Recently, when addressing a group of non-profit executives charged with encouraging and structuring large gifts to their institutions, I asked them, “How many of you work for an organization whose donors wish you didn’t exist, much less that you be perpetual?”
Many among the group reacted with puzzled, or even shocked, expressions on their faces. Very few raised their hands. I then asked them if they saw a difference between an organization, such as a museum, whose mission’s very essence is to be perpetual, versus an organization dedicated to curing a disease, addressing urgent environmental issues or other pressing needs. At that point, I repeated the question, and many of those in attendance raised their hands.
What then followed was a discussion of various gift planning vehicles and how some were more appropriate for planning gifts to help fund urgent program needs, such as curing diseases, as opposed to those that were more appropriate for meeting centuries-long needs, such as historic preservation of art and other treasures.
While it’s important that charities and their staff understand how to match various tools, such as charitable remainder trusts (CRTs), charitable lead trusts (CLTs), charitable gift annuities and other gift plans with the needs of their donors, which may otherwise preclude a desired gift, it’s equally important that advisors who are working with charitably inclined clients understand the mission of the charities they wish to support and work to structure gifts that strike a balance between the personal planning goals of the donor and his various charitable objectives. A gift structure that’s appropriate for one cause may be badly mismatched with the goals of another. This mismatch can especially come into play when a client is seeking recognition for a gift and/or credit toward a particular project or fundraising goal.
Less Can be More
For example, suppose an institution is in the midst of a $100 million campaign to raise funds to build a number of new buildings. While deferred gifts will be given partial credit in the campaign, it’s hoped that all pledges will be completed within the 7-year time frame of the campaign.
In that case, a $1 million charitable remainder unitrust (CRUT) created to make payments equal to 5 percent of the value of the trust each year for the life of a 65 year-old couple may not be met with the greatest enthusiasm by the institution, given that there will be no funds available to fund buildings for the remainder of what’s estimated to be the 25-year joint life expectancy of the donors.
Contrast this proposed gift with a term-of-years charitable remainder annuity trust (CRAT) structured to make payments of 10 percent per year to the donors for the 7-year campaign pledge period.
The charitable recipient would be likely to credit this gift more highly in the campaign, as the funds will be available at the end of the 7-year pledge period. While the amount will be less than may be received under the terms of the lower payout CRUT, the charity will receive the amount an estimated 18 years sooner.
For example, if the 5 percent CRUT earned a total return of 7.5 percent over the 25-year anticipated period of the trust, there would be just over $1.85 million remaining in the trust at its termination. The present value of that amount is $303,000 using the same 7.5 percent as a discount rate.
If the 10 percent CRAT, on the other hand, experienced the same investment returns over time, the expected remainder to be received in exactly seven years would be $780,000. The present value of that amount under the same assumptions as the CRUT would be $470,000.
Under campaign guidelines, the credit for the CRUT would be $303,000. The credit for the CRAT would be $470,000. Turning to the needs of the donors, they would much prefer to receive a fixed amount of $100,000 from the CRAT for seven years than $50,000 a year from a CRUT that could increase or decrease over time.
As the donors plan to begin making significant withdrawals from their tax-deferred retirement accounts beginning in five years at age 70, the $700,000 in payments from the CRAT will serve as a welcome source of predictable income that can be used to fund educational expenses for children and grandchildren, weddings, travel and other discretionary expenses in their remaining pre-retirement years. It could be seen as a “bridge to retirement.”
The charitable deduction for the CRUT is $337,000. The charitable deduction for the term-of-years CRAT is $343,000. The income tax savings will be nearly identical, so that isn’t a relative factor in making the choice. In addition, the donors avoid the same capital gains on the appreciated assets used to fund the trust in either case at the time the trust is funded.
In the case of the 10 percent CRAT, however, under the tier structure of reporting income from a CRT, a larger percentage of the income from the CRAT may be expected to be taxed at lower capital gains rates than the income paid from the 5 percent CRUT. The donors could thus enjoy a higher percentage of the payments received from the CRAT for personal use.
This example illustrates the importance of considering the financial needs of the donor in the context of the purpose of the gift from the perspective of the charitable recipient. While it isn’t always possible to strike a perfect balance between the needs of all of the parties to the transaction, in many cases, a modicum of thought can result in a much better fit for all concerned.
Meeting Temporary Needs
Suppose another client would like to fund a research project that’s anticipated to require funding for 10 years. The institution would like to temporarily endow this project to assure it will be funded through completion. This “endowment” helps them to attract researchers to implement the project. The client would also like to provide for a significant gift to his college-aged grandchildren when they’re in their late 20s to early 30s. In this instance, a CLT could be a very attractive alternative. Unlike the CRUT or CRAT described in the previous example, which wouldn’t provide funding for charitable purposes for as long as 25 years, a charitable lead annuity trust (CLAT) could be designed to distribute a fixed amount each year for the full 10-year length of the project before terminating and providing the desired gifts to the grandchildren.
Because of the initial flow of funds to charity prior to the receipt of the gift by the grandchildren, the client will only be required to report a taxable gift of 35 percent of the amount used to fund the CLAT. This could greatly reduce the amount of gift and estate tax exemption needed to eliminate gift tax on the amount eventually being given to the grandchildren.
In a variation on this theme, consider how a CLT may be used to fund current needs while also establishing an endowment over time. Imagine an institution wanting to fund a scholarship endowment that will begin to provide benefits to a student while also providing for a permanent source of endowment.
In that case, the gift might be structured so that a portion of the annual CLT payments are used to fund immediate scholarships, with the remainder placed in a permanent endowment. The gift can be structured so that the payout rate, time period and allocation of payments between current needs and endowment combine to result in a permanent endowment being funded by the time the CLT terminates.
