CHARITABLE LEAD TRUSTS
I. ATTRIBUTES OF CHARITABLE LEAD TRUST (“CLT”)
A. Payment – Charitable Lead Interest
Annual
(or more often) payments to charitable beneficiary for a number of years or for
a life or lives in being at the trust’s creation. But see subparagraph C below regarding
proposed regulations limiting permissible term.
1. ANNUITY TRUST
Payment is a fixed dollar
amount or a fixed percentage of the initial net fair market value of the trust
assets. IRC §§ 2522(c)(2), 2055(e)(2)
and 170(c); Treas. Reg. §§ 25.2522(c)(3) and 1.170A-6(c).
2. UNITRUST
Payment is a fixed
percentage of the net fair market value of the trust assets determined
annually. IRC §§ 2522(c)(2), 2055(e)(2)
and 170(c); Treas. Reg. §§ 25.2522(c)(3) and 1.170A-6(c).
The
Annuity Trust has traditionally been the preferred form of a CLT because
remaindermen benefit from appreciation of the trust assets without gift or
estate taxation (but with potential generation-skipping transfer taxation) and
the assets do not need to be revalued each year for determining the charitable
payment. However, the IRC now requires
the Annuity Trust (but not the Unitrust) to be valued at the end of the
charitable term for Generation-Skipping Transfer Tax (“GST”) purposes using the
interest rate used for valuing the charitable interest at the time of funding
the trust and applying it to the value of the remainder interest at the time of
funding, compounded annually. IRC §
2642(e). (See GST paragraph below.)
Formula
Clauses: The use of a formula clause has
been allowed by the Service as long as the gift is determinable at the time of
the transfer. Planning idea: make the
formula have one variable (either the term or the payment amount) calculated to
result in a certain gift amount.
B. Distributions in Satisfaction of Annuity or Unitrust Payment
The CLT instrument may provide for the payment of the annuity or unitrust interest to be made in cash or in kind. If the trust distributes appreciated property in satisfaction of the annuity trust or unitrust payment, the trust will realize capital gains on the assets distributed in kind to satisfy the annuity or unitrust payment. Rev. Rul. 83-75, 1983-1 C.B. 114. See also, P.L.R. 9201029 (Oct. 7, 1991) applying Rev. Rul. 83-75 to the income tax treatment of distributions of appreciated stock in satisfaction of a lead unitrust payment. Planning Opportunity: Establish the trust with appreciated stock and distribute stock to satisfy the annuity or unitrust payment. The CLT will recognize the gain and the CLT will receive an income tax charitable deduction for the amounts paid to charity resulting from the realization of the capital gain. (See discussion of income tax treatment of the non-grantor and grantor charitable lead trusts below.)
C. Term
Payments
can continue for the life or lives of one or more individuals, all of whom must
be living when the trust is created or for a term of years (limited only by the
applicable rule against perpetuities).
Treas. Reg. §§ 1.170A-6(c)(2)(i)(A)
and (ii)(A); Treas. Reg. §§ 20.2055-2(e)(2)(v)(a) and (vi)(a); Treas. Reg. §§
25.2522(c)-3(c)(2)(v)(a) and (vi)(a).
However, the Service issued proposed regulations on April 5, 2000,
(Proposed Reg. 100291-00, 65 Fed. Reg. 17835 (4/5/00) and Final Regulations,
effective January 5, 2001, whereby the permissible term for charitable lead
trusts is defined so as to prevent abuse in obtaining inflated charitable
deductions. The problem: taxpayers have
been using an unrelated individual’s measuring life as the term of the
charitable lead trust where that unrelated individual is seriously ill, but not
“terminally ill” as defined under I.R.C. § 7520 and the Regulations
thereunder. (See, for example, Treas.
Regs. § 20.7520-3(b)(3)). The value of
the charitable interest is calculated under the applicable actuarial tables,
which are based upon the average life expectancies of individuals of the same
age as the measuring life. However, the
life expectancy of the measuring life involved is, in fact, much shorter than
the life expectancy of individuals set forth in the actuarial tables. If the individual dies prematurely (which is
expected), the charity’s interest is terminated resulting in the remainder
beneficiaries receiving their interest sooner than anticipated by the tables at
a reduced gift or estate tax of that based upon the lives of those provided in
the tables. The measuring life
individual is paid a fee for allowing the trust creator to use such individual
as the measuring life. The Service
believes that this type of charitable lead trust is abusive and frustrates the
Congressional intent of allowing deductions for certain split-interest trusts
and further that the marketing of such is against public policy. The
Service’s Solution: the final
regulations would limit the permissible term for a guaranteed annuity interest
and unitrust interest to a specified term of years, or the life of certain
individuals living at the date of the transfer, such individuals being limited
to one or more of the donor, the donor’s spouse, or a lineal ancestor or spouse
of a lineal ancestor of all of the remainder beneficiaries. Additionally, an interest payable for a
specified term of years will also qualify where the governing instrument
contains a “savings clause” that is intended to qualify with the rule against
perpetuities. A trust will satisfy the
requirement that all of the noncharitable remainder beneficiaries are lineal
descendants of the measuring life individual (or the spouse of the measuring
life individual), if there is less than a 15% probability (computed based upon
the current applicable Life Table under Treas. Reg. § 20.2031-7 at the time the
property is transferred to the trust, taking into account interest of all
primary and contingent remainder beneficiaries living at that time) that
individuals who are not lineal descendants will receive any trust corpus. Treas. Dec. 8923. If a transfer is made to a trust on or after
April 4, 2000 that uses an individual other than a permitted measuring life
individual, the trust may be reformed to satisfy the rule or may be rescinded
for a transfer made on or before March 6, 2001.
See Treas. Reg. § 25.2522(c)-3(e). The final regulations apply to
transfers to inter vivos charitable lead trusts made on or after April 4, 2000
and to testamentary type transfers where the creator dies on or after such
date.
Although
comments to the proposed regulations pointed out that the limitations on the
measuring lives, although not a bad thing, were too narrow and precluded many
situations where the beneficiaries are not related to the creators of the
charitable lead trust, the Service did not adopt any of such suggestions,
except as they further broadened the class of the measuring lives as described
above.
D. Remainder Interest
The
remainder interest, after payment of the charitable lead amount, is distributed
to the noncharitable beneficiary or beneficiaries, which may include the donor,
donor’s estate, children, grandchildren or other trust or trusts for children
or grandchildren.
E. Testamentary and Inter Vivos CLTs
The
charitable lead trust may be established as an inter vivos trust (during life)
or as a testamentary trust (at death).
F. No Minimum Distribution
Unlike a Charitable Remainder Trust and a Private Foundation, there is no minimum percentage or amount that must be distributed annually and, therefore, the Charitable Lead Trust (“CLT”) is not subject to the Annual Minimum Distribution Amount, which is 5% of the initial fair market value of the trust assets (with a charitable remainder annuity trust) and 5% of the annual fair market value of the trust assets (with a charitable remainder unitrust), or 5% of the annual fair market value of the assets of the private foundation which amount must be paid within two years of receipt of the assets by the private foundation. Compare IRC §§ 664(d)(1)(A) and 664(d)(2)(A).
G. Private Foundation Rules
CLT is a split-interest trust under IRC § 4947(a)(2). As such, it is subject to the following private foundation rules:
1. Trust
must not be involved in self-dealing whether direct or indirect with
disqualified persons as precluded by IRC § 4941(d). Includes any direct or indirect: a) sale or
exchange or leasing of property between trust and a disqualified person; b)
lending of money or extension of credit between a trust and a disqualified
person; c) furnishing of goods, services, or facilities between a trust and a
disqualified person, unless such goods, services or facilities are made
available to the general public on at least as favorable a basis as they are
made to the disqualified person, Treas. Reg. § 53.4941(d)(3)(b)(1); d) payment
of compensation (or payment or reimbursement of expenses) by a trust to a
disqualified person, unless it is for personal services and such compensation
is reasonable and necessary to carry out the exempt purpose and is not
excessive, Treas. Reg. § 53.4941(d)(3)(c)(1); e) transfer to, or use by or for
the benefit of, a disqualified person of the income or assets of a private
foundation; and, f) agreement by a private foundation to make any payment of
money or other property to a government official [as defined in § 4946(c)]
other than an agreement to employ such individual for any period after the
termination of his government service if such individual is terminating his
government service within a 90 day period.
IRC § 4941(d).
A
disqualified person is a substantial contributor to the CLT (an individual,
trust, estate, corporation or partnership who or which contributes an aggregate
amount in excess of $5,000 to the CLT, if his or her total contributions are
more than 2% of the total contributions received), or a family member of a
substantial contributor (spouse, descendants and spouses of descendants), or
persons owning more than 20% of an entity which is a substantial contributor to
the CLT (includes an entity in which a disqualified person [considering the
attribution rules of I.R.C. § 4946(a)(4)] owns more than 35%.]
