Planning for Charitable Transfers

PLANNING FOR CHARITABLE TRANSFERS

Louis A. Mezzullo
McKenna Long & Aldridge LLP
Rancho Santa Fe, CA

April 1, 2013

TABLE OF CONTENTS

Page

I.GENERAL PRINCIPLES AND HISTORY

II.OVERVIEW OF CHARITABLE INCOME TAX DEDUCTION RULES

III.CHARITABLE REMAINDER TRUSTS

IV.CHARITABLE LEAD TRUSTS

V.POOLED INCOME FUNDS

VI.INTERESTS IN PERSONAL RESIDENCE OR FARM

VII.UNDIVIDED FRACTIONAL INTERESTS

VIII.EASEMENTS AND OTHER INTERESTS FOR CONSERVATION

IX.COPYRIGHTED WORKS OF ART

X.TAX-FREE DISTRIBUTIONS FROM INDIVIDUAL RETIREMENT PLANS FOR CHARITABLE PURPOSES.

XI.PRIVATE FOUNDATIONS, SUPPORTING ORGANIZATIONS, AND DONOR-ADVISED FUNDS.

PLANNING FOR CHARITABLE TRANSFERS

Louis A. Mezzullo
McKenna Long & Aldridge LLP
Rancho Santa Fe, CA

April 1, 2013

GENERAL PRINCIPLES AND HISTORY
I.R.C. §2522 and 2055 provide an unlimited gift and estate tax charitable deduction for transfers during lifetime or at death to the following:
Federal, state or local governments, provided the transfer is exclusively for public purposes.
Charitable corporations or associations that are organized and operated exclusively for charitable purposes.
Certain fraternal organizations, if the transferred property is to be used for charitable purposes.
Certain veterans organizations that are not operated for private gain.
If a lifetime transfer is entirely deductible as a charitable contribution and is a transfer of all of the donor’s entire interest in the property, and if no other interest in the property has been transferred from the donor to a person for a noncharitable purpose, no gift tax return must be filed to report the transfer.
However, if a donor is required to file a return to report noncharitable gifts, the donor must include any charitable gifts on the return. See instructions to Form 709.
The gift and estate tax charitable deduction will be available if the property passes to a charitable beneficiary as a result of a qualified disclaimer made pursuant to I.R.C. §2518.
The estate tax charitable deduction only applies to the extent that the transferred property is included in the donor’s estate.
Property passing pursuant to the exercise or non-exercise of a power of appointment may also qualify for the gift and estate tax charitable deduction, if the property passes to an appropriate charitable beneficiary.
The charitable deduction will apply only to the extent that the transferred assets are included in the estate of the person exercising the power of appointment.
Thus, property passing as the result of the exercise of a general power of appointment will give rise to a deduction, while property passing pursuant to the exercise of a special power of appointment may not give rise to a deduction.
Because the gift and estate tax deductions are unlimited for outright transfers, an estate planner will not contend with difficult gift or estate tax issues when a client wishes to make an outright transfer during lifetime or at death.
Difficult income tax issues may arise in the context of lifetime transfers, because of the limitations on the income tax deduction for charitable transfers.
From a gift and estate tax perspective, interesting planning opportunities arise when the client wishes to make a transfer to a charity through some means other than an outright transfer.
Prior to 1969, donors frequently made gifts and bequests of “split interests” to charities.
In a typical split interest arrangement, the donor would either retain a life interest in the property for himself or create a life interest for the benefit of a third party. In either case, the charity would receive the remainder interest in the property.
The value of the remainder interest qualified for the gift or estate tax charitable deduction and gave rise to an income tax charitable deduction.
In addition, if the donated property was highly appreciated property, the donor could avoid income taxation on the unrealized gain in the property’s value.
Donors benefited from an unrealistically low assumed rate of return in the tables used to determine the values of the retained life estate and the remainder interest passing to the charity.
The low assumed rate of return increased the value of the remainder interest and decreased the value of the life estate.
The traditional use of split interest gifts was severely restricted by the Tax Reform Act of 1969, under which deductions for split interest gifts were disallowed unless the gifts were made to certain types of entities, the gifts involved an interest in a particular type of property, or the transfer of the split interest was made for some specified purpose for which a charitable deduction is allowed.
OVERVIEW OF CHARITABLE INCOME TAX DEDUCTION RULES
A donor who itemizes deductions is entitled to an income tax charitable deduction for contributions to qualified charitable organizations.
