Pooled Income Fund

Pooled Income Fund

Technical Report posted in Pooled Income Fund on 5 May 2003| comments
audience: National Publication | last updated: 13 September 2012
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Abstract

This comprehensive paper provides a complete overview of pooled income funds, qualification requirements, income tax deduction rules, taxation of the fund and distributions, gift and estate tax consequences, and application of private foundation excise taxes.

Introduction

A pooled income fund is a trust that is established and maintained by a public charity. The pooled income fund receives contributions from individual donors that are commingled for investment purposes within the fund. Each donor is assigned "units of participation" in the fund that are based on the relationship of their contribution to the overall value of the fund at the time of contribution.

Each year, the fund's entire net investment income is distributed to fund participants according to their units of participation. Income distributions are made to each participant for their lifetime; after which, the portion of the fund assets attributable to the participant is severed from the fund and used by the charity for its charitable purposes. A pooled income fund could, therefore, also be described as a charitable remainder mutual fund.

Contributions to pooled income funds qualify for charitable income, gift, and estate tax deduction purposes. The donor's deduction is based on the discounted present value of the remainder interest. Donors can also avoid recognition of capital gain on the transfer of appreciated property to the fund.

Qualification as a Pooled Income Fund

IRC §642(c)(5) defines a pooled income fund as a trust--

(A) to which each donor transfers property, contributing an irrevocable remainder interest in such property to or for the use of an organization described in section 170(b)(1)(A) (other than in clauses (vii) or (viii)), and retaining an income interest for the life of one or more beneficiaries (living at the time of such transfer),

(B) in which the property transferred by each donor is commingled with property transferred by other donors who have made or make similar transfers,

(C) which cannot have investments in securities which are exempt from taxes imposed by this subtitle,

(D) which includes only amounts received from transfers which meet the requirements of this paragraph,

(E) which is maintained by the organization to which the remainder interest is contributed and of which no donor or beneficiary of an income interest is a trustee, and

(F) from which each beneficiary of an income interest receives income, for each year for which he is entitled to receive the income interest referred to in subparagraph (A), determined by the rate of return earned by the trust for such year.

In order to qualify as a pooled income fund, the trust must meet all of the requirements set forth in Code, the regulations promulgated thereunder, Revenue Rulings, and Procedures.1 In Rev. Proc. 97-3, the IRS announced that it will continue its policy of not issuing advance rulings regarding whether a transfer to a pooled income fund described in section 642(c) of the Code qualifies for charitable income, gift, or estate tax deductions under sections 170(f)(2)(A), 2522(c)(2)(A) or 2055(e)(2)(A).2 The Service will, however, continue to rule regarding provisions that deviate from those found in the sample documents published in the Revenue Procedures.

Qualified Charitable Organizations

Organizations that can operate a pooled income fund are public charities as described in IRC 170(b)(1)(A). The most common organizations described in this section generally include religious organizations, educational institutions, hospitals, medical educational and research organizations, and community foundations.3

Specifically excluded, however, are private operating foundations and supporting organizations as described in IRC 509(a)(2) and (3) unless they fit into one of the categories of public charities mentioned above (even though these organizations are also considered public charities for income tax deduction purposes). Private non-operating foundations are also excluded.

In the event the charitable organization maintaining a pooled income fund goes out of existence or otherwise loses its qualification as a public charity, the trustees are required to select an alternate qualifying organization within 60 days after the organization ceases to exist or within 60 days of the expiration of the period in which a pleading can be filed to contest the loss of qualification.4

Commingling Requirement

The governing instrument of the pooled income fund must require that property transferred to the fund by each donor be commingled with, and invested or reinvested with, other property transferred to the fund by other donors. Charitable organizations are permitted to operate multiple pooled income funds, provided that each such fund is maintained by the organization and is not a device to permit a group of donors to create a fund which may be subject to their manipulation.

Such manipulation is, however, highly unlikely because the regulations require the governing instrument of a pooled income fund to 1) prohibit a donor or income beneficiary of a pooled income fund from serving as a trustee of the fund, and 2) include a prohibition against self-dealing.5

The fund must not include property transferred under arrangements other than pooled income funds. However, a fund is permitted to invest jointly with other properties that are held by, or for the use of, the charity maintaining the fund. The regulations cite as an example, securities in the general endowment fund of the public charity to or for the use of which the remainder interest is contributed. In a private ruling, the Service approved the commingling of pooled income fund assets with other charitable funds, including charitable remainder trusts and excluding any tax-exempt securities, held by the organization.6 Where such joint investment or reinvestment of properties occurs, records must be maintained which sufficiently identify the portion of the total fund which is owned by the pooled income fund and the income earned by, and attributable to, such portion. Charitable organizations have also been permitted to merge two or more pooled income funds together for purposes of expense reduction and administrative convenience.7

The regulations further permit a bank that serves as trustee of more than one pooled income fund to investment the assets of multiple pooled income funds in a common trust fund as described in IRC §584.8

Prohibition Against Investing in Tax-Exempt Securities

The property transferred to the fund by any donor must not include any securities, the income from which is exempt from tax under subtitle A of the Code, and the fund must not invest in such securities. The governing instrument of the fund must contain specific prohibitions against accepting or investing in such securities.9

Fund Maintenance Requirements

The fund must be maintained by the same public charity to or for the use of which the irrevocable remainder interest is contributed. The requirement is satisfied where the public charity exercises control directly or indirectly over the fund. For example, this requirement of control shall ordinarily be met when the public charity has the power to remove the trustee or trustees of the fund and designate a new trustee or trustees.

Pooled Income Funds Maintained by Community Foundations

Community foundations often receive contributions that are maintained for the benefit of other charitable organizations selected by the donor. Referred to as "donor designated funds" these arrangements have been the subject of special clarification by the Service. Can a donor make a contribution to a pooled income fund maintained by a community foundation and require the remainder interest to be paid to a donor-designated fund for the benefit of a specific charitable organization? Yes.

In Rev. Rul. 96-38, the Service ruled that a fund maintained by a community trust satisfies the maintenance requirement of section 642(c)(5)(E) if, in the instrument of transfer, the donor either requests or requires that the community trust place the proceeds of the remainder interest in a fund that has been designated to be used for the benefit of specific charitable organizations provided the fund is a component part of the community trust.10

Maintenance by National Organization for Benefit of Subsidiaries

A national organization that carries out its purposes through local organizations, chapters, or auxiliary bodies with which it has an identity of aims and purposes may maintain a pooled income fund in which one or more local organizations, chapters, or auxiliary bodies which are public charities have been named as recipients of the remainder interests. For example, a national church body may maintain a pooled income fund where donors have transferred property to such fund and contributed an irrevocable remainder interest therein to or for the use of various local churches or educational institutions of such body. The fact that such local organizations or chapters have been separately incorporated from the national organization is immaterial.11

Income Distributions

Each beneficiary of a pooled income fund receives a prorata share of the total rate of return earned by the fund for such taxable year.12 When a donor transfers property to a pooled income fund, one or more units of participation are assigned to the beneficiary or beneficiaries of the retained income interest. The number of units of participation assigned is obtained by dividing the fair market value of the property by the fair market value of a unit in the fund at the time of the transfer.

