Using A Fancy Trust Without An Advisor

 

I am a fan of charitable remainder trusts. These are (sometimes) also referred to as split interest trusts.

What is an interest in a trust and how can you split it?

In a generic situation, an interest in a trust is straightforward:

(1) Someone may have a right to or is otherwise permitted to receive an income distribution from a trust. This is what it sounds like: if the trust has income, then someone might receive all, some or none of it – depending on what the trust is designed to do. This person is referred to as an “income” beneficiary.

(2) When there are no more income beneficiaries, the trust will likely terminate. Any assets remaining in the trust will go to the remaining beneficiaries. This person(s) is referred to as a “remainder” beneficiary.

Sounds complicated, but it does not have to be. Let me give you an example.

(1)  I set up a trust.

(2)  My wife has exclusive rights to the income for the rest of her life. My wife is the income beneficiary.

(3)  Upon my wife’s death, the assets remaining in the trust go to our kids. Our kids are the remainder beneficiaries.

(4)  BTW the above set-up is referred to as a “family trust” in the literature.

Back to it: what is a split interest trust?

Easy. Make one of those interests a 501(c)(3) charity.

If the charity is the income beneficiary, we are likely talking a charitable lead trust.

If the charity is the remainder beneficiary, then we are likely talking a charitable remainder trust.

Let’s focus solely on a charity as a remainder interest.

You want to donate to your alma mater – Michigan, let’s say. You are not made of money, so you want to donate when you pass away, just in case you need the money in life. One way is to include the University of Michigan in your will.

Another way would be to form a split interest trust, with Michigan as the charity. You retain all the income for life, and whatever is left over goes to Michigan when you pass away. In truth, I would bet a box of donuts that Michigan would even help you with setting up the trust, as they have a personal stake in the matter.

That’s it. You have a CRT.

Oh, one more thing.

You also have a charitable donation.

Of course, you say. You have a donation when you die, as that is when the remaining trust assets go to Michigan.

No, no. You have a donation when the trust is formed, even though Michigan will not see the money (hopefully) for (many) years.

Why? Because that is the way the tax law is written. Mind you, there is crazy math involved in calculating the charitable deduction.

Let’s look at the Furrer case.

The Furrers were farmers. They formed two CRATs, one in 2015 and another in 2016.

COMMENT: A CRAT is a flavor of CRT. Let’s leave it alone for this discussion.

In 2015 they transferred 100,000 bushels of corn and 10,000 bushels of soybeans to the CRAT. The CRAT bought an annuity from a life insurance company, the distributions from which were in turn used to pay the Fullers their annuity from the CRT.

They did the same thing with the 2016 CRT, but we’ll look only at the 2015 CRT. The tax issue is the same in both trusts.

The CRT is an oddball trust, as it delays - but does not eliminate – taxable income and paying taxes. Instead, the income beneficiary pays taxes as distributions are received.

EXAMPLE: Say the trust is funded with stock, which it then sells at a $500,000 gain. The annual distribution to the income beneficiary is $100,000. The taxes on the $500,000 gain will be spread over 5 years, as the income beneficiary receives $100,000 annually.

Think of a CRT as an installment sale and you get the idea.

OK, we know that the Furrers had income coming their way.

Next question: what was the amount of the charitable contribution?

Look at this tangle of words:

§ 170 Charitable, etc., contributions and gifts.

           (e)  Certain contributions of ordinary income and capital gain property.

(1)  General rule.

The amount of any charitable contribution of property otherwise taken into account under this section shall be reduced by the sum of-

(A)  the amount of gain which would not have been long-term capital gain (determined without regard to section 1221(b)(3)) if the property contributed had been sold by the taxpayer at its fair market value (determined at the time of such contribution),

This incoherence is sometimes referred to as the “reduce to basis” rule.

The Code will generally allow a charitable contribution for the fair market value of donated property. Say you bought Apple stock in 1997. Your cost (that is, your “basis”) in the stock is minimal, whereas the stock is now worth a fortune. Will the Code allow you to deduct what Apple stock is worth, even though your actual cost in the stock is (maybe) a dime on the dollar?

Yep, with some exceptions.

