In “Making Gifts Sooner Than Later … Accelerating Charitable Bequests,” Trusts & Estates (March 2015), Robert F. Sharpe, Jr. demonstrated how attractive the lifetime funding of bequest intentions are in the current environment of unprecedented high exemptions from transfer taxes and a low charitable midterm federal rate of interest. Here’s how the acceleration of previously funded charitable remainder trusts (CRTs) can be beneficial in both rising and declining financial markets.
Commutation of CRTs
The recipient of a unitrust or annuity trust amount can gift the right to all or a portion of the payment to the charitable remainderman or other charity. The donor will be entitled to an income tax deduction for the present value of the estimated income to be foregone. So long as the recipient of the trust payments relinquishes an undivided interest to the payments, an income tax deduction is allowed.1 This relinquishment is called a “commutation.” Commutation accelerates the charitable interest by terminating the trust. The assets from the trust are then available for use by the remaindermen for the charitable purpose originally determined by the donor under the terms of the trust.
How the donor balances his need for income with the desire to see his philanthropy at work during his lifetime drives the decision. The magnitude of the income tax deduction from the commutation may also be decisive in assessing the desirability of commutation.
Responding to Appreciating Markets
For many, the investment performance of the past years has been better than could have been anticipated, especially in the aftermath of the worst recession since World War II. Many donors have reaped the benefit of higher than anticipated payments in the case of charitable remainder unitrusts (CRUTs). Some of them may no longer need any payment from the trust. Or, a donor’s personal portfolio has grown better than anticipated, while the performance of the unitrust may not have been as impressive because of its conservative asset allocations. After reviewing his entire portfolio, the donor may now feel comfortable with existing resources generating adequate income to maintain his lifestyle and meet likely financial needs. He’s ready to terminate in full his rights to future unitrust amounts.
Alternatively, the donor only feels comfortable with relinquishing the right to payment from a portion of the trust and wishes to retain payments from the balance remaining in trust.
Let’s determine the income tax consequences of a full and partial commutation.
Full Commutation
Eight years ago, Jeff (now age 70) funded a CRUT with $400,000 for the benefit of his alma mater, which also is serving as trustee. In eight years, the CRUT has grown to $586,131. Jeff has seen his unitrust payment of 5 percent increase from $20,000 to $29,307. Were Jeff to eliminate his right to all future payments, the present value of foregone payments would be $279,426. The income tax savings from the deduction would be $92,211—the product of his marginal rate of 33 percent and the present value of the foregone payments. The charity would have the full value of the trust to fulfill Jeff’s charitable goals.
Partial Commutation
Jeff might decide he’d like to see the charity benefit now from all of the growth of the trust. He’d like to gift the entire appreciation of $186,131 to fund an immediate priority. Jeff waives his right to payment from 31.7 percent of the trust. The charity will receive trust principal of $186,131. Jeff will continue to receive the unitrust percentage of 5 percent on $400,000, subject to the investment performance of the trust. He’ll also be entitled to a charitable deduction of $88,734.The tax savings from the deduction will be $29,282, representing almost an extra year of payments. Jeff has received nine years of payments in eight years. He now feels especially confident in his decision to make a partial commutation.
A Note of Excessive Caution
For many years, the Internal Revenue Service issued private letter rulings on the commutation of CRTs. One of the most cited is PLR 20025209 (Dec. 26, 2002), which offered guidance in the calculation of the value of the commutation and identified the basis of the income interest as zero.
Since the issuance of Revenue Procedure 2008-3, the IRS won’t rule on the issue of whether the early termination of a CRT creates tax hazards. Those hazards include loss of the tax-exempt status of the CRT and whether the transaction should be taxed as a sale or exchange. Rev. Proc. 2013-3, 2013-1, IRB 113, Section 4 continues this no ruling policy absent “unique and compelling reasons” to justify the issuance of a ruling.
While the commutations described above don’t have the same potential for abuse as those involving a sale to a third party, which IRS Notice 2008-99 labeled a “transaction of interest,” one must be willing to complete a commutation without the protection of a PLR.
Responding to Down Markets
There are times a donor can be caught in a down market. The economic viability of the commutation should be examined not only when the charitable assets have appreciated, but also when they’ve depreciated. The donor has some options that might not initially be apparent.
The donor might salvage a CRUT income arrangement that hasn’t performed well. The donor may be receptive to relinquishing payments from the trust in exchange for a charitable gift annuity benefitting the charity receiving the payment from the trust. The donor still desires to benefit the original charity; thus, he funds a charitable gift annuity with that charity.
Commutation and Exchange
Seven years ago, Karen (then age 63) funded a CRUT with $400,000. Her 5 percent unitrust payment has shrunk from $20,000 to $15,000. Now, Karen would feel more comfortable with a fixed payment. After consulting with her lawyer and CPA, she initiates a discussion with the charitable remainderman. She’s willing to relinquish the right to all future payments in exchange for a charitable gift annuity from the same charity. But, the payment rate to her needs to be acceptable. Specifically, the amount received must be at least equal to or closely approximate the amount of income surrendered. The standard American Council on Gift Annuities (ACGA)rate can’t be assumed to be adequate.
PLR 200152018 (Dec. 28, 2001) comprehensively examines the tax consequences of such a transaction. The amount surrendered is a capital asset. The basis of this capital asset is zero, as the pro rata recovery of the basis rule isn’t applicable. The charitable remainder beneficiary isn’t receiving its interest in a single transaction, but rather in two. The amount received will be the present value of the agreed annuity stream plus the benefit (if any) from the charitable income tax deduction. The amount surrendered is the present value of the cash received for the commutation. This amount will be reduced by any capital gains and any applicable net investment income surtax. During the life expectancy of the donor, the payments will be partially taxed as capital gains and ordinary income per Treasury Regulations Section 1.1101-2(c), Example 8. The present value of her payments from the CRUT is $143,122. These full proceeds will be reduced by a 20 percent capital gains tax of $28,627 and the likely applicable 3.8 percent Medicare surtax of $5,439. Karen funds a charitable gift annuity with the net proceeds of $109,067 paying 5.1 percent, the recommended ACGA payout rate. Her income is now fixed at $5,562. Her charitable tax deduction, subject to the 30 percent of adjusted gross income limit, is $42,545, yielding tax savings of $14,040, as she’s in the 33 percent bracket. On these facts, Karen experiences a net cost of $17,263. She might need to reach an agreement with the charity for a payout rate higher than 5.1 percent for her to break even.
Of course, Karen can also decide to keep the proceeds for her own investing or make a gift to another charity.
The commutation of a CRT (including a net income charitable remainder unitrust and net income with makeup charitable remainder unitrust) in exchange for a charitable gift annuity may be just the way to ensure good deeds aren’t punished by poor markets!
Endnote
1. Private Letter Ruling 7949035 (Sept. 5, 1979), citing Internal Revenue Code Section 1.170A 07(a)(2)(i), noted a deduction for a contribution of a partial interest in property if that interest is the complete interest of the taxpayer. That interest may be in the form of an income interest or remainder interest.