A Charitable Deduction To An Estate

 

I had a difficult conversation with a client recently over an issue I had not seen in a while.

It involves an estate. The same issue would exist with a trust, as estates and trusts are (for the most part) taxed the same way.

Let’s set it up.

Someone passed away, hence the estate.

The estate is being probated, meaning that at least some of its assets and liabilities are under court review before payment or distribution. The estate has income while this process is going on and so files its own income tax return.

Many times, accountants will refer to this tax return as the “estate” return, but it should not be confused with the following, also called the “estate” return:

What is the difference?

Form 706 is the tax – sometimes called the death tax – on net assets when someone passes away. It is hard to trigger the death tax, as the Code presently allows a $13.6 million lifetime exclusion for combined estate and gift taxes (and twice that if one is married). Let’s be honest: $13.6 million excludes almost all of us.

Form 1041 is the income tax for the estate. Dying does not save one from income taxes.

Let’s talk about the client.

Dr W passed away unexpectedly. At death he had bank and brokerage accounts, a residence, retirement accounts, collectibles, and a farm. The estate is being probated in two states, as there is real estate in the second state. The probate has been unnecessarily troublesome. Dr W recorded a holographic will, and one of the states will not accept it.

COMMENT: Not all estate assets go through probate, by the way. Assets passing under will must be probated, but many assets do not pass under will.

What is an example of an asset that can pass outside of a will?

An IRA or 401(k).

That is the point of naming a beneficiary to your IRA or 401(k). If something happens to you, the IRA transfers automatically to the beneficiary under contract law. It does not need the permission of a probate judge.

Back to Dr W.

Our accountant prepared the Form 1041, I saw interest, dividends, capitals gains, farm income and … a whopping charitable donation.

What did the estate give away?

Books. Tons of books. I am seeing titles like these:

·       Techniques of Chinese Lacquer

·       Vergoldete Bronzen I & II

·       Pendules et Bronzes d’Ameublement

Some of these books are expensive. The donation wiped out whatever income the estate had for the year.

If the donation was deductible.

Look at the following:

§ 642 Special rules for credits and deductions.

      (c)  Deduction for amounts paid or permanently set aside for a charitable purpose.

(1)  General rule.

In the case of an estate or trust ( other than a trust meeting the specifications of subpart B), there shall be allowed as a deduction in computing its taxable income (in lieu of the deduction allowed by section 170(a) , relating to deduction for charitable, etc., contributions and gifts) any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, paid for a purpose specified in section 170(c) (determined without regard to section 170(c)(2)(A) ). If a charitable contribution is paid after the close of such taxable year and on or before the last day of the year following the close of such taxable year, then the trustee or administrator may elect to treat such contribution as paid during such taxable year. The election shall be made at such time and in such manner as the Secretary prescribes by regulations.

This not one of the well-known Code sections.

It lays out three requirements for an estate or trust to get a charitable deduction:

• Must be paid out of gross income.
• Must be paid pursuant to the terms of the governing instrument.
• Must be paid for a purpose described in IRC Sec. 170(c) without regard to Section 170(c)(2)(A). 

Let’s work backwards.

The “170(c) without …” verbiage opens up donations to foreign charities.

In general, contributions must be paid to domestic charities to be income-tax deductible. There are workarounds, of course, but that discussion is for another day. This restriction does not apply to estates, meaning they can contribute directly to foreign charities without a workaround.

This issue does not apply to Dr W.

Next, the instrument governing the estate must permit payments to charity. Without this permission, there is no income tax deduction.

I am looking at the holographic will, and there is something in there about charities. Close enough, methinks.

Finally, the donation must be from gross income. This term is usually interpreted as meaning gross taxable income, meaning sources such as municipal interest or qualified small business stock would create an issue.

The gross income test has two parts:

(1)  The donation cannot exceed the estate’s cumulative (and previously undistributed) taxable income over its existence.

(2)  The donation involves an asset acquired by that accumulated taxable income. A cash donation easily meets the test (if it does not exceed accumulated taxable income). An in-kind distribution will also qualify if the asset was acquired with cash that itself would have qualified.

The second part of that test concerns me.

Dr W gave away a ton of books.

