Tax Fundamentals of Charitable Contributions and Planned Giving

© 2005 All Rights Reserved

MacKenzie Canter, III
Copilevitz & Canter, LLC
1900 L Street, NW
Suite 215
Washington, DC 20036
(202) 321-6915
maccanter@aol.com

BASIC FEDERAL TAX LAWS AFFECTING CHARITABLE CONTRIBUTIONS...1

1. FEDERAL TAX RATES
2. CHARITABLE CONTRIBUTIONS OF LONG TERM CAPITAL GAIN ASSETS ARE MORE “TAX EFFICIENT”
3. THE THREE ESSENTIALS FOR A CHARITABLE CONTRIBUTION DEDUCTION: DONOR, GIFT, AND DONEE
4. CASH GIFTS TO THE EXEMPT ORGANIZATION
5. NON-CASH GIFTS TO THE EXEMPT ORGANIZATION
6. BARGAIN SALES
7. NO DEDUCTION FOR GIFT OF “PARTIAL INTEREST” IN PROPERTY
8. GIFT OF FUTURE INTEREST IN TANGIBLE PERSONAL PROPERTY
9. GIFT OF REMAINDER INTEREST IN PERSONAL RESIDENCE OR FARM
10. GIFT OF INTELLECTUAL PROPERTY
11. REDUCTION IN DEDUCTION FOR CERTAIN DEPRECIATION DEDUCTIONS
12. SUBSTANTIATION RULES
13. THE ALTERNATIVE MINIMUM TAX (“AMT”) AND THE CHARITABLE CONTRIBUTION DEDUCTION
14. GIFTS OF PENSION PLAN ASSETS
15. CODE § 514: TRAP FOR THE UNWARY
16. THE GENERATION SKIPPING TRANSFER TAX (“GST”) AND CHARITABLE GIVING

CHARITABLE CONTRIBUTIONS OF REAL ESTATE…………………39

1. ASSESS RISKS AND USE PREVENTIVE MEASURES
2. WRITTEN AGREEMENT WITH ALL PROPOSED GIFTS OF REAL ESTATE
3. CREATE ANCILLARY ORGANIZATION TO HOLD TITLE
4. THE GUEST TECHNIQUE

CHARITABLE GIFT ANNUITIES………………………………46

1. CHARITABLE CONTRIBUTION DEDUCTION
2. ANNUITY RATES
3. TAXATION OF ANNUITY PAYMENTS
4. TRANSFER TAXES
5. BARGAIN SALE RULES
6. DEFERRED GIFT ANNUITY
7. “HARD-TO-MARKET” PROPERTIES
8. EXCHANGE OF INCOME INTEREST IN CRT FOR CGA
9. TAX CONSEQUENCES TO CGA ISSUER
10. FEDERAL AND STATE REGULATION
11. RESERVES OR REINSURANCE

CHARITABLE LEAD TRUSTS………………………60

1. TYPES OF TRUSTS
2. GIFT TAXES
3. ESTATE TAXES
4. POST 2009 CREATION OF CHARITABLE LEAD TRUSTS

CHARITABLE REMAINDER TRUSTS……………………… …69

1. THE TWO TYPES OF CRTS
2. ELEMENTS COMMON TO CRAT AND CRUT
3. REVENUE PROCEDURE 2005-24: SPOUSAL WAIVER OF ELECTION REQUIRED
4. CALCULATING THE TAX DEDUCTION
5. EXEMPT FROM CAPITAL GAINS TAX
6. DISTRIBUTIONS ARE TAXED WHEN RECEIVED BY INCOME BENEFICIARY
7. CRAT SPECIFICS
8. CRUT SPECIFICS
9. “FLIP CRUTS”
10. THE “50%” AND “10%” RULES
11. WEALTH REPLENISHMENT TRUST (ALSO KNOWN AS ASSET REPLACEMENT TRUST)

BASIC FEDERAL TAX LAWS AFFECTING CHARITABLE CONTRIBUTIONS

No matter how sophisticated the planned gift, it is subject to basic federal tax laws which apply to all charitable contributions, both “lifetime” (inter vivos) and testamentary gifts.¹

Some rules determine whether the gift entitles the donor to a tax deduction (“allowability rules”). Other rules determine the amount of the contribution (“computational rules”). Still other rules determine how much of the deduction can be taken in one year (“deductibility rules”). Finally, there are rules pertaining to documentation (“substantiation rules”).

These basic rules will be reviewed before examining planned gift formats.

FEDERAL TAX RATES

1. Income Tax:

2. Capital Gains²

For taxpayers in the 25%, 28%, 33%, or 35% brackets, the capital gains tax rate is generally 15%. However, capital gains from the sale of “collectibles” and “qualified small business stock” are subject to a maximum 28% rate.

The capital gains rates apply if net long-term capital gains for the year exceed net short-term capital losses. Net short-term gains are taxed at the same rate as ordinary income.

3. Estate and Gift Taxes

The 2001 Tax Act provided for a gradual reduction of estate tax rates and an increase in the credit against estate tax. The estate tax is repealed in 2010, but reverts to the 2001 estate tax rate in 2011 if Congress does not act to make the repeal permanent.

Maximum Tax Rates and Maximum Estate Tax Exemption
2005 - 47 percent; $1,500,000
2006 - 46 percent; $2,000,000
2007 - 45 percent; $2,000,000
2008 - 45 percent; $2,000,000
2009 - 45 percent; $3,500,000
2010 - no estate tax
2011 - 55 percent; $1,000,000³

The repeal applies only to estate and the generation skipping transfer taxes (“GST”), not to the gift tax.⁴ The gift tax continues to apply at a maximum rate of 35 percent. This creates an anomalous situation where one may bequeath property tax-free but cannot make an inter vivos gift of the same property without potentially being subject to gift tax.

Currently, the tax basis of assets subject to estate taxes are “stepped-up” to date of death value. This allows heirs to avoid recognition of gain on appreciation that occurred prior to death. Under the new law, the “step-up” feature is eliminated in 2010. Heirs inherit assets with a “carryover” basis. The “carryover” basis is equal to either the fair market value of assets at date of death or the decedent’s basis, whichever is lower.

There are three (3) exceptions to the “carryover basis” requirement that takes effect in 2010.

• Each estate will receive $1.3 million of basis to be added to the “carryover” basis of any one or more assets held at death.
• An estate will receive additional basis for the decedent's unused capital loss carry forwards and net operating loss carry forwards.
• Estates will be allowed an additional $3 million of basis, to be allocated among the assets passing to a surviving spouse.

The annual exclusion for taxable gifts ($11,000 currently) continues to apply. The annual exclusion is indexed for inflation.

B. CHARITABLE CONTRIBUTIONS OF LONG TERM CAPITAL GAIN ASSETS ARE MORE “TAX EFFICIENT”

1. Cash Gift

Della Donor is in the top income tax bracket. If Della gives $1,000 to the charitable organization, she may deduct $1,000. For a taxpayer in the 40% tax bracket,⁵ a deduction of $1,000 saves $400 in tax. Thus, the “true cost” of the gift of $1,000 to the charitable organization is $600, viz., $1,000 less tax savings of $400. Della pays only 60% of the “real cost” of the gift.

2. Gift of Appreciated Property

Della owns 10 shares of stock in Zeta, Inc. She bought the stock in 2002 for $10 per share. The stock is now worth $100 per share. She contributes the Zeta stock in 2005 to the charitable organization. She has made a gift of $1,000, the same as if she had written a check for $1,000. She is entitled to a $1,000 deduction, the “fair market value” of the stock -- but there is another tax advantage, which often goes unnoticed.

If Della were to sell the stock, she would owe tax on capital gain equal to $1,000 less $100 (her purchase price) or $900. The tax which Della would owe on the sale is $135, viz., $900 x 15%. After paying this tax, she would have $865.

Instead of selling the stock, she contributes it to the charitable organization. She avoids the capital gains tax ($135) and realizes a tax saving equal to $400, the same as if she had contributed $1,000 by check.

What is the “true cost” to Della of making the gift of stock? If Della donates the stock to the charitable organization, she saves $400 in income taxes and avoids $135 in capital gains tax, a “double benefit” equal to $535 in tax savings. Viewed in “after-tax dollars,” Della pays only 46.5% of the cost of the gift of the appreciated stock.

Charitable gift planning stresses after-tax results, i.e., the real economic costs of giving.⁶ When viewed in this context, the difference between giving an asset to the charitable organization and selling it may be surprisingly small. As explained below, in some cases, involving testamentary gifts of retirement plan assets, the comparative “after-tax” cost to the donor is astonishingly low. This is because certain retirement plan assets may be subject both to the estate tax and tax on “income in respect of a decedent.” The combination of the two taxes can consume 70% or more of the retirement plan asset if bequeathed to an heir.

C. THE THREE ESSENTIALS FOR A CHARITABLE CONTRIBUTION DEDUCTION: DONOR, GIFT, AND DONEE

1. The Donor

The donor must have a bona fide “charitable intent.” Where a quid pro quo is present, a charitable intent is absent.

a. Examples of “Quid Pro Quo ” Transactions

In Winters, 30 AFTR2d 72-5696 (2nd Cir.1972), “gifts” to church school were held to be disguised tuition. In Sedam , 36 AFTR2d 75-5217 (7th Cir. 1975), the “gift” was ruled to be the “fee” to admit taxpayer's mother to a nursing home.

In Wineberg , 13 AFTR2d 323 (9th Cir. 1963), following contribution by donor of $5,000 to the church, church reduced by $5,000 the price of timberland it sold to the “donor.”

c. “Step Transactions”

The “step transaction” doctrine generally involves the Internal Revenue Service (“IRS”) “collapsing” ostensibly independent events into a single “transaction” and imputing taxable gain to the donor. It is not always clear what is a “step transaction,” as the following two cases illustrate.

Palmer donated appreciated stock in a corporation to a foundation. Palmer controlled both the corporation and the foundation. The next day, the corporation redeemed its stock from the foundation.⁷

The IRS asserted that Palmer realized income from the redemption of the stock. The IRS imputed the gain to Palmer. Presumably, the IRS’s position entailed the further conclusion—which was not part of the case—that Palmer was entitled to a charitable contribution deduction for the gift of the proceeds to the foundation. This would result in a “wash,” at best, with no tax benefit to Palmer. Palmer argued he was entitled to a deduction for the fair market value of the stock contributed to the foundation which, as a tax-exempt entity, received the income from the redemption tax-free.

