is “unearned” income. Congress can pass a law that says that college room and board is not unearned income or that Gold Star family benefits are not unearned income.

However, Congress would have started a list, and someone has to remember to update the list. Is this a reasonable expectation from the same crew who forgot to link leasehold improvements to the new depreciation rules? Talk to the fast food industry. They will burn your ear off on that topic.

Congress should have just left the kiddie tax alone.

Using An Annuity To Teach Tax

I intend someday to return to college and teach tax. It would be an adjunct position, as I have no intention of taking up another full-time job after this. One tax CPA career is enough.

I have previously taught accounting but not tax. There is some order to accounting: debits and credits, recording transactions and reconciling accounts. Tax and accounting may be siblings, but the tax Code does not purport to show anyone’s net income according to “generally accepted accounting principles.” It may, mind you, but that would be a coincidence.

Sometimes there are jagged edges to tax accounting. Have Johnson & Johnson issue financial statements pursuant to the tax Code and they would likely find themselves in front of the SEC.   

Let's say you are taking your first tax course. The syllabus includes:

·        What is income?

·        What is deductible?

·        Why doesn’t the answer make sense?

I am looking at Tobias v Commissioner. I give the taxpayers credit, as they were thinking outside the box. They knew they hadn’t made any money, irrespective of what the IRS said.

Edward Tobias was an attorney and kept an inactive CPA license. His wife was a school administrator. They had bought a variable annuity in 2003 for almost $230,000. In order to free up the cash, they sold stock at a loss of approximately $158,000. They put another $346,000 into the annuity over the years.

Fast forward to 2010. They withdrew $525,000 to buy and improve a residence. At that point in time, the deferred income (that is, the inside buildup) in the annuity policy was approximately $186,000. They insurance company sent them a Form 1099 for $186,000.

But they left the $186,000 off their 2010 tax return. They did attach an explanation, however:

The … account was funded with after-tax funds and all withdrawals have been made prior to annuitization. Accordingly, any potential gains should be applied to the prior capital loss carryforward, which is approximately $148,000. Additionally, this account has not recouped losses incurred in prior years and has incurred substantial withdrawal penalties; the calculation made by … is incorrect and is contested.”

You know the IRS was going to match this up.

The Tobias’ had a remaining capital loss of $148,000 from stock they sold to buy the annuity. In addition they had already put approximately $576,000 into the annuity, an amount less than the withdrawal. They were just getting their money back, even without taking that capital loss into consideration. 

The IRS on the other hand said they had $186,000 in income. The IRS also wanted an early distribution penalty of almost $19,000.

Who is right?

When the Tobias’ withdrew $525,000, they took deferred income with it. This is the “income first” rule of Code Section 72(e), and the rule has been there a long time. It says that – upon taking money from an annuity – the inside income is the first thing to come out. Like the fable of the frog and scorpion, that is what annuities do.

What about the $148,000 capital loss? A capital loss has a separate set of rules. Capital losses offset capital gains dollar-for-dollar. Past that they offset non-capital-gain income up to $3,000 per year. Annuity income however is not capital gain income, so we are stuck at $3,000.

But the economics were interrelated, argued the Tobias’. They sold the stock to buy the annuity. The loss on that should offset the income from the annuity, right?

No, not right.

When these transactions hit the tax return, each took on its own tax attribute. One attribute went to house Gryffindor, another to house Hufflepuff. They are all in Hogwarts, but they have been separated by the tax Sorting Hat. You cannot just mix them together - unless the Code says you can mix them together. Unfortunately, the Code does not say that.

So you have the odd result that the Tobias’ owed tax and penalty on more money than they made from the deal.

The answer makes sense to a tax guy.

It may just be a bit hard to teach.