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"The type of device
used depends upon the objectives of the individual client"
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One of Stephen R. Covey's Seven
Habits of Highly Effective People1 is
the adage to "begin with the end in mind." No where
should advisors consider this adage more than in the area of
planned giving.
For many years advisors have recommended and utilized a number
of variations of Charitable Remainder Trusts (CRTs) in part to
alleviate the burdens of the capital gains tax.2
Much of the marketing and consulting regarding CRT planning ignores
(or glosses over) the ongoing administration and essential income
tax impact of the four-tier accounting system that is essential
to CRT planning. Also often overlooked is an alternative to CRTs:
a Charitable Gift Annuity (CGA).3 Both
of these devices often involve a charitable income tax deduction
and a continuing income stream to the donors. Due to the ease
of administration and continuing income tax effects of the continuing
payments, the CGA may, in some cases, be simpler and have superior
income tax consequences.
One must keep in mind that the charitable income tax deduction
for these types of gifts is roughly the same. However, the need
for administration and the manner of the taxation of the stream
of payments to the donors is radically different and, with regard
to CRTs, depend upon the investments inside of the CRT. If counsel
fails to consider both of these issues, the particular charitable
gift device chosen may not work as anticipated, and in fact may
result in worse income tax results than if nothing at all were
done.
CRT PLANNING
Much has already been written on the types of CRTs and on
how to calculate the income tax deduction for the charitable
contribution. Accordingly, this article focuses on other important
issues of charitable remainder trust planning that have not gotten
much attention.
Continuing Income Tax Consequences. Section 664(b) of
the Internal Revenue Code creates a special four-tiered accounting
system to characterize the income tax consequences of payments
out of a CRT to the beneficiaries:
1. All amounts distributed to the recipients are characterized
and taxed as ordinary income to the extent that the trust has
ordinary income for the year and undistributed ordinary income
for past years.
2. If the payment amount exceeds the total amount of ordinary
income for the current year and undistributed ordinary income
for past years, capital gain income is distributed to the extent
of the trust capital gain income for the current year and undistributed
capital gain income from prior years.
3. If the payment amount exceeds the total amount of current
and accumulated ordinary income and capital gain income for the
year of distribution, then other income (generally, tax-exempt
income) is distributed to the extent of the trust's other income
for the year and such income that is undistributed for prior
years.
4. If any portion of the payout amount in a given year exceeds
the sum of current and accumulated income and gains, the balance
is treated as a return of principal.4
Although complex, the four-tiered system has a straightforward
purpose: it forces the taxpayer recipient to pay the highest
possible income tax on their distributions. Each year the
trustee must completely distribute all of the historical value
of income in one category before distributing the next category.
The practical impact of these rules is illustrated by the following
example:
EXAMPLE
George Generous creates a Charitable Remainder Annuity Trust
(CRAT) paying him $5,000 annually.
For 1998, assume the CRAT has income that consists of $2,000
in dividends, long-term capital gain of $1,000 on the sale of
stock, and $1,000 in interest from tax-free municipal bonds.
The distribution to George is characterized as $2,000 ordinary
income, $1,000 long-term capital gain, $1,000 tax-free income,
and $1,000 return of principal.
For 1999, the CRAT has $6,000 in dividends, $1,000 in long-term
capital gain on another sale of stock, and $500 in tax-exempt
interest income. George's $5,000 distribution is characterized
as entirely ordinary income. One thousand dollars of the dividend
income, the capital gain ($1,000), and the tax-exempt income
($500) remain after the distribution.
For 2000, the CRAT has $2,000 in dividends and $500 in tax-free
interest. The distribution is treated as $3,000 ordinary income
(i.e., $2,000 ordinary income this year and $1,000 ordinary
income left over from 1999), $1,000 long-term capital gains (left
over from 1999), and $1,000 tax-free interest ($500 from 1999
and $500 from 2000).