Reimbursement
for Expenses: Reimbursement to disqualified
persons for travel expenses cause the CLT and the disqualified person’s spouse
to be potentially liable for penalty taxes for self-dealing, for making
non-charitable expenditures, or possibly both.
Such reimbursement of expenses will not be taxed if the expenses are
reasonable and necessary to carrying out the exempt purposes of the CLT and are
not excessive. I.R.C. § 4941(d)(2). The Code does not explain what is “reasonable
and necessary.” Treas. Reg. §
53.3941(d)-3(c)(1). Generally, business
expense deductions under Treas. Reg. § 1.162-2(1) include travel fares, meals
and lodging and expenses incident to travel.
Travel expenses are not included if the trip is primarily personal in
nature. Treas. Reg. § 1.162-2(a). The Code does cross-reference Treas. Reg. §
1.162-7 to determine what is “excessive.”
Under Treas. Reg. § 1.162-7, an amount spent on director’s services will
not be deemed “excessive” if it is only such as would be paid “for like
services by like enterprises under like circumstances.” Treas. Reg. § 1.162-7 (i.e. As the
organization would pay to someone independent of the CLT).
A grant by one private foundation (a CLT in this case) to another private foundation does not constitute self-dealing within the meaning of I.R.C. § 4941 even when one entity serves as Trustee of both foundations. Rev. Rul. 82-136 (1982-2 C.B. 300). See also Treas. Regs. Examples 53.4941(d)-2(f)(2).
Excise
Tax on Acts of Self-Dealing: Any
disqualified person who engages in an act of self-dealing is assessed an excise
tax of 5% of that amount involved in the transaction for each year that the
transaction is uncorrected.
Additionally, a foundation manager who knows the act is prohibited but
approves it may also be subject to a tax of 2.5% of the amount involved (up to
$10,000 for each such act) for each year that the transaction is
uncorrected. If the transaction is not
timely corrected and the 5% was initially assessed, the disqualified person is
subject to being assessed an additional tax of 200% of the amount
involved. Any foundation manager who
does not correct the transaction may also be subject to an additional
assessment of 50% of the amount involved (up to $10,000 for each such act.)
2. Trust
must not retain excess business holdings as restricted by IRC § 4943(c). To apply, the entity in which an interest is
held must be engaged in a business enterprise.
IRC § 4943(a)(1). A business
enterprise includes the active conduct of a trade or business and also includes
any activity which is regularly carried on for the production of income from
the sale of goods or the performance of services and that constitutes an
unrelated trade or business. Treas. Reg.
§ 53.4943-10(a)(1). Production of a
profit is not required. Id.
An entity is not engaged in a business enterprise if 95% or more of
gross income is from passive activity, IRC § 4943(d)(3), or if the business is
a functionally related business defined in IRC § 4942(j)(4). A functionally related business is one which
is either (1) a trade or business which is a related trade or business (as
defined under I.R.C. § 513), or (2) an activity which is carried on within a
larger aggregate of similar activities or within a larger complex of other
endeavors which is related to the exempt purposes of the organization. I.R.C. § 4943(d)(3)(A); I.R.C. §
4942(j)(4). See Exception below.
If a CLT holds
business holdings, it must be determined whether the business holdings are
excess business holdings, meaning that they are in excess of permitted
holdings. I.R.C. § 4943(c)(1). Three rules apply as to permitted holdings:
1) General Rule: the
CLT’s holdings in a corporation’s voting stock is 20% of the voting stock
reduced by the percentage of the voting stock actually or constructively owned
by all disqualified persons, I.R.C. § 4943(c)(2)(A);
2) The 35% Rule:
Where the CLT and all disqualified persons together do not own more than 35% of
the voting stock of a corporation and it is established to the satisfaction of
the Secretary that effective control is in one or more persons who are not
disqualified persons with respect to the CLT, then the 20% General Rule becomes
a 35% rule, I.R.C. § 4943(c)(2)(B)-l; and,
3) 2% De Minimus Rule:
The CLT is not treated as having excess business holdings in any corporation in
which it, together with all other private foundations, owns not more than 2% of
the voting stock and not more than 2% in value of all outstanding shares of all
classes of stock, I.R.C. § 4943(c)(2)(C).
Exception For Gratuitous Transfer: If the CLT is determined to have excess business holdings and the receipt of the assets constituting excess business holdings is by gratuitous transfer, then the assets received are treated as being held by a disqualified person for 5 years after the gratuitous acquisition. I.R.C. § 4943(c)(6). The CLT must dispose of the excess business holdings within the 5 year period. An additional 5 year extension may be granted to the CLT in order to provide additional time for the CLT to dispose of the excess business holding received by gratuitous transfer. The discretion is given to the Secretary to extend the period of disposition in the case of unusually large gifts or bequests of diverse holdings with complex corporate structures. I.R.C. § 4943(c)(7). The extension may be given provided that the following requirements are met:
1) the CLT establishes that it has made diligent efforts to dispose of the excess business holdings within the initial 5 year period;
2) disposition of the excess business holdings within the initial 5 year period has not been possible (except at a price substantially below fair market value) by reason of such size and complexity or diversity of the excess business holdings;
3) before the end of the initial 5 year period, the CLT a) submits to the Secretary a plan for disposing of all of the excess business holdings involved; b) the CLT submits such plan to the Attorney General (or other appropriate State official) having administrative or supervisory authority or responsibility with respect to the CLT’s disposition of the excess business holdings and submits to the Secretary any response received by the CLT from the Attorney General (or other appropriate State official) to the plan within the 5 year period; and,
4) the Secretary determines that such plan can reasonably be expected to be carried out before the close of the extension period.
Corporate Redemption: One way to dispose of the excess business holding is to have the corporation redeem the excess business holding of the CLT. This includes holdings of a partnership in a corporation since the CLT is attributed with owning the shares of the corporation. However, in redeeming the stock, care must be taken not to violate the rules against self-dealing. (See generally, the discussion above regarding self-dealing.) In the case of a corporate redemption, the involved act of self-dealing is the direct or indirect sale or exchange of property between a disqualified person and a private foundation. I.R.C. § 4941(d)(1)(A). The CLT is treated as a private foundation for these purposes. However, as to acts which would be an act of self-dealing, an exception is provided where liquidation or redemption of stock held in a private foundation (or CLT) is to a disqualified person which is the corporation if:
1) the corporation makes a bona fide offer of liquidation or redemption on a uniform basis to the private foundation (or CLT) and to every other person who holds stock in the corporation; and,
2) the liquidation terms provide for the liquidation at a price which is no less than fair market value. Further, the corporation cannot use a note to redeem its stock from the private foundation (or CLT). Treas. Reg. § 53.4941(d)-2(c)(1); Treas. Reg. § 53.4941(d)-3(d). The exception for redemption on a uniform basis exception has been applied to partnerships in P.L.R. 9237032.
Excise Tax on Excess Business Holdings: the CLT is taxed on its excess business holdings in the amount of 5% of the value of the excess business holding. A penalty of 200% is imposed on the CLT if the initial penalty is assessed and the excess business holding is not timely corrected. I.R.C. § 4943(b). Although the CLT has a 5 year time period to dispose of the excess business holding, the disposition of such holding is subject to the restrictions against acts of self-dealing.
3. Trust
must not make investments which would jeopardize the carrying out of the exempt
purpose as prohibited by IRC § 4944. (See Exception below.) Although no investment is a per se violation,
this rule requires close scrutiny of the standard of care in investment of the
assets of the CLT when the trustees have invested in speculative investments
such as working interests in oil and gas, trading on margin, trading in commodity
futures, purchase of “puts” and “calls” and “straddles”, warrants and selling
short. This restriction addresses
actions of investing and does not cover assets received by a CLT by gift or
bequest.
Excise Tax on Jeopardizing Investments: The CLT is not allowed to invest its funds in
investments which could jeopardize the CLT’s ability to carry on its exempt
purpose. If it does, it is taxed 5% of
the amount of the improperly invested assets.
Additionally, each trustee who willfully participated in the making of
the investment knowing that it jeopardized the carrying out of the CLT’s exempt
purposes may be subject to being assessed a tax of 5% of the amount of the
improperly invested assets. If the
investment is not disposed of within 90 days after imposition of the initial
tax, the CLT is liable for an additional tax of 25% of the amount improperly
invested and each trustee who willfully participated in the making of the
investment knowing that it jeopardized the carrying out of the exempt purposes
may be subject to being assessed an additional tax of 5% of the amount of the
improperly invested assets.
4. Trust
must not make taxable expenditures as governed by IRC § 4945(d). This covers amounts paid for propaganda or to
attempt to influence legislation or the outcome of a public election, amounts
paid to carry on any voter registration drive, or amounts paid as certain
grants. IRC § 4945(d).