The Tax Court ruled that if the taxpayer retains control over the property or if the charity is acting as his or her agent, gain from the sale may be imputed to the taxpayer. The Tax Court also stated: “However, if the entire interest in the property is transferred and the assignor retains no incidence of either direct or indirect control, then the tax on the income rests on the assignee [i.e. the tax-exempt foundation].”

The Tax Court ruled in favor of Palmer, finding that “...the presence of an actual gift… and the absence of an obligation to have the stock redeemed...” negates the step transaction doctrine. (Emphasis added.)⁸

In Blake v. Commissioner, the Tax Court held that the prearranged sale of his yacht caused gain to be imputed to the donor.⁹ Blake gave securities valued at $700,000 to a charity to enable the charity to purchase his yacht. In effect, there was a quid pro quo required by Blake as a condition of the gift.

The charity accepted the gift and sold the stock. The charity used the proceeds to purchase from Blake the yacht for $675,000.The charity sold the yacht several months thereafter for $200,000.

The Tax Court treated the transaction as a single transaction with the charity selling the yacht on behalf of Blake. Blake owed tax on the gain from the charity’s sale of the securities.

Federal courts have not always agreed with the IRS that the step transaction doctrine applies. In fact, the IRS appears to have lost more cases than it has won----but these are reported decisions. There is no way to know how many taxpayers settled with the IRS, which continues to apply this doctrine to disallow charitable contributions.

It is prudent to err on the side of caution. Appearances matter. It is important that the facts-and-circumstances do not suggest the owner negotiated “through” the charitable organization as the “agent” of the owner which is, essentially, what occurred in Blake .

This means the charitable organization should not agree (whether by “handshake” or “informal understanding” or otherwise) with the donor to sell the donated property to any person identified by the donor. The charitable organization must use its independent discretion as to the disposition of the asset in a manner which advances the best interests of the charitable organization. Nothing should compromise the integrity of this discretion.

2. The Gift Must Be “Complete” And “Qualified”

Not all charitable contributions entitle the donor to a charitable contribution deduction, even though the gift is quite valuable and is desired by the Code § 501(c)(3) organization. Examples include:

a. Gifts with “strings” may not be “complete” if the “strings” are more than “insubstantial.” What is “insubstantial”?

Revenue Ruling 75-66¹⁰ provides an illustration. “An individual donated his entire interest in 800 acres of land to the United States and retained the right during his lifetime to train his personal hunting dog, and any other hunting dog he may subsequently own, on trails extending over the entire tract, including the right to maintain paths and lanes relating to the reserved use.”

The IRS ruled that this reserved right was “insubstantial.” The taxpayer was permitted a charitable contribution deduction.

The IRS ruled: “In the instant case, the retained right during the taxpayer's lifetime to train his personal hunting dog on the entire tract, in accordance with the regulations of the Department of the Interior on such use, is not substantial enough to affect the deductibility of the property contributed.”

What about the valuation? The ruling did not address this but the appraisal is required to consider all factors that affect “fair market value” (“FMV”).

What if a donor retained the right to hunt on the land following the donation? Technical Advice Memorandum 8140002 determined a charitable contribution deduction was allowable.

However, retaining the right to cast votes as to shares of stock donated to a charity was held to be “substantial.” See, Revenue Ruling 81-282, 1981-2 C.B. 78.

b. Contingent gifts, unless the contingency is “remote.”

c. Gifts of services.

d. Gifts of the right to use property.

e. Gifts of “partial interests.” No deduction allowed, except for formats, discussed infra , specifically authorized by the Code.

f. A gift of your blood to the Red Cross? No deduction allowed. See, Rev. Rul. 53-162, 1953-2 C.B. 127.

g. A gift of advertising space by a newspaper publisher? No deduction allowed. See, Rev. Rul. 57-462, 1957-2 C.B. 157.

3. The Donee: “Maximum Deduction Donees” vs. Private Foundations

Not all donees qualify and some that qualify are “more qualified” than others.

1. “50%-type donees”:¹¹ churches, schools, hospitals, governmental units and publicly supported charities. See, Code §§ 170(c)(2) and 170 (b)(l)(A)(iv).
2. “30%-type donees”: private foundations (other than certain “operating” foundations and “pass-through” foundations). Except for gifts of publicly-traded securities, donors who contribute non-cash appreciated assets to private foundations are limited to a deduction equal to cost basis, not FMV.

D. CASH GIFTS TO THE EXEMPT ORGANIZATION

1. Deductible up to a “percentage limit” equal to 50% of donor's adjusted gross income, less net operating loss carrybacks (referred to as “contribution base”). For corporations the “percentage limit” is ten percent (10%) of taxable income.
2. 2. What happens if “percentage limits” are exceeded? The excess is a “carryover deduction” which may be deducted in as many as five (5) consecutive years after the year when the gift was made. The same percentage limit applies in the “carryover” years.

E. NON-CASH GIFTS TO THE EXEMPT ORGANIZATION

1. There are three (3) types of property: intangible, tangible, and real. Special “related use” rules apply only to tangible personal property (“TPP”). These rules are discussed infra. Art, antiques, aardvarks, and automobiles are examples of TPP.
2. There are three (3) types of gain (or loss) property: ordinary income, short term capital gain, and long term capital gain. It is important to determine to which category the non-cash gift belongs. Planned giving usually involves “long term capital gain” assets .

a. Ordinary Income Property: The 1969 Tax Reform Act changed the Code to provide that if a taxpayer donated inventory, the taxpayer was required to reduce his or her deduction by an amount equal to any ordinary gain he would have received if the inventory had been sold. The practical result is the deduction is “zero” because the donor’s basis in such property has been reduced to zero. This remains the general rule.

However, in 1976 Congress enacted Code § 170(e)(3)(A) which provides an exception to the general rule.

Code § 170(e)(3)(A) provides that a corporation (other than a “sub-chapter” S corporation) which donates inventory is entitled to a charitable contribution deduction if certain conditions are met:

(1) The use of the inventory must be directly related to the tax-exempt purposes of the donee;
(2) The donee either must use the inventory “...solely for the care of the ill, the needy or infants...” or the donor must have “reasonably anticipated” that the inventory would be so used by the donee;
(3) The donee must not charge the beneficiaries for the transfer or distribution of the inventory (other than a reasonable service charge when the inventory is transferred by the donee to another qualified Code § 501(c)(3) organization); and,
(4) The donor must receive a written statement from the donee “representing that its use and disposition of the property will be in accordance” with the above rules.

If all of these conditions are met, the corporate donor is entitled to a charitable contribution deduction equal to its basis in the inventory plus one-half of appreciation in value, so long as the total deduction doesn't exceed twice the donor's basis in the inventory.¹²

This special exception subsequently was extended to contributions of scientific property used for research (Code §170(e)(4)) and computer technology and equipment for educational purposes (Code §170(e)(6)).

b. Short Term Capital Gain Asset (“STCG”): (owned for production of income, as an investment, or as an asset in a trade or business, for twelve months or less): donor can deduct only his or her cost basis, i.e. what he or she paid for the property.

c. Long Term Capital Gain Asset (“LTCG”): same as STCG asset but owned in excess of one (1) year.

Capital assets include investments, e.g., stocks bonds, collectibles, real estate, life insurance, and certain intellectual property, and certain business equipment (other than “stock in trade.”)¹³

Donor can take a deduction equal to the FMV of LTCG asset when given to the Exempt Organization and avoid capital gains tax on the appreciation in value.

3. Special “Related Use” Rule for Gifts of TPP Owned as an LTCG Asset

The rule requires the donor to reduce the gift by the amount of capital appreciation unless the donor either (1) has a good faith basis for believing the TPP will be used by the Exempt Organization in a substantive manner directly to further its tax-exempt mission (other than a need for cash) or (2) the Exempt Organization in fact so uses the TPP. If the donor meets either test, he or she is entitled to a deduction equal to FMV. Stated conversely (to be technically correct), the donor is not required to reduce the gift from FMV to adjusted basis. If neither test is met the deduction is equal to the lesser of basis or FMV.¹⁴

Example: Assume donor gives a Juan Miro painting, greatly appreciated in value, to the charitable organization in the expectation that the charitable organization will display it as part of a fine arts collection. The donor is entitled to a deduction equal to FMV even if the charitable organization after displaying the painting for a month decides to auction it at Christie's.

If donor gave the painting to the Animal Rescue League, his or her deduction would be limited to cost basis.

What is a related use? The IRS ruled etching of wildlife donated to a state and displayed to the public in state office buildings qualified as a related use. The donation of a stamp collection to a university was ruled a related use when the collection was displayed in the university’s art gallery and was used by the university’s art students. The donation of porcelain art objects to a not-for-profit retirement home was ruled a related use because the donated objects improved the quality of the residents’ living environment. The donation of a horse to a cancer charity could not be “stretched” into related use, and the Tax Court reduced the donor’s deduction by the appreciation in value of the horse.¹⁵

It is only when the TPP (e.g., antique) has appreciated in value that this rule comes into play. If the TPP (e.g., 1996 Ford Escort) is worth less than what the donor paid for it, the deduction is limited to FMV. This is why this rule, as a practical matter, does not apply to “car donation” programs, i.e., almost all cars donated to charity are worth far less than basis, e.g., what the donor paid for the car.¹⁶

4. Special “Percentage Limits” for gifts of LTCG assets

1. Deduction limited to 30% of donor's AGI less net operating loss carrybacks. (The limit is 50% for cash gifts and gifts of ordinary income and STCG property.)
2. Five year carryover is available, with 30% limit in each carryover year.
3. Cash gifts are counted first; i.e., 50% limit applies before the 30% limit.
4. “Step-Down Election.” The taxpayer is permitted to elect to reduce the amount of the deduction by the amount of long-term capital appreciation. The resulting deduction is equal to his or her basis in the property. Code § 170(b)(1)(C)(iii). This is the same reduction required in the case of TPP which is put to an unrelated use. If this election is made, the reduced deduction is eligible for the “50% percentage limit.” However, it is rare that this election is made. If it is made by the taxpayer, it must apply to all contributions of LTCG assets to “maximum deduction donees” which were made in the same year. Treas. Reg. § 1.170A-8(d)(2). Stated conversely, the election cannot be made on a “per item” basis.

F. BARGAIN SALES

When a taxpayer sells a LTCG asset to the charitable organization for an amount less than the asset’s FMV, a “bargain sale” results.