The fair market value of a unit in the fund at the time of the transfer is determined by dividing the fair market value of all property in the fund on the "determination date" by the number of units then in the fund. The initial fair market value of a unit in a pooled income fund is the fair market value of the property transferred to the fund divided by the number of units assigned to the income interest in that property. The value of each unit of participation will fluctuate with each new transfer of property to the fund in relation to the appreciation or depreciation in the fair market value of the property in the fund, but all units in the fund will always have equal value.

Determination Dates

The term "determination date" means each day within the taxable year of a pooled income fund on which a valuation is made of the property in the fund. The property in the fund shall be valued on the first day of the taxable year of the fund and on at least three other days within the taxable year. The period between any two consecutive determination dates within the taxable year shall not be greater than three calendar months. In the case of a taxable year of less than twelve months, the property in the fund shall be valued on the first day of such taxable year and on such other days within such year as occur at successive intervals of no greater than twelve calendar months. Where a valuation date falls on a Saturday, Sunday, or legal holiday (as defined in section 7503 and the regulations thereunder), the valuation may be made on either the next preceding day which is not a Saturday, Sunday, or legal holiday or the next succeeding day which is not a Saturday, Sunday, or legal holiday, so long as the next such preceding day or next such succeeding day is consistently used where the valuation date falls on a Saturday, Sunday, or legal holiday.

If property is transferred to a pooled income fund between determination dates, the unit value is obtained by taking the average value of the fund before and after the contribution, with "appropriate adjustments."13 Although the term "appropriate adjustments" is not defined, the example suggests the value should be time weighted between the determination dates.

Allocating Income to Units

The share of income allocated to each unit of participation is determined by dividing the income of the fund for the taxable year by the outstanding number of units in the fund at the end of the year, except that, income is allocated to units outstanding during only part of such year by taking into consideration the period of time such units are outstanding. For this purpose the actual income of such part of the taxable year, or a prorated portion of the annual income, may be used, after making such adjustments as are reasonably necessary to reflect fluctuations during the year in the fair market value of the property in the fund.

Payment Frequency

The fund is required to distribute income currently or within the first 65 days following the close of the taxable year in which the income is earned. Any such payment made after the close of the taxable year shall be treated as paid on the last day of the prior taxable year.

Most pooled income fund governing instruments provide guidelines for the frequency of income payments (e.g., at the end of each calendar quarter); however, many also permit the trustee to change the payment frequency on a discretionary basis. Payment frequency is not taken into consideration in computing deductions for income, gift, and estate tax purposes.

Measuring Terms

Although pooled income funds are considered trusts for federal tax purposes, the regulations exempt them characterization as trusts under local law; therefore, they may exist, like the charitable organizations they support, in perpetuity.14

Income interests payable from pooled income funds to non-charitable income beneficiaries are limited to the life of the beneficiary. Measuring terms measured by a term of years are not permitted. Following are permissible combinations and rules for their possible uses:

  • A donor can retain the income interest payable for his or her life.
  • A donor can designate payments to one or more other individuals, all of whom must be living and ascertainable at the time the property is transferred to the fund, for their life or lives.
  • The term "one or more individuals" can include a named class of beneficiary, as long as all members are alive at the time of transfer.
  • If income is paid to more than one income beneficiary, it can be paid concurrently, consecutively, or both concurrently and consecutively (joint and survivor).
  • The governing instrument must specify at the time of the transfer the particular beneficiary or beneficiaries to whom the income is payable and the share of income distributable to each person so specified.15 This requirement eliminates the possibility of spraying or sprinkling income among income beneficiaries.
  • A donor can retain an income interest for himself or herself, and an income interest for the life or lives of one or more other individuals, all of whom must be living at the time the property is transferred to the fund.

Like charitable remainder trusts, pooled income funds are prohibited from making income payments to one individual measured by the life of another individual.16 However, unlike charitable remainder trusts, measuring terms based on a fixed term of years or combination of life or lives and a term of years are not permitted.

Charity Permissible Income Beneficiary

In addition to paying income to named individuals, the public charity to or for the use of which the remainder interest is contributed may also be designated as one of the beneficiaries of an income interest. The donor need not retain or create a life interest in all the income from the property transferred to the fund provided any income not payable to an income beneficiary is contributed to the same public charity maintaining the fund. No charitable contribution deduction is allowed to the donor for the value of such income paid to the charity at the time of transfer or when payments are actually made.17 Neither are such payments made to charity taxable to the noncharitable income beneficiary, however.

Termination of Payments and Severance of Fund

The governing instrument of a pooled income fund must provide that the income interest of any designated beneficiary shall either terminate with the last regular payment that was made before the death of the beneficiary or be prorated to the date of his death.18

Severance Requirement

Upon the termination of the income interest retained or created by any donor, the trustee must sever from the fund an amount equal to the value of the fund units upon which the income interest was based. The amount so severed must either be paid to, or retained for the use of, the designated public charity, as provided in the governing instrument.

Based on the previously discussed commingling rules, severance may consist of a book entry that moves fund assets from the pooled income fund into the charitable remainderman's endowment fund without physical severance from the investment account.

Terminating an Income Recipient's Interest

Can a donor retain the right to terminate an income beneficiary's interest prior to the life measuring term? Yes, this power must be included within the governing instrument and must be exercisable solely by the trustor's will.19 Revocation is also limited to individuals; an income interest payable to charity is irrevocable.

Income Tax Consequences to Donors

No Recognition of Gain or Loss on Transfers to Fund

A donor does not generally recognize gain or loss on the transfer of property to a pooled income fund.20 As previously mentioned, the fund takes on the basis and holding period with respect to property transferred to it as determined in IRC §§1015(b) and 1223(2). If, however, the donor transfers debt-encumbered property to a pooled income fund, the donor may recognize gain as discussed in the next section.

In practice, this feature makes pooled income funds ideal for use by persons who desire to dispose of highly appreciated, low yielding property free of capital gains tax exposure in favor of assets that will produce higher amounts of cash flow. It is important to note the double tax leverage that can be accomplished by avoiding recognition of capital gain and creating an immediate charitable income tax deduction.

Transfers of Debt-Encumbered Property

If a donor transfers property to a pooled income fund that is subject to indebtedness, the amount of the indebtedness is treated as a bargain sale under IRC §1011(b) and the regulations thereunder. Accordingly, the donor will realize gain in an amount equal to the amount of that would have been realized had the donor sold a fractional interest in the property in an amount equal to the indebtedness.