5. Trust
is subject to “termination of private foundation status” of IRC § 507. The tax is the lower of the aggregate tax
benefit resulting from status as a private foundation or the fair market value
of its net assets. IRC § 507(c).
6. Trust
must meet “governing instrument language” of IRC 508(e). This includes provisions, the effects of
which are to require income to be distributed so as to not subject the
foundation to tax under IRC § 4942 and to prohibit foundation from engaging in
self-dealing, retaining any excess business holdings, making jeopardizing
investments and making taxable expenditures.
Exception:
Under IRC § 4947(b)(3)(A), the excess business holdings and jeopardy investment restrictions are not applicable if charitable interest of the CLT at inception does not exceed 60% of the aggregate fair market value of the trust assets at inception and the CLT income interest (and none of the remainder interest) is devoted to specified charitable purposes. This exception allows the qualified CLT to hold closely-held stock if the value of the charitable interest does not exceed 60% of the value of the trust assets at inception of the trust.
Planning
Opportunities:
By using such a testamentary CLT, a decedent may retain control of a family corporation while reducing the estate tax on transfer of the stock to children or other beneficiaries and receive an income tax basis adjustment on the family corporation stock at death.
II. BASIC DIFFERENCES BETWEEN GRANTOR CHARITABLE LEAD TRUST AND NON-GRANTOR CHARITABLE LEAD TRUST
A. Non-Grantor Charitable Lead Trust
1. Grantor
(donor) will not receive an income tax charitable deduction upon
contribution to the trust. IRC § 170(f).
2. Grantor (donor) will
receive a gift tax charitable deduction upon contribution to the trust.
3. Income of the trust is not
taxed to grantor. IRC § 641.
4. This trust is most
often used as transfer tax reduction technique.
5. The trust receives an
unlimited income tax charitable deduction for payments to charitable
organizations from gross income. IRC §
642(c). Excess income is taxed at
compressed trust income tax rate.
B. Grantor Charitable Lead Trust
1. Grantor
(donor) receives an income tax and gift tax charitable deduction upon
contribution to the trust. IRC § 170(f)(2)(B).
The income tax deduction is the present value of the charitable interest
in the charitable lead trust. Treas.
Reg. § 1.170A-6(c)(3). The income tax
charitable deduction is subject to the limitations on charitable deductions
made by individuals under IRC § 170(b).
2. Grantor
(donor) is taxed on the income from the trust as it is earned without a
corresponding annual income tax charitable deduction. IRC § 671-679.
3. Effect
is to convert future charitable contributions into a present income tax
deduction and is useful when the donor has an unusually large income in a
particular tax year.
4. Must
be inter vivos.
III. TAXATION OF NON-GRANTOR AND GRANTOR CHARITABLE LEAD TRUSTS
A. Non-Grantor CLT
1. INCOME TAXATION OF TRUST
a. Non-grantor
CLT is a complex trust for income tax purposes under § 641 and as such, is
fully taxable as a separate entity for income tax purposes.
b. It
is allowed, under IRC § 642(c), an unlimited income tax charitable deduction
for payments of gross income that are, pursuant to the governing instrument,
paid for charitable purposes outlined in IRC § 170(c). The grantor of the CLT is entitled to an income tax charitable deduction only if
the grantor is considered the owner of the income of the trust under the
grantor trust rules. See discussion above.
c. Distributions
to charity made in succeeding taxable year according to the governing
instrument may be treated as made in the prior taxable year. IRC § 642(c).
To do so, the Trustee must make an election on the income tax return (as
amended) for the year in which the payment is treated as made, and include a
statement that:
1) States the name and address of the
fiduciary;
2) Identifies the trust for which the
fiduciary is acting;
3) Indicates that the
Trustee is making an election under I.R.C. § 642(c)(1) in respect of
contributions treated as paid during such taxable year;
4) Gives the name and
address of each organization to which such contribution is paid; and
5) States the amount of
each contribution and date of actual payment, or, if applicable, the total
amount of contributions paid to each organization during the succeeding taxable
year, to be treated as paid in the preceding taxable year. Treas. Reg. § 1.642(c)-1.
If the
trust is a testamentary trust, then the obligation to pay the guaranteed
payment may commence with the Grantor’s death, but may be deferred from the
Grantor’s death until the end of the year when the funding of the charitable
trust occurs. P.L.R. 9047053.
d. To
the extent the lead payments are from unrelated business taxable income
(“UBTI”), the IRC § 642(c) charitable deduction is disallowed. (See
UBTI discussion below.) Notwithstanding,
the CLT is allowed an income tax charitable deduction for actual payments
allocable to UBTI which are made to charities, subject to the deduction
percentage limitations applicable to contributions by individuals, but is not
subject to the itemized deduction limitation reduction.
e. Excess
income (after payment of charitable distributions) will be taxed to the CLT at
compressed trust tax rates. IRC § 1(e);
IRC § 641. However, care must be taken
in drafting to assure the desired tax consequence. Income in excess of the required charitable
payment may be required to be distributed according to the governing
instrument, or required to be held in the CLT according to the governing
instrument. If the excess is required to
be distributed to charity, then the CLT will receive a full income tax
charitable deduction for the amounts paid to charity from the income. I.R.C. § 642(c). If the excess income is held in the CLT, then
the CLT will have taxable income that will be taxed at the trust compressed tax
rates. I.R.C. § 641. If the governing instrument gives the Trustee
the discretion as to whether to accumulate or distribute the excess income,
then other tax implications may arise depending upon who is serving as Trustee. (See
discussion of Independent Trustee below.)
I.R.C. §§ 671-678 provide the
situations in which a trust can be considered a grantor trust thereby taxing
the grantor on the income of the trust.
These provisions set forth the means by which a trust becomes a grantor
trust resulting in the grantor being taxed for income tax purposes on the
portion of the trust over which the grantor has specified powers. If a grantor or non-adverse party has the
power to effect the beneficial enjoyment of the corpus or income of a trust
because of a power of disposition, exercisable by the grantor alone or in
conjunction with others, the grantor is treated as the owner of the portion of
the trust over which the power exists.
I.R.C. § 674(a).
An adverse party is any person
having substantial beneficial interest in the trust which would be adversely
affected by the exercise or non-exercise of the power which he possesses
respecting the trust. I.R.C. §
672(a). The power to allocate or distribute
income is a power to direct the enjoyment of trust income and, therefore,
I.R.C. § 674(a) would apply unless the Trustee is an adverse party or one of
the exceptions applies. If the Trustee
has the discretion to accumulate or distribute excess income, this discretion
directly affects what the charity and the remainder beneficiaries receive. If the Trustee is not a beneficiary, or is
one of several beneficiaries, then he is either a non-adverse party as to the
interest of the other beneficiaries or is an adverse party only as to his own
interest and, therefore, the excess income (or the portion which is not subject
to his adverse interest) will be income taxable to the grantor. This discretionary power would not, as a
result, create a pure grantor trust whereby the grantor would be taxed on all
income of the trust but would tax the grantor only on that portion of the trust
over which the grantor or non-adverse party has the power to distribute or
accumulate income in excess of the annuity or unitrust payment. See
Jennifer I. Last, Is it a Grantor Charitable Lead Trust or Not? – How the
Grantor Trust Rules Interact with the Charitable Lead Trust, 30 J.P.
Marshall L. Rev. 1023 (Sum. 1997). Other
powers, such as a power to revoke, would create a purely “grantor” trust
thereby taxing the grantor on all income of the CLT. I.R.C. § 676(a).
2. UNRELATED BUSINESS TAXABLE INCOME (“UBTI”)
a. UBTI, In General
UBTI generally arises in two situations: 1) when the CLT has income from an unrelated trade or business; or, 2) when the CLT has income incurred with respect to debt-financed property. IRC § 512(a)(1); § 514(a)(1); and § 514(a)(2).
(1) INCOME FROM AN
UNRELATED TRADE OR BUSINESS
A CLT
must include in its unrelated business income the gross income from any
regularly conducted trade or business which is not substantially related to the
performance of the organization’s exempt function. Treas. Reg. § 1.513(b); U.S. v. American Bar Endowment, 477 U.S. 105, (1986). This includes income when an exempt
organization is a partner, limited or general, in a partnership which carries
on a trade or business wholly unrelated to the exempt organization’s purposes,
regardless of whether or not the income from the trade or business is actually
distributed. See IRC § 512(c)(1); Treas. Reg. § 1.681(a)-2(a). See
also, Service Bolt & Nut Co.
Profit Sharing Trust v. Comr., 78 T.C. 812 (1982). “Unrelated trade or business” does not
include: 1) any trade or business in which substantially all the work in
carrying on the trade or business is performed for the exempt organization
without compensation; 2) any trade or business carried on by an IRC § 501(c)(3)
organization or by an IRC § 511(a)(2)(B) governmental college or university,
primarily for the convenience of its members, students, patients, officers or
employees; or 3) any trade or business which consists of selling merchandise,
substantially all of which is received by the organization as gifts or
contributions. IRC § 513(a). The income and deductions are subject to the
modifications under § 512(b).
