Charitable planning can be
one of the most satisfying areas in which an advisor can
practice. When your clients' interests and charitable
organizations' interests are in line, the results can be
terrific. Charitable planning is a specialty, however, with
technical rules and an abundance of potential pitfalls. The
purpose of this article is to alert you to some of the
pitfalls you may encounter, enabling you to do a better job
for your clients. In our experience helping many clients
fulfill their philanthropic objectives and in sharing
experiences with other advisors, we have come across some
common traps for the unwary.
Disengage Yourself From
the Outcome
As human beings, advisors
can sometimes lose sight of their biases. If you hold
yourself out as a charitable planner, sit on charitable
boards or have seen the positive results of charitable
planning in other clients' situations, it pays to remember to
approach each client with a fresh perspective and to stay
objective. As advisors, your first duty is to your clients.
This responsibility as advisors means helping them uncover
their goals and priorities, including any charitable goals.
The most successful approaches endeavor to educate clients
about the costs, benefits, risks and rewards of charitable
planning. Detailed explanations of the various planning
vehicles, illustrations and schedules can all aid in
conveying this information. It is important to discuss with
your clients and agree upon assumptions, including rates of
return, inflation and life expectancy. Using software that
can predict the probability of what the client considers a
successful outcome is helpful. The client can then make an
informed decision.
Consult Other
Experts
Charitable planning and
implementation often cross many disciplines, including law,
accounting, investments, insurance and strategic
philanthropy. It is unlikely that there is even one advisor
who possesses genuine expertise in all of these areas, so for
those who don't have all these skills, there are teams. Teams
can be formal business relationships or informal alliances.
Taking a team approach to charitable planning could avert
many of the errors discussed below.
Errors in Drafting
Trust companies, investment
firms, charitable organizations, even the IRS, distribute
form documents for charitable vehicles. While this may add
value for a client or prospective donor, it is important that
the client retain an attorney experienced in charitable
planning to draft the document, rather than relying on a form
to save expenses. Look out for these provisions in charitable
remainder trust (CRT) forms:
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Trustee Provisions
While many form-CRT
documents do not name the client to serve as trustee,
generally there is nothing prohibiting the client from
serving as trustee of a CRT. In fact, most clients want to
maintain control. Thus, clients should be informed of this
opportunity in evaluating trustee options.
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Charitable Remainder
Beneficiary
Many forms do not permit the
client to name more than one charitable remainder beneficiary
or to change the charitable beneficiary during the client's
life. The client's advisors should present these
options.
In addition, it is important
for the client to decide whether he or she wants the
flexibility to ever name a private foundation as the
remainder beneficiary. This decision may affect the client's
ability to take the income tax deduction generated by the
gift to the CRT. As a general rule, clients may take
deductions for gifts of appreciated property to public
charitable organizations up to 30 percent of the client's
adjusted gross income (AGI) in the year the gift is made. If
the gift exceeds 30 percent of the client's AGI, the client
may carry the deduction forward over five years. With gifts
of marketable, appreciated securities to a private
foundation, a client may deduct gifts up to 20 percent of AGI
per year over six years. In the context of a CRT, if the
trust prohibits a private foundation from ever being named
remainder beneficiary, then contributions to the CRT will be
subject to the higher 30 percent limitation.
When a client is
establishing a charitable remainder trust, the client's
accountant should prepare income tax projections to determine
whether and how quickly the client will use the income tax
deduction. If the entire deduction at the private foundation
percentage limitations can be easily used, there is no reason
to restrict the remainder beneficiary to a public charitable
organization. While many clients will never establish a
private foundation, flexibility should be favored in
irrevocable instruments unless there is a countervailing
reason. On the other hand, if the client's ability to use the
deduction may be compromised by the 20 percent limitation, it
may be better to prohibit private foundations. If property
other than marketable securities is to be contributed, the
remainder beneficiary should be a public organization;
otherwise the deduction will be limited to cost basis.
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Early Distributions of
Trust Principal
If a client wants to make a
large current gift, but is concerned about cash flow,
accelerating the charitable remainder can be a good strategy.
Many form documents do not permit early distributions to the
remainder beneficiaries, so it must be custom-drafted. If a
properly drafted provision is included, the client can
accelerate all or a portion of the charitable remainder
interest during the client's life.