Example: Suppose a donor transfers property having a fair market value of $100,000, an adjusted cost basis of $50,000, and an indebtedness of $25,000 to a pooled income fund. The amount of gain realized by the donor is determined by first calculating the capital gain ratio and then multiplying that ratio by the amount of the indebtedness. The computation is as follows:

Where:
F = fair market value
B = adjusted cost basis
D = debt

Realized Gain = (1 - (B/F)) x D
  = (1 - ($50,000/$100,000) x $25,000
  = $12,500

Charitable Contribution Deduction

Generally, no deduction is allowed for other than a donor's entire interest in property for income, gift, and estate tax deduction purposes unless the contribution takes the form of a charitable remainder annuity trust, charitable remainder unitrust, or pooled income fund.21

Calculating the Present Value of Remainder Interest

For income, gift, and estate tax purposes, the deductible portion of a transfer to a pooled income fund is based on the present value of the remainder interest. The present value is determined by computing the present value (at the time of the transfer) of the life income interest and subtracting that value from the fair market value of the transferred property on the valuation date. The computation is generally based on the following factors:

  • The date of birth of all income beneficiaries
  • The net fair market value of the property transferred
  • The fund's highest rate of return during the preceding three years

Determining the Fund's Rate of Return

The yearly rate of return earned by a pooled income fund is determined by dividing the total amount of income earned by the fund for the taxable year by:

  • the average fair market value of the property in the fund for the taxable year; less
  • the corrective term adjustment

Average Fair Market Value

The average fair market value of property within a pooled income fund is the sum of the value of all property held by the fund on each of the fund's determination dates, divided by the number of valuation dates applicable to the fund.

Corrective Term Adjustment

The corrective term adjustment is designed to adjust the annualized rate of return for income payments that are made during the year. It is calculated by adding the products obtained by multiplying each income payment made during the year by the percentage applicable to the period in which the payment is made according to the following table:



Payment Period Percentage of Payment
Last week of 4th quarter 0%
Balance of 4th quarter 25%
Last week of 3rd quarter 25%
Balance of 3rd quarter 50%
Last week of 2nd quarter 50%
Balance of 2nd quarter 75%
Last week of 1st quarter 75%
Balance of 1st quarter 100%

If the taxable year of the fund is less than twelve months, the CTA is the sum of the products obtained by multiplying each income payment made by the fund during the year by the quantity (1-(the number of days from the first day of the taxable year to the date of the first payment / 365).

Funds Less than Three Years Old

If a pooled income fund has existed for less than three taxable years immediately preceding the year in which a transfer is made, the highest rate of return is determined by first calculating the average annual Applicable Federal Midterm Rate (as described in IRC §7520 and rounded to the nearest 2/10ths) for each of the three taxable years preceding the year of the transfer. The highest annual rate is then reduced by one percent to produce the applicable rate.

Sample Rate of Return Computation

Having described the average fair market value and corrective term adjustment, the following computations illustrate the determination of a pooled income fund's rate of return:

Step 1: Determine the Fund's Average Fair Market Value

Determination Date FMV of Fund
March 31 $500,000
June 30 $520,000
September 31 $510,000
December 31 $490,000
  --------------
Total $2,020,000
Divided by 4
Average FMV $505,000

Step 2: Calculate Corrective Term Adjustment

Date of Payment Income Payment CTA Factor   Product
March 31 $9,300 X 75% = $6975
June 30 $9,300 X 50% = $4,650
September 31 $9,300 X 25% = $2,325
December 31 $10,200 X 0% = $0
  ------------     -----------
Total $38,100   = $13,950

The yearly rate of return is 7.759%, determined as follows: ($38,100 / ($505,000 - $13,950)) = .07759

Sample Single Life Present Value Computation

On January 1, 1998, Mrs. Smith contributed $100,000 to a pooled income fund. Mrs. Smith's age closest to the date of transfer was 60. The highest rate of return during the previous three years was 7.5%. The steps for the computation as outlined in Reg. §1.642(c)-6(e) are as follows:

Pooled Income Fund
Single Life Present Value Calculation



A. Input Assumptions
 
Date of transfer 01/01/1998
Fair market value of property transferred $100,000.00
Is fund three years old or older Yes
Highest yearly rate of return for the preceding three years 7.5%
Mrs. Smith's nearest age on the date of the gift is 60
 
B. Calculation of Tax Deduction
 
1. Fair market value of property transferred $100,000.00
 
2. Highest yearly rate of return for the preceding three years 7.5%
 
3. Interpolation of Pub. 1457, Table S factor
(a) Nearest usable payout rate less than or equal to the Line 2 rate 7.4%
(b) Line 2 minus Line 3(a) 0.100000
(c) Line 3(b) divided by .20 percent 0.500000
(d) Factor from Table S at Line 3(a) rate 0.305400
(e) Factor from Table S at the rate .20 higher than the Line 3(a) rate 0.297920
(f) Line 3(d) minus Line 3(e) 0.007480
(g) Line 3(f) times Line 3(c) (interpolation adjustment) 0.003740
(h) Interpolated Table S factor (Line 3(d) minus Line 3(g)) 0.301660
 
4. Present value of remainder interest (Line 1 * Line 3(h)) $30,166.00

Sample Two Life Present Value Computation

On January 1, 1998, Mr. and Mrs. Smith contributed $100,000 to a pooled income fund. Mr. and Mrs. Smith's age closest to the date of transfer was 60. The highest rate of return during the previous three years was 7.5%. The steps for the computation as outlined in Reg. §1.642(c)-6(e) are as follows:

Pooled Income Fund
Two Life Present Value Computation



A. Input Assumptions
 
Date of transfer 01/01/1998
Fair market value of property transferred $100,000.00
Is fund three years old or older Yes
Highest yearly rate of return for the preceding three years 7.5%
Mr. Smith's nearest age on the date of the gift is 60
 
B. Calculation of Tax Deduction
 
1. Fair market value of property transferred $100,000.00
 
2. Highest yearly rate of return for the preceding three years 7.5%
 
3. Interpolation of Pub. 1457, Table R(2) factor
(b) Nearest usable payout rate less than or equal to the Line 2 rate 7.4%
(b) Line 2 minus Line 3(a) 0.100000
(c) Line 3(b) divided by .20 percent 0.500000
(d) Factor from Table R(2) at Line 3(a) rate 0.189640
(e) Factor from Table R(2) at the rate .20 higher than the Line 3(a) rate 0.182450
(f) Line 3(d) minus Line 3(e) 0.007190
(g) Line 3(f) times Line 3(c) (interpolation adjustment) 0.003600
(h) Interpolated Table R(2) factor (Line 3(d) minus Line 3(g)) 0.186040
 
4. Present value of remainder interest (Line 1 * Line 3(h)) $18,604.00

Claiming the Charitable Contribution Income Tax Deduction

Contributions to pooled income funds are treated, for purposes of the charitable contribution income tax deduction purposes, as a gift "to" a 50%-type public charity. The gross amount a trustor can claim for income tax purposes is equal to the net present value of the remainder interest and is subject to the percentage limitation and reduction rules of IRC §170. These rules are discussed in detail in Tax Review.

Proof of Computation

Any claim for a deduction on any return for the value of the remainder interest in property transferred to a pooled income fund must be supported by a statement attached to the return showing how the computation of the present value of remainder interest was performed.22

Appraisal Requirements

In the event the donor claims a charitable contribution income tax deduction in connection with a contribution of other than cash or publicly-traded securities to a pooled income fund, and the amount exceeds $5,000.00 (or $10,000 if the transfer involves closely-held stock), the donor must substantiate the value of the contributed property with a qualified appraisal. Furthermore, the qualified appraiser must sign Form 8283 - Noncash Charitable Contributions information return that is filed with the donor's individual income tax return. A complete discussion of valuation and appraisal requirements may be found in Tax Review.

