Charitable Split-Interest Trusts and Form 5227 Avoiding Compliance Pitfalls and Navigating Recent Regulatory Changes TUESDAY, SEPTEMBER 24, 2013, 1:00-2:50 pm Eastern IMPORTANT INFORMATION This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection and phone line (no sharing) if you need to register additional people, please call customer service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford accepts American Express, Visa, MasterCard, Discover. Respond to verification codes presented throughout the seminar. If you have not printed out the Official Record of Attendance, please print it now. (see Handouts tab in Conference Materials box on left-hand side of your computer screen). To earn Continuing Education credits, you must write down the verification codes in the corresponding spaces found on the Official Record of Attendance form. Complete and submit the Official Record of Attendance for Continuing Education Credits, which is available on the program page along with the presentation materials. Instructions on how to return it are included on the form. To earn full credit, you must remain on the line for the entire program. WHOM TO CONTACT For Additional Registrations: -Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10) For Assistance During the Program: - On the web, use the chat box at the bottom left of the screen - On the phone, press *0 ( star zero) If you get disconnected during the program, you can simply call or log in using your original instructions and PIN.
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Charitable Split-Interest Trusts and Form 5227 September 24, 2013 Dawn D. Hallman, Hallman & Associates hallmanlaw@gmail.com Rosemarie Steeb, Chiampou Travis Besaw & Kershner rsteeb@chiampou.com Donna J. Jackson, CPA, JD, LLM donnajacksonlaw@aol.com
Today s Program Identifying Kinds of Split-Interest Trusts [Dawn D. Hallman] Tax Consequences and Recent Developments [Rosemarie Steeb] Financial Accounting Requirements [Donna J. Jackson] Avoiding Common Mistakes [Panel Discussion] Slide 7 Slide 36 Slide 37 Slide 81 Slide 82 Slide 106 Slide 107 Slide 108
Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
Dawn D. Hallman, Hallman & Associates IDENTIFYING KINDS OF SPLIT-INTEREST TRUSTS
UNDERSTAND WHY PEOPLE GIVE THE PLANNING PYRAMID Tax Plan Philanthropic Motivator Better than the IRS Philanthropic Motivator Pure Form Wealth Enhancement Legacy Planning Wealth & Value Preservation Family Planning Education/ Bloodline/ Spendthrift Personal Protection Privacy/ Disability/ Retirement 8
CHARITABLE CONSIDERATIONS Annuity or UniTrust Fixed payment amount/ % Easy to zero out/ GST Kids or Grandkids Grantor/ Non Grantor Income Tax deduction? Totally out of estate Now or at Death Immediate benefits Estate Tax Wipeout Market Performance What are expected returns AFR What does the IRS say we will earn Asset Issues Taxes due? Liquid? 9
CHARITABLE REMAINDER TRUST (CRT) An agreement in which property or money is donated to a charitable organization the donor receives income from the investment during the remainder of his or her lifetime After the donor s death, the charitable organization receives the principal of the donation to be used for a purpose specified by the donor. 10
CHARITABLE REMAINDER TRUST (CRT) A CRT permits an estate owner to: increase the income potential from a highly appreciated asset obtain an income tax deduction and reduce estate taxes benefit a charitable organization change charities which will receive trust remainder 11
CHARITABLE REMAINDER TRUST DONOR Term Ends (Death of Donor) CHARITABLE REMAINDER TRUST Payments for Term Remainder of Assets in Trust CHARITY 12
CHARITABLE REMAINDER TRUST (CRT) Tax implications: delays impact of capital gains tax, permitting full use of highly appreciated asset(s) for investment creates a partial income tax deduction based upon IRS formula reduces estate or gift taxes because the remainder of the trust is distributed to the charity 13
UNITRUST (CRUT) A form of a charitable remainder trust in which the donor donates property or money in return for a fixed percentage of income, not less than 5% per statutory requirements, of the trust s net fair market value of its assets each year until the death of the beneficiaries or other specified term. 14
CRUT Key benefits: Delays impact of capital gains tax Permits full use of highly appreciated asset(s) for investment Increases potential net income to donor which may keep pace with inflation Creates immediate income tax deduction Reduces estate taxes through charitable gift 15
CRUT Other benefits: Allows control over investment choices May change investments without income tax on gains Trust can receive multiple gifts over time Provides long lasting value to charity of choice 16
Asset Fixed % Distribution of Trust Market Value for Certain Period or Life Distribution Recipients Transfer To CRUT -- Possible Higher Realized Income for Recipients CRUT Diversifies Portfolio & Produces Annual Distribution -- Income Tax At end of Distribution Period Deduction -- Full Use of Asset Charitable Organization Receives Remainder From CRUT -- Removes Asset from Estate -- Leaves Legacy to Charity 17
CHARITABLE REMAINDER ANNUITY TRUST (CRAT) A form of charitable remainder trust in which the donor donates property or money in return for a fixed percentage of the initial fair market value of its assets. Unlike the Unitrust, the payments to the beneficiaries are set at the inception value and do not change. 18
CRAT Key benefits: Delays impact of capital gains tax Permits full use of highly appreciated asset for investment Increases potential net income to donor Creates immediate income tax deduction Reduces estate taxes through charitable gift 19
CRAT Other benefits: Allows control over investment choices May change investments without income tax on gains Provides long lasting value to charity of choice Provides certain fixed income payment to lifetime beneficiaries 20
