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.

A House And A Specialized Trust

I saw a QPRT here at Galactic Command recently,

It had been a while. These things are not as common in a low interest rate environment.

A QPRT (pronounced “cue-pert”) is a specialized trust. It holds a primary or secondary residence and – usually – that is it.

Why in the world would someone do this?

 I’ll give you a common example: to own a second home.

Let’s say that you have a second home, perhaps a lake or mountain home. The children and grandchildren congregate there every year (say summer for a lake home or the holidays for a mountain home), and you would like for this routine and its memories to continue after you are gone.

A couple of alternatives come immediately to mind:  

(1)  You can bequeath the property under will when you die.

(2)  You can gift the property now.

Each has it pros and cons.

(1) The property could continue to appreciate. If you have significant other assets, this appreciation could cause or exacerbate potential estate taxes down the road.

(2) You enjoy having and using the property and are not quite ready to part with it. You might be ready years from now - you know: when you are “older.”

A QPRT might work. Here is what happens:

(1) You create an irrevocable trust.

a.    Irrevocable means that you cannot undo the trust. There are no backsies.

(2) You transfer a residence to the trust.

a.    The technique works better if there is no mortgage on the property. For one thing, if there is a mortgage, you must get money into the trust to make the mortgage payment. Hint: it can be a mess.

(3) You reserve the right to use the property for a period of years.

a.    This is where the fancy planning comes in.

b.    It starts off with the acknowledgement that a dollar today is more valuable than a dollar a year (or years) from now. This is the “time value of money.”

c.    At some point in time the property is going to the kids and grandkids, but … not … right …now.     

d.    If the property is worth a million dollars today, the time value of money tells us that the gift (that is, when the property goes to the kids and grandkids) must be less than a million dollars.  

e.    There is a calculation here to figure out the amount of the gift. There are three key variables:

                                               i.     The age of the person making the gift

                                             ii.     The trust term

                                           iii.     An interest rate

A critical requirement of a QPRT is that you must outlive the trust term. The world doesn’t end if you do not (well, it does end for you), but the trust itself goes “poof.” Taxwise, it would be as if you never created a trust at all.

(4) There is a mortality consideration implicit here. The math is not the same for someone aged 50 compared to someone aged 90.

(5) Your retained right of use is the same thing as the trust term. You probably lean toward this period being as long as possible (if a dollar a year from now is worth less than a dollar today, imagine a dollar ten years from now!). That reduces the amount of the gift, which is good, but remember that you must outlive the trust term. There is push-and-pull here, and trust terms of 10 to 15 years are common.

We also need an interest rate to pull this sled. The government fortunately provides this rate.

But let’s go sidebar for a moment.

Let’s say you need to put away enough money today to have $5 a year from now. You put it in a bank CD, so the only help coming is the interest the CD will pay. Let’s say the CD pays 2%. How much do you have to put away today?

·      $5 divided by (100% + 2%) = $4.90

OK.

How much do you have to put away if the CD pays 6%?

·      $5 divided by (100% + 6%) = $4.72

It makes sense if you think about it. If the interest rate increases, then it is doing more of the heavy lifting to get you to $5. Another way to say this is that you need to put less away today, because the higher interest is picking up the slack.

Let’s flip this.

Say the money you are putting in the CD constitutes a gift. How much is your gift in the first example?

$4.90

How much is your gift in the second example?

$4.72

Your gift is less in the second example.

The amount of your gift goes down as interest rates go up.

What have interest rates been doing recently?

Rising, of course.

That makes certain interest-sensitive tax strategies more attractive.

Strategies like a QPRT.

Which explains why I had not seen any for a while.

Let me point out something subtle about this type of trust.

·      What did we say was the amount of the gift in the above examples?

·      Either $4.90 or $4.72, depending.

·      When did the gift occur?

·      When the trust was funded.

·      When do the kids and grandkids take over the property?

·      Years down the road.

·      How can you have a gift now when the property doesn’t transfer until years from now?

·      It’s tax magic.

But what it does is freeze the value of that house for purposes of the gift. The house could double or triple in value before it passes to the kids and grandkids without affecting the amount of your gift. That math was done upfront and will not change.

A couple of more nerd notes:

(6) We are also going to make the QPRT a “grantor” trust. This means that we have introduced language somewhere in the trust document so that the IRS does not consider the QPRT to be a “real” trust, at least for income tax purposes. Since it is not a “real” trust, it does not file a “real” income tax return. If so, how and where do the trust numbers get reported to the IRS? They will be reported on the grantor’s tax return (hence “grantor trust”). In this case, the grantor is the person who created the QPRT.

(7)  What happens after 10 (or 15 or whatever) years? Will the trust just kick you out of the house?

Nah, but you will have to pay fair-market rent when you use the place. It is not worst case.