Written Acknowledgement from Charitable Organization

IRC §170(f)(8) requires that when a donor makes a charitable contribution deduction of $250 or more, the recipient charity must provide the donor with a contemporaneous written acknowledgement. The acknowledgement must be in the hands of the donor prior to the earlier of 1) the date on which the donor files a return for the taxable year in which the contribution was made, or 2) the due date (including extensions) for filing such return.

When the gift is made to a pooled income fund, the contemporaneous written acknowledgment must state that the contribution was transferred to the donee organization's pooled income fund and indicate whether any goods or services (in addition to an income interest in the fund) were provided in exchange for the transfer. The contemporaneous written acknowledgment is not required to include a good faith estimate of the value of the income interest.23

Taxation of Pooled Income Funds and Fund Distributions

Unlike charitable remainder trusts, which are conditionally exempt from income taxes, pooled income funds are, with one important exception discussed below, taxed as complex trusts.24 Pooled income funds seldom pay any tax, however, for several reasons.

First, pooled income funds receive an unlimited deduction for all amounts of income distributed to fund participants.25 Because pooled income funds are required to distribute all income earned each year, there remains no income to be taxed.

Second, pooled income funds are permitted a special deduction for long-term capital gains that are set aside permanently for charity.26 In essence, long-term capital gains produced by a pooled income fund are allocated to principal. Because principal is earmarked for charity, such amounts escape income taxation.

For purposes of tracking income and gain attributable to contributed assets, pooled income funds take on the donor's holding period and adjusted cost basis in the contributed property.27

Income Defined

The Declaration of Trust for most pooled income funds defines income as that term is defined in IRC §643(b). Under this section, the term income, when not preceded by the words taxable, distributable, undistributed net, or gross, means the amount of income of the trust for the taxable year determined under the terms of the governing instrument and local (state) law. The Uniform Income and Principal Act or Revised Uniform Income and Principal Act adopted by most states defines income to include interest, dividends, rents, and royalties.

Capital Gains as Income

Unless otherwise defined, income does not ordinarily include capital gains. Provided that such definition is compatible with state law, however, pooled income funds can expand the definition of income to include capital gains.

As mentioned earlier, the exemption from taxation for capital gains applies only to long-term capital gains. This means that unless short-term capital gains are defined as income, such gains will be subject to tax within the fund. Charities can avoid this result by 1) adopting an investment strategy that avoids producing short-term capital gains, or 2) by expanding a new fund's definition of income to include net short-term capital gains (provided such definition is permitted under state law). As a third option, some pooled income funds define income to include all net capital gains regardless of term.

Taxation of Fund Distributions

Pooled income fund beneficiaries are required to include in their gross income all amounts properly paid, credited, or required to be distributed to them during the taxable year or years of the fund ending within or with their taxable year.28

Distributions from pooled income funds are taxed under the conduit theory applicable to IRC §§661 and 662. Because pooled income funds distribute all income earned during the taxable year, the tax character of amounts distributed to each income beneficiary is directly proportional to the tax character of the entire distributed amount.

Depreciation and Tax Credit Pass-Through

Pooled income funds are permitted to invest in depreciable or depletable property; however, in order to protect the charitable remainder, the governing instrument must provide for the establishment of a funded depreciation or depletion reserve according to generally accepted accounting principals (GAAP).29

The depreciation deductions are allocated to the fund's income beneficiaries to the extent they exceed amounts set aside in the reserve fund.30 Where it is determined that the use of the depreciable property is consistent with the organization's tax-exempt purpose (as would occur in cases where the organization leases the property from the fund), the property must be depreciated using the straight-line method.31 In such cases, the amount of depreciation pass-through may be negligible.

In a 1987 private letter ruling, the Service concluded that a purchase of a certified historic building by a pooled income fund would make it eligible for investment tax credits under then IRC §48.32 With respect to the allocation of the credit, the Service ruled that it was to be apportioned between the fund and income beneficiaries on the basis of the income of the allocable to each. Because all income in the fund was allocated to income beneficiaries, so was the entire amount of the credit.

Rental Income Considered Passive Income

The Service ruled privately that the rental of land and buildings is a passive activity under IRC §469(c). Accordingly, the gross rental income produced by a pooled income fund, to the extent it exceeds expenses associated with the rental activity, is passive income to the income beneficiaries in the same proportion the fund's net rental income has to its entire distributable net income.33

Gift and Estate Tax Considerations

A pooled income fund consists of a charitable gift of remainder interest with a retained income interest. Gifts made to charity via a pooled income fund qualify for unlimited gift and estate tax deductions for the present value of the remainder interest. However, a gift or estate tax can be generated on the value of the retained income interest if it is transferred to someone other than the donor, the donor's spouse, or charity.

Donor as Sole Income Recipient

A donor makes a transfer to a pooled income fund naming herself as the sole life income recipient. The transfer qualifies for the charitable gift tax deduction in an amount equal to the present value of the remainder interest in the year the transfer is made.34 Because the donor retains the income interest, there are no further gift tax consequences. Upon her death, the full value of her fund units is includible in her estate.35 However, the full value of the fund units will be deductible from her taxable estate via the estate tax charitable deduction.36

Non-Donor as Income Recipient

When a donor makes a transfer to a pooled income fund naming another person as an income recipient, the donor has made a potentially taxable gift of an income interest to the income recipient.

Computation of Taxable Gift when Non-Donor is Sole Income Recipient

When one or more non-donors are the sole income recipients with respect to a transfer made to a pooled income fund, the amount of the taxable gift is equal to the present value of the retained income interest. It is equal to the amount transferred minus the present value of the remainder interest. The computation of the present value of remainder interest is identical to that used for income tax deduction purposes; however, the reduction rules of section 170 of the Code do not apply.

Example: A father, age 70, transfers $100,000 to a pooled income fund whereby the Instrument of Transfer names his son, age 40, as the sole life income recipient. The fund's highest rate of return during the preceding three years is 8%. Based on these assumptions, the present value of the remainder interest is $10,266. The son's income interest and, therefore, the taxable gift are $89,744.

Computation of Taxable Gift with Donor and Non-Donor Income Recipients

If the donor and a non-donor are co-income recipients, the amount of the taxable gift depends on whether the non-donor has a concurrent or successive income interest.

Non-Donor as Primary Life Income Recipient and Donor as Successor Life Income Recipient

When a non-donor is the primary income recipient for life followed by the donor, the amount of the taxable gift is equal to the present value of the income interest based on the non-donor's life. In other words, the presence of the donor as a successor income recipient has no impact on the non-donor's enjoyment of the income interest. The computation of the taxable gift is therefore no different than if the non-donor is the sole income recipient of the trust.

Donor as Primary Life Income Recipient and Non-Donor as Successor Life Income Recipient

When the donor is the primary income recipient followed by the non-donor as successor income recipient, the taxable gift is equal to the present value of the non-donor's survivor income interest. It is equal to the difference between the present value of the income interest based on the donor's and non-donor's joint lives and the present value of the income interest based solely on the life of the primary income recipient (donor).