(2) EXCLUSION OF ITEMS FROM
UBTI
Some
items excluded from UBTI are dividends and interest, royalties, certain rents,
certain gains or losses from the sale, exchange or other disposition of
property, income from research for the U.S., income of a college, university or
hospital, or income for fundamental research.
IRC § 512(b).
(a) Example 1
If the
CLT holds a pass-through interest (for income tax purposes) in a factory, which
is an operating business, the CLT will have UBTI to the extent it has income
from the operation of the factory.
(b) Example 2
If the
CLT holds an interest in a partnership which owns rental real property,
exclusively, and there is no debt related to the property, the CLT will not
have UBTI because the income is from passive rental real property.
(3) INCOME OR DEDUCTIONS
INCURRED WITH RESPECT TO “DEBT-FINANCED PROPERTY”
A CLT
has unrelated business income if it has income incurred with respect to
debt-financed property. IRC § 512(a)(1),
§ 514(a)(2). “Debt-financed property”
includes any property held to produce income (including gains from disposition
of property) and with respect to which there is an acquisition indebtedness
(determined without regard to whether the property is debt-financed property or
the property secures the debt) at any time during the taxable year. IRC § 514(b)(1); Treas. Reg. §
1.514(b)-1.
“Acquisition
indebtedness” is generally the indebtedness incurred in connection with the
acquisition or improvement of property, whether the debt is incurred before,
after, or at the time of the acquisition.
See IRC § 514(c)(1); Treas.
Reg. § 1.514(c)-1. If proceeds from the
debt financed property are used to acquire or improve property, the debt is
considered to be “acquisition indebtedness” related to “debt financed property”
even if the debt is not secured by the property. Deeds of trust, conditional sales contracts,
chattel mortgages, security interests under the Uniform Commercial Code,
pledges, agreements to hold title in escrow and tax liens not subject to IRC §
514(c)(2) are all treated as similar to mortgages for purposes of applying IRC
§ 514(c)(2)(A).
(4) EXCLUSIONS FROM “DEBT-FINANCED PROPERTY”
(a) Property
used by an organization in performing its exempt function, IRC § 514(b)(1)(A).
(b) Property used in an
unrelated trade or business where “debt-financed property” does not include any
property to the extent that the income from the property is taken into account
in computing the gross income of the unrelated trade or business so as to
prevent double taxation of a single item of income as both income from an
unrelated business under IRC § 514(a)(1) and debt-financed income under IRC §
514(b)(1)(B).
(c) Property used to derive
research income, IRC § 514(b)(1)(C); Treas. Reg. § 1.514(b)-1.
(d) Property used in
certain excepted trades or businesses [not including any property to the extent
that the property is used in a trade or business subject to the volunteer
exception, the convenience exception or the donations exception]. IRC §
514(b)(1)(D).
(e) Life income
contracts. Treas. Reg. §
1.514(b)-1(c)(3)(i).
(f) Property acquired for
prospective exempt use. Treas. Reg. §
1.514(b)-1(d).
(g) Although a very limited
exclusion, IRC § 514(c)(9)(A) provides that indebtedness incurred in acquiring
or improving any real property is excluded from the application of IRC § 514,
subject to the exceptions outlined in IRC § 514(c)(9)(B). The four “qualified organizations” eligible
to use the exception under IRC § 514(c)(9) are as follows:
(i) Educational
organizations described in IRC § 170(b)(1)(A)(ii);
(ii) Affiliated support
organizations described in IRC § 509(a)(3) of educational organizations
described in IRC § 170(b)(1)(A)(ii);
(iii) Qualified trusts under
IRC § 401 that consist of a trust that forms part of a stock bonus, pension, or
profit-sharing plan of an employer for the exclusive benefit of employees and
their beneficiaries; and,
(iv) Multiple-parent title
holding organizations described in IRC § 501(c)(25).
b. Effect of UBTI on Non-Grantor CLT
The Non-Grantor CLT, like an exempt organization, is subject to the rules regarding UBTI. IRC § 501(a), § 501(c)(3); § 511(a)(2)(A), § 511(b)(2). See Treas. Reg. § 1.501(c)(3)-1(e)(2); § 1.511-2(a)(1)(i), and § 1.511-2(b)(1). As a result of the application of these rules, to the extent the CLT has unrelated business taxable income that is paid to a charity, the charitable income tax deduction under IRC § 642(c) is disallowed because the unrelated business income is subject to taxation under the rules governing UBTI. Notwithstanding, the CLT is allowed a deduction for actual payments allocable to UBTI made to charity, subject to the adjusted gross income percentage limitations applicable to charitable contributions made by individuals. IRC § 681(a). The CLT is not subject to the reduction in the income tax charitable deduction applicable to individuals under the itemized deduction limitation.
c. Examples of Application of UBTI Rules to Non-Grantor CLT
A CLT owns an interest in a real estate limited partnership. The partnership will be required to incur
indebtedness to complete construction and finishing of certain rental units
before tenants take possession of the lease premises. Since the CLT will hold an interest in the
partnership and does not qualify under any exclusion or definition of a
“qualified organization”, the indebtedness is subject to IRC § 514 and,
therefore, the CLT has UBTI to the extent income arises from the debt-financed
property.
d.
Calculation of Reduction of Income Tax Charitable Deduction Resulting
From Non-Grantor CLT Being Subject to UBTI
(1)
STEP 1:
Determine the amount of UBTI under IRC § 512 and regulations, as if the
trust were an exempt organization, without taking the charitable contribution
deduction allowed under IRC § 512(b)(11).
The amount of UBTI depends upon the extent to which the property is
financed by the debt. This is determined
by applying the “debt/basis percentage” to the total gross income derived
during the taxable year from or on account of the property. The debt/basis percentage is (A) the “average
acquisition indebtedness” for the taxable year over (B) the “average adjusted
basis of the debt-financed property” for the period it is held by the CLT
during the taxable year. This is the
UBTI amount. A similar calculation is
made for deductions from debt-financed property.
“Average
acquisition indebtedness” is computed by obtaining the sum of the amounts of
the outstanding principal indebtedness on the first day in each calendar month
during the taxable year that the CLT holds the property and dividing such sum
by the total number of months during the taxable year that the CLT held the
property. (A fractional month is treated
as a full month. Treas. Reg. § 1.514(a)-1(a)(3)(ii).)
“Average
adjusted basis of debt-financed property” is determined according to the
general rules for determining basis under IRC § 1011. See
Treas. Reg. § 1.514(a)-1(a)(2)(i). The
average adjusted basis of the debt-financed property is computed by adding the
adjusted basis of the property on the first day of the taxable year that the
CLT holds the property and the adjusted basis of the property on the last day
during the taxable year that the CLT holds the property and dividing this
amount by two. (Adjustments for
depreciation, etc. must be made even though the organization is an exempt
organization. Treas. Reg. §
1.514(a)-1(a)(2)(ii). See also IRC § 1016(a)(2).
Example: If the CLT has debt pertaining to the rental
real property in the average amount of $500,000 over the tax year (calculated
as above), then $500,000 is the average acquisition indebtedness of the
debt-financed property. Further, if the
real property has a basis of $2,000,000 but has depreciation of $500,000, then
the adjusted basis would be $1,500,000.
The debt/basis percentage, therefore, would be $500,000/$1,500,000 = .33
or 33%. If the total gross income from
the property is $1,000,000, then the amount of UBTI would be $1,000,000 x .33 =
$330,000. IRC § 514(a)(1) and §
514(a)(2).
(2) STEP 2:
Allocate
the amount for which a charitable deduction would be allowable under IRC §
642(c) between the amount determined in Step 1 and any other income of the
trust. (Allocation is made based upon
ratio of amount determined under Step 1 to the taxable income of the trust,
determined without the reduction for personal exemption under IRC § 642(b), the
charitable contributions deduction under IRC § 642(c), or the deduction for
distributions to beneficiaries under IRC § 661(a).)
Example: If the trust provides the CLT is to pay
$750,000 to charity, then the otherwise allowable deduction under IRC § 642(c)
is $750,000. The portion allocable to
UBTI is $250,000, that is, the amount which bears the same ratio to $750,000 as
UBTI bears to total CLT income, i.e. 33%.
(3) STEP 3:
Reduce
the amount in Step 2 by the charitable contribution deduction allowed under IRC
§ 512(b)(11) as if the CLT were an organization exempt from tax under IRC §
501(a) by reason of IRC § 501(c)(3).