The books were transferred to the estate as part of its initial funding. The term for these assets is “corpus,” and corpus is not gross income. Mind you, you probably could trace the books back to the doctor’s gross income, but that is not the test here.

I am not seeing a charitable deduction.

“I would not have done this had I known,” said the frustrated client.

I know.

We have talked about a repetitive issue with taxes: you do not know what you do not know.

How should this have been done?

Distribute the books to the beneficiary and let him make the donation personally. Those rules about gross income and whatnot have no equivalent when discussing donations by individuals.

What if the beneficiary does not itemize?

Understood, but you have lost nothing. The estate was not getting a deduction anyway.

The Skip Tax - Part Two

 

How does one work with the skip?

In my experience, the skip is usually the realm of the tax attorneys, although that is not to say the tax CPA does not have a role. The reason is that most skips involve trusts, and trusts are legal documents. CPAs cannot create legal documents. However, let that trust age a few decades, and it is possible that the next set of eyes to notice a technical termination or taxable distribution will be the CPA.

Let’s pause for a moment and talk about the annual exclusion and lifetime exemption.

The gift tax has an annual exclusion of $18,000 per donee per year. There is also a (combined gift and estate tax) lifetime exemption of $13.6 million per person. If you gift more than $18 grand to someone, you start carving into that $13.6 million lifetime exemption.

The skip tax has the same exclusion and exemption limits as the gift tax.

The problem is that a gift and a skip may not happen at the same time.

Let’s take two examples.

(1)  A direct skip

That is the proverbial gift to the grandchild. Let’s say that it well over $18 grand, so you must file a return with the IRS.

You gift her a $100 grand.

The gift is complete, so you file Form 709 (the gift tax return) with your individual tax return next year.

The transfer immediately dropped at least two generations, so the skip is complete. You complete the additional sections in Form 709 relating to skips. You claim the annual exclusion of $18 grand, and you apply some of the $13.6 million exemption to cover the remaining $82 grand.

Done. Directs skips are easy.

(2)  An indirect skip

Indirects are another way of saying trusts.

Remember we discussed that there is a scenario (the taxable termination) where the trust itself is responsible for the skip tax. However, there is no skip tax until the exemption is exhausted. The skip may not occur for years, even decades, down the road. How is one to know if any exemption remains?

Enter something called the “inclusion ratio.”

Let’s use an example.

(1)  You fund a trust with $16 million, and you have $4 million of (skip) lifetime exemption remaining. 

(2)  The skip calculates a ratio for this trust.

4 divided by 16 is 25%.

Seems to me that you have inoculated 25% of that trust against GST tax.

(3)  Let’s calculate another ratio.

1 minus 25% is 75%.

This is called the inclusion ratio.

It tells you how much of that trust will be exposed to the skip tax someday.

(4)  Calculate the tax. 

Let’s say that the there is a taxable termination when the trust is worth $20 million.

$20 million times 75% equals $15 million.

$15 million is exposed to the skip tax.

Let’s say the skip tax rate is 40% for the year the taxable termination occurs.

The skip tax is $6 million.

That trust is permanently tainted by that inclusion ratio.

Now, in practice this is unlikely to happen. The attorney or CPA would instead create two trusts: one for $4 million and another for $11 million. The $4 million trust would be allocated the entire remaining $4 million exemption. The ratio for this trust would be as follows:

                       4 divided by 4 equals 1

                       1 minus 1 equals -0-.

                       The inclusion ratio is zero.

                       This trust will never have skip tax.

What about the second trust with $11 million?

You have no remaining lifetime exemption.

The second trust will have an inclusion ratio of one.

There will be skip tax on 100% of something in the future.

Expensive?

Yep, but what are you going to do?

In practice, these are sometimes called Exempt and Nonexempt trusts, for the obvious reason.

Reflecting, you will see that a direct skip does not have an equivalent to the “inclusion ratio.” The direct skip is easier to work with.

A significant issue involved with allocating is missing the issue and not allocating at all.

Does it happen?

Yes, and a lot. In fact, it happens often enough that the Code has default allocations, so that one does not automatically wind up having trusts with inclusion ratios of one.