Exceptions like what?

Like the above “amount of gain which would not have been long-term capital gain.”

Not a problem with Apple stock, as that thing is capital gain all day long.

How about crops to a farmer?

Not so much. Crops to a farmer are like yoga pants to Lululemon. That is inventory - ordinary income in nerdspeak - as what a farmer ordinarily does is raise and sell crops. No capital gain there.

Meaning?

The Furrers must reduce their charitable deduction by the amount of income that would not be capital gain.

Well, we just said that none of the crop income would be capital gain.

I see income minus (the same) income = zero.

There is no charitable deduction.

Worst … case … scenario.

I found myself wondering how the tax planning blew up.

In July 2015, after seeing an advertisement in a farming magazine, petitioners formed the Donald & Rita Furrer Charitable Remainder Annuity Trust of 2015 (CRAT I), of which their son was named trustee. The trust instrument designated petitioners as life beneficiaries and three eligible section 501(c)(3) charities as remaindermen.”

The Furrers should have used a tax advisor. A pro may not be necessary for routine circumstances: a couple of W-2s, a little interest income, interest expense and taxes on a mortgage, for example.

This was not that. This was a charitable remainder trust, something that many accountants might not see throughout a career.

Yep, don’t do this.

Our case this time is Furrer v Commissioner, T.C. Memo 2022-100.

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.

The Sum Of The Parts Is Less Than The Whole

 

I am looking at a case involving valuations.

The concept starts easily enough:

·      Let’s say that your family owns a business.  

·      You personally own 20% of the business.

·      The business has shown average profits of $1 million per year for years.

·      Altria is paying dividends of over 7%, which is generous in today’s market. You round that off to 8%, considering that rate fair to both you and me.

·      The multiple would therefore be 100% divided by 8% = 12.5.   

·      You propose a sales price of $1,000,000 times 12.5 times 20% = $2.5 million.  

Would I pay you that?

Doubt it.

Why?

Let’s consider a few things.

·      It depends whether 8 percent is a fair discount rate.  Considering that I could buy Altria and still collect over 7%, I might decide that a skinny extra 1% just isn’t worth the potential headache.

·      I can sell Altria at any time. I cannot sell your stock at any time, as it is not publicly-traded. I may as well buy a timeshare.

·      I am reasonably confident that Altria will pay me quarterly dividends, because they have done so for decades. Has your company ever paid dividends? If so, has it paid dividends reliably? If so, how will the family feel about continuing that dividend policy when a non-family member shows up at the meetings? If the family members work there, they might decide to increase their salaries, stop the dividends (as their bumped-up salaries would replace the lost dividends) and just starve me out.

·      Let’s say that the family in fact wants me gone. What recourse do I – as a 20% owner – have? Not much, truthfully. Own 20% of Apple and you rule the world. Own 20% of a closely-held that wants you gone and you might wish you had never become involved.

This is the thought process that goes into valuations.

What are valuations used for?

A ton of stuff:

·      To buy or sell a company

·      To determine the taxable consequence of nonqualified deferred compensation

·      To determine the amount of certain gifts

·      To value certain assets in an estate

What creates the tension in valuation work is determining what owning a piece of something is worth – especially if that piece does not represent control and cannot be easily sold. Word: reasonable people can reasonably disagree on this number.

Let’s look at the Estate of Miriam M. Warne.

Ms Warne (and hence the estate) owned 100% of Royal Gardens, a mobile home park. Royal Gardens was valued – get this - at $25.6 million on the estate tax return.

Let’s take a moment:

Q: Would our discussion of discounts (that is, the sum of the parts is less than the whole) apply here?

A: No, as the estate owned 100% - that is, it owned the whole.

The estate in turn made two charitable donations of Royal Gardens.

The estate took a charitable deduction of $25.6 million for the two donations.

The IRS said: nay, nay.

Why?

The sum of the parts is less than the whole.

One donation was 75% of Royal Gardens.  

You might say: 50% is enough to control. What is the discount for?

Here’s one reason: how easy would it be to sell less-than-100% of a mobile home park?

The other donation was 25%.

Yea, that one has it all: lack of control, lack of marketability and so on.