Example: Continuing with the previous example, suppose the father names himself as the primary income recipient and his son as the successor. The computation of the value of the son's successor income interest is as follows:



  PV of income interest based on joint lives $91,124
Minus: PV of income interest based on father's life $57,752
Equals: PV of son's successor income interest $33,372
Donor and Non-Donor Joint and Survivor Life Income Recipients

When the income amount is payable to the donor and non-donor in equal shares for each of their lives with the decedent's portion payable to the survivor, the donor has, in essence, made two gifts: (a) the present value of the non-donor's right to receive a survivor income interest from one-half of the transfer, and (b) the present value of income interest for the income recipients' joint lives from the remaining one-half of the transfer.

Example: Suppose the father names himself and his son as joint and survivor income recipients of the trust. While they are both living, each will receive one-half of the income amounts. When either dies, the survivor will receive the entire annuity amount for their lifetime. The computation of the taxable gift is as follows:

Gift 1 Computation



  PV of income interest based on joint lives $91,124
Minus: PV of income interest based on father's life $57,752
Equals: PV of son's successor income interest $33,372
Times: 50%
Equals: Gift 1 amount $16,686

Gift 2 Computation



  PV of annuity interest based on father's life $57,752
Plus: PV of annuity interest based on son's life $89,744
Minus: PV of annuity interest based on joint lives $91,124
Equals:   $56,372
Times: 50%
Equals: Gift 2 amount $28,186
 
  Combined gift amount from 1 and 2 $44,872

Marital Deduction

The rules concerning the qualification of transfers to pooled income funds for marital gift and estate tax deduction purposes are complex and, if not properly planned, can result in the unintended generation of a transfer tax.

A transfer to a pooled income fund that names a spouse as an income recipient is considered a gift of a terminable interest; however, unlike transfers to charitable remainder trusts, the transfer will not qualify for the gift tax marital deduction. Donors should, therefore, avoid making a completed gift at the time of transfer by reserving the right, exercisable by will, to revoke the spouse's income interest. Annual gifts will accrue to the donee spouse as income is received and will qualify for the gift tax marital deduction.

In the event the donor spouse predeceases the donee spouse, the fair market value of the fund units will be includible in the donor spouse's estate under IRC §2044. The decedent spouse's estate can, provided the surviving spouse is the sole income beneficiary, make an election to treat the present value of the remaining income interest as qualified terminable interest property (QTIP) thereby qualifying for the estate tax marital deduction. The present value of the remainder interest balance will qualify for the estate tax charitable deduction under IRC §2055. The estate tax marital deduction will not be available, however, if the couple divorces during the term the income interest is payable.

Availability of Annual Gift Tax Exclusion

If all or part of the income interest is given to someone other than a spouse, the $10,000 annual gift tax exclusion is available only if the non-donor recipient has a concurrent (present) rather than consecutive (future) income interest. If the non-donor income recipient is not the donor's spouse, the annual gift exclusion can be increased to $20,000 with the consent of the donor's spouse. Any remaining taxable gifts can be further offset by the donor's unified gift tax credit.37

Testamentary Power to Revoke Income Recipient's Interest

A donor can forestall the recognition of a taxable transfer to a non-spouse income recipient by reserving the power in the Instrument of Transfer to revoke the non-donor recipient's income interest, thereby making the transfer incomplete for gift tax purposes. This power must be exercisable solely by the donor's will.38

Taxable Gifts Accrue as Income is Received

For Instruments of Transfer that contain the power to revoke a recipient's income interest, taxable gifts are deemed made by the donor as income payments are actually received by the recipient. Such amounts are considered gifts of a present interest and, accordingly, qualify for the $10,000 annual exclusion.39

Estate Tax Consequences when Right of Revocation is Unexercised

A donor makes a transfer to a pooled income fund in which the Instrument of Transfer names her children as the sole joint-life income recipients. The donor also reserves the right, exercisable solely by her will, to revoke the children's income interests. The donor then predeceases her children, failing to revoke. The entire value of the trust is includible in her gross estate under IRC §2038(a). The present value of the charitable remainder interest is calculated based on the fair market value of the trust and the ages of the life income recipients on the date of the donor's death. The present value of the remainder interest qualifies qualifies for the estate tax charitable deduction under IRC §2055(a).40

Estate Tax Consequences when Right of Revocation is Absent

If the donor does not reserve the right to revoke her children's interests, the gifts become complete at the time the transfer is made to the fund. Furthermore, the value of the trust will not be includible in her estate. In such case, the donor will file a gift tax return for the value of the income interest that exceeds the $10,000 annual exclusion per recipient. The donor's unified gift tax credit is applied to the balance of any gift tax due. When the donor dies, the value of the original taxable gift is included in the calculation of her estate tax, with any prior gift taxes paid or unified credit used, credited against her tentative estate tax liability.

Donor's Intervening Income Interest

If the donor includes herself as the primary income recipient and names her children as successor income recipients, the full value of the trust will be includible in her estate regardless of the absence of a retained right of revocation.41 As before, the present value of the remainder interest (based on the fair market value of the trust and the successor income recipients' ages on the date of her death) will qualify as an estate tax charitable deduction. If the donor does not retain the right to revoke and incurs gift tax in the year the transfer is made to the fund, her estate will receive a credit for any previous gift taxes paid or unified gift tax credit used.

Private Foundation Excise Taxes

Prior to the Tax Reform Act of 1969, the only sanction available to a private foundation was the revocation of its tax-exempt status. In order to provide punishment commensurate with the violation, Congress created the private foundation excise taxes. Although pooled income funds are not private foundations, certain of the private foundation excise taxes are applicable to them.

Pooled income funds are, by virtue of IRC 4947(a)(2), subject (with limited exceptions) to the private foundation excise taxes imposed under sections 4941 (relating to taxes on self-dealing), 4943 (relating to taxes on excess business holdings), 4944 (relating to investments which jeopardize charitable purpose), and 4945 (relating to taxes on taxable expenditures).

Self-Dealing

Pooled income funds are subject to private foundation excise taxes imposed on acts of self-dealing between the foundation manager (i.e., the trustee) and a disqualified person. Acts of self-dealing generally include a sale, exchange or lease, loan or other credit (except a loan that bears no interest), furnishing goods, services or use of trust property, or payment of compensation, income or use of assets, between a private foundation (charitable remainder trust) and a disqualified person.42 With respect to a pooled income fund, a disqualified person is a:

  1. substantial contributor (a person who contributes more than $5,000 or the creator of the trust);43
  2. trustee (foundation manager);
  3. person who owns more than 20% of:
    - voting power of a corporation,
    - profit interest in a partnership, or
    - the beneficial interest of a trust or unincorporated enterprise, where the entity is a substantial contributor to the trust;
  4. spouse, ancestors, children, grandchildren, great grandchildren, and their spouses, of persons previously described; or
  5. corporation, partnership, trust, estate or enterprise of which more than 35% of the total ownership, and the rights thereof, are owned by persons previously described.