There are other considerations with QPRTs – like selling the place, qualifying for the home sale exclusion, and forfeiting the step-up upon the grantor’s death. We’ll leave those topics for another day, though.

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.

RERI-ng Its Ugly Head - Part Two

Let’s continue our story of Stephen Ross, the billionaire owner of the Miami Dolphins and of his indirect contribution of an (unusual) partnership interest to the University of Michigan.

What made the partnership interest unusual was that it represented a future ownership interest in a partnership owning real estate. The real estate was quite valuable because of a sweet lease. When that ship came in, the future interest was going to be worth crazy money.

That ship was a “successor member interest” or “SMI.”

We talked about the first case, which went before the Tax Court in 2014 and involved legal motions. The case then proceeded, with a final decision in July, 2017.

COMMENT: Yes, it can take that long to get a complex case through Tax Court. Go after Apple, for example, and your kid will likely be finishing high school before that tax case is finally resolved.

The SMI was purchased for $2.95 million.

Then donated to the University of Michigan for approximately $33 million.

COMMENT: This is better than FaceBook stock.

After two years, the University of Michigan sold the SMI (to someone related to the person who started this whole story) for around $2 million.

OBSERVATION: Nah, FaceBook stock would have been better.

Now RERI was in Court and explaining how something that was and will be worth either $2 or $3 million is generating a tax deduction of $33 million.

And it has to do with the SMI being “part of” of something but not “all of” something.  SMI is the “future” part in “all of” a partnership owning valuable leased real estate in California.

The concept is that someone has to value the “all of” something. Once that is done, one can use IRS tables to value the “part of” something. Granted, there are hoops and hurdles to get into those tables, but that is little obstacle to a shrewd tax attorney.

Ross found a shrewd tax attorney.

Virtually all the heavy lifting is done when valuing the “all of” part. One then dumps that number into the IRS tables, selects a number of years and an interest rate and – voila! The entrée round, my fellow tax gastronomes, featuring a $33 million tasty secret ingredient.

The pressure is on the first number: the “all of.”

This will require a valuation.

There are experts who do these things, of course.

Their valuation report will go with your tax return.  No surprise. We should be thankful they do not also have to do a slide presentation at the IRS. 

And there will be a (yet another) tax form to highlight the donation. That is Form 8283, and – in general – you can anticipate seeing this form when you donate more than $5,000 in property.

There are questions to be answered on Form 8283. We have spoken about noncash donations in the past, and how this area has become a tax minefield. Certain things have to be done a certain way, and there is little room for inattention. Sometimes the results are cruel.

Form 8283 wants, for example:

·      A description of the property

·      If a partial interest, whether there is a restriction on the property

·      Date acquired

·      How acquired

·      Appraised fair market value

·      Cost

I suspect the Court was already a bit leery with a $3 million property generating a $33 million donation.

And the Court noticed something …

The Form 8283 left out the cost.

Yep, the $3 million.

Remember: there is little room for inattention with this form.

Question is: does the number mean anything in this instance?

Rest assured that RERI was bailing water like a madman, arguing that it “substantially complied” with the reporting requirements. It relied heavily on the Bond decision, where the Court stated that the reporting requirements were:

“… directory and not mandatory”

The counterpunch to Bond was Smith:

“ the standard for determining substantial compliance under which we ‘consider whether … provided sufficient information to permit … to evaluate the reported contributions, as intended by Congress.’”

To boil this down to normal-speak: could RERI’s omission have influenced a reasonable person (read: IRS) to question or not question the deduction. After all, the very purpose of Form 8283 was to provide the IRS enough information to sniff-out stuff like this.

Here is the Court:

“The significant disparity between the claimed fair market value and the price RERI paid to acquire the SMI just 17 months before it assigned the SMI to the University, had it been disclosed, would have alerted respondent to a potential overvaluation of the SMI”

Oh oh.

“Because RERI failed to provide sufficient information on its Form 8283 to permit respondent to evaluate its purported contribution, …we cannot excuse on substantial compliance grounds RERI’s omission from the form of its basis in the SMI.”

All that tax planning, all the meetings and paperwork and yada-yada was for naught, because someone did not fill-out the tax form correctly and completely.

I wonder if the malpractice lawsuit has already started.

The Court did not have to climb onto a high-wire and juggle dizzying code sections or tax doctrines to deny RERI’s donation deduction. It could just gaze upon that Form 8283 and point-out that it was incomplete, and that its incompleteness prejudiced the interests of the government. It was an easy way out.

And that is precisely what the Court did.

RERI-ng Its Ugly Head - Part One

Here is the Court:

The action involves RERI Holdings I, LLC (RERI). On its 2003 income tax return RERI reported a charitable contribution of property worth $33,019,000. Respondent determined that RERI overstated the value of the contribution by $29,119,000.”

That is considerably more than a rounding error.