It is part sale and part gift (viz., the difference between the asset's FMV and the selling price.) The charitable contribution deduction is equal to FMV minus selling price, but the taxpayer also may have taxable capital gain on the “sale.”

The taxpayer's adjusted basis must be allocated between the “sale part” and the “gift part.”¹⁷

Example: Della Donor paid $30,000 in 1999 for Ponderosa which is worth $150,000. She sells Ponderosa to the charitable organization for $50,000. The result?

Deduction of $100,000 ($150,000 FMV minus selling price of $50,000). Della's basis ($30,000 ) is allocated as follows:

She realizes taxable LTCG of $40,000 ($50,000 - $10,000).

What if Ponderosa is contributed to the charitable organization and is subject to a first deed of trust? A bargain sale occurs. The “selling price” is equal to the debt encumbering the property. Does it make a difference if Della is not personally liable for the note secured by the deed of trust? No.

Irrespective of whether the charitable organization assumes the debt, e.g., mortgage, secured lien, or deed of trust, the donor is treated as having sold the asset to the charitable organization as a “bargain sale.” The selling price is the debt.

G. NO DEDUCTION FOR GIFT OF “PARTIAL INTERESTS” IN PROPERTY

Code § 170(f)(3) was enacted as part of the 1969 Tax Reform Act. It denies a charitable contribution deduction for a gift of a “partial interest” in property unless the “partial interest” meets certain statutorily approved formats, e.g., charitable remainder trust, gift to a pooled income fund, gift of qualified easement, and gift of remainder interest in personal residence or farm.

“Partial interest” does not mean a gift of a present interest in property owned by the taxpayer -- even if it is a “part interest.”

Example: Della Donor can donate to the charitable organization a 5% tenant-in-common interest in the office building and take a deduction, but she cannot take an income tax deduction if she donates a 100% remainder interest in the office building to the charitable organization.

Treas. Reg. § 1.170A-7(b)(1) provides that an undivided portion of a taxpayer's entire interest in property must consist of a fraction or percentage of each and every substantial interest or right owned by the taxpayer in the property and must extend over the entire term of the taxpayer's interest in the property . In other words, it cannot be “temporally divided.”

Gifts of an undivided present interest in part of the property qualify as charitable contributions. Here are some examples approved by the IRS:

a. A one-half interest in a life estate in an office building in which the donor holds no other interest.
b. A 20% share of a remainder interest in a trust in which the donor holds no other interest.
c. Fifty acres of land out of 100 acres owned by the donor.
d. Property where the donee is given the right, as tenant in common with the donor, to possession, dominion, and control of the property for portion of each year appropriate to the donee's interest in the property.¹⁸

H. GIFT OF FUTURE INTEREST IN TANGIBLE PERSONAL PROPERTY

A gift of a future interest, e.g., a remainder interest, in tangible personal property (“TPP”) does not result in an income tax charitable contribution deduction when the gift is made. An income tax deduction is available only after all intervening interests in and all rights to possession or enjoyment of the property have expired or are held by someone other than the donor or a related person. Code § 170(a)(3). This rule was enacted in 1963 to prevent donors from taking an income tax charitable deduction for a gift of a remainder interest in TPP if the donor or a relative retained the right to possess the property.

No similar provision exists in regard to gift and estate tax deductions. However, the partial interest rules enacted in 1969 under Code § 170(f) prohibit an income, gift, and estate tax charitable deduction for a gift of a remainder interest in TPP unless the property was conveyed to a charitable remainder trust or a pooled income fund .

The interplay of §§ 170(a)(3) and 170(f) may complicate planned gifts of TPP as illustrated below:

Example: X donates a remainder interest in an ancient Greek vase to a museum subject to the right to keep the vase for 5 years. The vase was not transferred to a charitable remainder trust or a pooled income fund. Sections 170(a)(3) and 170(f) would both prohibit an income tax deduction for this gift. Section 170(f), by reference to the estate and gift tax rules, also would prohibit a gift and an estate tax deduction because the vase was not transferred to a charitable remainder trust or a pooled income fund. X, therefore, would be subject to gift tax on the gift of the future interest in the vase to the museum. If X died within five years without having relinquished the right to keep the vase, Section 170(f) (but not Section 170(a)(3)) would prohibit an estate tax deduction for the value of the remainder interest conveyed to the museum.

Assume, however, X donates the vase to a charitable remainder trust or a pooled income fund. Section 170(f) would permit an income tax deduction and, by reference, a gift and estate tax deduction for the gift of the remainder interest in the vase to the museum. If the donor or a relative were an income beneficiary of the trust, § 170(a)(3) would postpone the income tax charitable deduction for the gift of the remainder interest until neither the donor nor his family held any intervening interest in the property itself. For example, if the museum retained the vase during the entire five year period during which the donor or a relative was an income beneficiary, no income tax charitable deduction would be available to the donor. If, however, the museum sold the vase to a third party, the sale would terminate the donor or a relative’s interest in the vase. (That the donor or a relative subsequently had an interest in the proceeds from the sale of the vase would not matter.) The donor then would be able to take a income tax charitable deduction for the value of the remainder interest when the trust sold the property.

Because the transfer of TPP to a charitable remainder trust or a pooled income fund may not permit the donor to take an immediate income tax charitable deduction, TPP should not be used to fund a charitable remainder trust if the donor or a relative is an income beneficiary.

I. GIFT OF REMAINDER INTEREST IN PERSONAL RESIDENCE OR FARM

The donor deeds his or her personal residence or farm to the charitable organization but reserves in the deed a life estate for donor and spouse.¹⁹

1. Charitable contribution deduction is equal to the value of the remainder interest which will pass to the charitable organization upon the death of the surviving life tenant. Treasury Regulation § 1.170A-12 explains how the deduction is computed. First, compute the nondepreciable aspect of the property. (Land does not depreciate; structures depreciate.) Next, refer to Treasury mortality tables; the older the life tenant, the larger the present value of the remainder.

The remainder interest may follow a life estate (i.e. the charitable organization will enjoy full and complete ownership of the residence or farm following the donor’s death) or a fixed term of years designated by the donor. For example, X may deed Blackacre to the charitable organization reserving in the deed all incidents of ownership for 15 years. Following the expiration of 15 years, the interest of X expires. See, Treas. Reg. § 1.170A-7(b)(4).

2. A vacation home qualifies as a “personal residence,” which need not be the taxpayer’s principal residence. Treas. Reg.§ 1.170A-7.²⁰

3. Household furnishings and other personal property, even if deeded with the house, do not qualify. Rev. Rul. 76-165, 1976-l C.B. 279.

4. Land and improvements used to produce agricultural products are regarded as a “farm.”

5. The provision for a gift of a remainder interest in a personal residence or farm is an exception to the rule requiring gifts of partial interests to be in trust. This exception is not applicable to other types of properties, such as an office building, warehouse, shopping center, or investment rental property. If a remainder interest is donated to the charitable organization in “nonqualified” properties, no tax deduction is allowable until the surviving life tenant dies.

J. GIFT OF INTELLECTUAL PROPERTY

If the taxpayer donates a patent or other intellectual property to a qualified organization after June 3, 2004, his or her charitable contribution deduction is limited to the basis of the property or the fair market value of the property, whichever is less. Intellectual property means any of the following:

• Patents.
• Copyrights (other than a copyright described in Code §§ 1221(a)(3) or 1231(b)(1)(C)).
• Trademarks.
• Trade names.
• Trade secrets.
• Know-how.
• Software (other than software described in Code § 197(e)(3)(A)(i)).
• Other similar property or applications or registrations of such property.

However, he or she also may be able to claim additional charitable contribution deductions in the year of the contribution and years following, based on the income, if any, from the donated property, paid to the Code § 501(c)(3) organization.

The following table shows the percentage of the organization's income from the property that the donor can deduct for each of your tax years ending on or after the date of the contribution. In the table, “tax year 1,” for example, means the first tax year ending on or after the date of the contribution. However, the donor can take the additional deduction only to the extent the total of the amounts figured using this table is more than the amount of the deduction claimed for the original donation of the property.

After the legal life of the patent or other intellectual property ends or after the 10th anniversary of the donation, no additional deduction is allowed.

The additional deductions cannot be taken for patents or other intellectual property donated to certain private foundations.

The taxpayer is required to inform the organization at the time of the donation that he or she intends to treat the donation as a contribution subject to the provisions discussed above. The organization is required to file an information return showing the income from the property and give the taxpayer a copy of the return.

K. REDUCTION IN DEDUCTION FOR CERTAIN DEPRECIATION DEDUCTIONS

If the taxpayer has taken depreciation on TPP, the FMV of the TPP must be reduced on a dollar-for-dollar basis for any depreciation deductions taken. See, Code § 1245. Similarly, the FMV must be reduced for any accelerated depreciation taken as to real estate. See, Code § 1250. The same is true for depletion allowances and intangible drilling costs in the cases of oil and gas wells.

J. SUBSTANTIATION RULES

1. Form 8283 - Noncash Charitable Contributions/ Qualified Appraisal

Donors claiming a deduction for charitable non-cash contributions, e.g., TPP, must file Form 8283 Noncash Charitable Contributions, if the total claimed value of all property contributed to the donee exceeds $500. (Form 8283 and instructions for completion may be found at www.irs.gov.)

If the value of the TPP exceeds $5,000, the donor must have a written “qualified appraisal” and must submit Form 8283 to the charitable organization for completion of Section B, Part IV, Donee Acknowledgment.

The Treasury Regulations define a “qualified appraiser” as a person experienced and knowledgeable about the property being appraised. The appraiser may not be the donor, donee, a person from whom the donor acquired the property, or anyone employed by or related to any of the above.

The appraisal report must describe the property in sufficient detail for identification purposes and include a statement of condition and an explanation of any restrictions on the property.

The “fair market value” must be stated along with an explanation of the specific basis and method of valuation used to determine that value. Other requirements include:

(i) dates of contribution and of appraisal;
(ii) statement that the appraisal was prepared for income tax purposes;
(iii) description of the fee arrangement between donor and appraiser; and
(iv) the appraiser's name, address, qualifications, signature, and tax-payer identification number [social security number].