Asset Fixed Amount Distribution of Initial Trust Value for Certain Period or Life Distribution Recipients One-time Transfer To CRAT -- Possible Higher Realized Income for Recipients CRAT Diversifies Portfolio & Produces Annual Distribution At end of Distribution Period Charitable Organization Receives Remainder From CRAT -- Income Tax Deduction -- Full Use of Asset -- Removes Asset from Estate -- Leaves Legacy to Charity 21
NET INCOME UNITRUST (NIMCRUT) A form of charitable remainder trust in which the donor donates property or money and receives income for the lifetime of the beneficiaries. The income payment is either the specified percentage of the market value in that year or the net income earned by the trust in that year. It also may contain a make-up provision in which the donor can elect to receive less income than the agreed upon percentage of market value in return for receiving a higher percentage in a subsequent year. 22
NIMCRUT Key benefits: Permits income payment flexibility Creates an additional retirement income source with no limits on contributions, no early withdrawal penalties, and no minimum distribution requirements 23
NIMCRUT Other benefits: Delays impact of capital gains tax Permits full use of highly appreciated asset(s) for investment Increases potential net income to donor which may keep pace with inflation Creates immediate income tax deduction Reduces estate taxes through charitable gift 24
25 Asset STAGE 1 Income, if any, Up to Fixed % of Trust Market Value Distribution Recipients Transfer To Net Income Trust STAGE 2 Fixed % Distribution of Trust Value for Certain Period or Life STAGE 1 Net Income Trust Holds Asset & Produces Annual Income, if any After Triggering Event, Converts To CRUT STAGE 2 CRUT Diversifies Portfolio & Produces Annual Distribution -- Allows time to convert illiquid assets -- Permits flexible income planning for future needs After Distribution Period Charitable Organization Receives Remainder From CRUT
CHARITABLE LEAD TRUST (CLT) A CLT permits an estate owner to: Transfer assets to heirs and receive significant estate or gift tax deductions Reduce exposure to income tax by providing income to a charitable organization 26
CLT Donor: Makes a gift of property to irrevocable trust charitable organization is income recipient and receives either an annual fixed % of the net fair market value of trust assets or an annual fixed amount for a certain period of time or the life of the donor or another individual. Receives either a gift tax charitable deduction or estate tax deduction depending upon whether or not trust is created during lifetime of donor. 27
CLT Key benefits: Permits transfer of assets to heirs with significantly reduced estate or gift taxes Can reduce income taxes Flexible planning tool to zero out estate tax Can create delayed inheritance/retirement benefit for heirs 28
CLT Other benefits: Allows excess return on investment within trust to go to heirs tax free May make multiple gifts Provides long lasting value to charity 29
Asset Distribution for Certain Period or Life Charitable Organization -- Charity receives income immediately Transfer To CLT CLT May Diversify Portfolio & Produces Annual Distribution At end of Distribution Period Beneficiaries Receive Remainder From CLT -- Gift or Estate Tax Deduction -- Reduced gift or estate taxes on the transfer of the trust 30 assets
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ADVANTAGES OF A CRT By setting up a CRT, a donor can avoid currently paying tax on the disposition of appreciated assets Donor can invest the sale proceeds to generate a future income stream. The donor forms a CRT and contributes assets (such as appreciated stock) to it. The donor receives an income tax charitable deduction (as well as a gift or estate charitable deduction) when the CRT is created. The amount of the deduction is measured by the actuarial present value of the charity s right to receive the corpus on termination of the noncharitable (remainder) interest. The CRT sells the stock but does not pay tax on the gain, because the CRT is generally a tax-exempt entity under IRC 664(c). 32
ADVANTAGES OF CRT CONT The CRT then invests the proceeds of the stock sale and pays the donor an income stream for a fixed term of years (or over the course of a life or lives), based either on the value of the assets at the time the trust is created (annuity trust) or a fixed percentage of asset value each year going forward (unitrust). Any gain is taxable to the income beneficiary only when it is distributed. On completion of the term, the CRT distributes the remaining assets to a charity, which can include a private foundation established by the donor. If the donor retains an interest in the trust for life, the assets remaining in the CRT at death are deductible for estate tax purposes. Another type of charitable trust is the charitable lead trust (CLT), which pays an income stream to the charity on the front end, with a remainder interest payable to noncharitable beneficiaries. CLTs are generally used to minimize gift and estate tax. 33
CRT REQUIREMENTS A CRT must make a minimum annual distribution of at least 5% of the fair market value (FMV) of the trust assets for either the lifetime of an individual or individuals or a term not to exceed 20 years. No distributions are permitted to any other individual, but a qualifying charity may in certain circumstances also receive income. Another individual or individuals can receive an interest for a term of years or for life following the first interest. However, state law may require that federal estate or state death taxes due upon the first beneficiary s death be equitably apportioned among the interests in the estate. In such cases, in the absence of clear direction to the contrary in a decedent s will, the secondary beneficiary will lose the life estate unless the secondary beneficiary pays any estate or death taxes for which the trustee may be liable on the first beneficiary s death (Revenue Ruling 82-128, 1982-2 CB 71). After the term of years or on the death of the measuring individual, the remainder interest (the present value of which must be at least 10% of the initial FMV of assets on funding) must pass to a qualifying charity. The trust must operate according to these rules from its inception. 34