Under the so-called “Pease” limitation, certain taxpayers with adjusted gross income above a certain amount (in 2013 the dollar amounts are $300,000 for joint filers and a surviving spouse, $275,000 for heads of households, $250,000 for single filers, and $150,000 for married taxpayers filing separate returns) must reduce their itemized deductions by the lesser of three percent of the excess of their adjusted gross income over this amount or 80 percent of the amount of itemized deductions otherwise allowable for the tax year. I.R.C. §68(b).
Note that for a taxpayer with other deductions subject to the reduction in excess of the amount of the reduction, making charitable contributions will not be affected by the reduction.
For example, if a taxpayer has other itemized deductions of $100,000, and a reduction based on his or her adjusted gross income of $20,000, making a $100,000 charitable contribution will result in a deduction of the entire $100,000 from taxable income.
Gifts to Public Charities.
If the gift is to a public charity (generally churches, universities, hospitals, and other broadlysupported charities), the donor is usually entitled to deduct the full amount of the contribution up to 50 percent of the donor’s adjusted gross income. I.R.C. §170(b)(1)(A).
However, for gifts to a public charity of capital gain property that has been held for more than one year and has appreciated, the donor may deduct the full fair market value of the gift only up to 30 percent of the donor’s adjusted gross income. I.R.C. §170(b)(1)(C)(i).
However, if the donor elects to limit the deduction to the donor’s basis, the 50% limit applies. I.R.C. §170(b)(1)(C)(iii).
Lower deduction limits apply to gifts to private foundations that are not private operating foundations.
The donor is usually entitled to deduct the full amount of the contribution up to 30 percent of the donor’s adjusted gross income. I.R.C. §170(b)(1)(B).
However, if long-term capital gain property is donated, the deduction will be limited to 20 percent of adjusted gross income. I.R.C. §170(b)(1)(D).
In some cases, if long-term capital gain property is donated, the amount that is deductible will be limited to the cost of the property rather than its fair market value. I.R.C. §170(e)(1).
This limit does not apply to contributions of “qualified appreciated stock,” which is stock for which market quotations are readily available, as long as the donor has not contributed more than 10% of the stock of the same company. I.R.C. §170(e)(5).
A fiveyear carryover applies to any portion of a charitable deduction that cannot be deducted because of the percentage limitations. I.R.C. §170(d).
In the case of gifts of appreciated property to charitable organizations, the donor avoids tax on the appreciation.
CHARITABLE REMAINDER TRUSTS
A charitable remainder trust (CRT) benefits one or more non-charitable beneficiaries during the lifetime of the non-charitable beneficiaries or for a term of years. At the termination of the non-charitable beneficiary’s interest, the CRT benefits a charity.
A CRT may be a charitable remainder annuity trust (CRAT) or a charitable remainder unitrust (CRUT).
Under a CRAT, a specific sum of money, which must be at least five percent (and not more than 50 percent) of the initial net fair market value of the property donated to the trust, is distributed at least annually to a non-charitable beneficiary.
For example, a CRAT to which $1,000,000 is contributed might provide that $50,000 per year is to be distributed to the donor during his or her lifetime.
Upon the death of the donor, any assets remaining in trust are distributed to the selected charity.

I.R.C. §664(d)(1).

Under a CRUT, the non-charitable beneficiary does not receive a fixed payment each year. Instead, the non-charitable beneficiary receives a unitrust amount, which is calculated as a percentage (not less than five percent or more than 50 percent) of the net fair market value of the trust assets, as determined at least annually.
For example, under a CRUT, the donor might be entitled to receive an amount equal to seven percent of the value of the trust assets, as determined on January 1 of each year.
Any assets remaining in trust at the death of the donor will be distributed to the selected charity.

I.R.C. §664(d)(2).

The CRUT is the more flexible of the two types of CRTs for planning purposes.
The creator of a CRUT may transfer additional assets to a CRUT at a later date.
Additional contributions may not be made to a CRAT. Treas. Reg. §1.664-2(b).
Under either type of CRT, the principal of the trust may be invaded to make the necessary annuity or unitrust payments to the non-charitable beneficiary.
However, under a CRUT, it is possible to prohibit unitrust payments in any year in which income is not sufficient to pay the unitrust amount.