The attorneys messed up.

They brought an asset into the estate at $25.6 million.

The estate then gave it away.

But it got a deduction of only $21.4 million.

Seems to me the attorneys stranded $4.2 million in the estate.

Our case this time was the Estate of Miriam M. Warne, T.C. Memo 2021-17.

Setting Up A Museum

Have you ever wondered why and how there are so many private art museums in the United States: The Brant Foundation, The Broad, The Warehouse?

Let’s posit the obvious immediately: wealthy people with philanthropic objectives.

This however is a tax blog, meaning there is a tax hook to the discussion.

Let’s go through it.

We already know that the tax Code allows a deduction for charitable contributions made to a domestic corporation or trust that is organized and operated exclusively for charitable purposes.  There are additional restrictions: no part of the earnings can inure to the benefit of a private individual, for example.

Got it: charitable and no sneak-arounds on the need to be charitable.

How much is the deduction?

Ah, here is where the magic happens. If you give cash, then the deduction is easy: it is the amount of cash given, less benefits received in return (if any).

What if you give noncash? Like a baseball card collection, for example.

Now we have to look at the type of charity.

How many types of charities are there?

Charities are also known as 501(c)(3)s, but there several types of (c)(3)s:

·      Those that are publicly supported

·      Those that are supported by gifts, dues, and fees

·      The supporting organization

·      The nonoperating private foundation

·      The operating private foundation

What happens is that the certain noncash contributions do not mix will with certain types of (c)(3)s. The combination that we are concerned with is:

 

·      Capital gain property (other than qualified stock), and

·      The nonoperating private foundation

 Let’s talk definitions for a moment.

 

·      What is capital gain property?

 

Property that would have generated a long-term capital gain had it been sold for fair market value. Say that you bought $25,000 of Apple stock in 1997, for example, when it traded at 25 cents per share.

 

By the way, that Apple stock would also be an example of “qualified stock.”

 

·      What is not capital gain property?

The easiest example would be inventory to a business: think Krogers and groceries. A sneaky one would be property that would otherwise be capital gain property except that you have not owned it long enough to qualify for long-term capital gains treatment.

 

·      What is a nonoperating private foundation?

 

The classic is a family foundation. Say that CTG sells this blog for a fortune, and I set up the CTG Family Trust. Every year around Thanksgiving and through Christmas the CTG family reviews and decides how much to contribute to various and sundry charitable causes.  Mind you, we do not operate any programs or activities ourselves. No sir, all we do is write checks to charities that do operate programs and activities.

Why do noncash contributions not mix well with nonoperating foundations?

Because the contribution deduction will be limited (except for qualified stock) to one’s cost (referred to as “basis”) in the noncash property.

So?

Say that I own art. I own a lot of art. The art has appreciated ridiculously since I bought it because the artist has been “discovered.” My cost (or “basis”) in the art is pennies on the dollar.

My kids are not interested in the art. Even if they were interested, let’s say that I am way over the combined estate and gift tax exemption amount. I would owe gift tax (if I transfer while I am alive) or estate tax (if I transfer upon my death). The estate & gift tax rate is 40% and is not to be ignored.

I am instead thinking about donating the art. It would be sweet if I could also keep “some” control over the art once I am gone. 

I talk to my tax advisor. He/she tells me about that unfortunate rule about art and nonoperating foundations.

I ask my tax advisor for an alternate strategy.

Enter the operating foundation.

Take a private foundation. Slap an operating program into it.

Can you guess an example of an operating program?

Yep, an art museum.

I set-up the Galactic Command Family Museum, donate the art and score a major charitable contribution deduction.

What is the museum’s operating program?

You got it: displaying the art.

Let’s be frank: we are talking about an extremely high-end tax technique. Some consider this to be a tax loophole, albeit a loophole with discernable societal benefits.

Can it be abused? Of course.

How? What if the Galactic Command Family Museum’s public hours are between 3:30 and 5 p.m. on the last Wednesday of April in leap years? What if the entrance is behind a fake door on an unnumbered floor in a building without obvious ingress or egress? What if a third of the art collection is hanging on the walls of the CTG family business offices?