TRUSTS AS A FINANCIAL TOOL As you can see, charitable trusts are useful to: Increase income from low yielding assets Transfer assets to heirs on a tax effective basis Reduce exposure to income tax or create a deduction by providing a gift to a charitable organization There are many variations to meet the needs of your clients. You should ensure your clients use a reputable estate planning attorney. 35
THANK YOU Dawn D. Hallman Hallman & Associates, P.C. 2230 McKown Drive Norman, Oklahoma 73072 www.hallmanlawoffice.com dhallman@hallmanlawoffice.com (405) 447-9455
Rosemarie Steeb, Chiampou Travis Besaw & Kershner TAX CONSEQUENCES AND RECENT DEVELOPMENTS
Topics Covered Income and transfer tax considerations: Charitable remainder trust (CRT) Charitable lead trust (CLT) Form 5227 presentation Compliance reminders Applicable Private foundation excise taxes Public inspection rules Unrelated business income (UBI) Hedge funds Debt financed income Advantages & planning 3.8% Medicare tax issues 38
Charitable Remainder Trust (CRT) Donor (Income Beneficiary) Donor receives an immediate income tax deduction for present value of the remainder interest (must be at least 10% of the value of the assets originally contributed) Transfer of highlyappreciated assets Annual (or more frequent) payments for life (or a term of years) CRT Public Charity (Remainder Beneficiary) At the donor s death (or at the end of the trust term), the charity receives the residual assets held in the trust 39
Income Tax Consequences - CRT Formation: A donor receives no charitable income tax deduction for a gift of a remainder interest to charity unless the trust is a CRT described in Section 664. Intervivos CRT - The grantor is entitled to an immediate income tax deduction in the amount of the present value of the remainder interest passing to charity. Testamentary CRT - The estate of the decedent whose will created a CRT is entitled to an estate tax deduction for the present value of the remainder interest passing to charity. 40
Charitable Contribution Deduction - CRT CRAT - At the time a CRAT is formed, the donor may deduct the fair market value of the property placed in trust less the present value of the annuity as a charitable contribution on his or her individual tax return and for estate and gift taxes Additional contributions cannot be made to a CRAT because the annuity amount is based on the value of the assets only valued as of creation. The governing instrument of the CRAT must prohibit additional contributions. CRUT - the deduction is the present value of the remainder interest Additional contributions can be made to a CRUT as long as the governing instrument provides a formula upon which to base the unitrust amount, which takes into account the additional contribution. 41
Charitable Contribution Deduction The value of the donor's federal income tax deduction is a function of: 1. The type of charitable remainderman; 2. The kind of property contributed to the CRT; and 3. Whether, at the end of the non-charitable term, the assets are: a) Distributed outright to the charitable remainderman; or b) Held in trust for the benefit of the charitable remainderman 42
Type Of Charitable Remainderman A public charity including churches, educational institutions, hospitals and medical institutions University endowment funds, governmental units, publicly supported organizations under Sections 170(c)(2) & 509(a)(2) (i.e., museums, drama companies, ballet companies, etc.) Supporting organizations under Section 509(a)(3) Private operating foundations Two types of non-operating private foundations: Distributing foundations Foundations that maintain a common fund 43
Impact Of Kind Of Property Contributed - CRT The donor gets a federal income tax deduction for the fair market value of the remainder interest passing to charity subject to the following percentage limitations. Gift of cash and non-appreciated property Passes outright to public charity at end of non-charitable term In the year of the gift, the donor's fair market value charitable income tax deduction is limited to 50% of his/her adjusted gross income (AGI) with a five-year carryforward. Held in trust for the benefit of public charity at end of noncharitable term In the year of the gift, the donor's fair market value charitable income tax deduction is limited to 30% of his/her AGI with a five-year carryforward. 44
Impact Of Kind Of Property Contributed CRT (Cont.) Gift of appreciated property Passes outright to public charity at end of non-charitable term In the year of the gift, the donor's fair market value charitable income tax deduction is limited to 30% of his/her AGI with a five-year carryforward. Held in trust for the benefit of public charity at end of non-charitable term In the year of the gift, the donor's fair market value charitable income tax deduction is limited to 20% of his/her AGI with a five-year carryforward 45
Income Tax Consequences - CRT Annually annuity recipient The distributions to the recipient of the annuity amount or unitrust amount are includable in the recipient's gross income reportable on Schedule K-1 Tiered structure - the highest-taxed items are deemed to be distributed first in the following order: Ordinary income to the extent of the CRT's ordinary income for that year and undistributed ordinary income from prior years Capital gains to the extent of the CRT's capital gains for that year and undistributed capital gains from prior years (short term gains first) Current and undistributed tax exempt income Corpus non-taxable 46