(1)Missed unitrust payments may be made up in later years when income is sufficient, up to the amount of unpaid unitrust amounts.

(2)The trust instrument must specifically require this distribution scheme; it may not leave the distribution of the income or unitrust amount to the discretion of the trustee.

I.R.C. §664(d)(3).

By establishing a CRUT in this fashion, a donor may invest assets for capital appreciation during the early years of the trust, while deferring payment of the unitrust amounts until later years.

(1)In this way, CRUTs may be used to provide retirement income.

A CRUT may also be established as a FLIP CRUT, which permits the CRUT to convert from an income only CRUT to a traditional CRUT upon the happening of certain events, such as death, attainment of a certain age, the birth of a child, a marriage or divorce, or the sale of an unmarketable asset such as real estate or closely held or restricted stock, that are not within the discretion of the donor. Treas. Reg.1.664-3(a)(1)(i)(c).

(1)A FLIP CRUT provides a number of planning possibilities, including providing for a surviving spouse, the education of a child, the possibility of a child’s divorce or disability, and additional income at retirement.

(2)It also provides a better result when nonmarketable assets are transferred to a CRUT.

(3)Once the asset is sold, the trust can convert to a straight unitrust so that investments can be made for total return and without any concern for current yield.

Under both the CRUT and the CRAT, the value of the remainder interest is determined actuarially based upon the value of the assets transferred to the trust and the value of the payments that are to be made to the non-charitable beneficiary.
The gift of the remainder interest will provide the donor with a current income and gift or estate tax deduction.
The income tax deduction will be subject to the limits otherwise applicable to the donor for charitable deductions.
The gift or estate tax deduction will offset the gift to the charity, but gift or estate tax may still be payable if the gift of the income interest to the non-charitable beneficiary is not otherwise protected from gift or estate tax.

(1)If the surviving spouse of the creator of the trust is the only non-charitable beneficiary of the CRT, the CRT will qualify for the gift or estate tax marital deduction. I.R.C. §2056(b)(8).

(2)If the surviving spouse is not the only non-charitable beneficiary of the CRT, the trust agreement must require the surviving non-charitable beneficiary to pay any federal estate and state death taxes for which the trustee might be liable after the donor’s death. I.R.C. § 664(d)(1)(B) and (d)(2)(B).

(a)This requirement prevents an improper diminution of the charitable remainder beneficiary’s interest in the trust assets.

(3)The IRS, in Revenue Procedure 2005-24, 2005-1 C.B. 909, required a spouse to waive any rights he or she had under state law, such as a right of election, in the trust assets of a CRT in order to qualify as a charitable remainder trust.

(4)However, because of a great deal of criticism from practitioners, the IRS extended indefinitely the effective date of the new requirement, but only if the surviving spouse does not exercise a right of election. Notice 2006-15, 2006 1 C.B. 501.

A higher unitrust or annuity payment will result in more funds being distributed to the lifetime beneficiary.
This will reduce the value of the remainder interest and therefore reduce the tax deductions that are available.
The actuarial value of the charitable beneficiary’s interest in the CRT must not be less than ten percent of the value of the assets transferred to the trust. I.R.C. § 664(d)(1)(D) and ((d)(2)(D).
This requirement applies to each contribution to a CRUT. I.R.C. § 664(d)(2)(D).

Although distributions to non-charitable beneficiaries under a CRAT or CRUT may be subject to income tax, the CRAT or CRUT itself is tax-exempt.
As such, these trusts may sell appreciated assets without incurring a capital gains tax.
A significant motive behind the creation of a CRUT or CRAT involves exploitation of the trust’s ability to dispose of highly appreciated assets without paying capital gains tax on the assets.
For example, assume a client owns $1,000,000 worth of stock in a publicly traded company, and the client’s basis in the stock is $100,000.
Assume further that, based upon the client’s income requirements and the company’s history of paying income, the client wishes to sell the stock and reinvest the proceeds in investments that produce more income.
If the client establishes a CRT and transfers the appreciated stock to the CRT, the trustee of the CRT will be able to sell the appreciated stock and reinvest the proceeds without incurring any capital gains tax.