Example: $250,000 - $99,000 (30% of $330,000, the
charitable contributions deduction which would be allowed under IRC §
512(b)(11)) = $151,000. This final
figure is the amount disallowed as an income tax charitable deduction for the
CLT.
(4) SUMMARY OF EXAMPLES:
(a) CLT has income of
$1,000,000 from rental real property.
The property is debt-financed property.
(See calculations under
Step 1 above.)
(b) Trustee is required to
pay $750,000 of CLT income to charity.
(c) UBTI = $1,000,000 x .33
= $330,000. (See calculation of debt/basis percentage under Step 1 above.)
(d) Deduction otherwise
allowable under IRC § 642(c) is $750,000.
(e) Portion allocable to
UBTI (See Step 2) = $250,000
[$330,000/$1,000,000 = x/$750,000].
(f) Portion allocable to
UBTI and disallowed as deduction (See
Step 3) = $250,000 - $99,000 (30% of $330,000, the charitable contribution
deduction which would be allowed under IRC § 512(b)(11)), or $151,000. (See
Treas. Reg. § 1.681(a)-2(c)(2).)
(g) The income tax
charitable deduction allowed CLT:
(i) Related to non-UBTI
CLT income under IRC § 642(c) = $500,000.
(ii) Related to UBTI of CLT
under IRC § 512(b)(11) = $99,000.
(iii) Total CLT income tax charitable deduction = $599,000.
3. ALTERNATIVE MINIMUM TAX (“AMT”)
Alternative
minimum tax is applicable to a charitable lead trust only to the extent the
alternative minimum tax exceeds the trust’s regular tax. IRC § 55(a).
If the trust’s regular tax is lower than the AMT, it is subject to
AMT. IRC § 55 et seq. The income subject to AMT is equal to the
excess of the trust’s “tentative minimum tax” for the tax year over the trust’s
“regular tax” for the tax year. IRC §
55(a). The tentative minimum tax is 26%
of the AMT base not exceeding $175,000 plus 28% of the excess, reduced by the
AMT foreign tax credit. IRC §
55(b)(1). The AMT base is the
alternative minimum taxable income less the exemption amount. IRC § 55(b)(1). (After 1993, exemption is $22,500 for trusts
which is phased out for high income taxpayers.
IRC § 55(d).) However, in 1982,
adjusted itemized deductions were eliminated as an item of tax preference for
irrevocable inter vivos charitable lead trusts.
See T.M. Portfolio 442-2nd:
Charitable Income Trusts. See also
Treas. Reg. § 1.58-3T. Temporary
regulations provided that itemized deductions, which are not alternative
minimum tax itemized deductions, are treated as tax preference items for former
IRC § 58(c) and should be apportioned between the trust and beneficiaries. Id. The effect of this change was that,
subsequent to this change, the only item of tax preference of consequence to a
charitable lead trust was the capital gains preference, which was eventually
eliminated. See T.M. Portfolio 442-2nd: Charitable Income Trusts.
4. CAPITAL GAINS TAX
Gains
may be allocated to corpus or income as governed by the trust instrument. When the instrument is silent on capital
gains, local law applies, generally allocating gains to corpus. If gains are allocated to corpus, they will
not be income tax deductible even if distributed to a charity as part of a lead
trust payment. See Rev. Rul. 83-75, 1983-1 C.B. 114.
5. TIER SYSTEM OF ALLOCATION
If neither local law nor the trust instrument dictates the nature of payment made to charitable beneficiaries, the amounts may be deemed to be pro rata distributions of the income of the trust. Treas. Reg. 1.643(a)-5(b) and § 1.662(b)-2; Rev. Rul. 71-285, 1971 - 12 C.B. 248. But see PLR 8727072. In PLR 9233038, the Service stated that the allocation in the trust would not be given effect for federal income tax purposes and that trust income would be deemed to come proportionately from each class of income. That case involved a 6% charitable lead unitrust which paid the unitrust amount to the grantor’s family foundation. The governing instrument provided that if ordinary income was not sufficient to pay the unitrust amount, the lead amount would be considered as taken first from long term capital gains, then out of tax exempt income, and finally out of principal. This was an attempt to impose on the charitable lead trust a tier system of taxation which applies to remainder trusts. Despite the Service’s ruling to allocate the income pro rata, the trust was, nevertheless, approved.
6. ESTATE/GIFT TAX
Grantor
contributes property to the trust and pays tax only on the value of the
remainder interest. Treas. Reg. § 1.170A-6(c)(3). The appreciation in a lead trust of trust
assets escapes transfer tax. It is
possible to achieve a charitable contribution deduction of close to 100% of the
trust assets by use of certain discount rates.
7. GENERATION SKIPPING TAX (“GST”)
Whether
or not GST applies depends upon the status of the remainder beneficiaries and
whether CLUT or CLAT.
a. Where
income or corpus is transferred to a skip person (certain relatives two or more
generations below grantor’s generation or, absent such relationship, any
individual born more than 37 ½ years after grantor), GST applies. IRC § 2601; § 2611; and § 2611. Under IRC § 2651(e)(3), a charity is
considered to be in the same generation as the grantor of the CLT and, therefore,
no GST is due upon the initial transfer of property to the trust, i.e. a CLT is
not a direct skip trust.
b. Generation
skipping transfers include: 1) taxable distributions, IRC § 2612(b); 2) taxable
terminations, IRC § 2612(b); and, 3) direct skips, IRC § 2612(c). Unless governed by the trust instrument, tax
on the transfer is charged to the property constituting the transfer property.
c. Tax
is highest estate and gift tax rate. IRC
§ 2641.
d. Tax
is in addition to any estate or gift tax.
e. GST
is determined by multiplying the taxable amount (GST transfer) times the
applicable rate under IRC §§ 2602 & 2641.
The applicable rate is the inclusion ratio times the maximum federal
estate tax rate. IRC § 2641. The inclusion ratio is determined by
subtracting the applicable fraction from 1, IRC § 2642, and takes into account
the amount of property transferred, the amount of GST exemption allocated to
the transfer, death taxes paid, and any estate or gift tax charitable deduction
allowed. IRC § 2642(a). See
PLR 8729051. Specifically, the
applicable fraction is determined by dividing the amount of GST exemption
allocated to the transfer by the value of the property transferred to the
trust, reduced by the sum of the property’s Federal Estate Tax or State Death
Tax, if any, allocable to recovery from the trust and any charitable deduction
allowed as to the property under IRC § 2055 or § 2522. IRC § 2642(a). For GST exemption allocation on transfers to
a charitable lead unitrust, the value of the property transferred to the
trust is determined on the date of funding or transfer (like for the gift and
estate tax). IRC § 2642(a). However, the GST exemption allocation at date
of transfer or funding in PLR 8729051 is no longer available to charitable lead
annuity trusts as a result of IRC § 2642(e). Under that section, the applicable fraction
is redefined for transfers to charitable lead annuity trusts after
October 13, 1987, the numerator being the allocated portion of the exemption at
the date of funding or transfer increased by the interest determined at the
rate used for valuing the charitable interest, compounded annually for the term
of the charitable interest, and the denominator being the value of the property
in the trust immediately after the termination of the charitable lead annuity
trust charitable interest. The amount of
the exemption allocated may not be reduced even though it is ultimately
determined that the allocation of a lesser amount to the charitable lead annuity
trust would have resulted in an inclusion ratio of zero (as where the trust
property does not appreciate to the extent expected). This means that the GST exemption cannot be
leveraged as to the charitable lead annuity trust but can be leveraged
as to the charitable lead unitrust.
See H.R. Rep. No 795, 100th
Cong. Second Sess., at 347.
B. Grantor CLT
1. INCOME TAXATION OF TRUST
Grantor
remains taxable on income earned by the trust (i.e. the initial deduction is
recaptured over the term of the trust as the trust’s income is taxed to
grantor) IRC § 671, et seq.
Planning
Opportunity:
However,
the grantor may alleviate the effect of being taxed on the income by having the
Trustee invest in tax exempt investments.
See PLR 8427022 regarding
approval of municipal bonds for assets of lead investment trusts.
a. Grantor receives an income tax charitable deduction for value of lead interest passing to charity. This contribution is subject to the 30% limitation under IRC § 170(b)(1)(B) because the gift is deemed to be “for the use of” rather than “to” charity. Treas. Reg. § 1.170A-8(a)(2). This limitation is imposed regardless of whether the charitable beneficiary is a public or private charity. If the contributed property is appreciated capital gain property, the limitation is 20%. IRC § 170(b)(1)(D). Because grantor receives an immediate income tax charitable deduction in the year of the transfer to the trust, no further charitable deductions are allowed to either grantor or the trust (unless in any year the payment to charity exceeds the required annuity or unitrust amount). Treas. Reg. §§ 1.170A-6(c) and 1.170A-6(d)(2)(ii); IRC § 170(f)(2)(B).
b. If the grantor dies or
relinquishes certain trust powers and, therefore, is not taxed on the income of
the trust prior to full recapture of the charitable deduction, the uncaptured
portion remaining is accelerated and taxed as ordinary income. The taxable portion is the value of the
initial charitable deduction less the discounted value of all amounts which
were actually paid to the charitable organization before cessation of tax to
the grantor. IRC § 170(f)(2)(b); Treas.