The donor must give to the donee a copy of an “appraisal summary” as part of Form 8283. The donor should complete Section B, Name, Identification Number, Description of Donated Property (line 5, col (a)), Physical Condition of Tangible Property (line 5, col (b)) and Taxpayer (Donor) Statement Part II, if applicable. A designated official of the donee signs the “Donee Acknowledgment.” The donee is neither required to agree to the claimed value nor “substantiate” the claimed value.

2. Charitable Contributions of $250 or More

A donor will not be entitled to a deduction for any charitable contribution of $250 or more unless the donor has received written substantiation from the charity. In cases where the charity has provided goods or services to the donor in exchange for making the contribution, the written statement must include a good faith estimate of the value of such goods and services (unless such goods or services are of insubstantial value).

This provision does not place an information-reporting duty on the charitable organization. Where an acknowledgment is required, the donor is responsible to obtain one from the charitable organization and keep it with the donor's personal records. The charitable organization need only send a letter thanking the donor. The charitable organization is not required to stipulate to any value---apart from the acknowledgment that the property is claimed to be worth $250 or more.

3. Form 8282 – Donee Information Return

The charitable organization is required to report, on Form 8282, Donee Information Return, the sale, exchange, consumption, transfer or other disposition of non-cash contributions (excluding certain publicly traded securities), for which the charitable organization signed, or was presented with for signature, an Appraisal Summary (Section B) on Form 8283, which exceeds $5,000, if the disposition occurs within two (2) years of the receipt of the contribution. (This is why donors from time to time seek an “understanding” that the donee will not sell the donated property for two years.)

The charitable organization is responsible for submitting Form 8282 to the IRS if the charitable organization disposes of the property within two (2) years. The original form should be mailed to the Internal Revenue Service Center, Cincinnati, Ohio 45944 with a copy of Form 8282 sent to the donor.

4. Charitable Contributions of Property over $500,000

If the donor wishes to take a deduction of more than $500,000 for a contribution of non-cash property made after June 3, 2004, he or she must attach a qualified appraisal of the property to his or her tax return. However, this rule does not apply to contributions of inventory, publicly traded stock, or intellectual property. Previously, the appraisal was required to be retained as part of the taxpayer's records but did not need to be attached to the Form 1040.

K. THE ALTERNATIVE MINIMUM TAX (“AMT”) AND THE CHARITABLE CONTRIBUTION DEDUCTION

1. AMT Summary

The AMT was enacted in 1969 after Congress learned that 155 people with adjusted gross incomes above $200,000 (approximately $1.2 million in 2005 dollars) paid zero federal income tax in 1967.

Until recently, the AMT affected fewer than 1% of taxpayers. Because the threshold income levels to which the AMT applies have not been indexed for inflation, the percentage of taxpayers subject to the AMT steadily has increased. It is estimated that in 2005, 17% of taxpayers earning between $75,000 and $1000, 39% of taxpayers earning between $100,000 and $200,000, and 78% of taxpayers earning between $200,000 and $500,000 will be subject to the AMT.²¹

Taxpayers compare what they owe under the regular federal income tax (the “regular tax”) and the AMT and pay the higher tax.

The AMT consists of two (2) tax brackets, 26 percent for AMT income below $175,000 and 28 percent for AMT income that exceeds this amount. The AMT allows a standard exemption of $45,000 for married persons filing joint returns and an exemption of $33,750 for most other taxpayers in 2005.

The AMT eliminates many of the deductions and tax preferences permitted under the regular tax. For example, under the AMT, deductions for state and local income taxes, real estate taxes, and personal exemptions for children are not available. The AMT also includes as income certain revenue excluded from taxable income in calculating the regular tax. For example, interest on certain types of tax-exempt bonds is taxable under the AMT but not under the regular tax.

Charitable contributions are deductible under the AMT and the regular tax.

The income to which the AMT is applied (“AMT income”) may be regarded (in a somewhat over-simplified manner) as the sum of regular taxable income and AMT “preferences.” An AMT “preference” is a tax saving permitted under the regular tax but disallowed under the AMT.

AMT preferences consist of “exclusions” and “deferrals.”

Examples of “exclusions” include personal exemptions, the standard deduction, certain mortgage interest deductions, and deductions for state and local income taxes.

“Deferrals” enable taxpayers to delay recognition of income under the regular tax. “Deferrals” include, for example, incentive stock options and depreciation deductions.

Taxpayers may be subject to the AMT in one year and not be subject to the AMT the next year. An AMT credit exists to reduce possible inequities that could occur for taxpayers whose tax situations fluctuate between the two systems.

The AMT credit arises in years when taxpayers are subject to the AMT. A tentative credit is determined by subtracting the regular tax from the AMT. This difference is known as the “net minimum tax.” The portion of the “net minimum tax” attributable to “exclusions” is eliminated. The remainder constitutes the “AMT credit.” If the net minimum tax is attributable solely to “exclusions,” there is no AMT credit. If the net minimum tax is attributable solely to “deferrals,” the AMT credit will equal the net minimum tax.

Example: Terry Taxpayer’s federal tax liability under the regular tax in 2004 was $22,000 and Terry’s tax liability under the AMT was $30,000. Terry’s net minimum tax, or the difference between Terry’s tax liability under the AMT and the regular tax is $8,000 (AMT of $30,000 minus regular tax of $22,000.) Assume the net minimum tax is attributable solely to “deferrals.” Terry’s AMT credit is $8,000. (If the net minimum tax were attributable solely to personal exemptions and other “exclusions”, the AMT credit would be zero.)

The AMT credit is used to reduce a taxpayer’s regular tax liability in a succeeding year in which the taxpayer’s regular tax liability exceeds the AMT . The credit cannot reduce the regular tax to an amount that is less than the AMT for that year.

Example: Terry Taxpayer had an AMT tax credit of $8,000 in 2004. In 2005, his regular tax liability exceeds his AMT tax liability. His regular tax liability is $25,000 and his AMT tax liability is $21,000. Terry’s AMT credit reduces his regular tax liability of $25,000 to $21,000, the amount of his AMT liability. His remaining AMT credit ($4,000) may be carried over to future years in which Terry is subject only to the regular tax.

2. The AMT and Charitable Giving

The Tax Reform Act of 1986 drastically reduced the tax benefits associated with gifts of appreciated long-term capital gain property if the donor was subject to the AMT. Donors subject to the AMT could only claim a charitable contribution deduction equal to the cost basis of the property, rather than the property’s FMV. The appreciated portion of the gift (the difference between FMV and cost basis) was a preference item, included as part of taxable income to which the AMT was applied. Fortunately, this rule was repealed in 1993 .

The benefit of a charitable contribution to a taxpayer subject to the AMT is marginally less valuable because the AMT tax rates are lower than the regular income tax rates.

Example: Assume Terry Taxpayer makes a charitable contribution of $10,000 in 2005 and is subject to the 28% AMT. Terry is in the 33% tax bracket under the regular tax. The value of the charitable contribution deduction to Terry is $2,800 (28% of $10,000) under the AMT and $3,300 (33% of $10,000) under the regular tax.

However, if a taxpayer is subject to the AMT and realizes an AMT credit in 2004, a charitable contribution may increase the value of the AMT credit available in later years .

Example: Tommy Taxpayer, a sole proprietor, had regular taxable income of $200,000 in 2004. (Tommy is in the 33% bracket under the regular tax.) His regular tax is $53,290. Tommy also has a “deferral” preference item of $100,000 based on accelerated depreciation on business equipment. Tommy’s AMT income, which includes the “deferral” preference item ($100,000), is $300,000. Tommy’s tax liability under the AMT is $80,500. Because his AMT of $80,500 exceeds his regular tax of $53,290, Tommy must pay the AMT of $80,500.

The difference between the AMT of $80,500 and the regular tax of $53, 290 equals the “net minimum tax” of $27,210. Because Tommy’s net minimum tax is attributable solely to accelerated depreciation, (a “deferral” preference item), Tommy will be permitted to treat the entire net minimum tax of $27,210 as an AMT credit.

Assume, further, Tommy makes a charitable contribution of $20,000 in 2004. Tommy’s regular tax liability decreases by $6,600 (33% of $20,000) to $46,690. His AMT decreases by $5,600 (28% of $20,000) to $74,900. Tommy’s AMT credit increases to $28,210 ($74,900-$46,690). Tommy’s charitable contribution of $20,000 provides an additional AMT credit of $1,000 ($28,210-$27,210). This increased AMT credit will reduce Tommy’s regular tax in future years.

L. GIFTS OF PENSION PLAN ASSETS

Normally, when the beneficiary receives a distribution from the estate, there is no federal income tax. Code § 102 provides an exclusion from income tax. However, as to certain types of bequests, this rule is reversed. Code § 691(a)(1) provides that the person who receives “income in respect of a decedent” (“IRD”) is subject to income tax. Moreover, the asset (“IRD asset”) which produces the IRD is included in the estate of the decedent. See, Code § 2039. So, if the estate is subject to federal estate tax, there is, in effect, double taxation as to assets which produce IRD. The asset which generates the IRD is subject to estate tax and the beneficiary is subject to income tax on the IRD itself.

The combination of state death taxes and the federal estate tax can exceed 50%. There is a maximum 35% federal income tax rate. The effective rate of overall taxation on IRD can be in excess of 85%. It is not as harsh as it appears, however. First, only about 2.5% of estates pay federal estate tax. Second, there is a deduction available to the recipient of IRD, as explained below, if federal estate tax was paid as to the asset which generated the IRD.

The first issue is what is “income in respect of a decedent”? If you receive income that otherwise would be taxable to the decedent (if he or she were alive to receive it), you realize IRD and report it on your Form 1040. This rule applies not only to installment sale proceeds but also to distributions from an IRA or other ERISA plan.

If the decedent's estate paid federal estate tax attributable to the IRD you received, you may claim an itemized deduction on your Form 1040 for the estate tax attributable to the IRD.²² However, no deduction is allowed for state death taxes attributable to the IRD .

This deduction is referred to as the Section 691(c) deduction. One problem is that, as noted, it is only a partial deduction----equivalent only to the allocable federal estate tax paid on the “IRD asset,” not state death taxes attributable to it. The second problem is if the estate was not subject to federal estate tax (only 2.5% are), the heir has no deduction to offset the taxable income.