Taxes Imposed on Acts of Self-Dealing

An initial tax of five percent of the amount involved is imposed on the disqualified person even though he may not have knowingly committed a prohibited act.44 An additional tax of two and one-half percent is levied on the trustee who willfully participates in an act of self-dealing knowing it was an act unless he has reasonable cause.45

If the act of self-dealing is not corrected during the taxable period or correction period, an additional tax of 200% of the amount involved is imposed on the disqualified person and a tax of 50% (to a limit of $10,000) is imposed on the trustee if the trustee refuses to agree to all or part of the correction.46

Gifts of Partial Interests in Jeopardy

Many individuals are attracted to the benefits of a pooled income fund, yet do not wish to transfer the entire value of an indivisible asset to the trust. In these circumstances, the individual could transfer an undivided fractional interest in the property to the trust and retain the difference. The donor then joins with the trustee via separate sales agreements in the disposition of the property. The transfer represents an undivided interest in every element of the donor's ownership in the property and, thus, should constitute a qualified tax-deductible gift of a partial interest.47

Problem: Letter Ruling 9114025 suggests that a transfer of an undivided fractional interest in property to a charitable remainder trust with an interest retained by a disqualified person may constitute a prohibited act of self-dealing.

The ruling stated, "Section 101(1)(2)(E) of the Tax Reform Act of 1969, Pub. L. No. 91-172, 83 Stat. 533 (1969), provides that section 4941 shall not apply to [the] use of property in which a private foundation and a disqualified person have a joint or common interest if the Interests [sic] of both were acquired before October 9, 1969. This provision contains a limited exception to application of 4941, and indicates that a disqualified person's use of jointly-owned property after October 9, 1969, will be self-dealing." Whether a common ownership interest constitutes a use of property is subject to debate. The example cited in Reg. §53.4941(d)-4(e)(2) illustrates the physical use of property, which may be distinguishable from mere ownership.

Ruling Solution: The taxpayers avoided the problem by establishing a partnership of the owners (husband and wife), and thereafter transferred portions of their partnership interests to the trust. Alternative Solution: In most cases it is the objective of the individual to sell their retained portion of the property outside of the trust. Therefore, the self-dealing issue can be avoided by the individual first selling a portion of their property outside of the fund and then contributing their entire remaining interest to the trust.

Transfers of Debt-Encumbered Property

The Code provides that a transfer of real or personal property by a disqualified person to a private foundation shall be treated as a prohibited sale or exchange if (a) the property is subject to a mortgage or similar lien which the private foundation assumes, or (b) it is subject to a mortgage or similar lien which a disqualified person placed on the property within the 10-year period ending on the date of transfer (to the trust).48

As a substantial contributor, the donor is a disqualified person with respect to the private foundation.49 The regulations provide, however, that the donor's status as a substantial contributor is disregarded in determining whether the transfer to the private foundation is self-dealing, because the donor's stature as a substantial contributor arises only as a result of the transfer.50

Loans of Fund Assets to Charitable Remainderman Permitted

The Service approved an arrangement whereby the charitable organization maintaining a pooled income fund borrowed fund assets in exchange for promissory notes. The ruling held that the arrangement was not a prohibited act of self-dealing even though the borrower was also the trustee of the fund.51 In a subsequent ruling, the Service approved the lending of fund assets to the charitable remainderman in exchange for unsecured promissory notes provided the notes paid a market rate of interest.52

Special Exception for Disqualified Corporations

A transaction between a private foundation and a corporation that is a disqualified person (e.g., a redemption) is not an act of self-dealing if the offer to purchase stock is made to all shareholders and on the same terms.53 In a separate ruling, the IRS stated that the retention by the trustee of a majority interest in a closely-held corporation is not a transaction that constitutes a prohibited act of self-dealing under section 4941. In the same ruling, the Service confirmed that, based on the facts of the ruling, taxes imposed under sections 4942, 4943, 4944, and 4945 do not apply.54

Application of Self-Dealing Rules to Employee Stock Ownership Plans

Section 4946(a)(1)(C) of the Code defines disqualified person to include a person who is an owner of more than twenty percent of the total combined voting power of a corporation that is a substantial contributor to a private foundation.

Section 53.4946-1(a)(5) of the regulations defines combined voting power to include the voting power represented by holdings of voting stock, actual or constructive, but does not include voting rights held only as a director or trustee.

An Employee Stock Ownership Plan's stock is subject to the direction of the individuals on whose behalf the shares have been allocated and to whom the beneficial interest in the shares has passed. Therefore, to the extent the ESOP trust has any voting power with respect to the corporation's stock, it is merely the voting power of a trustee. Thus, although the ESOP trust may hold legal title to any amount of stock that exceeds twenty percent of the total combined voting power of the corporation, it is not treated as the owner of the stock, for purposes of section 4946(a)(1)(C) of the Code.

Rev. Rul. 81-76 holds that an ESOP described in section 4975(e) of the Code is not treated as the owner of stock in a corporation where the stock is allocated to participating employees and, thus, is not a disqualified person.55

Excess Business Holdings

Pooled income funds are subject to a prohibition against excess business holdings only in the event that income is payable to a charitable organization.56 In such case, a pooled income fund's business holdings will be considered excessive if:

  • the foundation owns more than 20% of the voting stock of a corporation reduced by the percentage of voting stock owned by all disqualified persons,57 or
  • the foundation and all disqualified persons own more than 35% of voting stock, or control the corporation.58

The trustee is allowed five years to dispose of excess holdings prior to imposition of a tax (with a possible five-year extension).59 The Service has not ruled on whether or not the application of the excess business holdings rules apply only to the Instrument of Transfer which conveys the stock that is subject to excess business holdings, or applies to all property owned by the pooled income fund. In that latter case, the presence of one Instrument of Transfer that provides for income payments to charity could, in theory, subject all transfers to the excess business holdings rules.

Jeopardizing Investments

Like the rules applicable to excess business holdings, pooled income funds are subject to a prohibition against jeopardizing investments only in the event that income is payable to a charitable organization.60 If so, an excise tax is imposed on the trustee that invests in a manner that would jeopardize the trust's tax-exempt purpose (i.e., providing a remainder interest to an IRC §170(c) organization).

No category of investments is treated as a per se violation. However, the Service will closely scrutinize trading on margin (which will also cause debt-financed income), trading in commodity futures, investments in working interests in oil and gas wells, calls, puts, straddles, warrants, and selling short.61

Even though a violation of the rule might not cause an excise tax, a trustee who fails to exercise ordinary business care and prudence in balancing the competing interests of income recipient and remainderman may become subject to liability.

Private Foundation Expenditures

Private foundation expenditures as described in IRC §4945 are not relevant to pooled income funds because they are prevented prevented from making payments to other than the named income recipients or to the charitable organization maintaining the fund. A trustee would, therefore, never make political contributions, grants to individuals, or donations to private foundations as described in this section. An exception is made for payments for full and adequate consideration (e.g., trustee, administrative, investment management fees, etc.).62

Implementation

Declaration of Trust

Pooled income funds operate on the basis of a master trust agreement established by resolution and executed by the charitable organization maintaining the fund. The Service originally set forth the mandatory governing provisions of the Declaration of Trust in Rev. Rul. 72-196. This ruling has since been superseded, clarified, and amplified in Rev. Ruls. 82-38, 85-57, 88-53, 90-103, and 92-81.

Instrument of Transfer

Individual donors participate in a pooled income fund by executing an Instrument of Transfer. The instrument establishes:

  • the date of transfer
  • the number of income beneficiaries
  • the share of income payable to each income recipient and the sequence in which they will receive payments (e.g., concurrently and consecutively)
  • the right of the donor to revoke a non-donor's income interest, and
  • the use to which the charitable remainderman places the remainder interest.