But the default may not be what you intended. Say you have $5 million in lifetime exemption remaining. You simultaneously create two trusts, each for $5 million. What is that default going to do? Will it allocate the $5 million across both trusts, meaning that both trusts have an inclusion ratio of 50%? That is probably not what you intended. It is much more likely that you intend to allocate to only one trust, giving it an inclusion ratio of zero.

There is another potential problem.

The default does not allocate until it sees a “GST trust.”

What is a GST trust?

It is a trust that can have a skip with respect to the transferor unless one or more of six exceptions apply.

OK, exceptions like what?

Exception #1 – “25/46” exception. The trust instrument provides that more than twenty-five percent (25%) of the trust principal must be distributed (or may be withdrawn) by one or more persons who are non-skip persons before that individual reaches age forty-six (46) (or by a date that will occur or under other circumstances that are likely to occur before that individual reaches age forty-six (46)) (IRC §2632(c)(3)(B)(i)).”

Here is another:

Exception #2 – “25/10” exception. The trust instrument provides that more than twenty-five percent (25%) of the trust principal must be distributed (or may be withdrawn) by one or more persons who are non-skip persons and who are living on the date of the death of another person identified in the instrument who is more than ten (10) years older than such individual (IRC §2632(c)(3)(B)(ii)).”

Folks, this is hard terrain to navigate. Get it wrong and the Code does not automatically allocate any exemption until … well, who knows when?

Fortunately, the Code does allow you to override the default and hard allocate the exemption. You must remember to do so, of course.

There is another potential problem, and this one is abstruse.

One must be the “transferor” to allocate the exemption.

So what, you say? It makes sense that my neighbor cannot allocate my exemption.

There are ways in trust planning to change the “transferor.”

You want an example?

You set up a dynasty trust for your child and grandchildren. You give your child a testamentary general power of appointment over trust assets.

A general power of appointment means that the child can redirect the assets to anyone he/she wishes.

Here is a question: who is the ultimate transferor of trust assets – you or your child?

It is your child, as he/she has last control.

You create and fund the trust. You file a gift tax return. You hard allocate the skip exemption. You are feeling pretty good about your estate planning.

But you have allocated skip exemption to a trust for which you are not the “transferor.” Your child is the transferor. The allocation fizzles.

Can you imagine being the attorney, CPA, or trustee decades later when your child dies and discovering this? That is a tough day at the office.

I will add one more comment about working in this area: you would be surprised how legal documents and tax returns disappear over the years. People move. Documents are misplaced or inadvertently thrown out. The attorney has long since retired. The law firm itself may no longer exist or has been acquired by another firm. There is a good chance that your present attorney or CPA has no idea how – or if – anything was allocated many years ago. Granted, that is not a concern for average folks who will never approach the $13.6 million threshold for the skip, but it could be a valid concern for someone who hires the attorney or CPA in the first place. Or if Congress dramatically lowers the exemption amount in their relentless chase for the last quarter or dollar rolling free in the economy.

With that, let’s conclude our talk about skipping.

 

Spotting The Skip Tax - Part One

I was reviewing something this week we may not have discussed before. Mind you, there is a reason we haven’t: it is a high-rent problem, not easy to understand or likely to ever apply to us normals. If you work or advise in this area (as attorney, CPA, trustee or so on), however, it can wreck you if you miss it.

Let’s talk a bit about the generation skipping tax. It sometimes abbreviated “GST,” and I generally refer to it as the “skip.”

Why does this thing even exist?

It has to do with gift and estate taxes.

You know the gift tax: you are allowed to make annual gifts up to a certain amount per donee before having to report the gifts to the IRS. Even then, you are spotted an allowance for lifetime gifts. While there may be paperwork, you do not actually pay gift tax until you exhaust that lifetime allowance.

You know the estate tax: die with enough assets and you may have a death tax. Once again, there is an allowance, and no tax is due until you exceed that allowance. The 2024 lifetime exemption is $13.6 million per person, so you can be wealthy and still avoid this tax.

As I said, we are discussing high-end tax problems.

Then there is the third in this group of taxes: the generation skipping tax. It is there as a backstop. Without it, gift and estate taxes would lose a significant amount of their bite.

Why Does the Skip Exist?

Let go through an example.

When does the estate tax apply (setting aside that super-high lifetime exemption for this discussion)?

