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.

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.

Splitting With The IRS Over Insurance

I am reading a case where the Tax Court just entered a “partial” summary judgement. This means that at least one issue has been decided but the remaining issue or issues are still being litigated.

And I think I see what the attorneys are up to.

We are talking about split-dollar life insurance. 

This had been a rather humdrum area of tax until 2002. The IRS then issued new rules which tipped the apple cart and sent planners scrambling to review – and likely revise – their clients’ split dollar arrangements (SDAs). I know because I had the misfortune of being point man on this issue at a CPA firm. There is a certain wild freedom when the IRS decides to reset an area of tax, with revisions to previous interim Notices, postponed deadlines and clients who considered you crazed.

To set-up the issue, a classic split dollar arrangement involves an employer buying a life insurance policy on an employee. The insurance is permanent – meaning cash value build-up - and the intent is for the employee to eventually walk away with the policy or for the employee’s estate to receive the death benefits. The only thing the employer wants is a return of the premiums it paid.

Find a policy where the cash value grows faster than the cumulative premiums paid and you have a tax vehicle ready to hit the highway. 

Our case involves the Morrissette family, owners of a large moving company. Grandmom (Clara Morrissette) had a living trust, to which she contributed all her company stock. She was quite concerned about the company remaining in the hands of the family. She had her attorney establish three trusts, one for each son. The sons, trusts and grandmom then entered into an agreement, whereby each son – through his trust – would buy the company stock of a deceased brother. If one brother died, for example, the remaining two would buy his stock. In the jargon, this is called a “cross purchase.”

This takes money, so each trust bought life insurance on the two other brothers.

This too takes money, which grandmom forwarded from her trust.

How much money? About $30 million for single-premium life policies.

Wow.

Obviously the moving company was extremely successful. Also obviously there must have been a life insurance person celebrating like a madman that day.

The only thing grandmom’s trust wanted was to be reimbursed the greater of the policies’ cash value or cumulative premiums paid.

Which gets us to those IRS Regulations from back when.

The IRS had decreed that henceforth SDAs would be divided into two camps:

(1) The employee owns the policy and the employer has a right to the cash value or some other amount.

This works fine until the premiums get expensive. Under this scenario the employee either has income or has a loan. Income of course is taxable, and the IRS insisted that a loan behave like a loan. The employee had to pay interest and the employer had to report interest income, with whatever income tax consequence followed.

And a loan has to be paid back. Many SDAs are set-up with the intent of the employee walking away someday. How will he/she pay back the loan at that time? This is a serious problem for the tax planners. 

(2)  The employer owns the policy and the employee has a right to something – likely the insurance in excess of the cash value or cumulative premiums paid.

The employee has income under this scenario, equal to the value of the insurance he/she is receiving annually. The life insurance companies publish tables, so practitioners can plan for this number.

But this leaves a dangerous possible tax issue: what happens once the cash value exceeds the amount to which the employer is entitled (say cumulative premiums)? Let’s say the cash value goes up by $250,000, and the employer’s share is met. Does the employee have $250,000 in income? There is a lot of lawyering on this point.

The Court decided that the grandmom had the second type – type (2) of SDA, albeit of the “family” and not the “employer” variety. The sons’ trusts had to report income equal the economic benefit of the life insurance, the same as an employee under the classic model.

This doesn’t sound like much, but the IRS was swinging for a type (1) SDA. If the sons’ trusts owned the policies, the next tax question would be the source of the money. The IRS was arguing that the grandmom trust made taxable gifts to the sons. Granted the gift and estate tax exclusion has been raised to over $5 million, but $30 million is more than $5 million and would trigger a hefty gift tax. The IRS was smelling money here.                 

The partial summary was solely on the income tax issue.

The Court will get back to the gift tax issue.

However, having won the income tax issue must make the Morrissette family feel better about winning the gift tax issue. According to the IRS’ own rules, grandmom’s trust owned the policies. What was the gift when the trust will get back all its money? The attorneys can defend from high ground, so to speak.

And there is one more thing.

Grandmom passed away. She was already in her 90s when the sons’ trusts were set up.

She died with the sons’ trusts owing her trust around $30 million.

Which her estate will not collect until the sons pass away or the SDAs are terminated. Who knows when that will be?

And what is a dollar worth X years from now? 

One thing we can agree on is that it not worth a dollar today.