A “Living Endowment”
A leading educational institution recently learned that a 79-year-old alumnus would like to make a $10 million commitment to fund a future endowment through his estate. He didn’t believe he could make the gift during his lifetime because the bulk of his assets consisted of highly lucrative, but illiquid, real estate holdings.
After discussions with the donor and his advisors, it was decided he would fund a “living endowment.” Under the terms of his gift commitment, he made a $10 million pledge that would be funded to the extent possible during his lifetime and be considered an enforceable debt of his estate.
In the meantime, he would commit to making payments each year in an amount equal to the institution’s endowment spend rate, multiplied by the amount of his gift commitment.
The institution was then more than pleased to announce a $10 million gift to the campaign. At the same time, the donor’s advisors were pleased that they would continue to be involved in the management of his real estate and other assets for the remainder of his lifetime.
An Income-Splitting Trust?
In recent years, the term “blended gifts” has been used to describe gift-planning arrangements that provide funds for both current and future needs.1 These gifts often come about in the context of a major financial event in a client’s life.
The sale of a business interest is a relatively common example. In such cases, a paramount goal of the transaction is tax-free diversification of a highly concentrated, low yielding investment that would give rise to significant amounts of capital gains tax if sold. In short, it’s the situation an individual often faces after selling a business and receiving a large amount of zero-basis stock in an acquiring company.
At the same time, a client may be at the stage of life when he’s reflecting on his values and desires to give back some of the wealth he enjoys as a result of his business success.
The gift-planning tool that many planners would naturally start with would be a CRT. When the beneficiaries of the trust are young and have a life expectancy that will span decades, the opportunity for growth in their income over time is a high priority. A CRUT could be the tool of choice.
Take the case of a 55-year-old couple who recently sold a closely held business in exchange for $20 million of stock in a publicly held company that pays minimal dividends. Their basis in the stock is very low, and virtually all of their sales proceeds would be subject to state and federal capital gains tax in the 30 percent range.
The prospect of paying $6 million in capital gains tax for the ability to diversify obviously wouldn’t appeal to them, but they’re also wary of having the bulk of their wealth concentrated in one asset that yields little income. They would like to increase their income from this asset by at least $200,000 per year.
It’s suggested that they place $5 million of the stock in a CRUT that will pay them 5 percent of the value of the trust assets each year. Their payments the first year would be $250,000.
The stock can then be sold free of capital gains tax at the time of the sale as a result of the tax-exempt status of the trust. This results in the entire $5 million being available to reinvest rather than the approximately $3.5 million that would remain after the sale of the securities. In addition to the $1.5 million in capital gains tax savings, they would be entitled to a charitable income tax deduction of $1.1 million that they can use over a period of as many as six years to eliminate tax on future income in that amount.
From the perspective of the donors and their advisors, this gift yields many attractive benefits. More assets continue under management with greater earnings capacity for the donors over time, and they benefit from significant tax savings as a result of their irrevocable transfer to the trust.
The charity isn’t especially pleased, however. The donors have a joint life expectancy of 34 years, and the charity may receive nothing for that period of time or even longer, given the prospect of longer life expectancies in the future. From the donors’ perspectives, however, they’ve parted with $5 million in assets and retained only the income. The donors are thus expecting significant recognition for this gift. The charity has offered to give them credit in the campaign for the $1.1 million charitable deduction value the Internal Revenue Service places on the gift.
Is there a way to tweak this gift to make it more palatable to the charity without gutting the benefits for the donor or reducing the assets in the trust?
What if the donors agree to go one step further and “split” the income interest in the split-interest trust? In this case, suppose the trust specified that 80 percent of the 5 percent income payment each year be made to the donor and 20 percent be transferred to the charity.
The first year, the donors would receive $200,000 and the charity $50,000. From the donors’ perspective, the $200,000 is some 14 percent more than the $175,000 they would have received had they sold the stock and reinvested the after-tax proceeds at 5 percent. From the charity’s perspective, the $50,000 represents the same amount it would have from a $1.25 million endowment with a 4 percent spend rate. It calculates the present value of its anticipated income stream to be approximately $900,000. Because of that, it’s willing to increase the gift credit from $1.1 million to $2 million.
The donors are also pleased that the funds being paid to charity won’t pass through their taxable income. This has a number of positive benefits. The amount given to charity each year won’t serve to increase their adjusted gross income (AGI), which could cause a phase-out of various credits and exemptions including the Pease limitation on itemized deductions. In addition, should they be subject to a 30 percent or 50 percent of AGI limit on deductions, these funds will go to charity tax-free regardless. Not receiving income in the first place is the same as receiving it and then fully deducting it.
If the trust assets grow by 3 percent per year, the charity will receive just under $14 million when the trust is expected to terminate, after having received $3 million of the $15 million the trust would distribute during its existence.
This trust functions like a hybrid of a CRUT and a charitable lead unitrust, what I’ve in the past referred to as a “lunitrust.”
In effect, what’s happening is the donors are receiving more income than they would have enjoyed had they diversified the holding outside the trust, while the charity is receiving income from the funds that otherwise would have been diverted to the payment of capital gains taxes.
This gift is an example of a very valuable “blended gift.” It meets both current and future needs of the charitable recipient, while the donors make a very meaningful gift that fulfills their desire to give back now rather than decades in the future.
Planners and charities need to realize they both must be concerned with current and future economic needs. If they work together to balance those needs in light of all concerned, they’ll be responsible for making special philanthropic investments that will benefit society both now and for generations to come.
1. Robert F. Sharpe, Jr., “The Emergence of Blended Gifts,” Trusts & Estates (May 2016), at p. 10.