For a more detailed overview, see Charitable Remainder Trusts, 2. Treas. Regs (a)(5)(i).

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1 Two CRUTs and a CLAT: Using Split Interest Charitable Trusts to Defer Gain and Eliminate Estate Taxes Terence Condren & Thomas Cosinuke December 3, Framing the Discussion a. "True charity is the desire to be useful to others with no thought of recompense." Emanuel Swedenborg b. "But it never hurts to get a nice tax deduction at the same time." Condren & Cosinuke c. Although the tax tail should never wag the charitable goal dog, it is our duty as advisors to help our clients accomplish their charitable goals in the most tax efficient manner possible. With that in mind, here are three case studies that illustrate how our clients can do well while doing good. 2. Although there are a large number of ways for clients to pursue their charitable goals, today we will discuss just two of them: Charitable Remainder Unitrusts and Charitable Lead Annuity Trusts. a. Charitable Remainder Unitrust Trust (CRUT): A Brief Overview 1 i. A CRUT is a tax-exempt irrevocable trust authorized under I.R.C. Section 664. It is a creative way for a client to provide a benefit to charity at death while creating an income stream, deferring capital gain taxes and capturing an income tax deduction during life. A CRUT has three main components: the term, the payout rate and the remainder. ii. Term 1. A CRUT can run for a fixed term of years (up to a maximum of 20 years), for one or more measuring lives or for a combination of a fixed term and measuring lives A fixed term of years can be attractive if there is a concern that a measuring life may end prematurely. 3. Linking the term to the lives of the donor and the donor's spouse integrates the CRUT into the client's retirement plan by creating an income stream that will last for life and that may rise over time. iii. Payout rate 1. A CRUT pays a fixed percentage of its fair market value (as measured each year) to one or more individuals during the term of the CRUT. 3 If the value of the CRUT grows over time, then the annual payout will increase proportionately, but the payout will also decline in the same manner if the value of the CRUT drops. 1 For a more detailed overview, see Charitable Remainder Trusts, 2 Treas. Regs (a)(5)(i). 3 I.R.C. 664(d)(2)(A).

2 2. The rate must be between 5% and 50%, inclusive. 4 Typically, the rate is between 5% and 8%. 3. A high payout rate captures more of the financial benefit for the family and reduces the ultimate distribution to charity, but a high payout rate also increases the risk of a declining income stream for the family. iv. Remainder 1. At the end of the CRUT's term, whatever is left in the CRUT is distributed to one or more charities. These charities can be public charities (e.g., a donor advised fund, the United Way, a college, a religious organization, etc.) or private foundations (e.g., a charitable corporation created by the donor). 2. The donor can reserve the right to change the charities as often as he/she wishes. Retaining this right causes the CRUT's value to be included in the donor's estate, 5 but that inclusion is offset in its entirety by a charitable estate tax deduction, 6 so there's no drawback to retaining this power. 3. At the time the CRUT is funded, the present value of the remainder must be equal to at least 10% of the initial fair market value of the CRUT. 7 This is a one-time test. A higher payout rate will reduce the present value of the remainder interest, so a CRUT that runs for the lives of the donor and the donor's spouse has a maximum allowable payout rate that is far less than the stated maximum limit of 50%. For example, a CRUT than runs for the lives of two 40 year olds has a maximum allowable payout rate of just 5.250%, whereas a CRUT than runs for the lives of two 60 year olds can have a payout rate of 9.316% The donor receives a current income tax deduction equal to the fair market value of the remainder interest, 9 so a CRUT will always generate an income deduction equal to at least 10% of its initial fair market value. 10 v. Taxation of payments worst in, first out 1. Although a CRUT is a tax-exempt entity, the income beneficiary is taxed on the payments that he/she receives from the CRUT Ibid. 5 I.R.C. 2036(a)(2); I.R.C I.R.C. 664(d)(2)(D). 8 These examples assume funding in October The remainder interest is valued using the highest Section 7520 rate in effect for the month of the transfer and for the preceding two months. Treas. Regs A higher Section 7520 rate is advantageous, but not significantly so. 9 I.R.C. 170(f)(2)(A). 10 The deduction applies both to federal income taxes and to Vermont income taxes. 11 I.R.C. 664(b).

