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.

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.

Taxpayer Loses Charitable Deduction for Lack of Appraisal

Joseph Mohamed seems a good sort. He and his wife live in Sacramento, California. He is a successful real estate professional. In 1998 they formed the Joseph Mohamed Sr. and Shirley M. Mohamed Charitable Remainder Unitrust II. Tax pros call this a “CRUT.”

QUESTION: What is a CRUT? This is a special trust involving a charity. You can guess that a purpose of the trust is to make a charitable donation. In a CRUT, an annuity goes to the donor (in this case, Joseph and Shirley) for a period of years. At the expiration of that period, the remainder goes to a charity. In the Mohamed’s case, that period is twenty years. Why would you do that in place of simply donating twenty years out? Because the CRUT allows you to claim the charitable deduction now.

In 2003 and 2004 the Mohameds donated several properties to the CRUT. The properties were worth somewhere between $18 million and $21 million. Joseph Mohamed prepared his own taxes. This means he ran into Form 8283 to report the property donations. He did not read the instructions though, as he did not think he had to. The form seemed straightforward enough.

Form 8283 has several parts. Part 1 Section B required a description of the donated property and “can be completed by the taxpayer and/or appraiser.” It also had the following text:

“If your total art contribution deduction was $20,000 or more you must attach a complete copy of the signed appraisal. See instructions.”  

Mohamed was contributing real estate, not art. He read that to mean that he did not have to attach an appraisal. He did attach all types of statements and documentation to his return, including his own valuation of the real estate.

The return gets audited (who is shocked?). The IRS was displeased that Mohamed had self-valued such a large dollar donation of property. The IRS first goes after the valuation. Makes sense. Mohamed then gets an independent appraisal which shows that the properties are worth more than he claimed.

The IRS then pulls back and realizes something. Regulation 1.170A-13(c) requires the following for donations of this nature and amount:

1.      A qualified appraisal must be made not more than 60 days before the donation and no later than the due date of the return.

2.      It must be signed by a qualified appraiser, who cannot be the donor or person claiming the deduction.

3.      The qualified appraisal must contain defined information, such as a description of the property, its basis and fair market value.

Mohamed had a problem. You see, he did not have a qualified appraisal. That requires an independent appraiser, and he obtained that after the filing of his return. There was of course no signature, as there was no qualified appraisal. While he attached numerous statements to his return, they did not completely address the litany of questions that the IRS wanted in Reg 1.170A-13(c).

The IRS disallowed the donations. Mohamed goes to Tax Court and raises three arguments:

1.      The extreme result indicates that the Regulations are invalid.

2.      The IRS-designed Form 8283 misled him.

3.      He substantially complied with the documentation requirements.

The Court quickly dismissed arguments 1 and 2. It went through an analysis (which we will skip) and concluded that the Regulations were valid and reflected Congressional intent. The IRS, for example, was ordered by Congress to issue Regulations requiring appraisals for donations of property in excess of $5,000. A Regulation that implements Congressional intent is difficult to rule invalid. The Court was sympathetic to argument 2, but it pointed out that the form is not the tax law. The Court even added that “a taxpayer relies on his private interpretation of a tax form at his own risk.”

Now we get to argument 3. What does “substantially comply” mean? There was a previous case (Bond) where the Court found substantial compliance, but succeeding cases have ever compressed the reach of that decision. The Court determined that substantial compliance meant complying with the “essential requirement” of the statute. Problem is, the “essential requirement” of the statute is the need to obtain a qualified appraisal. With that verbal loop, there was no way that Mohamed could substantially comply.

Here is the Court:

We recognize that this result is harsh – a complete denial of charitable deductions to a couple that did not overvalue, and may well have undervalued, their contributions – all reported on forms that even to the Court’s eyes seemed likely to mislead someone who did not read the instructions.”

MY TAKE: I am sympathetic to the Mohameds, but I am also confused. They must have used a tax professional in the past to establish the CRUT. They then make a near-$20 million donation but do not hire a pro to walk it through? It doesn’t make sense to me.

In both Mohamed and Durden there was no question that contributions were made; there were also no question as to the amounts. The taxpayer may have felt comfortable thinking: what are they going to do, put me in jail? No, they won’t put you in jail, but they will take away your charitable deduction. Don’t think that a court will bail you out, as there may be limits to what a court can do.

What is the answer? I would encourage the use of a tax professional if there is even a whiff of a question on your return. I know – it costs money. The problem is that you may not know you have hit a slick spot until after the IRS contacts you. As Mohamed and Durden have shown, that may be too late.