Reg. § 1.170A-6(c)(4). This acceleration
provision is not to be construed to disallow a deduction to the trust for
amounts paid by the trust to charitable organizations subsequent to the
cessation of grantor being taxed as the owner of the trust. Treas. Reg. § 1.170A-6(c)(4).
2. ALTERNATIVE MINIMUM TAX
A
grantor of a charitable lead trust is subject to AMT on the same basis as an
individual taxpayer. See discussion above. For a grantor of a grantor trust, items of
income and deductions and preference items are included in the grantor’s
income.
3. CAPITAL GAINS TAX
The
extent to which a grantor is taxed on the income and capital gains of the CLT
depends on the grantor’s power over the trust.
A grantor is taxed on the portion of income to which such grantor is
considered to be the owner. See Treas. Reg. § 1.671-3(a)(3). If a grantor has a reversionary power which
extends only to ordinary income, then the grantor will be taxed only on those
items included in ordinary income and not those allocated to corpus. Treas. Reg. § 1.671-3(b)(1). If the grantor is considered the owner of the
entire trust, then the grantor is taxed on all ordinary income and capital
gains of the trust.
4. TIER SYSTEM OF ALLOCATION
A tier
system of allocation of income described in the previous section applicable to
non-grantor CLTs would only be applicable where a grantor is not taxed on the
entire income of the trust. Where a
grantor is taxed on all of the income of the CLT, a tier system of allocation
of income would serve no purpose.
5. ESTATE TAXES
In most
cases, because of the grantor’s or the grantor’s spouse’s retention of certain
powers necessary to make the trust a grantor trust for income tax purposes,
corpus is included in grantor’s estate for federal estate tax purposes. See
IRC §§ 2036, 2038, and 2035. Although
the result is questionable, if grantor desires to avoid inclusion of the assets
in the gross estate in the event he or she dies during the trust term, extra
care should be taken in drafting to assure that the circumstances which make
the trust a grantor trust for income tax purposes under the grantor trust rules
of IRC § 671 et seq. do not cause the assets to be included in
the grantor’s estate or constitute an act of prohibited self-dealing. See
442 T.M., Charitable Income Trusts: The “Super Trust” Grantor Charitable Lead
Trust. See also above discussion regarding income tax acceleration upon
death of grantor.
6. GIFT TAX
If the
gift tax charitable deduction is not obtained, the entire corpus will be
subject to gift tax. To prevent this,
the trust must be in the form of a charitable lead annuity trust or charitable
lead unitrust. No distinction is made
between gifts “for the use of” and “to” charity.
7. GENERATION SKIPPING TAX
If a CLT
is considered to be a grantor CLT for income tax purposes only, then the
discussion in the previous section applicable to non-grantor CLTs is fully
applicable. See discussion pertaining to non-grantor CLTs above.
8. UNRELATED BUSINESS TAXABLE INCOME
UBTI
concerns are not an issue because the grantor is taxed on the income and the
trust is not limited by IRC § 681 concerning limitation of a trust’s IRC §
642(c) income tax charitable deduction.
IV. SPECIAL CONSIDERATIONS
A. Trustee
The creator of a CLT must be cautious in choosing a trustee so as to fall within the desired tax rules.
1. INDEPENDENT TRUSTEE OR QUALIFIED APPRAISER FOR VALUATION OF ASSETS
Although the governing
instrument of an intervivos or testamentary CLT is not required to provide for
the appointment of an independent trustee or qualified appraiser for the
valuation of those assets that are not readily ascertainable, the initial
valuation of those assets must actually be determined by an independent trustee
or qualified appraiser according to the income tax substantiation
requirements. See Treas. Reg. §
1.664-1(a)(7) and H.R. Rep. No. 413, 91st Cong. 1st Sess.
60 (1969), 1969-3 C.B. 200, 239, 423, 644 (discussing need for independent
trustee in valuing assets of charitable remainder trusts at the time of the
initial valuation [for a charitable remainder annuity trust] or each year [for
the charitable remainder unitrust] and Treas. Regs. § 1.664-1(a)(7). See
also P.L.R. 9623018 (Mar. 5, 1996) applicable to charitable remainder
trusts. But see, Rev. Rul. 80-83, 1980-1 C.B. 210, (qualifying a trust as a
charitable remainder trust where the creator of such trust was serving as
Co-Trustee and was a director on the board of a publicly held corporation whose
stock was owned by the charitable remainder trust and holding that the
Co-Trustee/director was bound by a fiduciary duty in his capacity as Co-Trustee
and as director to exercise independent judgment on behalf of the trust and the
corporation and that the Service is not bound by the valuation in determining
the charitable deduction.) The Final
Regulations changed the rule regarding the need to have an independent trustee
to allow for valuation by an independent trustee or a qualified appraiser. Treas. Reg. § 1.664-1(a)(7). Although an
income tax charitable deduction may not be sought, as with a non-grantor CLT,
the substantiation requirements for income tax charitable deductions give
guidance as to what the Service requires for the valuation of assets for estate
and gift tax purposes and, therefore, the cautious creator of a CLT will follow
such substantiation requirements. See Treas. Reg. §. 1.17OA-13(c)(5).
Before the new Final
Regulations were passed in 1998, in determining whether or not an independent
trustee was required, guidance could be found in the legislative history of the
rules governing charitable remainder trusts as discussed above. H.R. Rep. No. 413 (Pt. 1), 91st
Cong., 1st Sess. 50 (1969).
The legislative history of section 664 indicates that Congress
contemplated denying the charitable deduction when a grantor of a CRT, who was
also Trustee, transferred hard-to-value assets (i.e. all assets other than
cash, cash equivalents and marketable securities) to a CRT unless an
independent trustee valued the hard to value assets. H.R. Rep. No. 413, 91st Cong., 1st Sess. 60
(1969), 1969-3 C.B. 200, 239. Thus, if
the grantor was the trustee of a CRT, the governing instrument had to provide
that the annual valuation of the hard to value assets be prepared by an
independent valuation trustee. The
December 10, 1998 Final Regulations changed this requirement. Under the Final Regulations, a trust’s
unmarketable assets must either be valued by an independent trustee or by a
qualified appraiser. Treas. Regs. 1.664-1(a)(7).
An independent trustee is a
person other than the grantor, or the grantor’s spouse, a noncharitable
beneficiary or a party related or subordinate to either of them. Treas. Regs. 1.664-1(a)(7)(iii). A co-trustee who is independent may value the
trust’s unmarketable assets. A qualified
appraiser is defined in Treas. Regs. Section 1.170A-13(c). Even though the legislative history addresses
only charitable remainder unitrusts, the conservative view is that the Service
may require an independent valuation trustee or qualified appraiser in regards
to a charitable lead trust as well.
Because of this legislative history, it is common practice in drafting
charitable remainder trusts to provide for the appointment of an independent
valuation trustee or qualified appraiser if either of the following
circumstances is present:
(a) the trustee of the unitrust is the donor or a party related
or subordinate to the donor; or,
(b) one of the charitable remaindermen of the unitrust is or may
be a private foundation with respect to which the donor is a “disqualified
person,”
Related or Subordinate Party: A party is a related or subordinate party if
the party is a non-adverse party and is also the donor’s (a) spouse (if living
with the donor); (b) parent, (c) issue, or (d) brother or sister. I.R.C. § 672(c). Brothers and sisters of the halfblood are
considered related or subordinate parties for these purposes. Rev. Rul. 58-19, 1958-1 C.B. 251. Additionally, an employee of the donor or of
a corporation in which the holdings of the donor and/or the unitrust are
significant with respect to control, or in which the donor is an executive,
also is a related or subordinate party.
I.R.C. § 672(c)(2).
A non-adverse party is any party who is not an adverse party, I.R.C. § 672(b), including any party who has a substantial beneficial interest in the trust (including a general power of appointment over the trust) which would be adversely affected by the exercise or non-exercise of the power over the trust. A beneficial interest includes the right to share in trust income or corpus (either at present or in the future) and also includes a general power of appointment over the trust. Treas. Reg. § 1.6720-1(a)(b). An interest need only be “not insignificant” to be a substantial interest. Treas. Reg. § 1. 672(a)-1(a). Clearly, a remainder beneficiary or income beneficiary of a trust, contingent or otherwise, would have more than an insignificant interest in the trust and, therefore, would have a “substantial interest.” A party’s interest is adverse to the exercise or nonexercise of any power over the trust if, and to the extent that, such exercise or non-exercise of any power will affect the amount of income or principal received by the other party. Treas. Reg. § 1.672(a)-1(a)-(d).
