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.