Investment Planning. As you can see, the investments
inside of a CRT can have profound income tax effects on the individual
recipient of the CRT payments. For example, if a highly appreciated
stock is contributed to a CRT, after which the stock is sold
and the proceeds invested in ordinary income-producing assets,
the distribution to the taxpayer donor could be ordinary income
instead of long-term capital gain that he would have recognized
on the sale of the asset outside of the CRT. It is essential
to do CRT planning with the continuing income tax consequences
of the CRT in mind and to obtain the assistance of a qualified
financial planner familiar with CRTs.
Ongoing Administration. Administration of a CRT includes
making investment decisions, filing annual tax returns, and planning
and making distributions. There is a continuing need for a trustee
who annually administers the trust assets.
CGA COMPONENTS
Continuing Income Tax Consequences. As with the CRT,
the tax results of the CGA transaction do not end with the contribution
to charity, the resulting charitable contribution, and usually
an income tax deduction. The tax consequences continue for the
life of the annuitant. The continuing tax results vary depending
on the nature of the asset contributed.
Contribution of Cash. When cash is contributed to purchase
the annuity, the taxation of the stream of payments follows the
general rules for taxation of annuities. Since a part of the
donor annuitant's cash contribution represents his/her investment
in an annuity, a portion of each annual annuity payment is a
tax-free return of capital. This amount is called the "exclusion
ratio."5 The balance of each payment
represents ordinary income. The CGA permits a donor annuitant
to recover a portion of each annuity payment as a tax-free return
of capital until such principal is all returned. Consequently,
the income tax results of the CGA are simpler than those of the
CRT and perhaps preferable. The CRT utilizes the four-tiered
accounting system where the "return of principal" is
the last type of distribution to come out of the CRT. In a CGA,
tax-free "return of principal" begins with the first
annuity payment.
Contribution of Appreciated Property. When appreciated
property rather than cash is contributed to the CGA, these transactions
are treated as "bargain sales" for income tax purposes
and result in a taxable capital gain in addition to ordinary
income. A portion of the otherwise tax-free return of principal
is treated as capital gain. The tax results are affected by the
allocation of the donor's basis in the property between the gift
element and the sale element of the transaction. The gain equals
the amount by which the sale element (the present value of the
annuity) exceeds the portion of the basis that is allocated to
the sale element.6
The timing of the recognition of the gain for tax purposes depends
upon the terms of the annuity contract. The gain is recognized
ratably over the period of years the annuity payments are received
if the annuity contracts meet the following two requirements:
1) the annuity is nonassignable (or assignable only to the charity);
and 2) the donor (or the donor and a designated survivor) is
the only annuitant(s).7 Under other circumstances,
the gain must be recognized in the year that the annuity contract
is entered.
Administration. A CGA is one of the easiest forms of
planned giving. Once the annuity agreement is completed and the
gift made, the manner in which the charity invests its assets
to carry out its obligations is exclusively the charity's business.
The donor looks to the charity's stability and reputation for
security for the payment. If the gift proceeds are exhausted
before the annuity payment obligations, the charity must reach
other resources to continue the annuity payments. If the charity
failed to make the agreed-upon payment, the donor would be a
primary creditor of the charity. On the other hand, if the earnings
from the charity's investments of the gifted property exceed
the annuity payment requirements, the difference is available
immediately to the charity.
CONCLUSION
The type of device used depends upon the objectives of the
individual client. Gift planning advisors should design planned
giving techniques for clients with the "end in mind."
Based on the specific continuing income tax results, one type
of planned giving device may be simpler and more tax efficient
than another. The continuing income tax results of a particular
type of planned giving device may create unexpected and adverse
income tax consequences for a device that initially appears appropriate
and suitable for a particular client. |
DAVID W. WICK is in private practice
with the law firm of Sjoberg & Tebelius PA in Woodbury. A
1982 graduate of the University of Iowa College of Law, he focuses
his practice in estate planning for families and small business. |