That is a bit extreme, but you get the drift.

One last point about the deduction if this technique is done correctly. Let’s use the flowing example:

                  The art is worth             $10,000,000

                  I paid                            $          1,000

We already know that I get a $10,000,000 charitable deduction.

However, what becomes of the appreciation in the art – that is, the $9,999,000 over what I paid for it? Does that get taxed to me, to the museum, to anybody?

Nope.

Losing A Tax Exemption

The taxation of tax-exempts can sometimes be tricky.

The reason is that a tax-exempt can – depending on the facts – owe income tax. This type of income is referred to as unrelated business income, and the tax issue developed because Congress did not want tax-exempts to mimic the activities of for-profit companies while not paying tax.

There are certain areas – such as permitting third-party use of membership data – that can trigger the unrelated business tax.

Another would be the rental of real estate with associated indebtedness.

The organization will owe tax on these activities.

Then there is the worst-case scenario: the revocation of the tax-exempt status itself. Think Elon Musk putting Tesla in a 501(c)(3) – the IRS is going to blow-up that arrangement.

Let’s discuss a recent case that walked the revocation ledge.

There is an organization in New York. It is open to seniors from age 55 to 90. To become a member a senior must submit an application and application fee. 

It appears to have four principal activities:

·      To provide burial benefits for members and assistance to surviving family

·      To provide information and referrals to seniors regarding burial as well as general concerns

·      To provide organized activities for senior citizens

·      To provide annual scholarships to needy, promising students

The organization charges fees as follows:

·      An application fee of $100 for seniors age 55 to 70

·      An application fee of $150 for seniors age 71 to 90

·      A $30 annual fee

·      A $10 fee every time a member dies

It doesn’t appear unreasonable to me.

There was an interesting and heartwarming twist to their activities: the organization would pay a separate amount directly to the family of a deceased member, pursuant to a Korean tradition. The organization paid, for example, $11 thousand directly to a funeral home and over $3,200 to the family of a deceased member.

Since we are talking about them, you know that the organization went to audit.

The IRS wanted to revoke their tax-exempt status.

Why?

The is an over-arching requirement that a tax-exempt be operated “exclusively” for an exempt purpose. There is some latitude in the “exclusive” requirement, otherwise de minimis and silly stuff could cost an organization its exemption.

Still, what did the IRS see here?

The first is that benefits were available only to members.

COMMENT: The organization had expressed an intent to include nonmembers, but as of the audit year that goal remained aspirational.

OBSERVATION: The organization had told the IRS of its intent to include nonmembers when it requested exempt status. Upon audit and failure to find nonmember benefits, the IRS argued that the organization had failed to operate in the manner it had previously represented to the IRS. 

Second is that a member was required to pay dues. In fact, if a member failed to pay dues for 90 days after receiving written notice, the organization could terminate the membership and – with it – the requirement to pay any burial benefits.

COMMENT: Sounds a bit like an insurance company, doesn’t it?

Third is that the amount of burial benefits was based on the number of years the deceased had been a member. A member of 12 years would receive more than a member of 5 years.

The IRS brought big heat. The organization was organized in 1996, applied for exempt status in 1998 and was being audited for 2013.

OK, a reasonable number of years had passed since receiving exempt status.

The organization had reported over $2.3 million in revenues on their Form 990.

Sounds to me like they were doing well.

In 2008 they bought a condominium, paying over $800 grand.

Oh, oh.

You can begin to understand where the IRS was coming from. As operated, the organization was looking like a small insurance company. It was accumulating a bank balance; it had bought real estate. The IRS wanted to see obvious charitable activities. If the organization could swing $800 grand on a condo, then they could shake loose a few dollars and waive dues for someone who was broke. They were operating dangerously close to a private club. That is fine, but do not ask for (c)(3) status.

The organization had a remaining argument: there was no diversion of earnings or money. There couldn’t be, as no benefits occurred until someone passed away.

The Court however separated this argument into two parts:

(1)  The earnings and assets of the organization cannot inure (that is, return to) to a member.

The organization successfully argued this point.

(2)  There must be no private benefit.