Disqualified Person: The following are disqualified persons with respect to the CLT for valuation purposes:
(a) A settlor of or substantial contributor to the CLT;
(b) A trustee of the CLT;
(c) An owner of more than 20% of the equity interest in a
partnership or corporation or beneficial interest of a trust or unincorporated
enterprise that is a substantial contributor to the CLT;
(d) A member of the family of
any of the three preceding categories of persons (family members including:
spouse, ancestors, children, grandchildren, great-grandchildren and the spouses
of children, grandchildren and great-grandchildren);
(e) A corporation in which the four preceding categories of
persons own, directly or indirectly, more than 35% of the total combined voting power;
(f) A partnership in which the first four categories of persons
own, directly or indirectly, more than 35% of the profits interest; and,
(g) A trust or estate in which the first four categories of
persons hold, directly or indirectly, more than 35% of the beneficial interest.
I.R.C. § 4946(a)(1). Although a Trustee of the CLT is a disqualified person, if such Trustee would not be a disqualified person but for the party’s service as Trustee and is not a related or subordinate party, such Trustee may serve as an independent valuation trustee because such party meets the qualification for an independent trustee discussed in the legislative history to the charitable remainder unitrust rules.
2. INDEPENDENT TRUSTEE AND GRANTOR TRUST RULES
The grantor of a CLT is treated as the owner of any portion of the CLT that the beneficial enjoyment of the corpus or the income is subject to a power of disposition, exercisable by the grantor or a non-adverse party, or both, without the approval or consent of any adverse party. I.R.C. § 674(a). An exception is provided if the determination of the beneficial enjoyment of the corpus or income is irrevocably payable for charitable purposes, I.R.C. § 674(b)(4). This includes the power to choose among charitable beneficiaries or to affect the manner of their enjoyment of a beneficial interest. Treas. Regs. § 1.674(a)-l(b)(1)(iii); § 1.674(b)-1(b)(4). An additional exception is provided if the power is exercisable by a trustee or trustees, none of whom is the grantor, and no more than half of whom are related or subordinate parties who are subservient to the wishes of the grantor. I.R.C. § 674(c); Treas. Regs. § 1.674(c)-l. (See above discussion of related or subordinate parties).
3. RELATED PARTY AS TRUSTEE
In P.L.R. 9331015, a child of the Grantor of a CLT was named to serve as Trustee of the CLT. The CLT did not specifically identify the charitable recipients of the CLT payments. The child, serving as Trustee, was to choose the charitable recipients of the CLT payments but the charitable recipients had to be charitable organizations other than those controlled by the child. The Service ruled that the CLT was not disqualified because a child of the Grantor was serving as Trustee. Their reasoning was that “there is no provision in § 2522 of the Code or the corresponding regulations that prohibits a relative of the Grantor from serving as Trustee of a charitable lead trust.” P.L.R. 9331015 (May 6, 1993).
The ruling does not turn on
the fact that the Trustee cannot pay the lead payments to charitable
organizations that are controlled by the Trustee, rather such is merely a fact
in the case. The conservative position
in this situation would be to draft the CLT to fall within the limits of P.L.R.
9331015 and to not allow the child, as Trustee, to choose to pay the lead
payment to charitable organizations controlled by the child. Alternatively, the CLT instrument could require
the lead payment to be paid to the charitable organization controlled by the
child, thereby removing the discretion of the child in the payment and thereby
avoiding the factual scenario set forth in P.L.R. 9331015.
General Power of Appointment: The ability of related parties, serving as Trustees, to choose the charitable recipients of the lead payments, does not cause any estate inclusion under I.R.C. § 2041 as such power does not encompass the power to appoint the assets to the trustee, himself, the trustee’s creditors, the trustee’s estate or the creditors of the trustee’s estate. P.L.R. 9532007, P.L.R. 9331005. But see P.L.R. 9304020 where independent trustee was requested to consult with Grantor’s children on selection of charitable recipients of lead payments and Service ruling that mere consultation does not rise to level of general power of appointment.
I.R.C. § 2036 Inclusion in
Grantor’s Estate: If a grantor creates a CLT and
the charitable lead payment is required to be paid to the Grantor’s private
foundation of which the Grantor is an officer and director, then the Grantor
has retained the right to designate the enjoyment of the property sufficient to
cause the assets to be included in the Grantor’s estate. Rifkind v. United States, 5 Cl. Ct.
362 (1984) This reasoning stems from
Rev. Rul. 72-552, 1972-2 C.B. 525, where a Grantor made inter vivos gifts to a
charitable corporation of which the donor was president and, in serving as
president, had the ability to direct the disposition of the charitable
corporation’s funds. The Service ruled
that the value of the inter vivos gifts was includible in the gross estate of
the donor because of the retained power of disposition. The cases addressing this issue track the
following progression:
P.L.R. 9534004 (May 16,
1995) provides that where the donor was neither the Trustee of the CLT nor the
director of the private foundation to which the lead payment was required to be
paid, the trust corpus was not included in the donor’s estate under I.R.C. §
2036. In P.L.R. 9539009 (June 29, 1995),
the Grantor created a charitable lead trust of which his children were the
trustees and also created a private foundation of which his children and his
spouse were Co-Trustees but of which he could appoint himself as trustee. The charitable lead trust was required to pay
the lead payment to Grantor’s private foundation; however, the governing
instrument of the private foundation was
to be amended to provide that Grantor could never participate, as Trustee or
otherwise, in decisions regarding the distribution of the assets of the private
foundation. The Service ruled that
because the Grantor could never participate in the ultimate disposition of the
funds of the private foundation, that the gift was complete and that the
Grantor did not retain any powers that would cause the assets of the private
foundation to be included in his estate for federal estate tax purposes. Id.
Generally, in planning, the
Grantor will want to have the CLT pay to his or her private foundation without
resulting in any estate inclusion. Thus,
the following conclusions may be arrived at in analyzing the situation in which
a Grantor creates a CLT and the lead payment is either required to be paid to
Grantor’s private foundation or the lead payment may be, in the discretion of
the Trustee, paid to Grantor’s private foundation.
Donor CLT Private
Foundation
1. Donor Not
Trustee Donor is
director/officer
Mandatory
payment to Private
foundation
Nexus
(§ 2036 inclusion)
2. Donor’s Children Trustees Donor cannot participate in decisions as to distribution of
unitrust amount
Mandatory
payment to / Private
Foundation
Nexus Broken
(No
§ 2036 inclusion)
3. 3rd
party Trustee Donor
is director/officer
Discretionary
payment to / private foundation
Nexus Broken
(No § 2036 inclusion)
But see P.L.R. 9331015 (May 6, 1993) where Grantor created charitable lead
trust, children of Grantor served as Co-Trustees and Co-Trustees had ability to
choose charitable beneficiaries and where Service held that the fact that the
designation will be made by the Co-Trustees will not in and of itself lead to a
conclusion that the gift is incomplete under the rationale of Rev. Rul. 77-275,
assuming that the Grantor does not control the designation through influence
over the co-trustees. An interesting
fact also mentioned by the Service was that the trust prohibited the Trustees
from making unitrust distributions to organizations in which the Grantor
occupied a fiduciary office although the Service’s decision did not turn on such
fact.
B. Disqualified Person As General Partner Of Partnership/Avoidance Of Self-Dealing
A transaction between a partnership which has an partnership interest owned by a CLT and a disqualified person is not a direct act of self-dealing because the CLT is not directly involved in such transaction. However, a transaction between such partnership and a disqualified person may be an indirect act of self-dealing. In that situation, because the partnership is controlled by the CLT, it is as though the disqualified person is acting with the CLT itself. (See description of Self-dealing above for general rules against self-dealing.) An act of indirect self-dealing may arise:
1)
Where there is a transaction between a disqualified person and an
organization “controlled” by a private foundation;
2)
Where a disqualified person transacts with respect to a private
foundation’s interest or expectancy in property held by an estate or revocable
trust. Treas. Reg. § 53.4941(d)-1(b)(3);
and,
3)
Where a grant is made to an intermediary organization, which
intermediary organization uses the grant to benefit a government official.
The mere voting of stock held in a partnership is not a violation of any direct act of self-dealing. However, each act must be reviewed on a case by case basis to determine whether a prohibited act of direct or indirect self-dealing has occurred. Where a partnership interest is owned by a CLT, an indirect act of self-dealing may arise most likely under the first situation listed above. Control may arise under two tests set forth in Treas. Regs. § 53.4941(d)-1(b)(5):
1)
If the private foundation (CLT) or one or more of its managers (acting
only in such capacity) may, only by aggregating their votes or positions of
authority, require the organization to engage in a transaction that if a
disqualified person engaged in with the private foundation (CLT), would
constitute self-dealing; or,
2)
If a disqualified person (together with one or more persons who are
disqualified persons because of their relationship) may, only by aggregating
their votes or positions of authority with that of the private foundation
(CLT), require the organization to engage in such a transaction.