Her estate valued the SDA receivables at approximately $7 million.

And the IRS is coming after her. There is no way the IRS is going to roll-over on those split dollar arrangements reducing her estate by $23 million.

You know the IRS did not think this through back in 2002 when they were writing and rewriting the split dollar rules.

Will Yahoo take Alibaba For A Spin?

I have – on and off – been following the Yahoo and Alibaba story. 

It has to do with a proposed spin of a corporate subsidiary. Unless someone has reason to be there, corporate reorganizations – such as spins - are not the easiest reading.  

To set it up, Yahoo owns approximately 15% of Alibaba Group, which itself is a Chinese internet giant. Yahoo has proposed spinning its Alibaba shares into a separate publicly traded company. Spinning in a tax context means getting it out of Yahoo itself and into the hands of the shareholders. This in turn has caught the IRS’ eye, mostly because Yahoo wants to do this on a tax-free basis.

There is gigantic money here. Yahoo’s stake in Alibaba may be worth around $35 billion. Albeit Yahoo is not intending to spin all its Alibaba stock, it would spin enough to trigger an $8 to $10 billion tax – if its tax advisors do not get it right.

QUESTION: How would you like to be the tax honcho that gives this thing a green light? No pressure …

We have talked about reorganizations before. It is a complicated area of tax law, but they have gained in importance as a means of mitigating the double taxation of corporations.  Proctor & Gamble, for example, uses several flavors of reorganizations on a routine basis. What is different about Yahoo?

In general, the IRS likes to see at least a couple of historically active businesses inside the corporate shell. Perhaps one business makes soap and the other makes baby lotion, and they have for as many years as Carter has liver pills. For whatever reason, the soap business wants to go one way and the baby lotion business another. The IRS sees two historically active businesses before and two afterwards. Comply with some technicalities and the IRS is willing to accept that there exists a business purpose for the reorganization – that is, a purpose other than avoiding the tax man.

Let’s stir the pot. Say that you stuff one of the companies with a lot of investment assets, such as Alibaba stock. How does the IRS feel now?

Well, I suppose that would vary. If the stock were 15% of total assets, I suspect you would not draw a long, piercing stare from the IRS. What if it climbs to 50%, 60%, 70%? We can both anticipate the IRS getting increasingly cynical as those percentages climb.

And that is where Yahoo is going.

Yahoo CEO Marissa Mayer

Yahoo is proposing to stuff Yahoo Small Business, an existing small line of business, into a subsidiary. Yahoo would then drop the Alibaba stock and spin the resulting subsidiary to its shareholders.  The value of the Alibaba stock would completely dwarf the value of Yahoo Small Business.

But why?

Let’s say the new company will be called Yaboo. Yaboo would be stuffed with so much Alibaba stock that it would essentially be a “tracking” stock for Alibaba. Throw in some market arbitrage and Alibaba may find Yaboo an attractive target for acquisition.

Then again, maybe Yahoo just wants to kick Yahoo Small Business out of the nest so it can learn to fly. On the same plane of reality, I am still available if an NFL team wants to make me an offer.

Generally speaking, tax advisors approach the IRS when they get into these high-stakes situations. They may meet informally in order to gauge IRS sentiment before requesting a private letter ruling, for example. The ruling is “private” in that it is directed to one taxpayer (Yahoo) and its unique facts (Alibaba). Yahoo’s advisors would meet with IRS attorneys to discuss, review and argue. If the IRS agrees with the proposed transaction, then Yahoo would request the ruling. If the IRS disagrees, Yahoo would not. It is unlikely that you or I would do this, as failure to submit a ruling request would be considered invitation to an audit. A company the size of Yahoo is under constant audit, however, so this threat is considerably diminished. 

You know – absolutely know – that Yahoo is going to request a private letter ruling. There is way too much money at stake here.

And then on September 2 the IRS came out with Notice 2015-59, saying that it was stopping its practice of issuing rulings on transactions that are suspiciously similar to the proposed Yahoo spin.

Whoa.

Now what does Yahoo do? Does it rely on an opinion from its law firm without an IRS ruling? Does it retract the spin? Does it adjust the spin so the percentages of the stock and active business are not so skewed?

Remember: just because the IRS says it does not make it so. There is complex law here, and a Court may have to decide.