In Private Letter Ruling (“PLR”) 199901023, the decedent named a charitable remainder unitrust (“CRUT”) as the beneficiary of her IRA: “X is a participant in a qualified retirement plan...X has designated [CRUT] as the beneficiary of X's interest in the retirement plan. Thus, upon X's death, the proceeds of this plan will be paid in a lump sum to [CRUT].”²³

The IRS held that the IRD would be income to the CRUT. Because the CRUT is tax exempt, it does not pay any income tax. The ruling held the plan distributions are ordinary income to the CRUT. This entailed the further conclusion that the payments from the CRUT to the CRUT income beneficiaries are “first tier” (“ordinary income”) in the four tier tax system applicable to income beneficiaries of CRTs. See, Code § 664(b). The Service went on to rule, however, that the Section 691(c) deduction, referred to above, does not “flow through” to the income beneficiaries but, rather, is treated as belonging to the CRUT which is tax-exempt. The IRS ruled that the Section 691 deduction can be used by the CRT to reduce “first tier” ordinary income in the “four tier” income classification scheme unique to CRTs. See, Code § 664(b).

Assume the CRT must pay out $50K per year to the non-charitable income beneficiary. Assume, further, the CRT is funded with various assets including an IRA. For 2005 the CRT has $10K in interest income, which is “first tier” ordinary income, $20K of long term capital gain income, which is “third tier” income, and $40K of “first tier” income attributable to the IRA. Assume, further, the decedent’s estate paid $15K in federal estate tax attributable to the IRA. Here is how the income for 2005 is computed: the “first tier” income is $10K (interest income) and $40K in IRA income. Against this total of $50K the CRT is allowed the Section 691 deduction of $15K (equal to federal estate tax paid by decedent's estate). So the net “first tier” income is $35K, to which is added $15K of capital gain income for a total payment to the non-charitable income beneficiary of $50K.

M. CODE § 514: TRAP FOR THE UNWARY

When the charitable organization is offered a gift of property subject to debt, it must consider if and how Code § 514 may apply to cause the charitable organization to be subject to the tax on unrelated debt-financed income. The Tax Reform Act of 1969 extended the reach of the tax on unrelated business income to investment income from debt-financed property by adding § 514 to the Code. The House Report notes the debt-financed property provisions were adopted to prevent the perceived abuse represented by Commissioner v. Brown , 380 U.S. 563 (1965).

“Debt-financed property” means any property (1) held to produce income for which (2) there is “acquisition indebtedness” at any time during the tax year (or 12-month period before the disposition date of that property).²⁴

The tax imposed by Code §514 is not limited to income. It also applies to capital gain . When property held to produce income (the use of which is not exempted from Code § 514) is disposed of at a gain during the tax year and there was “acquisition indebtedness” on this property at any time during the 12-month period before the disposition, the property is debt-financed property and UBIT applies.

For example, the outstanding principal debt secured by a mortgage on real estate donated to the charitable organization is treated as “acquisition indebtedness” even though the charitable organization did not assume or agree to pay the debt. However, there are a number of exceptions.

(1) If property subject to a mortgage or other encumbrance is conveyed to the charitable organization by testamentary transfer (bequest or devise), the debt will be disregarded for Code § 514 purposes for a “grace period” of 10 years following the date of the conveyance.

2. The same 10 year “grace period” will apply to encumbered property conveyed as an inter vivos gift to the charitable organization if the mortgage (or other debt) was recorded on the property 5 years prior to the date of the gift and the donor owned the property for at least 5 years.

These exceptions for property received by gift, bequest, or devise do not apply if the charitable organization assumes and agrees to pay all or part of the debt secured by the mortgage or makes any payment to the donor for his or her equity in the property.

An important exception is the “substantial use” exception. If substantially all (85% or more) of any property is used for the charitable organization's exempt purposes, the property is not treated as debt-financed property.

Another exception applies to debt-financed real estate acquired by the charitable organization for eventual use in connection with its exempt purposes if the real estate is located in the “neighborhood” of property currently used by the charitable organization for its exempt purposes. In such case, there is a 10 year “grace period.” There are a number of sub-exceptions. See, Code § 514(b)(3).

Example: X, a charity, owns as an investment an office building subject to “acquisition indebtedness.” The building produced $20,000 of net rental income last year. The average adjusted basis of the building during that year was $100,000, and the average acquisition indebtedness with respect to the building was $50,000. Accordingly, the debt/basis percentage was 50% (the ratio of $50,000 to $100,000).

Rental income is normally exempt from tax. However, because the office building is 50% “debt-financed,” 50% of the net rental income is taxed to the charity at corporate income tax rates.

If an organization sells debt-financed property, it must include, in computing unrelated business taxable income, a percentage of any gain or loss. The percentage is that of the highest “acquisition indebtedness” with respect to the property during the 12-month period preceding the date of disposition, in relation to the property's average adjusted basis.

The tax on this percentage of gain or loss is determined according to the usual rules for capital gains and losses.

N. THE GENERATION SKIPPING TRANSFER TAX (“GST”) AND CHARITABLE GIVING

1. Summary of GST

The “generation-skipping transfer tax” (“GST”) is imposed on certain transfers of property between persons who are more than one generation apart.²⁵ For example, a gift from a grandparent to a grandchild may be subject to the GST because the gift “skips” an intervening generation.²⁶

The GST is imposed on every generation-skipping transfer which occurs in any one of three (3) taxable events: a) a “taxable termination” of an interest in a trust, such as the death of a child who is an initial beneficiary, if, after the termination, all interests in the trust are held by or for the benefit of persons two or more generations below that of the transferor, e.g., the donor’s grandchildren; b) a taxable distribution of income or principal from a trust to or for the benefit of persons two or more generations below that of the transferor; or c) a “direct skip,” which is a transfer of an interest in property to or for the benefit of a person who is at least two generations below that of the transferor.

Taxable Termination Example: Grandpa Jones establishes a trust for his son Tom who has two children. The trust will distribute income and principal to Tom as needed for the remainder of Tom’s life. After Tom’s death, the remaining trust assets will be distributed to Tom’s children. Because Grandpa Jones’s grandchildren are the only beneficiaries of the trust following Tom’s death, Tom’s death is a “taxable termination.”

Taxable Distribution Example: Grandma Richards established a trust that pays income to son Paul. The trustee has discretion to distribute income from the trust to Paul’s children. If the trustee distributes income from the trust to Paul’s children, a “taxable distribution” occurs because money was transferred to beneficiaries who were two or more generations removed from Grandma Richards, the creator of the trust.

Direct Skip Example: Daniel Donor gives $50,000 to his grand-nephew Phil. Because Daniel and Phil are more than one generation apart, the gift is a “direct skip.”

The annual gift tax exclusion permits individuals to make gifts up to $11,000 (indexed to inflation) per recipient each year without incurring gift tax. For example, if Donor gives $11,000 to each of his three grandchildren, Donor will not pay gift tax. Gifts that qualify for the annual gift tax exclusion are also exempt from the GST. Thus, Donor, in the above example, also is exempt from the GST.

A “GST Exemption” permits individuals to make a certain amount of generation skipping transfers during his or her life or at death without being subject to the GST. The amount of the “GST Exemption” is set forth below:

• 2005 - $1,500,000
• 2006 - 2008 - $2,000,000
• 2009 - $3,500,000
• 2010 - no GST tax
• 2011 - $1,100,000.

Example: Grandma Lindsay rewarded her grandson Graham with a gift of $200,000 in 2006 following his graduation from college. This is a “direct skip” transfer. The first $11,000 of the gift is exempt from both federal gift tax and the GST due to the annual gift tax exclusion. The remaining portion of the gift, $189,000, is not subject to the annual gift tax exclusion and is subject to the GST. Grandma Lindsay is able to use $189,000 of her lifetime GST exemption of $2,000,000 to shelter the gift to Graham from the GST.

2. Application of the GST to Planned Giving

The GST may apply to charitable gift annuities, charitable remainder trusts and charitable lead trusts if the non-charitable beneficiary is a grandchild or another person who is two generations or more younger than the donor.

A. Charitable Gift Annuities

Donors who establish charitable gift annuities (“CGAs”) most often designate themselves, their children, or someone else one generation younger as the recipient of the annuity. Under these circumstances, the GST will not apply. The GST will apply only if the designated annuitant is a grandchild or another person who is two or more generations younger than the donor.

Example: Derrick transferred $200,000 to the charitable organization in exchange for a deferred CGA in which Derrick designates his grand-niece, Doris, as the annuitant. The annuity will begin in ten years. Assume the net present value of the annuity stream to Doris is $120,000, the value of the taxable gift to Doris. This gift to Doris, a “direct skip” transfer, is subject to federal gift tax and the GST. When Derrick files Form 709 and reports the taxable gift, Derrick also will report the generation skipping transfer to Doris and allocate a portion of his GST exemption, $120,000, to avoid paying GST tax.

B. Charitable Remainder Trusts

If a donor establishes a charitable remainder trust (“CRT”) and the income beneficiary is a grandchild, a “taxable distribution” will occur and the GST will apply to the present value of the income stream to be distributed to the beneficiary. To reduce the amount of the GST, the donor should allocate a portion of the donor’s GST exemption to the CRT at the time the CRT is created. If this allocation is properly made by using Form 709, the GST tax will not be due each time distributions of income are made to the grandchild.

C. Charitable Lead Trusts

Of the different types of planned gifts, the GST will apply most frequently to a charitable lead trust (“CLT”) because a CLT is used to make inter-generational transfers of assets that likely will appreciate while held in trust. If a CLT is established with the income or “lead” interest being paid to the charitable organization and the remainder interest designated for the donor’s grandchildren, a “taxable termination” occurs when the charitable “lead” interest terminates and the remaining trust assets are transferred to the grandchildren. The GST due at such time may be minimized if the donor uses a charitable lead unitrust (“CLUT”), rather than a charitable lead annuity trust (“CLAT”), because a donor may allocate his or her GST exemption to a CLUT but not to a CLAT.

If the donor allocates his or her GST exemption in an amount equal to the value of the gift to the grandchildren, no additional GST tax will be due when the CLUT terminates and the grandchildren receive the remaining assets of the trust. Under most circumstances, a donor should not use a CLAT if the ultimate beneficiaries will be the donor’s grandchildren.

Example: John, grandfather of five, established a CLUT that will pay income to the charitable organization for the remainder of John’s life. At death, the CLUT will terminate and the remaining trust assets (the “remainder interest”) will be distributed to John’s grandchildren.