The story involves California real estate, a billionaire and a university perhaps a bit too eager to receive a donation.

The story is confusing, so let’s use a dateline as a guide.

February 6, 2002 

Hawthorne bought California real estate for $42,350,000. Technically, that real estate is in an LLC named RS Hawthorne LLC (Hawthorne), which in turn is owned by RS Hawthorne Holdings LLC (Holdings).

Holdings in turn is owned by Red Sea Tech I (Red Sea). 

February 7, 2002 

Red Sea created two types of ownership:

First, ownership for a period of time (technically a “term of years,” abbreviated TOYS).

Second, a future and successor interest that would not even come into existence until 2021. Let’s call this a “successor” member interest, or SMI. 

QUESTION: Why a delayed ownership interest? There was a great lease on the California real estate, and 2021 had significance under that lease.

March 4, 2002     

RERI was formed.

March 25, 2002

RERI bought the SMI for $2,950,000.

August 27, 2003

RERI donated the SMI to the University of Michigan.

A key player here is Stephen Ross, a billionaire and the principal investor in RERI. He had pledged to donate $5 million to the University of Michigan. 

Ross had RERI donate the SMI. 

The University agreed to hold the SMI for two years, at least, before selling.

Do you see what they have done? Start with a valuable piece of leased real estate, stick it in an LLC owned by another LLC owned by another … ad nauseum, then create an LLC ownership stake that does not even exist (if it will ever exist) until 2021.

What did RERI donate to the University of Michigan?

You got it: the thing that doesn’t exist for 18 years.

I find this hard to swallow.

“Successor” LLC interests are sasquatches. You can spend a career and never see one. The concept of “successor” makes sense in a trust context (where they are called “remaindermen”), but not in a LLC context. This is a Mary Shelly fabrication by the attorneys.

So why do it?

Technically, the SMI will someday own real estate, and that real estate is not worth zero.

RERI hired a valuation expert who determined it was worth almost $33 million. This expert argued that the lease on the property – and its reliable series of payments – allowed him to use certain IRS actuarial tables in arriving at fair market value (the approximately $33 million).

Wait. It gets better.

The two years pass. The University sells the property … to an entity INDIRECTLY OWNED by Mr. Ross for $1,940,000.

This entity was named HRK Real Estate Holdings, LLC (HRK).

More.

HRK had already prearranged to sell the SMI to someone else for $3 million.

Still more.

That someone donated the same SMI and claimed yet another deduction of $29,930,000.

REALITY CHECK: This thing sells twice for a total of approximately $5 million but generates tax deductions of approximately $63 million.

Yet more.

Who did the valuation on that second donation? Yep, the same guy who did RERI’s valuation.

The IRS disallowed RERI’s donation to zero, zip, zilch, nada. The IRS was clear: this thing is a sham.

And there begins the litigation.

How something can simultaneously be worth $33 million and $2 million?

This is all about those IRS tables.

Generally speaking, the contribution of property is at fair market value, usually described as the price arrived at between independent buyers and sellers, neither under compulsion to sell or buy and both informed of all relevant facts.

Except …

For annuities, life estates, remainders, reversions, terms of years and similar partial interests in property. They are not full interests so they then have to be carved-out and adjusted to present value using IRS-provided tables.

OBSERVATION: Right there, folks, is why the attorneys created this Frankenstein. They needed to “separate” the interests so they could get to the tables.

RERI argued that it could value that real estate 18 years out and use the tables. Since the tables are concerned only with interest rates and years, the hard lifting is done before one gets to them.

Not so fast, said the IRS.

That real estate is in an LLC, so it is the LLC that has to be valued.  There are numerous cases where the value of an asset and the value of an ownership interest in the entity owning said asset can be different – sometimes substantially so. You cannot use the tables because you started with the wrong asset.

But the LLC is nothing but real estate, so we are back where we started, countered RERI.

Not quite, said the IRS. The SMI doesn’t even exist for 18 years. What if the term owner mortgages the property, or sells it, or mismanages it? That SMI could be near worthless by the time some profligate or incompetent is done with the underlying lease.

Nonsense, said RERI. There are contracts in place to prohibit this.

How pray tell is this “prohibited?” asked the IRS.

Someone has to compensate the SMI for damages, explained RERI.

“Compensate” how? persisted the IRS.

The term owner would forfeit ownership and the SMI would become an immediate owner, clarified RERI.

So you are making the owner of a wrecked car “whole” by giving him/her the wrecked car as recompense, analogized the IRS. Can the SMI at least sue for any unrecovered losses?

Uhhhh … no, not really, answered RERI. But it doesn’t matter: the odds of this happening are so remote as to not warrant consideration.

And so it drones on. The case goes into the weeds.

Who won: the government or the billionaire?

It was decided in a later case. We will talk about it in a second post.