Additionally, an
organization will be considered to be controlled by a private foundation (CLT)
or by a private foundation (CLT) and disqualified persons if such persons are,
in fact, able to control the organization (even if aggregate voting power is
less than 50%) or if one or more of such persons has the right to exercise veto
power over the actions of such organization relevant to any potential acts of
self-dealing. Id.
If the Trustee of the CLT,
in his or her capacity as Trustee has no ability to control the partnership or
to cooperate with any other person or persons to collectively control the
partnership and cannot exercise veto power over any actions of the partnership,
no indirect act of self-dealing should arise.
The actions of the Trustee acting not as Trustee, but as general partner
of the partnership are not imputed to the CLT sufficient to establish “control”
within the meaning of Treas. Regs. § 53.4941(d)-1(b)(5). See
also Rev. Rul. 76-158, 1976-1 C.B. 354.
Therefore, the partnership would not be “controlled” by the CLT and no
act of indirect self-dealing should arise.
See examples under Treas.
Regs. § 53.4941(d)-1(b).
However, if additional
capital contributions may be made to a partnership that would alter the capital
make-up of the partnership and therefore affect future distributions, an act of
self-dealing may arise because the disqualified person has exchanged the
subsequent capital contribution to the partnership for a larger partnership
interest. See P.L.R. 9705013 (Oct. 31, 1996).
As a result of the
foregoing, it is important to construct the partnership agreement where an
interest is to be held by a CLT to provide for appropriate restrictions so as
to not violate any act of self-dealing, direct or indirect. The partnership agreement should also provide
that if the voting procedure of an act of the partnership is violative of an
act of self-dealing, that the general partner has the ability to modify the
procedure so as to not violate any prohibition against acts of self-dealing.
C. Treatment of CLT Payment Received By Private Foundation
Treas. Reg. § 53.4942(a)-2
provides that the undistributed income of a private foundation of which the
mandatory payout is determined is increased by the income portion of
distributions from charitable lead trust described in I.R.C. § 4947(a)(2) and
includes the greater of: (a) the amount of such distribution which is treated
as income (within the meaning of section 643(b)), or (b) the guaranteed
annuity, or fixed percentage of the fair market value of the trust property
(determined annually), which the private foundation is entitled to receive for
such year, regardless of whether such amount is actually received in such year
or in any prior or subsequent year. If
this provision is held valid, a private foundation would be required to include
in its distributable amount, the amounts of income (or the guaranteed annuity
or unitrust payment) from a CLT.
However, the Tax Court and the Ninth Circuit Court of Appeals
invalidated the Regulation, determining that the Regulation was not amended at
the time the underlying statute was amended and that the Regulation was an
unwarranted extension of the statute.
See
V. ADVANTAGES OF CHARITABLE LEAD TRUST
A. Generally
used by wealthy individuals with sufficient current assets to provide current
benefits to charity with later return to the donor or donor’s non-charitable
beneficiaries, normally family members.
If the property is transferred at the end of the charitable term to
donor’s named beneficiaries, it can be at a value less than the value at the
time the trust was funded and less than the value of the property at the time
it is received by donor’s named non-charitable beneficiaries, i.e. children,
grandchildren or trusts therefor.
B. Used
in conjunction with the Charitable Remainder Trust, can provide significant
estate and gift tax reduction to enhance property going to donor’s named
non-charitable beneficiaries.
C. Can
remove an appreciating asset from grantor’s estate (whether grantor (Super) CLT
or non-grantor CLT).
D. Can
avoid the percentage limitations on an income tax charitable deduction imposed
on individuals if the trust is a non-grantor CLT. If the trust is a non-grantor testamentary
CLT, the beneficiary receives a step-up in basis as to assets passing to the
non-grantor testamentary CLT.
E. Is
not subject to the special valuation rules of IRC § 2702. See
Treas. Reg. § 25.2702-(1)(c)(3), (4) and (5) excepting charitable remainder
trusts, pooled income funds and charitable lead trusts from IRC § 2702.
Vi. DISADVANTAGES/LIMITATIONS OF CHARITABLE LEAD TRUST
A. If
CLT income is insufficient to fund the payment to charity, the Trustee must
make distribution from corpus (in kind or cash from sale of corpus), or by
borrowing (with UBTI ramifications – debt financial income), or possibly from
additional contributions (if unitrust version).
B. Income
of Non-Grantor CLT in excess of guaranteed payment may be retained by the trust
(and trust income tax paid) or distributed to charity (and additional trust
income tax charitable deduction taken).
Treas. Reg. § 1.170A-6(c)(2)(i)(C).
No additional income tax charitable deduction is allowed to an
individual under IRC § 170(f)(2)(B) for payment of excess income of non-grantor
CLT to charity. Treas. Reg. §
1.170A-6(c). However, this does not
disallow an income tax charitable deduction to a grantor of a grantor
charitable lead trust under IRC § 671 and Treas. Reg. § 1.671-2(c) for a
charitable contribution made by the trust in excess of the guaranteed payment required
to be made by the trust. Treas. Reg. §
1.170A-6(d)(2). A non-grantor charitable
lead trust is allowed a charitable deduction for any excess payments paid from
gross income, which pursuant to the governing instrument, is paid for an exempt
purpose or a set-aside income tax deduction under IRC § 642(c). See
T.M. 442-2nd: Charitable Income Trusts - 11.B.3.
C. No
payment may be made to noncharitable beneficiaries during the charitable term
of the trust. Treas. Reg. §§
1.170-6(c)(2)(i)(E) and (ii)(d).
D. Section
642(c) full income tax charitable deduction disallowed for any taxable year to
the extent such deduction is allocable to the CLT’s UBTI for that year. Notwithstanding, the CLT is allowed a
deduction for actual payments allocable to UBTI made to charities, subject to
the percentage limitations applicable to contributions by individuals, but not
subject to the itemized deduction limitation reduction applicable to
contributions by individuals.
E. It
is questionable whether a trust with a prepayment clause qualifies as CLT
because prepayment and commutation is inconsistent with the regulatory
requirements for charitable lead interests and the allowance of a charitable
deduction for the charitable interest. See Rev. Rul. 88-27, 1988-1 C.B. 331;
IRC § 2522(c)(2) and P.L.R. 9734057.
VIi. DRAFTING CONSIDERATIONS/FILING REQUIREMENTS
A. Make
election by attaching information to first return on which take a charitable
deduction.
B. Trustee
should have power to name successor charitable organization in case the current
organization loses its charitable qualification.
C. Set
forth a tier system, not contrary to state law, for allocation of payments to
charitable beneficiaries; otherwise local law may characterize.
D. Allocate
trustee fees to income so they may be deducted by the trust.
E. File
Form 1041 and Schedule K-1, possibly Form 1041-A, and Form 5227. If UBTI is greater than $1,000, must file
Form 990-T. Possibly use Form 4720,
Breach of Excise Tax, if a violation of the private foundation rules occurs.
F. Instrument
should expressly negate any local statutory power of invasion if allowed under
state law.
G. Must
make quarterly payments of taxes resulting from UBTI. (Form 990W).
H. To
minimize CLT income tax as to the non-grantor CLT, the trust instrument should
allow for a reserve for depreciation, and depletion deductions. Otherwise, these items will be allocated pro
rata between the CLT and charity based on income retained/received by each. IRC §§ 642(c), 611(b)(3) and 167(d); Treas.
Reg. §§ 1.642(e)(i), 1.611-1(c)(4) and 1.167(h)-1(b). It is also appropriate to give the Trustee
the power to allocate capital gains between income and corpus so a charitable
income tax deduction can be achieved if it is necessary to distribute gain to
charity as part of a lead trust payment.
I. The
trust instrument should preclude payment of estate taxes from the trust and,
regarding a testamentary lead trust, should state specifically that the trust
will not be funded until all estate taxes are paid. See PLR
7914008. See also, Rev. Rul. 82-128, 1982-2 C.B. 71.
J. The
trust instrument should contain a provision covering the lead trust payment of
a short taxable year.
K. The
trust instrument should give the Trustee the power to amend the trust for the
purpose of maintaining the trust’s tax qualified status as a qualified
CLT.
L. The
charitable lead annuity trust instrument should prohibit additional
contributions. See PLR 8034093 and 802195.
M. The CLT instrument
should provide for an independent valuation trustee.
N.
The CLT instrument should set forth how to distribute or accumulate
excess income, after considering the tax implications resulting from each
alternative.
O.
Consider whether to include a spendthrift provision based upon whether
or not the remainder interest in the trust will be sold or transferred.
P.
Consider final regulations for determining appropriate term and any
necessary reformations.
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