John transferred property worth $1,000,000 to the trust and the value of the remainder interest was $250,000. John reported the $250,000 gift to his grandchildren on Form 709 and allocated $250,000 of his GST exemption to the trust. When John died 20 years later, the CLUT terminated and the remainder interest was worth $2,000,000. Following this “taxable termination,” no additional GST was due. If John had not allocated $250,000 of his GST exemption to the trust when it was created, the GST would have applied to the full value of the remainder interest, $2,000,000, rather than the initial value of the remainder interest, $250,000.

CHARITABLE CONTRIBUTIONS OF REAL ESTATE

We are living in what well may be the “Golden Age” for gifts of real estate. It is estimated that the inter-generational wealth transfer between the “WWII generation” and their children, the “Boomers,” is in the range of $40 to $100 trillion dollars. Real estate remains the form in which capital is most concentrated. Much of this capital is in the form of real estate. Seventy-five percent of individuals over age 65 own real estate—and 83% own real estate “free and clear” of debt.²⁷

With the rewards of real estate gifts come perils, which must not be overlooked. Nor should they be exaggerated. These perils should be understood and analyzed on a case-by-case basis. There is a broad variance both in the type of risk and magnitude. In this area, the adage applies with force: an ounce of prevention is worth a pound of cure. This prevention can consist in declining to accept the gift. Alternatively, it can consist in the use of the liability reduction or avoidance strategies discussed infra .

A. ASSESS RISKS AND USE PREVENTIVE MEASURES

It is impossible to review in this article all potential sources of liabilities. It is obvious that if real estate subject to a tenant lease is contributed to the charitable organization, the relationship of landlord and tenant presents potential risks. If the real estate is open to the public, e.g., shopping center, the owner is potentially liable for harm to “invitees,” e.g., failure to provide adequate security and slips-and-falls, etc. General and comprehensive premises liability insurance can protect against most of these risks.

With ownership of real estate, there is the potential for environmental liability. The principal federal environmental statute is the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), 42 U.S.C. § 9601 et seq . CERCLA, also known as the “Superfund law,” was enacted in 1980. CERCLA imposes joint and separate liability for cleaning up contamination caused by hazardous substances by four (4) types of potentially responsible parties:

* current owner or operator of facility,

* owner or operator at time of disposal,

* generators of any hazardous substances located on site,

* any transporter of hazardous substances to a site the transporter selected.

Another federal environmental statute which may apply is the Resource Conservation and Recovery Act, 42 U.S.C. § 9601 et seq. Finally, most states now have their own versions of CERCLA.²⁸

Major Points to Remember:

* Exempt organizations are not exempted from environmental liability statutes.

* Current and past owners and operators (potentially responsible parties or “PRPs”) are usually joined as defendants in CERCLA litigation, even if they have only recently acquired title to the property which was contaminated years ago.

* The “innocent landowner” defense may be difficult to prove. The burden is upon the defendant to show that a third party was solely responsible for the contamination.

* The “innocent landowner” defense may apply if the defendant can demonstrate it acquired the property after the contamination occurred and did not know and had no reason to know through the exercise of due diligence that the property was contaminated. “Due diligence” requires investigation appropriate to the type of property. An environmental audit by a qualified environmental engineer or consultant shows “due diligence.” 29

B. USE A WRITTEN AGREEMENT WITH ALL PROPOSED GIFTS OF REAL ESTATE

* A written agreement always should be used--even with donations . The “Donation Agreement” or “Bargain Sale Agreement” should permit the charitable organization to inspect the property for a specified period, e.g. sixty days, with the absolute right to terminate the Agreement during this “inspection period.”

* The “inspection period” provides the charitable organization, in effect, a “free option” to market the property during the “inspection period,” i.e., the charitable organization may be able to locate, in advance of taking title, a purchaser. Why is this important? The charitable organization's goal in many cases is to reduce the interval of ownership to as short a period as possible to reduce risks of ownership and avoid “carrying costs,” such as insurance, real estate taxes, etc.³⁰

* Typically, in real estate contracts, the owner makes representations and warranties regarding the property. Potential purchasers of the property from the charitable organization often require extensive representations and warranties. Warranties made by the owner in the acquisition contract may be made assignable by the charitable organization to a purchaser. Unless this “assignability” provision is in the agreement, the charitable organization cannot assign warranties made by the donor.

* The agreement should contain certain environmental provisions.³¹  The agreement should require the donor to disclose environmental conditions which affect the property and claims which may have been presented by any third party, whether a private party or a governmental agency, which relate to any alleged environmental conditions. The agreement may require the donor to provide a Phase I environmental report. The donor may be asked to indemnify and hold harmless the charitable organization from and against any liabilities or claims of an environmental nature which relate to the period of the donor’s ownership (and, ideally, for all prior owners). The indemnity should cover legal fees, court costs, and litigation expenses (which should be defined to include expert witnesses). Even if the charitable organization is found to be an “innocent landowner,” the cost of establishing this defense can be very expensive.

* A written agreement always should be used when the gift is a “remainder interest.” In this type of gift, the donor conveys title to the charitable organization, reserving for the donor (and spouse) a “life estate.” The agreement should require the owner of the life estate to: pay all taxes, utilities, and assessments related to the property; maintain the property in good order, including making necessary repairs; keep the property insured for fire and other hazards, with the “remainderman” identified as an additional “named insured” to the extent of its interest; and keep in force and effect premises liability insurance with the “remainderman” named as an additional insured. Other items: sharing of proceeds from insurance if the property is destroyed; sharing of proceeds from eminent domain; and right of inspection by the charitable organization, e.g. annually or if capital repairs are made. If these items are not addressed in the agreement between the donor and the charitable organization, misunderstandings easily can occur. Just as “good fences make good neighbors,” so, too, do good agreements preserve good relations.

C. CREATE ANCILLARY ORGANIZATION TO HOLD TITLE

Isolating the real estate in an ancillary organization is an obvious means to reduce the potential risk of ownership. Many Code § 501(c)(3) organizations have created such organizations to own assets which could be problematic, e.g., certain types of real estate, shares in partnerships or limited liability companies, etc. The two most common types are the Code § 501(c)(2) title holding company and the Code § 509(a)(3) supporting organization (“SO”).

The SO has an obvious advantage over the title holding company. The SO is a § 501(c)(3) organization (sub-defined in Code § 509(a)(3) which operates to support another Code § 501(c)(3) organization (with certain exceptions). Contributions to a Code § 509(a)(3) organization are deductible as charitable contributions, just as if given to the “supported organization.” Hence, the donor can be directed to convey title to the SO, thus avoiding the need for the “supported organization” to be in the “chain of title.”

It is also possible for the Code §501(c)(3) organization to be the sole member of a limited liability company. The IRS has ruled that the LLC will be disregarded for tax purposes if the single member is a Code §501(c)(3) organization. However, the IRS has not followed the logic of its ruling to make the further ruling that a contribution to such an LLC qualifies as a charitable contribution deduction.32

D. THE GUEST TECHNIQUE

In Winston F.C. Guest , 77 T.C. 9 (1981), an exempt organization (Temple) never took title to property, yet the donor was entitled to a charitable deduction. The Temple sought to avoid “double transfer taxes,” e.g., on the sale of the property to the Temple and the subsequent sale of the property by the Temple to the third party.

Guest notified the Temple: “I am contributing to you certain properties...without any restrictions...” A representative of the Temple wrote to Guest a letter of gratitude and acceptance. The Temple's letter to Guest requested Guest to “retain title as nominee in our behalf. When we have completed our negotiations [for resale of the properties] we will instruct you to prepare deeds in the name of the purchaser ...”

Guest executed a deed conveying title to the property in favor of a partnership the Temple designated.

The IRS argued that because title to the property never was conveyed to the Temple, Guest was not entitled to a charitable contribution deduction. The Tax Court disagreed, stating: “We conclude that petitioner [Guest] did make a bona fide gift of the Properties to the Temple upon deeding the property to the [partnership].”

In other words, the Tax Court ruled there was no need for title to vest in the Temple in order to entitle Guest to the charitable contribution deduction. This principle was confirmed in a subsequent Tax Court decision.

In Stark v. Commissioner, 86 T.C. 243 (1986), Nelda Stark agreed to convey land worth $1,800,000 to the United States Forest Service for a public recreation area.The Forest Service and Stark agreed she would sell her land to a third party identified by the Forest Service with whom the taxpayer had had no other dealings. Stark conveyed the land to Fender (the individual identified by the Forest Service), who paid $1,200,000 to Stark. Fender then conveyed the land to the Forest Service in return for other acreage (like-kind exchange). Id . at 244-46.

The Tax Court held that Stark was entitled to a charitable contribution deduction in the amount of $600,000, based on the transfer of property worth $1,800,000 to a third-party buyer (Fender) identified by the Forest Service, in exchange for the price of $1,200,000 paid by Fender. Citing Guest , the court held that the contribution to the Forest Service was complete when Stark conveyed the property to Fender at the direction of the Forest Service. 86 T.C. at 255-57.

CHARITABLE GIFT ANNUITIES

Charitable gift annuities are one of the oldest, simplest, and most popular planned giving techniques. The majority of inter vivos planned gifts are in the form of a charitable gift annuity (“CGA”).

The concept is simple: cash or property is transferred to the charitable organization in exchange for an annuity, usually payable monthly or quarterly, for one or two lives, e.g., the donor and a designated survivor.

The CGA is a “general obligation” of the charitable organization. It is not limited to the specific property transferred in exchange for the CGA. In contrast, the income from a charitable remainder trust is derived solely from the trust corpus. The CGA is not a trust. It is a contract between the donor and the charitable organization.

A. CHARITABLE CONTRIBUTION DEDUCTION

A CGA is part gift and part the purchase of an annuity. The gift is the difference between the cash or value of the property transferred to the charitable organization and the present value of the annuity issued by the charitable organization. Purchase of a CGA results in a charitable contribution because the donor in effect “overpays.” The donor could purchase the identical annuity from a commercial issuer, e.g. an insurance company, for a fraction of the cost of the CGA. Thus, the price to purchase the CGA exceeds the cost of a comparable, commercial annuity. This “overpayment” results in the charitable contribution.

The valuation of the CGA depends on the life expectancy of the annuitant and the interest rate used to discount the value of future annuity payments to present value. Life expectancy is calculated by reference to “Actuarial Values, Book Aleph” in IRS Publication 1457. The “discount rate,” as set forth in Code § 7520, is equal to 120 % of the applicable federal “mid-term” rate, for the month in which the annuity is purchased. These rates change monthly.33 The values do not distinguish between male and female mortality. The donor may elect to use an interest rate for either of the two (2) preceding months. Software programs, e.g., PG Calc and Crescendo, fortunately are available to make these calculations.