Consider the following
example: Joe sets up a 6 percent standard charitable
remainder unitrust, to which he contributes $1 million. This
trust would pay Joe $60,000 in year one. Assuming the trust
principal also earns $60,000 in year one, the trust would pay
him the same $60,000 in year two. If Joe decides in year two
that he would like to make a $20,000 outright charitable
gift, he could satisfy the gift with $20,000 of his other
assets. But if Joe doesn't want to part with $20,000 of his
other assets, he could accelerate a $20,000 portion of the
remainder interest in his CRT. If he did so, the trust
principal at the end of year two would be $980,000 and Joe's
year-three payment would be $58,800. In this case, Joe is
only out of pocket $1,200 in year two. In addition, as a
result of his gift in year two, Joe would receive an income
tax deduction equal to the present value of his income
interest in the $20,000. The decreased principal will also
diminish his payments in future years.
If the opportunity to make a
charitable gift in this manner arises, take care that the
transaction is conducted in such a manner as to avoid
self-dealing, as discussed below.
Investing and
Administrative Errors
In addition to skilled
drafting, careful investment and administration of charitable
trusts are essential. Charitable trusts, like all
split-interest trusts, require a sound investment policy that
balances the interests of the life and remainder interests. The
Prudent Investor Rule charges the trustee to consider each
investment in the context of the whole portfolio and does not
eliminate per se any particular investment. In addition,
complex tax rules apply to charitable trust investments and
cannot be overlooked. Here are some of the most common issues
we have come across in our practices:
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An Ad Hoc Investment
Approach
In many instances, a client
may serve as trustee of a charitable trust. While this may be
technically possible and even desirable in many cases, it is
important that the client be cognizant of the fiduciary
duties of trustee. As trustee, the client cannot favor the
life beneficiary over the remainder beneficiary, and vice
versa. In the case of a split-interest charitable remainder
trust, the state attorney general may intervene on behalf of
the charitable beneficiary to prevent the beneficiary's
interests from being compromised.
Thus, while a client may
want and be able to serve as trustee of his or her charitable
trust, it is generally advisable for the client to hire
investment advisors experienced in investing charitable
trusts. Such an investment advisor will typically develop an
asset allocation and investment policy statement for the
trust that addresses these issues and prohibits improper
investments. It is equally important for the investment
advisor to consult with the other members of the client's
advisory team.
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Lack of
Diversification
Most states impose a duty to
diversify on trustees. Where the client is serving as
trustee, he or she may have a difficult time diversifying.
Where the charitable entity is funded with stock from the
client's business or with real estate that the client has
owned for a long time, diversification may be particularly
difficult. The difficulty can stem from internal causes
(e.g., emotional attachment) or external causes (e.g., stock
trading restrictions or market conditions). In these cases,
it is even more important that the client work with advisors
experienced in such areas to develop a disciplined
diversification plan as part of the investment policy and
asset allocation.
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Unrelated Business
Taxable Income (UBTI)
An example of an improper
investment is one that generates unrelated business taxable
income (UBTI). UBTI is most commonly created by debt-financed
income. The most common examples of UBTI are assets purchased
on margin; publicly traded limited partnerships, which pass
through debt-financed income; rental real property acquired
with debt; and alternative investments, such as hedge
funds.
The consequences of
generating UBTI can be severe. If a CRT or supporting
organization recognizes even one dollar of UBTI, it would be
taxable on all its income for that year. If the year happens
to be the year in which the entity sells a large block of
appreciated property (such as the low basis property it
originally received), the effect can be very bad indeed. UBTI
in a charitable lead trust (CLT) can severely limit the
trust's ability to deduct the income interest paid to a
charitable organization.
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Self-Dealing
An excise tax is imposed on
each act of "self-dealing" in which a charitable trust or
foundation engages. Self-dealing is typically a transaction
between the charitable entity and a "disqualified person."
The term "disqualified person" includes a substantial
contributor to the entity; a foundation manager, including an
officer, director or trustee of the entity; and family
members of a contributor or foundation manager. An excise tax
of 5 percent is charged to the disqualified person and an
additional 2.5 percent excise tax is levied on the foundation
manager who knowingly participates in an act of
self-dealing.
The most common forms of
self-dealing are transactions between the client and the
charitable entity that he or she established, such as sales,
loans, payment of unreasonable compensation and use of trust
property for the client's benefit. One less obvious potential
act of self-dealing is the satisfaction of a charitable
pledge. Even if a pledge is not legally binding, there is the
possibility that the satisfaction of such a pledge with
charitable trust or foundation assets could be construed as
self-dealing.
Be a Better Planner
With care, you can use
charitable planning to help your clients meet their financial
and philanthropic goals. You should understand the costs and
benefits of charitable planning to properly educate clients
about these techniques, and also be aware of the potential
pitfalls to avoid in implementation. Working in teams of
advisors from different disciplines with charitable experience
is probably one of the best ways to serve clients competently
in this area.
Please call Jeff W. Anderson,
J.D. at 423-439-5352, or e-mail us at
andersjw@etsu.edu, for
more information.
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