The surprising flexibility in the design of charitable gift annuities permits a donor to achieve his financial and philanthropic goals. In my June 2015 column, I reviewed the goals and aspirations of the three “Harrys’.” Harry, Sr. and Harry, Jr. commuted separately funded gift annuities to provide funds for Harry III’s medical school education. The result of this charitably savvy plan was the underwriting of most of Harry III’s medical school education from the commuted payments and gifted tax savings.1 General Counsel Memorandum 39826 (Aug. 27, 1990) permitted installment payments for either a number of years certain or a lump sum amount. A donor could assign the rights to the annuity payment, so long as the assignment was completed before the first annuity payment was due.2
The question arises whether some form of a charitable remainder unitrust (CRUT) could accomplish identical goals as the commuted payment annuity. The answer is a “qualified” yes. Let’s examine how to structure the CRUT and assess the viability of the technique. I’ll then identify the key issues in deciding between the CRUT and commuted payment annuity.
CRUT for Term of Years
A donor seeks to fund a trust with a payout rate and duration likely to defray at least part of the cost of the college education of a child or grandchild. Funded with highly appreciated stock, the tax-exempt trust can sell stock without paying capital gains tax at the trust level. The beneficiary will be taxed on the realized capital gains according to the tier accounting rules. The payout rate will be higher than most unitrusts. The duration of the payments most likely will be for a fixed term, which may not exceed 20 years. The charity benefits after the payouts to the non-charitable beneficiaries have concluded. The recipient of the CRUT amount has funds for college. The donor has income tax savings, which, at the donor’s discretion, could be directly contributed to the non-charitable donee.
Let’s now examine the precise income and transfer tax consequences in establishing this CRUT.
Mother Irene, age 40, has sufficient resources to begin planning for the college education of her 5-year-old daughter, Audrey. She would like to arrange for a stream of payments beginning when Audrey starts college in the fall of 2029 and ending on her graduation four years later. During the 18-year duration of the trust, Irene wants the maximum possible payments being paid for the benefit of Audrey. Irene realizes the optimal payout means the minimum charitable deduction. She would also like to know how much would be available to Audrey if the payout rate is the Internal Revenue Code minimum of 5 percent, and she would be able to gift the income tax savings, which will be larger than from an optimal payout CRUT. Her advisors assume a total return of 7 percent, 4.5 percent from capital appreciation and 2.5 percent from income.
The optimal payout rate permitting the CRUT to satisfy the 10 percent residuum rule would be 12.007 percent. Audrey will receive $105,351 in after-tax proceeds including Irene’s tax savings. By contrast, the minimum payout rate of 5 percent will leave Audrey with $96,204 in after-tax proceeds including Irene’s tax savings. Irene believes the optimal payout rate of 12.007 percent maximizes the chance of the funding goals for Audrey being satisfied.
Income Tax Consequences
Irene receives an income tax deduction for the present value of the remainder interest going to the charitable remaindermen. The optimal payout rate of 12.007 percent produces an income tax deduction of $10,002; the minimum payout rate of 5 percent produces an income tax deduction of $39,913. The tax savings are respectively $3,301 and $13,304, as Irene is in the 33 percent marginal tax bracket.
The payments will be taxed to Audrey who will be a “kid” under the kiddie tax rules.3 Because the payments aren’t from an annuity, the premature distribution penalty of 10 percent won’t apply.4
After weighing these consequences, Irene finds maximizing the payout to Audrey of more importance than the size of the tax deduction.
Transfer Tax Consequences
The remainder interest will qualify for a charitable gift tax deduction. The gift tax treatment of the non-charitable recipients depends on whether an immediate right to income exists for them. If the donor doesn’t retain any rights of revocation, there’s a completed gift of the non-charitable interest.
So long as Irene hasn’t consumed her unified gift and estate tax exemption, no gift taxes will be owed on Irene’s transfer to Audrey. If Irene had consumed her unified gift and estate exemption or chooses to preserve it to benefit to-be-born children, she’ll need to retain a right of revocation.
If Irene retains a testamentary right of revocation of the income interest, there isn’t a completed gift. This right relieves her from consuming her unified gift and estate exemption in the amount equaling the present value of the unitrust interest. Each annual distribution to Audrey would qualify for the annual exclusion.