This makes more sense if one flips the wording: there must be a public benefit. The Court did not see a public benefit, as the organization was not providing benefits to nonmembers or allowing for reduction or abatement of dues for financial need. Not seeing a public benefit, the Court saw a private benefit.

The organization was operating in a manner too close to a for-profit business, and it lost its tax-exempt status.

I get the technical issues, but I do not agree as vigorously as the Court that there was that much private benefit here. Society has an interest in promoting the causes and issues of senior citizens, and the organization – in its own way – was helping. By aiding seniors with government agencies, it was reducing the strain on social services. By assisting seniors with planning and paying for funeral services, it was reducing costs otherwise defaulting to the municipality.

One would have preferred a warning, an opportunity for the organization to right its course, so to speak. What happened instead was akin to burning down the bridge.  

Still, that is how issues in this area go: one is working on a spectrum. The advisor has to judge whether one is on the safe or the non-safe side of the spectrum.

The Court decided the organization had wandered too far to the non-safe side.

Our case this time was The Korean-American Senior Mutual Association v Commissioner.

Donating Eyeglasses

Some tax cases take near forever to wrap-up.

I am looking at a case involving tax year 2008; it was decided in April, 2020. It involves over $300 grand in taxes and penalties.

Let’s set it up.

A.  Take an accounting firm with offices in Cerritos, California and Kansas City, Missouri.

B.   Through them the taxpayers (Campbell) learned of a donation program involving Lions in Sight. The program was rather straightforward.

a.    A company (ZD Products) consolidates eyeglass frames (let’s say approximately 170,000).

b.   The company breaks down that number into lots (let’s say approximately 3,400 frames).

c.    It then sells the lots for approximately $50 grand each.

d.   If you buy a lot, you are advised to wait a year before doing anything. Not to fear, they will take care of your lot for you.

e.    After a year you donate the lot to Lions in Sight.

                                             i.     This is prearranged.

                                           ii.     Lions in Sight is affiliated with the Lions Club International. Its mission is to collect and provide used eyeglasses for use worldwide and to provide eye care assistance to the needy and low-income. In truth, it sounds like a fine charity.

f.     You will get a bright shiny appraisal saying that your donation was worth approximately $225 grand.

It sounds like the program ran well. In 2007 Lions in Sight had so many frames in storage that they requested ZD Products to store a sizeable new donation until 2008, when they could free up space.

Nice problem to have.

The IRS became aware and did not care for this at all. No surprise: one puts in $50 grand and – a year and a day later – gets a donation worth $225 grand.  Quick math tells me that someone with a tax rate over 23% comes out ahead.

What do we have? Someone takes a good cause (the Lions Club), stirs in a for-profit party (both the company selling the eyeglasses and the company organizing the deal), and has a sacerdote (the appraiser) bless the bona fides. Everybody wins; well, everybody but the IRS.   

We have seen something similar to this with conservation easements. Take a good cause – say preserve a wetland … or just green space. Bring in the marketers, attorneys and valuation experts. Stick the property into an LLC; sell interests in the LLC; donate the LLC interests to who-knows-who and – voila – instant big bucks tax deduction for someone who was never really that interested in wetlands or green space to begin with.

I have a question for you. Why do you think that the IRS has so many rules concerning donations? You know them: you need a receipt; past a certain dollar limit you need a letter from the charity; past another dollar limit you need an appraisal; somewhere in there you have a form attached to your tax return just for the donation.

Tripwires.

Let me give you one.

If you need an appraisal, then the appraisal has to be for what you actually donated.

Bear with me.

This story started off with approximately 170,000 eyeglass frames. They are of varying sizes, styles, quality and value. An appraisal is done on the mother lode.

Break the lode into lots of approximately 3,400.

Donate the lots.

The appraisal was done on the 170,000.

You need an appraisal on your 3,400.

You do not have this. Best you have is 34/1,700 of an appraisal.

But it is virtually impossible that each lot will be the same. There are too many combinations of styles, sizes, designers, costs and whatnot.  Just taking a percentage (34/1,700) is not good enough – not for this purpose.

You have no appraisal.

You have no deduction.

Tripwire.

The case for the home gamers is Campbell v Commissioner.