Income Tax Consequences CRT (Cont.) Annually annuity recipient (Cont): Net income make-up charitable remainder unitrust (NIMCRUT) The unitrust payment from a NIMCRUT is based on a fixed percentage of the value of the trust assets at the beginning of the year, but is limited to the trust's annual income. If the trust income is less than the payment based on the fair market value of trust assets, the trust may increase payments to the beneficiary in subsequent years to compensate for a prior deficiency. Tiered distribution rules still apply 47
Income Tax Consequences CRT (Cont.) Annually annuity recipient (Cont): CRAT and the fixed-percentage CRUT: The trustee may be forced to make a distribution in kind if the income is insufficient to satisfy the annuity amount of the CRAT or the unitrust amount of the fixed percentage CRUT A distribution in kind is deemed to be a sale of the property so distributed causing the recipient to recognize capital gain on the property in kind distributed. For example, if a donor funds a fixed percentage CRUT with closely held C stock and then the stock cannot be sold after such funding, the trustee will be obligated to distribute enough stock to the donor to meet the annual fixed percentage and the CRUT will realize the capital gain on that stock even though it was not sold; that capital gain will be passed through to the recipient under the income tax characterization rules above causing the recipient to recognize gain. 48
Income Tax Consequences CRT (Cont.) Annually annuity recipient (Cont): CRAT and the fixed-percentage CRUT: If NIMCRUT, the trustee will not be forced to make a distribution in kind. Rather, the trustee can satisfy the unitrust amount based on the income earned by the CRUT. Obviously, if a non-income earning asset, such as real estate, is used to fund a CRT, it is best to choose a CRUT with the lesser of income feature. 49
Income Tax Consequences CRT (Cont.) Annually trust: A CRT is a tax exempt entity; therefore, the CRT pays no income tax on its income unless it has unrelated business taxable income (UBTI). A CRT is not taxed on any retained gain it realizes upon selling appreciated property, whether donated by the grantor or appreciation occurring after the donation. 50
Transfer Tax Consequences - CRT The retention of a right to revoke by the donor results in the CRT assets being includable in the donor's estate at his/her death The gift tax consequences is based on the recipient of the annuity amount or unitrust amount: Just the donor: The donor gets a charitable gift tax deduction for the value of the remainder interest passing to charity. The donor and spouse only: The donor has made a gift to his/her spouse of the value of the annuity amount or unitrust amount going to his/her spouse but such gift is shielded by the marital deduction. The donor also gets a charitable gift tax deduction for the value of the remainder interest passing to charity 51
Transfer Tax Consequences CRT (Cont.) The gift tax consequences is based on the recipient of the annuity amount or unitrust amount (Cont): Spouse and others (e.g. the donor, then spouse and then children) - The donor has made a gift to his/her spouse that does not qualify for the marital deduction. Further, the donor has made a gift to his/her children. However, the donor can retain the right to revoke by will his/her spouse and children's rights to the annuity amount or unitrust amount without disqualifying the trust as a CRT and if so, the gifts are incomplete. Someone other than the donor's spouse: The donor has made a gift to that person in the amount of the present value of the annuity amount or unitrust amount unless the donor retains the right to revoke by will that person's right to the annuity amount or unitrust amount. 52
Donor (Income Beneficiary) Charitable Lead Trust (CLT) Transfer of cash, stock and/or other assets At the donor s death (or at the end of the trust term), the remainder beneficiaries receive the residual assets held in the trust CLT Donor s Children 53 (Remainder Beneficiary) Annual (or more frequent) payments for life (or a term of years) Public Charity (Income Beneficiary) 53
Types Of CLTs Grantor or non-grantor trust depending on whether the grantor retains the power to control beneficial enjoyment, the power to revoke the trust, or any of the attributes described in IRC sections 672 677. A retained reversionary interest triggers grantor trust treatment if the reversion is valued at more than 5% of the trust property's fair market value at the time the trust is formed 54
Income And Transfer Tax Consequences - CLT Income tax: Formation Annually Transfer tax: Inter Vivos - Gift tax Testamentary - Estate Grantor Grantor can deduct the present value of the income interest, subject to charitable contribution limits Grantor will include trust income on individual income tax return, but no deduction for charitable contributions made by the trust Grantor deducts the present value of the income interest at the time of formation. No deduction is allowed as the payments are made to the charity by the trust. Not applicable No deduction Nongrantor Trust recognizes income offset by the annuity or unitrust payment each year, but cannot deduct any excess contribution Grantor deducts the present value of the income interest at the time of formation. No deduction is allowed as the payments are made to the charity by the trust. Estate deducts the present value of the income interest at the time of formation. The trust cannot deduct charitable contributions as they are made. 55