It applies when (a) someone with a certain level of assets (b) dies.

How would a planner work with this?

Here is an idea: what if one transfers assets to something that itself cannot die? Without a second death, the estate tax is not triggered again.

What cannot die, without going all Lovecraftian?

How about a corporation?

Or – more likely – a trust?

When Does The Skip Apply?

It applies when someone transfers assets to a skip person.

Let’s keep this understandable and not go through every exception or exception to the exception.

A skip person is someone two or more generations below the transferor.

          EXAMPLE:

·       A transfer to my kid would not be a skip.

·       A transfer to my grandchild would be a skip.

What Constitutes a Transfer?

There are two main types:

·       I simply transfer assets to my grandchild. Perhaps she finishes her medical degree, and I buy and deed her first house.

·       I transfer assets through a trust.

The first type is called a direct skip. Those are relatively easy to spot, trigger the skip immediately and require a tax filing.

You already know the form on which the skip is reported: the gift tax return itself (Form 709). The form has additional sections when the skip tax applies.

          EXAMPLE:

·       I give my son a hundred grand. This is over the annual dollar limit, so a gift tax return is required. My son is not a skip person, so I need not concern myself with the skip tax sections of Form 709.

·       I give my grandson a hundred grand. This is over the annual limit, so a gift tax return is required. My grandson is also a skip person, so I need to complete the skip tax sections of Form 709.

What Is the Second Type of Transfer?

Use a trust.

Here is an example:

• Create a trust in a state that has relaxed its rule against perpetuities (RAP).

a.     This rule comes from English common law, and its intent was to limit how long a person can control the ownership and transfer of property after his/her death.

• Fund the trust at the settlor’s death.

a.     If that someone is Jeff Bezos or Elon Musk, there could be some serious money involved here.

•   The settlor’s children receive distributions from the trust. When they die, the settlor’s grandchildren take their place.

• When the grandchildren die, the great grandchildren take their place, and so on.

What we described above BTW is a dynasty trust.

The key here is - before the skip tax entered the Code in the 1970s - the then-existing gift and estate tax rules would NOT pull that trust back onto anyone’s estate return for another round of taxation.

Congress was not amused.

And you can see why a skip is defined as two generations below the transferor. Congress wanted a bite into that apple every generation, if possible.

How Does Skipping Through A Trust Work?

There are two main ways: 

EXAMPLE ONE: Say the trust has a mix of skip and nonskip beneficiaries, say children (nonskip) and grandchildren (skip). The IRS chills, because the trust might yet be includable in the taxable estate of a nonskip person. Say the last nonskip person dies (leaving only skips as beneficiaries) AND nothing is includable in an estate return somewhere. Yeah, no: this will trigger the skip tax. To make things confusing, the skip refers to this as a “termination,” even though nothing has actually terminated.   

EXAMPLE TWO: The trust again has a mix of skip and nonskip beneficiaries. This just like the preceding, except we will not kill-off the nonskip beneficiary. Instead, the trust simply distributes to a skip or skips (say the grandchildren or great-grandchildren). This triggers the skip tax and is easier to identify and understand.

If Skipping Through A Trust, When Is the Tax Due?

Look at Example One above. This could be years – or decades – after the creation of the trust.  

The trustee is supposed to recognize that there has been a skip “termination” of the trust. The trustee would file the (Form 709) tax return, and the trust would pay the skip tax.

And – yes – in the real world it is a problem. What if the trustee (or attorney or CPA) misses the termination as a taxable event?

Malpractice, that’s what. An insurance company will probably be involved.

What About Example Two?

This is a backstop to the first type of transfer. In the second type there is still a nonskip beneficiary, meaning that the trust has not “terminated” for skip purposes. The trust distributes, but the distribution goes to a skip.

Say the trust distributes a 1965 Shelby Mustang GT350 R.

First, nice.

Second, the skip tax is paid by the beneficiary receiving the distribution. The trust does not pay this one.

Third, the trustee may want to warn the beneficiary that he/she owes skip tax on a car worth at least $3.5 million.

Fourth, realistically the trust is going to pay, whether upfront or as a reimbursement to the beneficiary. The tax paid is itself subject to the skip tax if it comes out of the trust.