The concept is to determine the difference between the cost of the CGA and its (cheaper) commercial equivalent. This difference is the charitable contribution to the charitable organization.

B. ANNUITY RATES

The higher the rate, the lower the charitable deduction– and the less the issuer will retain following the donor’s death. CGA issuers may “lose” in several ways:

1. setting annuity rate too high;
2. return on investments is too low; or
3. the annuitant lives “too long.”

The American Council on Gift Annuities, Inc. (“Council”)34 was established in 1927 to recommend CGA rates. The Council meets periodically to make adjustments to recommended rates. The rates the Council recommends are designed to leave the CGA issuer with a “residuum” equal to approximately 50% of the purchase price of the CGA. In setting rates the Council “projects” rates of return for investments. These tend to be conservative projections. For example, the current rates are based on a 1% annual expense load and a 6% expected rate of return.

The Council, in April, 2005, voted to make no changes to its recommended schedule of gift annuity rates. The schedule, in effect from July 1, 2004 - June 30, 2005, will remain effect for the period July 1, 2005 - June 30, 2006, unless economic conditions warrant an interim review of the schedule. The rates vary, depending on the age of the annuitant.

The charitable organization adheres to the Council’s recommended rates.

C. TAXATION OF ANNUITY PAYMENTS

Federal rules applicable generally to annuities (Code § 72) govern the tax treatment of payments from a CGA. Generally, a fraction of each payment an annuitant receives is tax-free as a return of principal.35 This fraction is based on a ratio of the “investment in the contract” (the price paid for the CGA less the charitable deduction) to the expected return of the CGA (amount payable annually multiplied by life expectancy of the annuitant based on IRS tables).

An annuitant who reaches his or her projected life expectancy is deemed to have “recovered the investment” in the contract. He or she no longer may exclude any portion of the annuity from gross income, i.e., all subsequent payments are taxable as ordinary income. If the annuitant dies before reaching anticipated life expectancy and the CGA terminates (with a portion of the “investment in the contract” not having been recovered), the “unrecovered” balance may be deducted on the final income tax return.

The CGA can be very effective when a donor owns an appreciated asset that produces a low rate of return, e.g., farm land or growth stocks which pay little, if any, dividends. The CGA can be used to “spread” capital gains tax over the donor’s life expectancy, thus avoiding a large tax bill.

Example: Dorothy Donor owns Whiteacre. Dorothy has owned the land for ten years. Dorothy conveys Whiteacre to the charitable organization in return for a CGA. When the charitable organization sells Whiteacre, no capital gains tax is due on the sale. A portion of the annuity income paid to Dorothy is taxed as capital gains income. The CGA enables Dorothy to convert a low-earning asset into a high-yield annuity, while spreading out the capital gains tax over her life expectancy.

The gain is recognized ratably over the period of years the annuity payments are expected to be received if:

1. The annuity is nonassignable or is assignable only to the charitable organization.
2. Dorothy is the only annuitant or Dorothy and a designated survivor are the only annuitants. See, Treas. Reg. § 1.1011-2(c); Ex. 8.

Under any other circumstances, the gain must be fully recognized in the year the CGA is issued in return for Whiteacre.

The above example is that of a “bargain sale” discussed infra.

D. TRANSFER TAXES

1. Gift Taxes

If the annuity is payable to anyone (“third party”) other than the donor or the donor's spouse and if the donor has no power to revoke the payment,³⁶  gift tax liability may result. Two gifts occur, viz., one to the charity and one to the third party. The donor is entitled to a gift tax charitable deduction for the gift to the charity. The annuity for the third party, however, is a taxable gift,³⁷ equal to the present value of the annuity. If there is one annuitant and the annuity payments are payable immediately, the gift likely will be treated as a “completed present interest” gift eligible for the $11,000 annual exclusion (indexed to the rate of inflation). If the donor is married and the spouse consents, the spouse’s annual exclusion also may be used, thereby doubling the exclusion.

A CGA which begins payments to a third party in the future, i.e., a “deferred CGA” discussed in more detail infra, will not qualify for the annual gift tax exclusion because it is a gift of a future, not a present interest. Gift tax is owed based on the present value of the annuity.

If the donor purchases a two-life CGA, with the annuity payments payable to the donor and then to a survivor for life, the gift of the annuity interest to the survivor (if not the spouse) will result in a taxable gift to the second annuitant. Because the second annuitant’s receipt of the annuity depends on the second annuitant surviving the donor, the gift is a “future interest” and not a gift of a “present interest”, which does not qualify for the annual exclusion. This result can be avoided if the donor retains the power to revoke the gift during the donor's lifetime or in the donor's will. The reservation of this power avoids a “completed” gift to the second annuitant. A taxable gift, however, will occur in any year in which the right to revoke the gift is not exercised and the annuitant receives a payment.

2. Estate Taxes

If a donor purchases a CGA for himself or herself, the assets transferred in return for the CGA are not included in the donor’s estate, even if the donor dies within three years of purchasing the CGA.

If a donor purchases a gift annuity for a third party and dies within three years of the purchase, any gift tax paid with respect to the gift of the annuity interest is includable in the donor's estate.

If a donor creates a two-life CGA and reserves the power to revoke the gift (thus preventing a “completed” gift and imposition of the gift tax), the retained power to revoke the second annuitant's interest will cause the date-of-death value of the annuity to the second annuitant to be included in the donor's gross estate upon the donor's death.

Even if the donor releases the retained power to revoke the second annuitant's interest within three years of the donor's death, the annuity value nonetheless will be included in the estate. See, Code § 2035(a). The date-of-death value of the annuity will be equal to the cost of purchasing a comparable commercial annuity.

E. BARGAIN SALE RULES

If cash or unappreciated property is used to purchase a CGA, no gain results and the transaction is tax-free to the donor. The donor’s basis in the CGA is the annuity’s fair market value (“FMV”), viz., the equivalent cost of a comparable commercial annuity. If, however, appreciated property is used to purchase the CGA, the following bargain sale rules apply for purposes of calculating gain to the donor.

A bargain sale results when appreciated property is transferred to the charitable organization and the donor receives consideration (e.g., an annuity) in exchange. A bargain sale also will result if appreciated property, subject to debt, is transferred to a charity.³⁸  In the case of a CGA, the charitable deduction is equal to the difference between the FMV of the property transferred and the present value of the CGA received in exchange (amount realized). In addition, the transfer of the appreciated property results in capital gain to the donor. To determine the gain, the basis in the transferred property must be allocated to the sale element of the transaction (i.e., the value of the CGA) and the gift element (the amount by which the value of the transferred property exceeds the value of the CGA).

The basis is allocated as follows: adjusted basis of transferred property x FMV of the annuity/ FMV of transferred property = bargain sale adjusted basis allocated to the property transferred in exchange for the CGA. The donor recognizes capital gain equal to the value of the CGA, less the bargain sale adjusted basis. This capital gain will be recognized ratably over the period of years the annuity payments are expected to be received if the exceptions in the preceding example apply. Otherwise, the capital gain will be recognized in full in the year the CGA is purchased.

Example: Daniel Donor purchases a CGA with an FMV (comparable commercial cost) of $15,000 in exchange for appreciated securities with an FMV of $20,000. Daniel’s basis in the securities is $4,800. His bargain sale adjusted basis is $3,600, viz., basis of $4,800 multiplied by fraction of the value of the CGA received in exchange ($15,000) over $20,000 (FMV of the securities). He realizes a capital gain of $11,400 [$15,000 (FMV of CGA) - $3,600 (bargain sale adjusted basis)].

As noted, if property subject to debt is transferred in exchange for the CGA, a bargain sale also occurs. The amount of the debt will be included in the amount realized for purposes of calculating capital gain. When debt-encumbered real estate is the asset, the CGA is generally preferred to the charitable remainder trust, which is subject to certain excise taxes, e.g., “self-dealing”, applicable to private foundations.

F. DEFERRED GIFT ANNUITY

CGAs may provide for immediate or deferred payments. In an immediate CGA, the annuitant begins receiving periodic payments within one year after the CGA is purchased. In a deferred CGA, the annuitant begins receiving the periodic payments more than one year after the CGA is purchased. A deferred payment CGA may designate the specific date payments will commence or it can be flexible, permitting the donor to determine the future starting date of the annuity, based on future circumstances.

A donor who does not require extra income currently may decide to defer the starting date of the annuity payments until sometime in the future, e.g., the donor’s retirement. By deferring the starting date of the annuity, the donor increases the amount of the annuity payment that will be paid in the future. However, because the commencement date of the annuity has been postponed, the total amount the charity is obligated to pay the donor over the donor’s remaining life expectancy will decrease. This results in a higher charitable contribution deduction because the charity will receive a higher portion of the value of the property transferred in exchange for the CGA following the donor’s death.

By deferring the starting date of the CGA, the donor receives a higher charitable contribution deduction during his or her higher income years and receives a larger income stream in later years, e.g., during retirement, when the donor, presumably, will have a greater need for more income.

Example: George and Laura are both 60 years old. They wish to purchase a CGA from the charitable organization and are prepared to fund the CGA with a gift of $50,000. While they will be able to use a charitable income tax deduction this year they do not need the income from the annuity until they retire at age 70. The charitable organization development office prepared the following proposal that compares the charitable income tax deduction and annuity payable between an immediate and a deferred CGA.

By deferring the starting date of the annuity by ten years, when they are retired and presumably in need of additional income, George and Laura almost double their charitable contribution deduction and increase substantially the annual income from the annuity when payments begin.

The annuity agreement for a deferred CGA may include a flexible starting date to be determined in the future. In a letter ruling issued by the IRS in 1997,³⁹ the IRS approved the issuance of a deferred CGA which did not specify the starting date for the annuity. The donor, who purchased the annuity when he was 50, could elect to have payments begin anytime after 55 and before 80. The annuity payment will vary depending on the age of the annuitant when he elects to begin receiving annuity payments. The initial charitable contribution deduction was based on the lowest possible deduction available, assuming the donor elected to receive annuity payments at the earliest possible date, viz., at 55. If he elected to begin receiving the annuity payments at a later age, the total value of the annuity payments would decrease thereby increasing the value of the charitable contribution deduction.⁴⁰

Deferred CGAs have many advantages over traditional immediate CGAs. These include, for example, a higher current federal income tax deduction and more income available during retirement or to fund the college tuition of a grandchild. Deferred CGAs also are a good way to supplement IRAs or income from other retirement plans.