This strategy of preserving the exemption has risks. Specifically, if Irene’s relinquishment didn’t in fact occur before her death, IRC Section 2036(a)(2) requires inclusion of the present value of the remaining unitrust payments. While the 40-year-old Irene should very likely survive the 18-year term of trust, the risk should be communicated. The risk, of course, would be more prominent for older donors. Furthermore, this relinquishment must occur more than three years before Irene’s death as required under Section 2035.
Irene would like to increase the amount of funds available by minimizing the income taxes to be paid by Audrey. She’s willing to lower the payout rate and shorten the duration of the trust if the result increases the after-tax proceeds to Audrey. Specifically, she would like to know if a variable annuity is the best investment. Such an investment presents fiduciary administration issues and a potentially thorny tax issue.
A net income with makeup CRUT (NIMCRUT) would pay the lesser of the net income or the payout percentage. The makeup feature allows any shortfalls from prior years to be made up to the beneficiary when the net income of the trust exceeds the required payout. Such an arrangement compels the determination of whether the governing state’s trust law permits the allocation of any post-contribution capital gains to either the income or principal accounts as determined by the trustee. Assuming the trust is in such a favorable jurisdiction, the tax laws may compel the donor to assess whether the tax consequences are worth accepting. First, all payments from the annuity will be ordinary income to the extent of distributable gain.5 Second, all gain is taxable because the annuity is held by a non-natural person.6 Although these payments to the NIMCRUT should be tax-exempt, the fiduciary accounting is complicated by the need for defining fiduciary income. Third, the Internal Revenue Service won’t issue a private letter ruling regarding the status of the trust (or the taxability of the payments).7 While Technical Advice Memorandum 98-25-001 (June 19, 1998) determined the purchase of deferred annuities was neither an act of self-dealing nor of disqualification, only the taxpayer requesting the ruling may rely on it. Were the IRS to conclude the terms of the CRUT holding deferred annuities provided constructive receipt of the income through control of the timing of the payment of the unitrust amount to the non-charitable beneficiary, the goal of deferral to future years of need would be frustrated. Even worse, the IRS would deny the charitable income and gift tax deductions.
Commuted Payments vs. NIMCRUT
Although there’s no straightforward formula for deciding between the options, some general planning pointers are clear. The donor needs to balance the need for certainty of result in the amount of the payments against investment and inflationary risk and must assess the legal and administrative costs.
The strength of the commuted payment gift annuity is certainty of result, assuming the sponsoring charity is financially strong. The amount of the commuted payment will reflect the length of deferral, as does the federal income tax deduction. The legal expenses should be no more than the time it takes to review the agreement on behalf of the donor. There will be no trustee expenses. The major risk to the donor will be the diminution of the purchasing power of the payment due to inflation.
The strength of the conventional CRUT would be the potential for the non-charitable beneficiaries to benefit from rising markets. This growth preserves the purchasing payments made to the non-charitable beneficiaries. Under a conventional CRUT, the payments could be taxed in part as preferential capital gains even if the trust were funded initially with cash. That wouldn’t be the case for a commuted payment gift annuity funded with cash. However, these benefits come with the cost of much higher legal fees and trustee compensation. The charitable deduction also isn’t increased to reflect the benefit of any deferral of the commencement of payments. The income tax deduction for a commuted payment annuity is increased to reflect the length of the deferral. The NIMCRUT might be a viable technique to minimize federal income taxes on the accumulations but not without the risk of additional scrutiny on a technique the IRS refuses to approve without reservation.
And of course, be sure the number crunching of the deductions and projected payments confirm the donor’s initial preference for one technique over another.
1. See Christopher P. Woehrle, “Making Gifts ‘Again’ Part 2: Accelerating Charitable Gift Annuities,” Trusts & Estates (June 2015), at p. 10.
2. See Private Letter Ruling 9407008 (Nov. 12, 1993).
3. Internal Revenue Code Section 1(g)(2)(a)(ii)(II) notes a student’s earned income must provide at least one-half of support.
4. IRC Section 72(u)(2) imposes the penalty on “income on the contract.” See also PLR 9009047 (Dec. 5, 1989).
5. IRC Section 72(u)(2).
6. IRC Section 72(u)(1).
7. See Revenue Procedure 2014-3.