(1)Thus, more principal will be available to be invested to produce income for the non-charitable beneficiary, and, ultimately, more principal should be available to benefit the charity.

(2)The CRT may not qualify as a CRT if this avoidance of capital gain appears to be the only motive for creating the trust.

(3)There is an overriding requirement that the CRT operate as a charitable trust at all times during its existence; it may not merely operate as a vehicle for tax avoidance.

Under either the CRAT or the CRUT, the likelihood that the charity will receive some benefit must not be so remote as to be negligible from an actuarial standpoint.
Several rulings indicate that there must be at least a five percent chance that the charitable remainder beneficiary of a charitable remainder annuity trust will receive some trust corpus. Rev. Rul. 77-374, 1977-2, C.B. 330; Rev. Rul. 70-452. 1970-2 C.B. 199.
Many of the technical requirements applicable to CRTs can be best understood in light of the perceived abuses relating to the valuation of split-interest charitable gifts that occurred prior to 1969.
To prevent taxpayers from exploiting these abuses, Congress and the Internal Revenue Service imposed a number of requirements that allow the value of the interests of the charitable and non-charitable beneficiaries to be determined with a reasonable degree of actuarial certainty.
Flexibility in drafting CRTs is allowed only to the extent that this certainty with respect to valuing each beneficiary’s interest will not be undermined.
If this certainty in valuation is undermined, the charitable income, gift, and estate tax deductions attributable to transfers to these trusts may be improperly exploited by the creators of CRTs.
Some of the requirements imposed on both types of CRTs, which may be understood in the context of a desire for certainty in valuation, are the following:
The CRT may be set up to benefit more than one non-charitable beneficiary, either concurrently or consecutively.
However, the non-charitable beneficiary must be living at the time the trust is created.
If the non-charitable beneficiaries are members of a class, a gift for the benefit of a class which might be enlarged by the addition of after-born members does not qualify unless the period for which the annuity or unitrust amount is to be paid to such class consists solely of a term of years.

I.R.C. §§664(d)(1)(A) and (2)(A); Treas. Reg. §§1.664-2(a)(3) and -3(a)(3).

The income interest of the non-charitable beneficiary may be paid over the lifetime(s) of the non-charitable beneficiary or for a term not exceeding 20 years.
Note that a term of years (up to 20) can be followed by the life of an individual, but a term of years may not follow the life of an individual.

Treas. Reg. §§1.664-2(a)(5) and -3(a)(5).

No distribution in excess of the annuity or unitrust entitlement may be distributed to any non-charitable beneficiary. I.R.C. §§664(d)(1)(B) and (2)(B).
Neither type of CRT may provide for mandatory or discretionary invasions of principal for the benefit of the non-charitable income beneficiary, even if the invasion power is limited by an ascertainable standard.
This requirement prevents a reduction in the remainder interest that may not be taken into account in calculating the value of the remainder interest at the time of the initial contribution to the trust.
As mentioned above, the principal may be invaded to make the annuity or unitrust payment.
Under either type of trust, the creator of the trust may retain the right to designate one or more new or replacement charitable remainder beneficiaries.
The trust agreement must require the surviving non-charitable beneficiary to pay any federal estate and state death taxes for which the trustee might be liable after the donor’s death. I.R.C. §§664(d)(1)(B) and (2)(B).
Like the prohibitions on the invasion of principal, this requirement prevents an improper diminution of the charitable remainder beneficiary’s interest in the trust assets.
If the surviving spouse of the creator of the trust is the only non-charitable beneficiary of the CRT, the CRT will qualify for the gift or estate tax marital deduction.
Note that one desired tax result (eliminating all transfer taxes) may be achieved without observing the requirements of a CRT if a QTIP or other trust qualifying for the marital deduction is established for a spouse, with the remainder interest passing to a charity.

(1)This will not allow the donor to take a current income tax deduction, but no transfer tax will be paid, because the initial transfer in trust for the spouse will be protected by the unlimited marital deduction, while the transfer of the remainder interest, which will be included in the estate of the surviving spouse, will be shielded from tax by the unlimited charitable deduction.