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.

Common Law Versus Statutory Employee

 

I am looking at a case concerning employee status and payroll taxes.

I see nothing remarkable, except for one question: why did the IRS bother?

Let’s talk about it.

There was a 501(c)(3) (The REDI Foundation) formed in 1980. Richard Abraham was its officer (a corporate entity must have an officer, whether one gives himself/herself a formal title or not). Mr A’s wife also served on the Board.

REDI did not do much from 1980 to 2010. In 2010 Mr A – who was a real estate developer for over 40 years – developed an online course on real estate development and began offering it to the public via REDI. Mr A was a one-man gang, and he regularly worked 60 hours or more per week on matters related to the online course, instruction, and student mentoring.

COMMENT: Got it. It gave Mr A something to do when he “retired,” if 60 hours per week can be called retirement. I have a client who did something similar, albeit in the field of periodontics.

So REDI went from near inactive to active with its online course. For its year ended May 2015 it reported revenues over $255 grand with expenses of almost $92 grand.

COMMENT: Had REDI been a regular corporation, it would have paid income taxes on profit of $163 grand. REDI may have been formed as a corporation, but it was a corporation that had applied for and received (c)(3) status. Absent other moving parts, a (c)(3) does not pay income taxes.

The IRS flagged REDI for an employment tax audit.

Why?

REDI had not issued Mr A a W-2. Instead, it issued a 1099, meaning that it was treating Mr A as an independent contractor.

Let’s pause here.

A W-2 employee pays FICA taxes on his/her payroll. You see it with every paycheck when the government lifts 7.65% for social security. Your employer matches it, meaning the government collects 15.3% of your pay.

A self-employed person also pays FICA, but it is instead called self-employment tax. Same thing, different name, except that a self-employed pays 15.3% rather than 7.65%.

My first thought was: Mr A paid self-employment tax on his 1099. The government wanted FICA. Fine, call it FICA, move the money from the self-employment bucket to the FICA bucket, and let’s just call … it … a … day.

In short: why did the IRS chase this?

I see nothing in the decision.

Technically the IRS was right. A corporate officer is a de facto statutory employee of his/her corporation.

§ 3121 Definitions.

 

(d)  Employee.

 

For purposes of this chapter, the term "employee" means-

 

(1)   any officer of a corporation; or

 

Yep, know it well. Been there and have the t-shirt.

Mind you, there are exceptions to 3121(d)(1). For example, if the officer duties are minimal, the Code does not require a W-2.

Mr A argued that very point.

Problem: there was only one person on the planet that generated revenues for REDI, and that person was Mr A. Revenues were significant enough to indicate that any services performed were also substantial.

There was another argument: REDI had reasonable basis under Section 530 for treating Mr A as a contractor.

COMMENT: Section 530 is an employment relief provision if three requirements are met:

·      Consistency in facts

·      Consistency in reporting

·      Reasonable basis

Section 530 was intended to provide some protection from employment tax assessments for payors acting in good faith. On first impression, 530 appears to be a decent argument. Continuing education instructors are commonly treated as contractors, for example. If REDI treated instructors with similar responsibilities the same way (easy, as there was only one instructor) and sent timely 1099s to the IRS, we seem to meet the three requisites.

Except …

Section 530 deals with common law workers.

Corporate officers are not common law workers. They instead are statutory employees because the statute – that is, Section 3121(d) – says they are.

Mr A was a statutory employee. REDI was therefore an employer. There should have been withholding, tax deposits and payroll return filings. There wasn’t, so now there are penalties and interest and yada yada yada.

I probably would have lost my mind had I represented REDI. Unless Mr A was claiming outsized expenses against 1099 income, any self-employment tax he paid would/should have approximated any FICA that REDI would remit as an employer. Loss to the fisc? Minimal. Let’s agree to switch Mr A to employee status going forward and both go home.

Why did this not happen? Don’t know. Sometimes the most interesting part of a case is not in the decision.

Our case this time was The REDI Foundation v Commissioner, T.C. Memo 2022-34.

Ohtani’s New Baseball Contract

I was reading about Shohei Ohtani’s new contract with the Las Angeles Dodgers. If the name rings a bell, that is because he both bats and pitches. He is today’s Babe Ruth. He played with the Los Angeles Angels in 2023, led the American League with 44 home runs and pitched over 130 innings with a 3.14 ERA.

I am more an NFL than an MLB fan these days, but it is hard to ignore this guy’s athletic chops. It is also hard to ignore his new contract.

•  Contract totals at $700 million
•  He will draw “only” $2 million for the first 10 years.
•  He will draw the deferral (that is, $68 million annually) beginning in 2034 and through 2043.

At $700 million, Ohtani’s is the largest MLB contract ever, but what caught my eye was deferring 98% of the contract for over a decade. Do not be concerned about his cash flow, however. $2 million a year is sweet (that is way over CPA bank), and I understand that his endorsements alone may exceed $50 million annually. Cash flow is not a problem.

Why would Ohtani do this?

For one, remember that athletes at his level are hyper-competitive. There is something about saying that you received the largest contract in MLB history.

Why would the Dodgers do this?

A big reason is the time value of money. $100 ten years from now is worth less than $100 today. Why? Because you can invest that $100 today. With minimal Google effort, I see a 10-year CD rate of 3.8%. Invest that $100 at 3.8% and you will have a smidgeon more than $145 in ten years. Invest in something with a higher yield and it will be worth even more.

Flip that around.

What is $100 ten years from now worth today?

Let’s make it easy and assume the same 3.8%. What would you have to invest today to have $100 in ten years, assuming a 3.8% return?

Around $70.

Let’s revisit the contract considering the above discussion.

Assuming 10 years, 3.8% and yada yada, Ohtani’s contract is worth about 70 cents on today’s dollar. So, $700 million times 70% = $490 million today.

My understanding is the experts considered Ohtani’s market value to be approximately $45 million annually, so our back-of-the-envelope math is in the ballpark.

Looks like the Dodgers did a good job.

And deferring all that money frees cash for the Dodgers to spend during the years Ohtani is on the team and playing. He may be today’s Ruth, but he cannot win games by himself.

There is one more thing …

This is a tax blog, so my mind immediately went to the tax angle – federal or state – of structuring Ohtani’s contract this way.

Take a look at this bad boy from California Publication 1005 Pension and Annuity Guidelines:

          Nonresidents of California Receiving a California Pension

In General

California does not impose tax on retirement income received by a nonresident after December 31, 1995. For this purpose, retirement income means any income from any of the following:

• A private deferred compensation plan program or arrangement described in IRC Section 3121(v)(2)(C) only if the income is either of the following:

1.    Part of a series of substantially equal periodic payments (not less frequently than annually) made over the life or life expectancy of the participant or those of the participant and the designated beneficiary or a period of not less than 10 years.

Hmmm. “Substantially equal periodic payments” … and “a period of not less than 10 years.”

Correlation is not causation, as we know. Still. Highly. Coincidental. Just. Saying.

Ohtani is 29 years old. 98% of his contract will commence payment when he is 40 years old. I doubt he will still be playing baseball then. I doubt, in fact, he will still be in California then. He might return to Japan, for example, upon retirement.

That is what nonresident means.

Let me check something. California’s top individual tax rate for 2024 is 14.4%.

COMMENT: Seriously??

Quick math: $680 million times 98% times 14.4% equals $95.96 million.

Yep, I’d be long gone from California.