G. “HARD-TO-MARKET” PROPERTIES

Transfers of “illiquid” properties, e.g., tangible personal property, closely held stock, or real estate may present challenges and certain risks. The charitable organization is obligated to pay a fixed annuity, based on the FMV of the property exchanged for the CGA. But what if the net proceeds realized by the charitable organization from the sale of the asset are less than FMV? This result reduces the “residuum” that ultimately goes to the charitable organization following the annuitant’s death.

To reduce this risk, the charitable organization must take into account, in determining the “face” amount of the CGA, the expenses it my incur in connection with the property. A “contingent” agreement which gives the charitable organization the ability during an “inspection period” to “test the market” may protect the charitable organization. If the “FMV” is not consistent with “the reality of the market,” the charitable organization may decline to issue the CGA.

H. EXCHANGE OF INCOME INTEREST IN CRT FOR CGA

CGAs may be used in conjunction with charitable remainder trusts (“CRT”) to provide immediate funds to a charity. For example, the charitable “remainderman” of a CRT may need funds for the construction of a building. Under these circumstances, the “remainderman” may be able to persuade the beneficiary of the income interest in the CRT to transfer the interest in exchange for a CGA. The transfer of the income interest to the remainderman results in termination of the CRT, i.e., the income interest merges with the remainder interest.⁴¹

This technique also may be used where the beneficiary of a net income charitable remainder unitrust is not satisfied with the income from the CRT and would like to exchange the uncertainty of the net income interest for the certainty available from a CGA. Such a technique may be advisable where the income beneficiary is elderly and does not have many other assets or income.

I. TAX CONSEQUENCES TO CGA ISSUER

Generally, there are no tax consequences to the charitable organization when it issues a CGA. There are two possible exceptions to this rule.

First, when the property transferred in exchange for the CGA is subject to debt, the charitable organization may be subject to Code § 514 relating to debt-financed unrelated business income.⁴²

Second, the charitable organization must be careful that proceeds from selling CGAs are not treated as unrelated business income (“UBI”) under Code § 514(c)(5). Such income will not be treated as UBI if the following requirements are satisfied:

1. the value of the CGA is less than 90% of the value of the property transferred in exchange for the annuity and no other consideration is given by the charity;
2. the CGA is payable over the life of one or two individuals who are living at the time the CGA is issued;⁴³
3. the CGA does not guarantee either a minimum number of payments or a specified maximum number of payments; and
4. the CGA does not provide for any adjustment in the annuity amount based on the income received from the transferred property or other property.

J. FEDERAL AND STATE REGULATION

The Philanthropy Protection Act of 1995 (“Act”) requires charities issuing CGAs to provide prospective donors written information describing the “material terms of the operation” of the organization’s CGA program. The Council, on its web site,⁴⁴ provides a sample CGA disclosure statement to be distributed to each prospective donor before a CGA is purchased and recommends including the following information: a) a purchase of a CGA will result in a charitable gift and guaranteed payments to the annuitant(s) for life; b) the donor will be entitled to income, gift and estate tax deductions; c) the annuity rates offered by the charity are lower than those available for annuities issued by insurance companies and other financial institutions; d) the annuity payments are a general obligation of the charity and are backed by its assets; and e) common investment funds managed by the charity are exempt from the registration requirements of the federal securities laws.

The Council also recommends that charities include in the disclosure statement (1) the book value of the organization’s invested funds; (2) the organization’s types of investments, e.g., stocks, bonds, money market accounts etc.; (3) whether a reserve fund is mandated by a particular state governing issuance of the CGAs; and (4) the date the charity was established.

A majority of states regulate the issuance of CGAs. Regulations may include the following (depending on the state):

1. Notice required prior to issuing CGAs;
2. Permits (or certificates of authority);
3. Mandatory reserves;
4. Annual reporting requirements;
5. Minimum level of experience (frequently ten or more years) in satisfying their CGA payment obligations; and
6. Limits on the type of property an issuer may accept in exchange for a CGA.

Only six (6) states, including the District of Columbia, do not have laws that specifically regulate the issuance of CGAs. Ten (10) states, including Maryland, require charities to have permits to issue CGAs. Thirty (30) states, including Maryland and Virginia, require a mandatory “disclosure” statement in agreements executed in connection with the issuance of CGAs. Some states, including Maryland, require charities to meet a minimum threshold of unrestricted reserves and to be in operation for a minimum period of time before issuing CGAs.

The charitable organization should be certain that all CGAs issued comply with state law. The “regulating states” are the “situs” state of the charity (where it maintains its CGA records and has its executive offices) and the legal residence of the donor at the time the gift is made.

Before a CGA is issued in a particular state, that state’s laws concerning CGAs should be reviewed.

K. RESERVES OR REINSURANCE

A CGA issuer either should set aside a reserve to meet future payment obligations or purchase “reinsurance”, viz., a commercial annuity with a payout rate equal to the CGA.

As noted, the rates recommended by the Council are designed to leave the issuer with approximately 50% of the original value of the property transferred for the CGA. By purchasing reinsurance at a cost less than the value of the property transferred in exchange for the CGA, the charitable organization may realize its residuum shortly after the CGA is purchased. If a large number of CGAs are issued, the reserve funding option is preferred. It will result in a greater financial benefit to the issuer. The charitable organization has elected the reserve funding option.

CHARITABLE LEAD TRUSTS

A charitable lead trust (“CLT”) is an irrevocable trust which often is described as the converse of the charitable remainder trust (“CRT”). This is accurate superficially. There are a number of features which make the CLT unique– and far more complex.⁴⁵

Instead of receiving the remainder interest (as in a CRT), the Code § 501(c)(3) organization receives the income or “lead” interest, while the remainder interest eventually returns to the grantor or is distributed to others, such as the donor's children or grandchildren. The grantor may specify the Code § 501(c)(3) organization (or organizations) to receive the payments from the trust or the grantor may leave the selection of the organization(s) to the trustee.⁴⁶

Payments to the Code § 501(c)(3) organizations may be made for a term of years or until the death of one or more named individuals, each of whom must be alive when the trust is created. Unlike charitable remainder trusts, the term of a CLT may exceed twenty years.⁴⁷

A. TYPES OF TRUSTS

1. CLAT and CLUT

A qualified CLT must be either an annuity trust (CLAT) or unitrust (CLUT).⁴⁸  There is no minimum annual distribution required. (In comparison, the CRT must pay at least 5% annually.)

In a CLAT, the annuity is a guaranteed fixed-dollar amount payable annually. The trust need not specify the actual dollar amount to be paid. The annuity may be determined by a formula, e.g., 10% of the net fair market of the assets initially transferred to the CLAT. Use of a formula is advisable if the value of the assets is uncertain. Some practitioners believe the annuity paid by the CLAT may vary if the variation is prescribed by a formula in the trust, e.g., the amount of the annuity shall increase by 10 percent per year.⁴⁹ A CLAT may not use a formula tied to a fluctuating index, such as the consumer price index, because future inflation rates cannot be determined when the trust is formed.

While charitable remainder annuity trusts must prohibit additional contributions, neither the Code nor the regulations expressly prohibit additional contributions to a CLAT. However, the IRS has ruled that a CLAT that permits additional contributions will not qualify. Therefore, it is advisable to prohibit additional contributions to a CLAT to avoid any possibility the CLAT will not qualify.⁵⁰

In a charitable lead unitrust (“CLUT”), a fixed percentage of the trust's fair market value determined annually must be paid to the charitable organization each year. Unlike charitable remainder unitrusts, however, the income-only option is not permitted. Additional property may be transferred to a CLUT.

In addition to the requirement that the CLT must provide either a guaranteed annuity or unitrust amount, the trust must provide:

1. the income interest shall be paid to a qualified tax-exempt entity, e.g., the charitable organization;
2. the income interest must be paid at least annually;
3. payments must continue for a specified term or for one or more lives of certain qualified individuals;⁵¹ and
4. the lead interest must be in trust.⁵²

A qualified CLT, generally, will entitle the grantor either to a gift tax charitable deduction (for an inter vivos CLT) or estate tax charitable deduction (for a testamentary CLT). The grantor also will be entitled to an income tax deduction for the present value of the income “stream” to be paid to the charitable organization, but only if the trust is a “grantor” trust (explained below). However, the grantor is taxed on the payments from the CLT to the charitable organization. This is the quid pro quo for the “up-front” income tax deduction. The grantor each year must pay income tax “out of pocket” on the income of the grantor CLT.

Not surprisingly, this feature is unattractive (or abhorrent) to most donors. This is why “qualified grantor” CLTs are exceedingly rare. Thus, variants of the CLT which do not produce an income tax deduction are far more popular, in the rarefied world of CLTs. There are far more CRTs than CLTs.

2. “Grantor” or “Nongrantor” Trusts

a. Grantor Qualified Trusts

If the grantor or his spouse retains certain control over the administration of the CLT, or the grantor or his spouse will receive the remainder interest, or other elements of the “grantor” trust rules are satisfied, the CLT will be treated as a “grantor” trust. If the grantor trust is also a “qualified” CLT, the grantor will be entitled to a current income tax charitable deduction equal to the present value of the income stream to be paid to the Code §501(c)(3) organization. However, as noted, the grantor remains taxable on the trust income annually during the term of the trust without being permitted any corresponding charitable deduction for the annual payments to the Code § 501(c)(3) organization.

Grantors should establish grantor qualified CLTs in a year when the grantor expects to be in a high tax bracket but expects to be in a lower tax bracket in future years when the trust is expected to receive income. If trust income exceeds the annuity or unitrust amount, and the trust instrument requires such excess to be paid to the Code §501(c)(3) organization, the grantor will be permitted to take an annual income tax charitable deduction for such excess payments to the Code §501(c)(3) organization.

b. Grantor Nonqualified Trusts

If the grantor establishes a nonqualified trust, no “up-front” income, and no gift or estate tax deductions are permitted. The grantor remains liable for tax on trust income, but will receive an annual income tax charitable deduction for the trust's payments to the Code §501(c)(3) organization. Because the grantor may exercise substantial control over the trust, including the power to revoke all interests including the charitable interest, no completed gift is made and no gift tax is due upon formation of the trust. Such trusts may be ap