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Form 5227 Compliance Reminders Due date April 15 extended with Form 8868 (not 7004) for up to six months three months at a time (i.e. until July 15 and then October 15) All filed with IRS Center in Ogden, UT Copy of trust instrument must be attached to initial return Balance sheet (Part IV) all trusts must complete columns a and b based on the accounting method the trust uses in keeping its books and records Column c only applies to CRUTs and should be completed as of the valuation date valuation date and method must be used each year Short tax years the annuity or unitrust amount for short tax year is computed by multiplying the full year annuity or unitrust amount by the number of days in the trust s tax year divided by 365 or 366 for leap years 57
Applicable Private Foundation Excise Taxes Since some but not all of the unexpired interest are charitable the following private foundation excise taxes also apply to CRTs and CLTs: Self-dealing (Section 4941) Excess business holdings (Section 4943) Investments that jeopardize charitable purposes (Section 4944) Taxable expenditures (Section 4945) and political expenditures (Section 4955) 58
Self-Dealing The trust must not be involved in self-dealing. This includes any of the following direct or indirect transactions between the trusts and a disqualified person: Sale, exchange, or leasing of property; Lending of money or extension of credit; Furnishing of goods, services, or facilities, unless such goods, services, or facilities are made available to the general public on at least as favorable a basis as they are made to the disqualified person, Payment of compensation (or payment or reimbursement of expenses), unless it is for personal services and such compensation is reasonable and necessary to carry out the exempt purpose and is not excessive; Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the trust 59
Disqualified Person A disqualified person is: A substantial contributor to the trust, A family member of a substantial contributor (i.e. spouse, descendants, and spouses of descendants), or Persons owning more than 20% of an entity that is a substantial contributor to the trust A substantial contributor is an individual, trust, estate, corporation, or partnership who contributes an aggregate amount in excess of $5,000 to the trust, if his or her total contributions are more than 2% of the total contributions received 60
Example Of Potential Self-Dealing Reimbursement to disqualified persons for travel expenses Could cause the trust and the disqualified person' to be potentially liable for penalty taxes for self-dealing, for making non-charitable expenditures, or possibly both. Such reimbursement of expenses will not be subject to the excise tax if the expenses are reasonable and necessary to carrying out the exempt purposes of the trust and are not excessive. The Code does not explain what is "reasonable and necessary follow guidance under business expense deductions rules include travel fares, meals, lodging, and expenses incident to travel. Travel expenses are not reasonable and necessary if the trip is primarily personal in nature. An amount spent on director's services will not be deemed "excessive" if it is only such as would be paid "for like services by like enterprises under like circumstances. 61
Example Of Potential Self-Dealing (Cont.) Attendance by grantor/trustee at fundraising event for one of trust s charitable beneficiaries where donor benefits are received. The grantor/trustee who participated in the event should reimburse the trust for the value assigned to the benefits received so as to minimize appearance of self dealing. If the trustee reimbursement comes after year end then reflect as an accounts receivable on the balance sheet 62
Consequences To Self-Dealing Any disqualified person who engages in an act of self-dealing is assessed an excise tax of 5% of that amount involved in the transaction for each year that the transaction is uncorrected. A trustee who knows that the act is prohibited but approves it may also be subject to a tax of 2.5% of the amount involved (up to $10,000 for each such act) for each year that the transaction is uncorrected. If the transaction is not timely corrected and the 5% was initially assessed, the disqualified person is subject to being assessed an additional tax of 200% of the amount involved. Any trustee who does not correct the transaction may also be subject to an additional assessment of 50% of the amount involved (up to $10,000 for each such act.) 63
Excess Business Holdings Section 4943 Section 4943 imposes an excise tax on the value of the "excess business holdings" of the trust. A trust created after May 26, 1969 has excess business holdings to the extent that it, together with all disqualified persons, owns in the aggregate more than 20% of the voting stock of an incorporated business enterprise (or corresponding interests in non-incorporated business enterprises). In general, where a trust acquires excess business holdings by gift or bequest, the trust has five years from the date it acquires such holdings to dispose of them 64
Jeopardizing Investments Section 4944 Section 4944 imposes an excise tax on a trust (and under some circumstances trustees) for investing any amount in such a manner as to jeopardize the carrying out of its exempt purposes. The imposition of an excise tax on "jeopardy" investments is intended to assure that the trustees adopt a "prudent person" approach toward the investment of trust assets. 65
