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.