How Much Is the Skip Tax?

Right now, it is 40 percent.

It changes with changes to the gift and estate tax rates.

That 1965 Shelby GT 350R comes with a skip tax of at least $1.4 million. It takes a lot of green to ride mean.

How Do You Plan for This Tax?

The skip is very much a function of using trusts in estate planning.

Trust taxation can be oddball on its own.

Introduce skip tax and you can go near hallucinatory.

This is a good spot for us to break.

We will return next post to continue our skip talk.

Embezzlement And A Payroll Tax Penalty

It has been about a month since I last posted.

To (re)introduce myself, I am a practicing tax CPA. I like to think practice allows a certain reality check on topics we discuss here. I am hesitant to discuss topics I do not work with or have not worked with for a long time. On the other hand, I can be acerbic while bloviating within my wheelhouse. I have strong opinions, for example, with IRS administration of “reasonable cause” relief for certain penalties. Here is one: work someone 80, 90 or more hours per week, deprive him/her of adequate rest, maintain the stress meter at redline, and ... stuff ... just ... happens. Maybe - if we had a government union to drag high achievers down to the level of the common spongers - then stuff would stop happening.

The downside is that this blog is maintained by a practicing CPA, and we just finished busy season.

Let’s ease back into it.

Let’s talk about the big boy penalty - the BBP.

There are penalties when someone fails to remit withheld payroll taxes to the IRS. It makes sense when you think about it. Your employer withholds 6.2% of your gross paycheck for social security and another 1.45% for Medicare. Your employer is also withholding federal income tax. All that is your money - your employer is acting only as a go-between - and not remitting the tax to the IRS is tantamount to stealing from you. And from the IRS.

I have seen it many times over the years. Sometimes still do. Not grievous stuff like Madoff, but nonetheless happening when a business is laboring.

I get it: the business is doing the best it can. I am not saying it is right, but growing up includes acknowledging that a lot of things are not right.

The BBP is a 100% penalty on the withheld employee taxes.

You read that right: 100 percent.

It applies if you are a “responsible person.” That makes sense to me if you are the big cheese at the Provolone factory, but the IRS has been known to consider ordinary Joe’s – somebody stuck at a miserable job for a needed paycheck before another job allows an escape – to be responsible persons. A common thread is that someone has the authority to write checks, meaning the person can decide where the money (however limited) goes. Sounds great in a classroom, but it can lead to stupid in the real world.

Let’s look at Rodney Taylor.

He has degrees in political science, speech, and theater. He is multilingual. He has worked domestically and internationally. He now owns a management company called Taylor & Co.

He says that he suffers from a limited learning disability, one involving mathematics.

Couldn’t tell, but I believe him.

Over the years he delegated much of his financial stuff to professionals such as Robert Gard, his CPA.

OK.

Gard embezzled between one and two million dollars from Taylor. Some of those monies were earmarked as payroll tax deposits.

Gard had a heart attack during a meeting when his fraud was unearthed. It appears that Taylor is a good sort, as Gard survived and attributed his survival to actions Taylor immediately took in response to the heart attack.

And next we read about the lawsuits. And the insurance companies. And banks. And insurance reimbursements. You know the storyline.

While all of this was happening, Taylor paid himself a $77 thousand bonus.

STOP! Pay it back. Immediately. Not Kidding.

Taylor transferred funds from the company’s bank account to a new something he was launching.

DID YOU NOT HEAR STOP???

You know the IRS had a BBP issue here.

Taylor argued that he could not be a responsible person, as he was embezzled. He had difficulties with mathematical concepts. He hired people to do stuff.

I do not know who was advising Taylor - if anyone - but he lost the plot.

• Taylor owed the IRS.
• Taylor was CEO, hired and fired, controlled the financial affairs of the company, and made the decision to sue Gard. He couldn’t be any more responsible if he tried.
• Meanwhile, Taylor diverted money to himself while still owing the IRS.

The IRS gets snarky when you prioritize yourself when you still owe back payroll taxes.

Bam! Big boy penalty.

Yeah, and rain is wet.

Sometimes it … is … just … obvious.

Our case this time was Taylor v Commissioner, T.C. Memo 2024-33.

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.