Exceptions To Sections 4943 And 4944 The excess business holdings provisions of Section 4943 and the "jeopardy investment" provisions of Section 4944 do not apply to a split-interest trust if either: All of the income interests (and none of the remainder interests) of the trust are devoted solely to charitable purposes and all amounts in trust for which a charitable deduction was allowed have an aggregate value of not more than 60% of the aggregate fair market value of all amounts in trust; or A charitable deduction was allowed for amounts payable under the terms of the trust to every remainder beneficiary, but not to any income beneficiary, as is the case with the majority of charitable remainder trusts. 66
Public Inspection Requirements Form 5227 be open to public inspection, except for information related to non-charitable trust beneficiaries, which is disclosed on Schedule A that is not open to public inspection. To inspect a return, the petitioner must submit a written request to the IRS that must include the name of the trust, the trustee s address, the type of return and the year for which the return was filed. 67
Unrelated Business Income (UBI) Prior To 2006 The CRTs tax exempt status would be suspended for any year that the CRT generated UBTI forcing the trust to pay tax on the entire amount of income for that year. The CRT would be taxed as a complex trust with an allowable deduction for amounts required to be distributed to the beneficiary. Any remaining income would be subject to income tax at the appropriate trust tax rates. 68
UBI After 2006 The Tax Relief and Health Care Act of 2006 (the 2006 Act ) changed the income tax rules on CRTs for any year in which the CRT incurs UBTI. No longer is the entire trust income subject to tax. Rather, an excise tax is imposes equal to 100% of the amount of the UBTI incurred by the CRT. The UBTI is considered income of the trust for purposes of determining the character of the distributions made to CRT beneficiaries, without a reduction of such income for the excise taxes paid by the CRT. Example: CRT with $4.5M of stocks & bonds and $500K in hedge funds. The investment return after deduction for the amounts paid to the beneficiary is a total of $240,000 of which $5,000 is UBTI. he CRT owes an excise tax of $5,000. Prior to 2006, the CRT tax obligation could have been as high as $84K. 69
Are Hedge Funds Appropriate For CRTs? A prudent fiduciary of a CRT should consider the following factors before adding hedge funds to the trust s investment portfolio: How much UBTI is present? Percentage of hedge fund return generated in the form of ordinary income an investment mix that promises to distribute a heavy annual dose of ordinary income or short term capital gain become less attractive than one which promises a lower tax cost to the non-charitable recipient Other investment considerations: Liquidity needs Risk of downside volatility Tolerance for fees and expenses Offshore fund reporting requirements 70
UBI Debt-Financed Income Unrelated business taxable income includes income from debt-financed property. A trust has debt-financed income it acquires realty subject to a mortgage. The trust will not have unrelated business taxable income if for a period of 10 years following the gift: The trust does not assume the debt or Meets all the following requirements: 1. The debt was placed on the property more than five years before the date of the gift; 2. The property was held by the donor for more than five years before making the gift; and 3. The CRT does not assume the debt. See PLR 9533014 PLR 9015049. 71
Advantages Of A CRT Non-recognition of capital gains A donor can contribute highly appreciated property to a CRT and benefit from the appreciated value of the asset because the donor's unitrust amount from a CRUT will be greater due to such assets high value not reduced by income tax on the appreciation. The donor benefits from the appreciation and at the same time the donor avoids immediate payment of the tax from the appreciation. The key is to make sure that as of the date of the funding (not just creation) of the CRT that there is no legal obligation to sell such asset. If, when the trust receives the asset, the trustee is subject to an obligation to sell, the IRS will ignore the gift to the CRT and treat the transaction as if the donor sold the asset. The donor then gets the worst of both worldspayment of tax and loss of the asset. 72
Advantages Of A CRT (Cont.) Growth of assets in a tax-exempt entity: Since a CRT is a tax-exempt entity, the value of the assets in the CRT can grow at a faster rate because gain realized on the sale of assets of the CRT is not recognized for income tax purposes in the CRT. The recipient of the unitrust amount from a CRUT gets the benefit from such growth since the fixed percentage is applied to a larger capital base. If family members are concerned that their inheritance will be reduced, the donor may use the tax savings created by the charitable contribution deduction to buy life insurance. This plan reduces the client's taxable estate and provides a liquid inheritance for heirs. 73
Advantages Of A CLT CLTs are attractive for clients with ample income seeking to transfer assets at minimal estate and gift taxes. By prolonging the payment period to the charitable beneficiary, the present value of the remainder interest is decreased and the value of the gift is reduced. In deciding whether to use a CLAT or CLUT, consider the donor's goals. If the donor seeks to maximize the payment that the non-charitable beneficiary will receive at the trust termination, a CLAT is preferable if the trust assets are expected to significantly appreciate in value. A CLAT also favors the remainderman if the amount paid to the charitable beneficiary is less than the trust's annual income, since the excess accumulates for the benefit of the non-charitable beneficiary. 74