Disclosure Statement

Organizations maintaining pooled income funds are required to provide prospective donors with a written statement that provides a full and fair disclosure of the operation of the fund. The statement must be updated annually.

The requirement of providing a disclosure statement is not based on any federal tax law requirement; rather, it has its origin no-action letters issued by Securities and Exchange Commission that enable pooled income funds to avoid registration as a security. The following discussion deals with the origin of this requirement.

A pooled income fund in many ways resembles a mutual fund. Does this similarity require that a pooled income fund be considered an "investment company" and, therefore, subject to the rules of the Securities Act of 1933, the Securities and Exchange Act of 1934, and Investment Company Act of 1940? And if so, would registered representatives be the only ones permitted to market and execute pooled income fund transactions on behalf of charitable organizations?

In 1972, the American Council on Education attempted to clarify these issues with a request for ruling from the Securities and Exchange Commission. The Council proposed that pooled income funds should not be considered securities based on the presumptions that:

  1. the actual establishment and maintenance of the pooled trust would provide no opportunities for personal profits to private promoters or organizers since the Code requires that a pooled trust be established and maintained only by a bona fide public charity for the exclusive purpose of raising funds for its charitable purposes;
  2. the persons who solicit donations for a college or university, including donations to a pooled trust, would be either volunteers, such as alumni, who would receive no compensation, or persons employed in connection with the college's overall fund-raising activities, only a relatively small part of which ordinarily involve contributions to a pooled trust. Persons employed in connection with the college's fund-raising activities would receive no commissions or other special compensation based upon the amount of gifts transferred to the pooled trust; and
  3. a transfer to a pooled income fund does not constitute a "sale for value."

The SEC rejected the Council's arguments, but took the position that it would issue a "no action" letter. In response to numerous subsequent requests for no-action letters, the SEC issued Release 33-6175 in which it issued a blanket no-action for pooled income funds. In the release, the SEC reiterated its position that a pooled income fund is a security because although it is organized for a charitable purpose, the net earnings do inure for the benefit of a private individual. The SEC then outlined the circumstances under which it will take no action:

  1. the pooled income fund is qualified to receive tax-deductible contributions under IRC §642(c)(5);
  2. that each prospective donor receive a written disclosure statement that fully and fairly describes the operation of the pooled income fund; and
  3. that all persons who solicit contributions on behalf of the pooled income fund are volunteers or are employed as a part of the organization's overall fund-raising. Additionally, no solicitor can receive any commissions or other compensation that is based on amounts transferred to the pooled income fund.

Investment Considerations

Many organizations maintain several pooled income funds having different investment objectives. These objectives can include maximizing current distributable income, maximizing capital appreciation, or a combination of the two.

Asset Allocation

The investment objective of the fund dictates the asset allocation. The majority of pooled income funds are invested in a managed securities portfolio consisting of debt instruments for income and equities for income and capital appreciation. Other pooled income funds anticipate far more sophisticated investment strategies.

Potential Investment Dilution

Non-income-producing property that is not readily marketable may not be suitable for transfer to a pooled income. Although the transfer of such property is beneficial to the donor, other fund participants may experience a dilution of the income producing power of their units -- particularly if the value of the contributed property in relation to the overall value of the fund is significant. The organization maintaining the fund might consider purchasing such property from the fund and selling it in due course; however, the organization should also weigh the benefit of the gift against the expense, risk, and the opportunity cost of investing the funds elsewhere.

Real Estate Pooled Income Funds

Colleges and Universities have lead the way in the use of pooled income funds created for the purpose of owning real property that is used by the organization in connection with its charitable purposes. Under this type of arrangement, a charitable organization establishes a pooled income fund to which donors make contributions of cash or other property. The fund liquidates the contributed property and uses the proceeds to construct new facilities or purchase property from the charitable organization. The organization in some cases leases land to the fund at a nominal cost for this purpose. In order to facilitate the construction process, the charitable organization may also lend money to the fund, or secure independent construction and long-term financing.

Although not specifically required, the fund most often uses the property in connection with its tax-exempt purposes (e.g., dormitories) with the rental income (net of debt-service, operating expenses, and funded depreciation) distributed to fund beneficiaries according to their units of participation. As was previously discussed, the fund may pass depreciation deductions (to the extent they exceed the required depreciation reserve) and tax credits (in their entirety) through to income beneficiaries.

Planning Considerations

Comparing Pooled Income Funds to Other Life Income Gift Arrangements

Within the context of life income gift arrangements, the principal advantage of pooled income funds, from the donor's perspective, are their economy and convenience of implementation, management, and administration.

Implementation

For donors, no trust need be drafted because it is already in place; all that need be executed is a one or two page Instrument of Transfer. Although donors are well advised to have the Disclosure Statement, Declaration of Trust, and Instrument of Transfer reviewed by their professional advisors, they will not incur the delay and expense of having a separate trust instrument created, as would be required with a charitable remainder trust.

Administration

A second significant advantage of the pooled income fund is the relatively modest cost of administration. Whereas charitable remainder trusts require the creation the filing of tax and information returns for each individual trust, an organization maintaining a pooled income fund is required to file only one set of returns regardless of the number of fund participants. In this respect, the administrative convenience is similar to that for charitable gift annuities with one important exception. Organizations maintaining charitable gift annuities may be required to be licensed to offer charitable gift annuities in the state of the donor's domicile. Pooled income funds are not considered insurance contracts and are, therefore, exempt from these requirements.

Minimum Contributions

The third advantage of pooled income funds is their ability to economically accept smaller contributions than charitable remainder trusts. By the vary nature of their commingling requirements, pooled income funds can more easily diversify investments, meet investment management account minimums, and adhere to a uniform investment policy. These features combined with relatively simple tax reporting compliance lend an economy of scale that permits charitable organizations to offer significantly lower minimums than for charitable remainder trusts. The minimums for charitable gift annuities are usually comparable, however.

Higher Income at Lower Ages

Pooled income funds must distribute all of their accounting income each year regardless of the age of the income beneficiary. This is distinguishable from charitable gift annuities where the annuity rate payable is age sensitive. It is also distinguishable from charitable remainder trusts in that pooled income funds are not subject to the ten-percent minimum remainder interest qualification floor.

Taxation of Contributions and Income Distributions

With the exception of transfers of debt-encumbered property, a donor does not recognize gain or loss on the transfer of appreciated property to a pooled income fund or charitable remainder trust. Provided certain conditions, similar transfers in exchange for a charitable gift annuity does not result in the immediate recognition of gain.

The phrase "capital gains avoidance" on contribution of appreciated assets is really a misnomer when discussing retained income vehicles. If capital gains were truly avoided, one would be able to reinvest the proceeds of the sale in tax-exempt securities. What pooled income funds, charitable remainder trusts, and charitable gift annuities do, in one way or another, is to defer the immediate recognition by the donor of capital gain on the transfer of appreciated property to the charitable organization or gift vehicle. What is significant is the way that income distributions from each of these vehicles are taxed.

From the standpoint of the taxation of payments, pooled income funds offer perhaps the least attractive income tax result when compared to charitable remainder trusts and charitable gift annuities. The majority of pooled income funds are structured so they can distribute only items that are taxable ordinary income. They typically allocate long-term capital gains to principal and are specifically prohibited from receiving or investing in tax-exempt securities.