3 2. Inside the CRUT, all income items retain their character. For example, long-term capital gains realized by selling appreciated property inside of the CRUT retain that character when such gains are paid out to the income beneficiary. CRUTs can generate different types of income including tax-free interest income from municipal bonds, taxable interest income from government and corporate bonds, qualified dividends from public traded stocks and short-term and long-term capital gains. 3. Each payment from the CRUT to the income beneficiary is taxable based on the amount and type of income "trapped" inside the CRUT, but such income is not recognized proportionally. Instead, the worst income (from the taxpayer's point of view) is distributed first until that that "bucket" of income is exhausted and then the next least favorable bucket of income is distributed until its drained, and so forth. 12 a. Bucket 1: Ordinary income i. Ordinary income other than qualified dividends ii. Qualified dividends b. Bucket 2: Capital gain income i. Short-term gains ii. Long-term gains c. Bucket 3: Tax-exempt income d. Bucket 4: Tax-free return of principal e. Example: Assume Client contributes $1,000,000 of a long-term single stock position with a zero basis on January 1, 2015 to a CRUT that pays 5% a year to him at the end of each year. The CRUT immediately sells the property and invests the proceeds in a diversified portfolio. During 2015, the CRUT earns $10,000 of U.S. government bond interest, receives $20,000 of qualified dividend income and realizes $5,000 of short-term capital gains. On December 31, Client receives a $50,000 payment from the CRUT. Client recognizes the following income on the payment: 13 i. $10,000 of ordinary income ii. $20,000 of qualified dividend income iii. $5,000 of short-term capital gains iv. $15,000 of long-term capital gains (relating to the sale of the contributed property) b. Charitable Lead Annuity Trust (CLAT): A Brief Overview 12 I.R.C. 664(b). 13 This is a simplified example that does not take any deductions into account. The rules for how deductions are allocated among the various buckets of income are beyond the scope of this presentation. See Treas. Regs (d)(2) for more information.

4 i. A CLAT is a non-tax-exempt irrevocable trust that meets the requirements of I.R.C. Section 2522(c)(2)(B) (for gift tax purposes) or Section 2055(e)(2)(B) (for estate tax purposes). A CLAT is the opposite of a CRUT in almost every way. The income stream goes to a charity rather than to an individual, the remainder goes to one or more individuals rather than to charity, the payout is a fixed dollar amount rather than a percentage of the trust's value as measured each year and a CLAT is not a tax-exempt entity. ii. Term 1. A CLAT can run for one or more measuring lives, for a term of years or a combination of those factors. Unlike a CRUT, a fixed-term CLAT can run for more than 20 years If the term of a CLAT is based on a measuring life, the measuring life must be related to the donor of the CLAT or to one of the noncharitable remaindermen. 15 This rule evolved in response to the use of "Ghoul CLATs" where the measuring life was a person with a low life expectancy who was completely unrelated to the donor or to the remainderman and who was selected as the measuring life solely due to poor health. A CLAT that terminates early due to a premature death can create significant estate tax savings. 16 iii. Payout rate 1. A CLAT distributes a defined fixed dollar amount at least annually to one or more charitable organizations. Unlike a CRUT, the payout amount does not vary with the value of the CLAT. 2. The payout rate can change over time, so long as the changes are mapped out in the governing instrument. A backloaded CLAT where the annuity increases at 20% per year is permissible, but it is also possible to have a significant non-linear increase in the payout amount towards the end of the CLAT (a so-called "shark fin CLAT"), although this technique may carry significant audit risk. 17 Backloading a CLAT increases the chances of property being left in the CLAT at the end of the term because smaller payments are made up front, thereby allowing more growth to accumulate inside the CLAT. iv. Remainder 14 Estates, Gifts and Trusts Portfolios > Charitable Contributions > Portfolio 866-2nd: Charitable Lead Trusts > Detailed Analysis > II. Basic Requirements for Charitable Deduction Qualifying Nongrantor Charitable Lead Trust and Grantor Charitable Lead Trust > B. Guaranteed Annuity or Unitrust > 1. Guaranteed Annuity> a. Payment 15 Treas. Regs (c)-3(c)(2)(vi)(A), (vii)(a) 16 For a detailed discussion of how CLATs and other planning techniques can be used in the context of a low life expectancy, see 17 Estates, Gifts and Trusts Portfolios > Charitable Contributions > Portfolio 866-2nd: Charitable Lead Trusts > Detailed Analysis > IV. Additional Considerations for Qualifying Nongrantor Charitable Lead Trusts > Varying the Amount of the Guaranteed Annuity