Advantages Of A CLT (Cont.) A CLAT provides a fixed distribution, or annuity, to one or more charities in each year of the trust. Distributions can be the same each year or can increase annually at a rate established when the trust is put in place. Starting with a small annual payment but increasing the amount over the course of the trust may result in assets of greater value passing to the noncharitable beneficiary. For instance, a $1 million CLAT providing steady payments of $108,000 to charity for 10 years would result in $369,000 passing to the non-charitable beneficiary if it earned 6% per year. If, however, that $1 million CLAT started with an initial payment of $33,000, increasing by 25% each year for 10 years, $476,000 would pass to the non-charitable beneficiary. In both cases, the taxable value of the gift to the non-charitable beneficiary would be zero. 75
Advantages Of The Unitrust Appreciation in the value of trust assets causes unitrust payments to increase, maximizing the payment to the charity in a CLUT or to the non-charitable beneficiary in a CRUT. Alternatively, if trust assets in a unitrust decline in value, the noncharitable life tenant will receive a reduced annuity payment. The IRS has allowed early termination of CRUTs when the donor is dissatisfied with the annual return or needs access to the corpus. To avoid repayment of the tax benefits from the initial charitable contribution, the charity must receive the present value of its proportionate interest. Distributions made to the non-charitable beneficiary are taxed as long-term capital gains. NOTE: The annual valuation requirements for unitrusts increase administrative costs over annuities. 76
Recent Increase In Use Of CLTs The IRS discount rate is used to determine the assumed rate of return for assets contributed to a CLAT and affects the calculation of the lead payments (that is, how much must be paid to charities in order to zero out or eliminate the taxable gift component). When the discount rate is low, the annual payout to charity can be reduced. A trust funded with $1 million when the discount rate is 6% would need to pay the charitable recipient almost $136,000 per year for 10 years in order to have that stream of payments have a present value of $1 million. If, however, the discount rate is 1.4% (as it was in March 2012), the charitable recipient would need to be paid only $108,000 per year for the same result. That means that in today s environment, if this trust had an annualized return in excess of only 1.4%, it would not only be able to satisfy the annuity payment to charity but also would have funds remaining at the end of 10 years for the non-charitable beneficiaries. 77
Recent Increase In Use Of CLTs (Cont.) Low initial asset values might grow at a higher than expected rate, delivering more to your beneficiaries without increasing potential tax liability There is an expectation that the values of assets used to fund a CLT may be only temporarily depressed and that over an extended investment cycle, values will normalize and perhaps appreciate. 78
Preferable Assets To Fund CRT Low basis, highly appreciated, marketable securities - The sale proceeds can then be invested to produce payments to the recipient who benefits from the appreciation of his/her securities via the annuity amount or unitrust amount, but has no taxable recognition of the gain from the sale of the securities while the proceeds or those in that they are invested are held by the CRT. Investment by the CRT in tax free securities may not be wise if the CRT has accumulated undistributed ordinary or capital gains since the recipient still has to recognize the income therefrom under the tier approach applicable to distributions to recipients. It is not a good idea to transfer a donor's personal residence to a CRT, whether unencumbered or encumbered, because the donor cannot live in the residence without committing a prohibited act of self-dealing. Also using encumbered real estate caused unrelated business taxable income A CRT is not a qualified subchapter S shareholder, and therefore, a donor cannot use subchapter S stock to fund a CRT. 79
3.8% Medicare Tax Issues Use a CRT to harbor net investment income in a tax-exempt environment while at the same time leveling income over a longer period of time to keep modified adjusted gross income for the beneficiary below the threshold amount. Use a non-grantor CLT to offset net investment income against charitable deductions dollar-for-dollar in a tax-efficient manner. While a CRT itself is not subject to the 3.8% Medicare surtax on net investment income, distributions from the CRT to non-charitable beneficiaries will be potentially subject to the tax as the income is distributed. To avoid "unfairly" causing Medicare taxes to beneficiaries that receive income in 2013 or beyond that was actually created prior to the Medicare tax (and just not yet distributed), the new rules stipulate that only income in the trust that was created in 2013 or later will be treated as net investment income. 80
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Donna J. Jackson, CPA, JD, LLM FINANCIAL ACCOUNTING REQUIREMENTS
FINANCIAL ACCOUNTING REQUIREMENTS Donna Jackson, CPA, JD, LLM 10400 Vineyard Blvd, Suite C Oklahoma City, OK 73120 (405) 840-1874
Financial Accounting Requirements 84 A charitable remainder trust should not pay the estate tax or gift tax of the donor. The creation of an income interest for a person other than the donor creates a gift equal to the value of the property transferred less the APVRI. If the donor s spouse is the only person other than the donor to receive an income interest, then the gift tax marital deduction (IRC 2523(g)) eliminates most gift tax concerns.
Define Principal And Income 85 The definition of trust accounting income is a function of the language of the trust s governing instrument and the principal and income statute of the applicable state. Where one or more provisions of the trust s governing instrument are in conflict with the principal and income statute, the trust s governing instrument takes precedence.
