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.

Can A Land Fill Make A Charitable Donation?

I have a client on extension for their individual tax return. They donated real estate last year. I am waiting on an appraisal and a signed Form 8283 before sending in the return.  

Charitable contributions have become a “gotcha” area for the IRS. The rules border on the insane. Does it make sense to you that I need a letter from the charity for donations over $250 even if I have a cancelled check? The IRS will accept a cancelled check as proof of a travel expense or of a child-care payment, but not for proof of a donation. Fail to follow their rules and you may lose the deduction altogether.

Sure enough, someone thought they followed the rules. Let’s go through the story of Boone Operations.

Boone Operations owned a landfill (Speedway). Right next to them, the city of Tucson (Arizona) also owned a landfill (Tucson). Both were surrounded by commercial and residential development. 

Tucson must have been a mess. The flare in its collection system kept going out and water kept collecting because of poor drainage. Tucson stopped accepted waste materials, but there were issues closing the place down. The neighbors howled; hearings were held. Douglas Kennedy (Kennedy), Boone’s owner, was concerned that Tucson was going to drag him down. He offered to help. In 1996 the two parties were happy and holding hands. Boone agreed to:

·        Share the cost of an interim gas system

·        Negotiate a permanent gas system

·        Cooperate to extend Boone’s aquifer permit to Tucson

You also had the following text in an agreement the attorneys drew up:

6.  Acceptable Waste Fill and Soil Fill

[Boone] agrees to provide [Tucson] with, and [Tucson] agrees to accept, acceptable waste fill and soil.

6.1 Placement of Acceptable Waste Fill

Boone shall, at no cost to [Tucson], fill the *** with acceptable waste to the approved final grades.

Seems clear: Boone will provide waste fill.

The promising relationship between Boone and Tucson soon soured:

·        6/99 - Boone places waste on Tucson to comply with agreement

·        10/99 – the Department of Solid Waste Management wants to know why Boone placed waste on Tucson

·        11/99 – Tucson wants Boone to remove the waste  

·         03/00 – Boone sues Tucson for $20 million

·        04/01 – Tucson provides Boone a settlement offer

·        09/01  -  Tucson files civil and criminal charges

·        04/02 – Boone files with the Superior Court

Shame. They seemed like such a nice couple.

Anyway, in December 2002, they settle. Tucson agreed to a number of things, including (a) paying $450,000 for Boone to construct drainage, (b) helping with easements and (c) releasing Boone and Mr. Kennedy from lawsuits.

And then the magic words:

8.1 Prior Contribution.  [Tucson] acknowledges that as of the date of the Settlement Memorandum, it had accepted Boone’s charitable contribution of 95,000 cubic yards of Acceptable Fill.

8.2 Future Contribution.  Boone agrees to make another charitable contribution of an additional 105,000 cubic yards of Acceptable Fill.

To the uninitiated, it appears that Boone has made a contribution of 200,000 cubic yards of Acceptable Fill to Tucson, don’t you think?

Boone files tax returns showing a donation of $449,000 for one year and $706,000 for another.

The IRS disallows the deductions. It has two arguments:

           

(1)  Boone failed to obtain contemporaneous written acknowledgement.

(2)  Boone received significant cash and noncash consideration and failed to prove that the value of the fill provided exceeded the consideration received.

The IRS argued that a written acknowledgement must include the following magic words:

·        The amount of cash and a description (but not value) of any property other than cash contributed.

·        Whether the donee organization provided any goods or services in consideration, in whole or part, for any property described.

·        A description and good faith estimate of the value of any goods and services received, or, if such goods and services consist solely of intangible religious benefits, a statement to that effect.

What does Boone have? The Settlement Agreement from December 2002. Without the magic words, however, Boone does not have “written acknowledgement.”  Since the donation was over $250, no deduction is allowed without written acknowledgement.

The Court then went on the argument (2). It went through the appraisal process in painstaking detail. There appear to have been significant errors in the appraiser’s calculations, for example, leading to an overvaluation of the donated fill. The Court also pointed out that Boone and Mr. Kennedy were released from a potential lawsuit. That release could have a value. If so, should that value be taken into account?

I question why the Court did this. The Court had already disallowed the deduction for lack of written acknowledgement. Why keep going?

My thinking? The Court expects a challenge on issue [1], and it thinks it could be reversed by a superior court. The Court therefore kept going, reasoning that if was reversed on issue [1] it would be sustained on [2].

You know how this turned out: the Tax Court disallowed the charitable deductions under both arguments.

COMMENT: Please do not mess with IRS in this area. If you are thinking about a significant donation of anything other than cash, please call your tax advisor first.  Get your papers lined up and do not play “gotcha” with the IRS.

Can You Deduct Burning Down Your House?

Can you take a deduction for burning your house to the ground?

You may laugh, but I was reviewing a recent case on this issue. It is the third case involving a home barbeque I can remember over as many years.

The case from 3 years ago was Rolfs v Commissioner. It was – understandably – considered quite outside the box.

Theodore Rolfs and his wife (the Rolfs) owned a house on a 3-acre lakefront property in Wisconsin. The house was modest, built around 1900 and it would be fair to say that it was in need of an upgrade.

The Rolfs wanted to renovate, but the work required was so extensive that tearing down the house and constructing anew was a very viable option.

They estimated it would cost $10,000 to $15,000 to demolish the house and remove the debris.

They went a different path and donated the house to the fire department. There were restrictions on the donation: the fire department was to use the house for training exercises, with the understanding that the training would happen shortly after the donation. The Rolfs donated only the house. They did not donate the land on which the house sat.

The Rolfs needed a value for their donation. They contacted Richard Larkin, president of Larkin Appraisals, Inc. who valued the house at $76,000.

The Rolfs donated the house and took a charitable deduction of $76,000 on their tax return. They attached the appraisal report and a letter from the fire chief thanking them for the donation.

The IRS disallowed the charitable contribution.

The IRS argued that a charitable donor does not expect a financial benefit in exchange for the donation. The Rolfs however expected a substantial benefit: the $10,000 to $15,000 in avoided demolition costs, for example, not to mention the benefit of the tax deduction itself.

The IRS further argued that the restrictions the Rolfs imposed affected the value of any donation. The fire department could only use the house for training purposes, and the house was to be destroyed shortly after the donation.

The Rolfs countered that they had an appraisal for $76,000.  And what was the IRS talking about with “restrictions?” After the fire department did its thing, there was NO house standing. The fire department did not want a house. They wanted a house they could burn to the ground. Whatever “restrictions” the IRS was talking about went up in smoke.

The case went to Tax Court.

In a Solomonic gesture, the Court reasoned that there might be a donation, but the amount of any donation would be the value of the house over the value of any demolition and clean-up services received.

The Court observed that the Rolfs donated the house without its underlying land. This meant that an independent buyer would have to move the house. The house was very old and badly in need of renovation. What would someone pay for this? Not surprisingly, the house was almost worthless.

The house was not worth more than the demolition and removal services received from the fire department. The Court decided there was no donation. The Rolfs lost their case.

But they made the tax literature.

There are variations that might have resulted in a different outcome. For example, what if the house had enough value to make it worth the cost and effort of moving?

There is another way to help tax-subsidize a house demolition, however. Have you heard of “deconstruction?” This involves dismantling the house rather than razing it under a bulldozer. It is more expensive, but with deconstruction more home materials remain in usable condition. The materials are then donated, generating a tax deduction. If the value of the tax deduction exceeds the additional cost of the teardown, one has effectively tax-subsidized his/her demolition costs.

The value of the materials can add up. I was reading an article where the lighting fixtures alone were worth over $100 thousand. Can you imagine?