Advisors who truly understand the power of charitable planning are few and far between. Even though many practitioners know the rudimentary elements of charitable remainder trusts (CRT) and have steered a few clients into a donor-advised fund (DAF) at year end, many other philanthropic tools provide wonderful solutions that go beyond the simple CRT or DAF. Consider, the almost forgotten pooled income fund (PIF), nominally used by universities to raise money to build new stadiums or hospitals to add new treatment centers, then left to trickle away to a few surviving donors getting low returns and wondering what happened. Why, now, is there new interest in these old, boring gift vehicles?
Tide Has Turned
PIFs have been around since 1969 and, until very recently, had fallen out of favor. Perhaps because interest and dividend rates have been at historical lows for several years and most PIFs were established some years ago, the combination of low return and low tax deduction reduced the broad appeal. Recently, though, the tide seems to have turned, with savvy practitioners establishing new funds to take advantage of current low applicable federal rates.
Under Internal Revenue Service regulations, A PIF’s charitable income tax deduction is typically computed using a complicated formula based on the prior three years’ highest rate of return on the assets in the PIF. Older PIFs yield relatively low tax deductions and, with the flexibility and control available with a CRT, there’d be no really good reason for a potential donor to compromise and use a PIF. Until now.
The IRS regulations tell planners: “If a pooled income fund has existed for less than three taxable years immediately preceding the year in which a transfer is made, the highest rate of return is determined by first calculating the average annual Applicable Federal Midterm Rate (as described in IRC §7520 and rounded to the nearest 2/10ths) for each of the three taxable years preceding the year of the transfer. The highest annual rate is then reduced by one percent to produce the applicable rate.”1 That means a PIF established in 2016 will use an effective discount rate of 1.2 percent.
For those familiar with charitable planning, the low rate means that the charitable income tax deduction for ANY age is remarkably high. For example, a 65-year-old husband and wife, contributing to a PIF, would receive a charitable income tax deduction equivalent to 76 percent of their gift. The same couple making the same contribution to a CRT with a 5 percent payout rate (the minimum amount allowed by law) would receive a 33 percent deduction. Same asset, quite a different result. While giving to charity isn’t typically motivated by the income tax deduction, it doesn’t hurt to have a larger deduction.
Opportunities for Creative Planning
The current low discount rate for newly created PIFs creates a number of opportunities for creative planning. First, PIFs aren’t governed by the “10 percent remainder interest” rule that disqualifies many younger donors from using CRTs. This means that many of the Silicon Valley millionaires (and others) now have an alternative exit strategy from their capital gains tax woes. Furthermore, the opportunity for a multi-generational income plan becomes possible even if there are very young children or grandchildren.
Advisors must also know that a PIF is very much like a net income CRT. That is, a PIF is typically required to pay out all dividends, interest, rents, royalties and short term capital gains. However, some of the more donor friendly PIFs operate with the “power to adjust,” which allows the treatment of a portion of post gift realized capital gains to be distributed as income as well. This type of “total return” PIF is essential for evening out income distributions.
As it happens, though, there are several, donor friendly and advisor friendly organizations that see this opportunity. Donors want more flexibility and control as shown by many recent surveys and proven by the explosive growth DAFs. However, DAFs don’t return any income to the donor. CRTs allow the donor to receive income but often fail the 10 percent remainder test because of the donors’ ages. Including children is almost always out of the question. PIFs stand somewhere in the middle; they return income, they have no 10 percent remainder qualification, which allows a multi-generational income opportunity, and they provide a sizable tax deduction if they’re less than three years old.
While the donor can’t be the trustee of a PIF, unlike a CRT, there are many reasons why advisors should learn the many attributes and rules of PIF planning. They’re a powerful planning tool that will allow clients to receive income tax deductions, avoid capital gains taxes, diversify their portfolios, create multi-generational income streams and, most importantly, help satisfy their philanthropic intentions.
1. Treasury Regulations Section 1.642(c)-6.