Conversely, the taxation of charitable remainder trust distributions is dependent on the adjusted cost basis of the funding assets, the investment strategy employed within the trust, and application of the four-tier system of taxation. Thus, the taxation of charitable remainder trust distributions can run the gamut from being completely tax-exempt to being entirely taxable as ordinary income. In the majority of cases, charitable remainder trusts are funded with highly appreciated property that is immediately sold with the proceeds reinvested in a balanced account consisting of fixed income instruments and equities. The taxation of distributions is therefore most often comprised of a mixture of ordinary income and long-term capital gains.

The taxation of annuity payments from charitable gift annuities consist of a combination of tax-free return of the donor's basis in the contributed property, ordinary income, and capital gains (if appreciated property was transferred in exchange for the annuity).

Although charitable remainder trusts and charitable gift annuities can provide more favorable income tax treatment of distributions, donors and their advisors should consider that each of these vehicles provide differing gross distribution amounts and differing charitable contribution income tax deduction amounts; accordingly, an analysis that compares the net after-tax cost of the contribution should first be made. This amount can then be used in the to comparison of net after-tax cash flow and return on investment of each vehicle.

A Possible Solution for Debt Encumbered Property

As with charitable remainder trusts, the regulations are not clear with respect to the income tax consequences of contributions of debt-encumbered property. Unlike a charitable remainder trust which in the event it accepts debt-encumbered property risks being treated as a grantor trust thereby forfeiting its tax-exempt status (and qualification), pooled income funds have no tax-exempt status to forfeit. Furthermore, the special exemption from tax for long-term capital gains permanently set aside for charity enables a pooled income fund to accept debt-encumbered property, sell it, and pay no tax on long-term capital gains.

That's the good news. On the downside, when debt-encumbered property is transferred to a pooled income fund, the entire amount of the indebtedness is an amount realized by the donor for purposes of computing gain under the bargain sale rules of IRC §1011(b). In essence, the transaction is treated as though the charity has handed the donor cash in the amount of the indebtedness. If the property is appreciated, gain attributable to the debt is realized by the donor in the same ratio the donor would have realized gain had the entire property been sold on the date of transfer.

Another potential problem involves the possible application of the self-dealing rules discussed infra. Finally, the transfer of debt-encumbered property might trigger a "due on sale" clause that accelerates that repayment of indebtedness. Provided the pooled income fund had liquidity with which to retire the indebtedness, this would cause dilution of the income earning capacity of the fund. As an alternative, if the charitable organization believes the property is readily marketable, it might consider purchasing the property from the fund immediately after transfer and selling it in due course. As mentioned previously, the organization should weigh the potential investment risk and expense against the net benefit of the gift.


  1. See Rev. Rul. 72-196, 1972-1 C.B. 194; superseded, clarified, and amplified by Rev. Rul. 82-38, 1982-1 C.B. 96; Amplified by Rev. Rul. 85-57, 1985-1 C.B. 182; and Rev. Rul. 90-103, 1990-2 C.B. 159back

  2. Rev. Proc. 97-3, 1997-1 I.R.B. 84back

  3. IRC §642(c)(5); IRC §170(b)(1)(A)back

  4. Rev. Rul. 85-57, 1985-1 C.B. 182back

  5. Reg. §1.642(c)-5(b)(6); Reg. §1.642(c)-5(a)(6)back

  6. Ltr. Rul. 8903019back

  7. Ltr. Ruls. 9203010 and 9513012back

  8. Reg. §1.642(c)-5(b)(3)back

  9. Reg. §1.642(c)-5(b)(4)back

  10. Rev. Rul. 96-38, 1996-2 C.B. 44; superseding Rev. Rul. 93-8, 1993-1 C.B. 125 and Rev. Rul. 92-108, 1992-2 C.B. 121back

  11. Reg. §1.642(c)-5(b)(5); Rev. Rul. 92-107, 1992-2 C.B. 120; Ltr. Ruls. 9542011 and 9345007back

  12. Reg. §1.642(c)-5(c)back

  13. Reg. §1.642(c)-5(c)(2)(iii)back

  14. Reg. §1.642(c)-5(a)(2)back

  15. Reg. §1.642(c)-5(b)(2)back

  16. Rev. Rul. 79-61, 1979-1 C.B. 220back

  17. Reg. §1.642(c)-5(a)(2)back

  18. Reg. §1.642(c)-5(b)(7)back

  19. Reg. §1.642(c)-5(a)(2)back

  20. Reg. §1.642(c)-5(a)(3)back

  21. IRC §§170(f)(2)(A); 2522(c)(2); and 2055(e)(2)back

  22. Reg. §1.642(c)-6(a)(3)back

  23. Reg. §1.170A-13(f)(13)back

  24. Reg. §1.642(c)-5(a)(2)back

  25. IRC §661(c)back

  26. Reg. §1.642(c)-2(c)back

  27. IRC §1015; Reg. §1.642(c)-5(a)(3)back

  28. Reg. §1.642(c)-5(b)(7)back

  29. Rev. Rul. 90-103, 1990-2 C.B. 159; modified by Rev. Rul. 92-81, 1992-2 C.B. 119; amplifying Rev. Rul. 82-38, 1982-1 C.B. 96; GCM 39709; Ltr. Rul. 8832010back

  30. Ltr. Ruls. 8713044; 8838033; 8830042; 8831023; and 8843037back

  31. Ltr. Rul. 8823011back

  32. Ltr. Rul. 8736008; Discussions of rehabilitation and historic building tax credits are now found in IRC §47.back

  33. Ltr. Rul. 8806065back

  34. IRC §2522(c)(2)back

  35. IRC §2036(a)back

  36. IRC §2055(e)(2)back

  37. IRC §2503(b); 2505(a)back

  38. Reg. §1.642(c)-5(b)(2)back

  39. IRC §2503(b)back

  40. Lober v. United States, 346 U.S. 335 (1953)back

  41. IRC §2036(a)back

  42. IRC §4941(d)(1)back

  43. IRC §507(d)(2)back

  44. IRC §4941(a); Reg. §53.4941(a)-1(a)back

  45. IRC §4941(a)(2)back

  46. IRC 4941(b)(2)back

  47. IRC §170(f)(3)(B)back

  48. IRC §4941(d)(2)(A)back

  49. IRC §§507(d)(2)(A); 4946(a)(1); and 4946(b)back

  50. Reg. §53.4941(d)-1(a); See also Ltr. Rul. 9533014 which dealt with the application of this issue to a charitable remainder trust.back

  51. Ltr. Rul. 8940078back

  52. Ltr. Rul. 9101018back

  53. IRC §4941(d)(2)(F); Ltr. Rul. 9015055back

  54. Ltr. Rul. 9210005back

  55. Rev. Rul. 81-76, 1981-1 C.B. 516; See also Ltr. Rul. 9542040back

  56. IRC §4947(b)(3)back

  57. IRC §4943(c)(1)back

  58. IRC §4943(c)(2)(B)back

  59. IRC §§4943(c)(6); 4943(c)(7)back

  60. IRC §4947(b)(3)back

  61. Reg. §53.4944-1(a)(2)back

  62. Reg. §1.664-2(a)(4)back

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