5 1. At the end of the term, a CLAT distributes to one or more noncharitable beneficiaries, typically the donor's children or a trust for their benefit. If the CLAT's growth during the term exceeds the Section 7520 rate in effect when the CLAT was created, then there will be assets left over for grantor's children even though the grantor did not make a taxable gift when funding the CLAT. The math in terms of trying to beat the Section 7520 rate in order to leave a benefit to the family is identical to using a grantor retained annuity trust (GRAT). 2. CLATs can be used in conjunction with generation-skipping transfers (GSTs), but it is impossible to predict the inclusion ratio at the end of the CLAT, so a CLAT is not a good choice for making GSTs. 3. Unlike a CRUT, the donor cannot retain the right to change the identity of the remaindermen. v. Grantor CLAT v. non-grantor CLAT 1. Unlike a CRUT, a CLAT may or may not create a charitable income tax deduction for the grantor when it is funded. A grantor CLAT does create a deduction whereas a nongrantor CLAT does not A grantor CLAT is a CLAT where the grantor reserves certain powers (e.g., the right to reacquire trust assets in exchange for property of equivalent value) sufficient to invoke the grantor trust rules. A grantor CLAT generates an income tax deduction in the year of funding equal to the present value of the annuity interest that will be paid to charity. Two drawbacks are that (1) the donor must recognize all of the CLAT's income going forward and (2) the CLAT's annual distributions to charity do not generate additional income tax deductions for either the CLAT or the donor. A grantor CLAT is sometimes used when the donor experiences a spike in taxable income that is not likely to be repeated in the future, such as an executive who retires and receives a lump sum distribution from a nonqualified deferred compensation plan. 3. A nongrantor CLAT is its own taxpayer, and it does not generate a charitable income tax deduction for the grantor. This can be a good approach for a donor who wants to benefit charity but who is unable to benefit from additional charitable income tax deductions due to adjusted gross income (AGI) limitations. 3. Case Studies a. Using a Charitable Remainder Unitrust in conjunction with an Employee Stock Ownership Plan i. Client 1. A client owned a closely-held business and was looking to retire. 18 I.R.C. 170(f)(2)(B); Treas. Reg A-6(c).

6 2. The client wanted the employees to benefit from the transition, but none of them could afford to buy the business from the client. 3. The client was interested in providing a benefit to charity at the end of his life. ii. Technique 1. The client created an Employee Stock Ownership Plan (ESOP) and sold the business to the ESOP, which got a loan from a bank to pay for the business. An ESOP is a qualified retirement plan for employees that invests primarily in the corporation's own securities The client reinvested the sales proceeds in qualified replacement property (QRP) in order to defer recognizing a gain. QRP is defined as the securities (equity and debt) of domestic operating corporations The client wanted to diversify the portfolio outside the bounds of the QRP rules, generate an income stream for his retirement and benefit charity upon his death. He contributed the QRP to a CRUT, which then sold the QRP and invested the proceeds in a much more broadly diversified portfolio, including international stocks, emerging market debt and private equity partnerships. iii. Results 1. The client received an immediate income tax deduction equal to the present value of the charity's remainder interest based on the fair market value of the QRP contributed to the CRUT. 2. The client achieved better diversification than what was allowed by the QRP rules. 3. Client created an income stream which will last until the death of himself and his wife, and established a charitable financial legacy that will distribute to the family's donor-advised fund, which will be the primary charitable vehicle for the client's family. b. Using a Charitable Remainder Unitrust in conjunction with a 1031 exchange to defer gain on the sale of NYC co-op apartment i. Client 1. The client owned a co-op in NYC valued at $1.8 million and had rented it out for the past eight years. 2. The client wanted to sell the co-op and invest in new income-producing real estate worth $1.2 million without paying a capital gains tax. 3. The client was interested in providing a benefit to charity. ii. Technique 19 For a thorough discussion of ESOPs, see U.S. Income Portfolios: Compensation Planning > Portfolio 354-8th: ESOPs. 20 I.R.C. 1042(c)(4).

