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.

Does A Charitable Remainder Trust Have To Be Charitable?

Over the years I have been able to work with very wealthy people. That level of wealth allows the tax attorneys and CPAs to bring out their toys. Granted, there may not be as many toys as when I came out of school, but the toys can still be impressive.

A favorite is the charitable remainder trust.

The concept is simple: you transfer money or other assets to a charity. They in turn agree to pay you an amount for a number of years, which may be the rest of your life. When you pass away, the balance of the trust (the remainder) goes to the charity.

Let’s add some horsepower under the hood:

(1)   You fund the trust with appreciated assets: real estate or stocks, for example. Odds are the trustee will sell the assets, either immediately or over time, to free-up the cash with which to pay your annuity.

Here is the tax gimmick: if you sold the stock or real estate, you would have a big tax bill. The trust sells the stock or real estate and you have … nothing. It’s like a Penn and Teller show!

(2)   Since the trust does not pay tax, more money is left to invest. This could allow larger annual payouts to you, a larger donation at the end, or a combination of the two.

(3)   I exaggerated a bit. While the trust does not pay tax, you will pay tax every year as you receive your payment. Still, you are paying over a period of years, likely a better result than paying immediately in the year of sale.

(4)   You get an immediate tax deduction for the part of the trust that will go to charity. Even if that is decades off, you get a tax deduction today.  

There are some crazy mathematics when working with this type of trust. The answer can vary wildly depending upon age, assumed rates of return (for the invested assets), discount rates (for the passage of time), whether you take an dollar annuity or a percentage annuity, the amount of the annuity and so on.

And then advisors have added bells and whistles over the years. For example, it is possible to put a “limit” on the annual annuity. How? One way is to restrict the annuity to the “income” of the trust. If the income exceeds the annuity, then the annuity is paid in full. If the annuity exceeds the income, then the annuity gets reduced.

Add one more bell and whistle: let’s say that the annuity gets a haircut. Can that reduction accumulate and be carried-over to be paid in the future, or is it forever lost? You can design the trust either way.

A charitable remainder trust with this income limit is referred to as a “NIMCRUT.” Yes, the “NI” stands for net income. Working in this area is like learning a foreign language.

Now, let’s talk about the Estate of Arthur Schaefer. We said the mathematics are crazy, as each piece can move the answer and there seems to be an endless supply of pieces. That “NI” we talked about is itself a piece. Can “NI” blow up our trust?

Mr. Schaefer settled two charitable remainders trusts during his lifetime, one for each son. He made them “NIMCRUTS,” with the provision that any income limitation would carryover and be payable in a later year, if able. Schaefer of course took a tax deduction for the charitable part.

OBSERVATION: These two trusts would also be gifts (to the sons) and trigger a gift tax return.

But he included one more thing: he set the annuity payouts fairly high – 10% for one trust and 11% for the other.

That creates a problem. If you expect the trust to pay out 10% (or 11%) a year, you better invest in stocks that are going to go exponential or you will eventually run out of money. There will be nothing left for the charity. Heck, there may not be anything left for the two sons.

No problem, said the trustee. You see, if the trusts do not have enough income (remember: NIMCRUT), then the 10% or 11% will never be paid. Those trusts can never run out of money. 

Problem, said the IRS. Throwing that NIMCRUT in there is fancy shoes and all, but you cannot take the NIMCRUT limit into account when that is the only way that the charity will ever receive a penny. Maybe Schaefer should have toned-down the 10% or 11% thing a bit and not put so much pressure on the NIMCRUT limit to get these trusts to work.

The matter wound up in Tax Court.

NOTE: Schaefer passed away and it was his estate that was litigating with the IRS. This happened because of the way the estate tax and the gift tax overlap, but we will spare ourselves the tortuous details.

It appears that there was a very sharp tax attorney behind these two trusts, looking at quotes by the Court:

            “We find the text of section 664(e) ambiguous.”

            “The regulations are less clear.”

But there is danger when a tax attorney walks out on a narrow ledge:

“… where a statute is ambiguous, the administrative agency can fill gaps with administrative guidance to which we owe the level of deference appropriate under the circumstances.”

Oh, oh. “Administrative” here means the IRS.

            “… we find the Commissioner’s guidance to be persuasive.”

And so the estate lost, meaning that somewhere in here the charitable donations were lost. Someone was writing the IRS a check.

Charitable remainder trusts are great tax vehicles. I have worked with them to a greater or lesser degree for over two decades, but one has to have some common sense. It is a “charitable” remainder trust. Something has to go to charity. Granted, the mathematics may border on Big Bang Theory, but the overall concept still applies. If it takes a high-powered attorney to parse the tax Code to the Tax Court, the deal may not be for you.