Trust Provisions 86 A number of desirable optional provisions exist that can increase the utility and flexibility of a CRT. For example, the donor may: Retain the power to change the charitable remainder beneficiary. Provide the trustee with the ability to accelerate the distribution of principal to the charity Spendthrift clause designed to restrict the income beneficiary s ability to alienate his or her interest Give the income beneficiary the flexibility to make a charitable gift of his or her income interest
Proper Payments 87 Several potential traps exist regarding the proper amount to pay the income beneficiary. A CRT must use the calendar year as its tax year. As a result, it will have a short tax year in the first and last year of the trust. For any short year, prorate the annuity or unitrust payment. The proration is done on a daily basis. Considerations for Leap-Year
Payment Traps 88 Assuming that the current year s unitrust payment will be the same as the prior year s unitrust payment Paying the income beneficiary of a NIMCRUT or a Flip-CRUT (pre-flip) the full fixed percentage amount without regard to the trust s accounting income.
Valuation Issues 89 Unmarketable assets provide the greatest challenge. A CRT trustee will need to know the value of the trust s assets. For example: Valuing the initial contribution to the trust; Determining the annual valuation of the trust s assets and liabilities required to compute the unitrust amount; Valuing additional contributions for the incremental change in the unitrust amount; and Computing how much of an asset to transfer to make an in-kind distribution
Treas. Reg. 1.664-1(a)(7) 90 Two alternative methods for securing the value of a CRT s unmarketable assets. First, the valuation can be performed exclusively by an independent trustee. Second, the value can be determined by a current qualified appraisal.
Compliance 91 Ensure continued qualification of CRT Be familiar with the laws and regulations governing CRTs Be familiar with terms of the trust Monitor the activity of the trust for compliance
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Areas Of Concern 93 Trustee powers Principal and income allocations Prohibited investments Self-dealing transactions Transactions that could produce UBTI
Annual Reporting 94 In some states, the trustee is required to make a periodic statement or accounting to the income beneficiaries, remainder beneficiaries, and/or a court. Charities that prepare financial statements in accordance with GAAP are required to include certain information about charitable remainder trusts. The type of information to be included depends on whether the charity serves as trustee (or not) and whether the charity s interest is revocable or irrevocable.
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Recording Balance Sheet 97 Limitations Assets recorded at historical cost (does not show true value of asset) Use of cost estimates (not true financial position) Omission of valuable non-monetary assets
Reporting 98 Financial statements Tax return presentation More requirements than fiduciary accounting to court
Reporting 99 A fiduciary accounting shall contain sufficient information to put the interested parties on notice as to all significant transactions affecting administration during the accounting period.
Financial Accounting Requirements 100 The presentation of the information in an account shall allow an interested party to follow the progress of the fiduciary s administration of assets during the accounting period without reference to an inventory or earlier accounting that is not included in the current account. An account is not complete if it does not itemize assets on hand at the beginning of the accounting period.
Reporting 101 The first account for a decedent s estate or a trust should detail the items received by the fiduciary and for which he is responsible. It should not simply refer to the total amount of an inventory filed elsewhere or assets described in a schedule attached to a deed of trust. In later accounts for an estate or trust, the opening balance should not simply refer to the total value of principal on hand as shown in detail in the prior account, but should list each item separately.
Reporting (Cont.) 102 Instead of retyping the complete list of assets in the opening balance, the accountant may prefer to attach as an exhibit a copy of the inventory, closing balance from last account, etc. Transactions shall be described in sufficient detail to give interested parties notice of their purpose and effect. Too much detail may be counterproductive to making the account understandable. In accounts covering long periods or dealing with extensive assets, consolidate information. Ie: securities being accounted for over a long period of time, a statement of the total dividends received on each security with appropriate indication of changes in the number of shares held will be more readily understandable and easier to check for completeness than a chronological listing of all dividends received. Although detail should generally be avoided for routine transactions, it will often be necessary to a proper understanding of an event that is somewhat out of the ordinary.
Reporting (Cont.) 103 Separately show and explain the following: Extraordinary appraisal costs Interest and penalties in connection with later filing of tax returns An extraordinary allocation between principal and income Computation of a formula marital deduction gift involving non-probate assets
Carrying Values 104 Carrying values based on date of death may be adjusted to reflect changes on audit of estate or inheritance tax returns. Where appropriate under applicable local law, a successor fiduciary may adjust the carrying value of assets to reflect values at the start of his administration. Assets received in kind in satisfaction of a pecuniary legacy should be carried at the value used for purposes of distribution. Though essential for accounting purposes, carrying values are commonly misunderstood by laymen as being a representation of actual values. To avoid this, the account should include both current values and carrying values.
Other Accounting 105 Considerations Gains and losses incurred during the accounting period shall be shown separately in the same schedule The account shall show significant transactions that do not affect the amount for which the fiduciary is accountable.
THANK YOU 106 Donna Jackson, CPA, JD, LLM 10400 Vineyard Blvd, Suite C Oklahoma City, OK 73120 (405) 840-1874
Panel Discussion AVOIDING COMMON MISTAKES
Avoiding Common Mistakes 108 No/limited experience Failure to maintain proper documentation Lack of expertise of trustee Choosing trustee Trust terms are incomplete Non-liquid assets in trust (5% annual requirement cannot be met)