7 1. Client contributed 1/3 of the co-op to a FLIP CRUT so that he owned the co-op as tenants-in-common with the CRUT. a. A FLIP CRUT is a CRUT that pays the lesser of its net income and the stated percentage of its fair market value to the grantor each year until a triggering event, such as the sale of an asset held in the CRUT, at which point the CRUT pays out the stated percentage of its fair market value each year to the grantor without regard to net income Client then sold the co-op to a qualified intermediary and reinvested his 2/3 of the proceeds into new income-producing real estate via a Section 1031 exchange. The 1/3 interest held in the CRUT was sold for cash, and the cash was invested in a broadly diversified portfolio. a. A Section 1031 exchange allows a taxpayer to exchange one income-producing property for another without recognizing a gain. b. A Qualified Intermediary is a company that acquires the property from the taxpayer, transfers the property to thirdparty buyer, acquires a replacement property for the taxpayer and then transfers the replacement property to the taxpayer. 22 iii. Results 1. The client avoided recognizing gain on 2/3 of the co-op because he reinvested that portion of the co-op in like-kind property under Section The client diversified away from real estate inside the CRUT, created an income stream from the proceeds of the sale of the 1/3 interest, and will provide a benefit to charity at his death. 3. The client received an income tax deduction when he funded the CRUT. The deduction was equal to the fair market value of the present value of the remainder interest. c. Using a zeroed out Charitable Lead Annuity Trust to eliminate estate taxes i. Client 1. The client insisted on paying no estate taxes at death, despite the likelihood of having a $50 million estate. 2. The client had established significant irrevocable trusts during life for his children, but did not want to leave everything to charity. ii. Technique 1. During life, the client created an unfunded backloaded zeroed out CLAT. a. The CLAT provided that the annuity rate would be equal to the minimum rate necessary to produce a remainder interest of $1 21 Treas. Regs (a)(1)(i)(c). 22 Treas. Regs (k)-1(g)(4).

8 based on the applicable Section 7520 rate as of the client's death. b. The annuity was set to increase by 20% a year, starting the year after the client's death. The annuity was to be paid to the client's private foundation. c. The annuity was set to terminate ten years after the client's death and any property remaining in the CLAT would then distribute to a non-gst trust for the benefit of the client's children. 2. The client revised his estate plan to leave an amount equal to his available federal estate tax exemption (the client was a New Hampshire resident, so there was no state estate tax) to his children's trusts with the excess to flow to the CLAT. iii. Results 1. No estate tax will be paid at the client's death because the CLAT will create an estate tax deduction sufficient to reduce the client's taxable estate to an amount equal to the client's available estate tax exemption. 2. The children's trusts may receive an extra contribution when the CLAT ends if the CLAT beats the Section 7520 rate in effect at the time of the client's death. 3. The CLAT will pay a ten year rising annuity to the family foundation and then distribute the remainder (if any) after ten years to the children's trusts. 4. Conclusion: As advisors, we can use split interest charitable trusts to help our clients accomplish their goals in the most tax-efficient way possible by building integrated wealth management plans that combine asset diversification, income tax planning, estate tax planning and charitable planning. IMPORTANT UBS INFORMATION REGARDING THIS PRESENTATION This presentation is provided for informational and educational purposes only. This presentation provides general information on the topic discussed and is not intended as a basis for decisions in specific situations. Because of the complexities involved with developing tax planning strategies, experienced legal and tax counsel should be consulted before implementing a strategy. The views expressed herein are those of the author in his personal/individual capacity, and may not necessarily reflect the views of UBS Financial Services Inc.