For a tax geek, this is like the latest installment of Mission Impossible.

Buffett's Berkshire Hathaway Is Buying Duracell From Procter & Gamble

You may have read that Warren Buffett (through Berkshire Hathaway) is acquiring the Duracell battery line of business from Procter & Gamble in a deal worth approximately $4.7 billion. The transaction will be stock-for-stock, although P&G is stuffing approximately $1.7 billion of cash into Duracell before Berkshire takes over. Berkshire will exchange all its P&G stock in the deal. Even better, there should be minimal or no income tax, either to P&G or to Berkshire Hathaway.

Do you wonder how?

The tax technique being used is called a “cash rich split off.” Believe it or not, it is fairly well-trod ground, which may seem amazing given the dollars at play.

Let’s talk about it.

To start off, there is virtually no way for a corporation to distribute money to an individual shareholder and yet keep it from being taxable. This deal is between corporations, not individuals, albeit the corporations contain cash. Lots of cash.

How is Buffett going to get the money out? 

·        Buffet has no intention of “getting the money out.” The money will stay inside a corporation. Of course, it helps to be as wealthy as Warren Buffett, as he truly does not need the money.

·        What Buffett will do is use the money to operate and fund ongoing corporate activities. This likely means eventually buying another business.

Therefore we can restrict ourselves to corporate taxation when reviewing the tax consequences to P&G and Berkshire Hathaway.

How would P&G have a tax consequence?

P&G is distributing assets (the Duracell division) to a shareholder (Berkshire owns 1.9% of P&G stock). Duracell is worth a lot of money, much more money than P&G has invested in it. Another way of saying this is that Duracell has “appreciated,” the same way you would buy a stock and watch it go up (“appreciate”) in value.

And there is the trip wire. Since the repeal of General Utilities in 1986, a corporation recognizes gain when it distributes appreciated assets to a shareholder. P&G would have tax on its appreciation when it distributes Duracell. There are extremely few ways left to avoid this result.

But one way remaining is a corporate reorganization.

And the reorganization that P&G is using is a “split-off.” The idea is that a corporation distributes assets to a shareholder, who in turn returns corporate stock owned by that shareholder. After the deed, the shareholder owns no more stock in the corporation, hence the “split.” You go your way and I go mine.

Berkshire owns 1.9% of P&G. P&G is distributing Duracell, and Berkshire will in turn return all its stock in P&G. P&G has one less shareholder, and Berkshire walks away with Duracell under its arm.

When structured this way, P&G has no taxable gain on the transaction, although it transferred an appreciated asset – Duracell. The reason is that the Code sections addressing the corporate reorganization (Sections 368 and 355) trump the Code section (Section 311) that would otherwise force P&G to recognize gain.

P&G gets to buy back its stock (via the split-off) and divest itself of an asset/line of business that does not interest it anymore - without paying any tax.

What about Berkshire Hathaway?

The tax Code generally wants the shareholder to pay tax when it receives a redemption distribution from a corporation (Code section 302).  The shareholder will have gain to the extent that the distribution received exceeds his/her “basis” in the stock.

Berkshire receives Duracell, estimated to have a value of approximately $4.7 billion. Berkshire’s tax basis in P&G stock is approximately $336 million. Now, $336 million is a big number, but $4.7 billion is much bigger.  Can you imagine what the tax would be on that gain?

Which Berkshire has no intention of paying.

As long as the spin-off meets the necessary tax requirements, IRC Section 355 will override Section 302, shielding Berkshire from recognizing any gain.

Berkshire gets a successful business stuffed with cash – without paying any tax.

Buffett likes this type of deals. I believe he has made three of them over the last two or so years. I cannot blame him. I would too. Except I would take the cash. I would pay that tax with a smile.

There are limits to a cash-rich split off, by the way.

There can be only so much cash stuffed into a corporation and still get the tax magic to happen. How much? The cash and securities cannot equal or exceed two-thirds of the value of the company being distributed. In a $4.7 billion deal, that means a threshold of $3.1 billion. P&G and Berkshire are well within that limit.

Why two-thirds?

As happens with so much of tax law, somebody somewhere pushed the envelope too far, and Congress pushed back. That somebody is a well-known mutual fund company from Denver. You may even own some of their funds in your 401(k). They brought us IRC Section 355(g), also known as the two-thirds rule. We will talk about them in another blog.