Reformation of Pooled Income Funds May Not be Necessary

Reformation of Pooled Income Funds May Not be Necessary

Article posted in Pooled Income Fund on 14 September 2004| 4 comments
audience: National Publication | last updated: 18 May 2011
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Summary

Last January, the IRS published final regulations regarding pooled income funds and their ability to obtain an income tax deduction for amounts permanently set aside for charity based on state law definitions of income. Following recent conversations with IRS, PGDC editorial board member Reynolds Cafferata reports that IRS representatives have concurred informally that a release by the trustee of the power to adjust capital gains between income and principal should be adequate to allow a pooled income fund to maintain its deduction for capital gains permanently set aside for charity without need for a judicial proceeding.

by Reynolds T. Cafferata

On January 2, 2004, the Internal Revenue Service published final regulations under Section 642(c) of the Internal Revenue Code affecting pooled income funds (the "Regulations"). Treas. Reg. § 1.642(c)-2. A pooled income fund is required to distribute its income to the beneficiaries of the pooled income fund. The Regulations limit the definition of income under state law and in the trust instrument in order for the pooled income fund to be entitled to an income tax deduction for capital gains permanently set aside for charity.

If a pooled income fund does not fall within limitations in the Regulations, a judicial proceeding to reform the pooled income fund to comply with the Regulations must be commenced by October 2, 2004, or if a non-judicial means is used, that process must be completed by October 2, 2004. If the reformation is not timely commenced or completed, the pooled income fund will not be entitled to the deduction for capital gains set aside for charity for tax years beginning after January 2, 2004. In January of this year, the PGDC advised of the possibility that some pooled income funds may need to be reformed in light of the Regulations (see New Regulations May Require Amendment of Pooled Income Funds). Subsequent discussions with the IRS and Treasury indicate that many pooled income funds may not need to be reformed, including those administered in states that have adopted the Revised Uniform Principal and Income Act, such as California.

Treasury Regulation § 1.642(c)-2(c) provides that: "No amount of net long term capital gain shall be considered permanently set aside for charitable purposes if, under the terms of the fund's governing instrument and applicable local law, the trustee has the power, whether or not exercised, to satisfy the income beneficiaries' right to income by payment of either: an amount equal to a fixed percentage of the fair market value of the fund's assets (whether determined annually or averaged on a multiple year basis); or any amount that takes into account unrealized appreciation in the value of the fund's assets. In addition, no amount of net long-term capital gains shall be considered permanently set aside for charitable purposes to the extent that the trustee distributes proceeds from the sale or exchange of the fund's assets as income within the meaning of § 1.642(c)-5(a)(5)(i)."

Power to Adjust Between Income and Principal

For example, California Probate Code Section 16336 gives a trustee administering a trust in California the power to adjust trust receipts between principal and income to balance the interests of the income beneficiary and the remainder beneficiary. Absent further limitation, California Probate Code Section 16336 may authorize a trustee to take into account unrealized appreciation in determining the income of a trust. Accordingly, a pooled income fund administered under California law and subject to Probate Code Section 16336 might not qualify for the deduction for capital gain permanently set aside for charity under Section 642(c) of the Internal Revenue Code. California Probate Code Section 16336(b)(4), however, provides that the trustee does not have the power to adjust between principal and income with respect to any amount that is permanently set aside for charitable purposes. This limitation would appear to apply to a pooled income fund. Unfortunately, the reporter's notes to the Revised Uniform Principal and Income Act upon which the California statute is based do not explain the purpose or scope of the limitation on adjustments with respect to amounts permanently set aside for charity.

Releasing the Power

California Probate Code Section 16336(d) allows the trustee to release the power to adjust in two circumstances. First, if trustee may release the power if it is uncertain whether possessing the power will cause a result that is prohibited from the use of the power to adjust such as making an adjustment from an amount permanently set aside for charitable purposes. Second, trustee can release the power if the trustee determines that holding the power will or may deprive the trust of a tax benefit. Both of the grounds for the release of the power to adjust appear applicable to the pooled income fund and the Regulations. It is uncertain whether the power to adjust would result in an amount permanently set aside for charity being allocated to income. Furthermore, possessing the power to adjust may deprive the pooled income fund of the benefit of the deduction for capital gains permanently set aside for charity. Accordingly, the trustee of a pooled income fund administered in California should be able to expressly release the power to adjust and protect the capital gains set aside deduction for the pooled income fund.

Informal Discussions with IRS

The above analysis was discussed informally with representatives of the IRS and Treasury. Those representatives were not in the position to provide formal guidance, and their informal conversations are not binding on the IRS. In any event, however, the representatives did concur in the analysis that if a state has adopted a power to adjust with a limitation on that power with respect to amounts permanently set aside for charity, such as the California law, the pooled income fund in that state that otherwise qualified as pooled income fund would continue to qualify as a pooled income fund. Furthermore, the representatives informally concurred that the provision in the California that law allows the trustee to release the power to adjust could be used by the trustee to effectively insure that the pooled income fund continues to qualify for the deduction for capital gains permanently set aside for charity if the trustee permanently released the power to adjust.

The comments and explanations of the Regulations state that they are issued in response to changing state law, particularly the adoption of many states of some form of the Revised Uniform Principal and Income Act. This background gave the implication that pooled income funds administered in states that had adopted some form of the Revised Uniform Principal and Income Act might need to have their governing instruments changed through judicial means in order to limit the ability of the trustee to use the powers under the Revised Uniform Principal and Income Act. IRS and Treasury representatives indicated that the primary focus was upon the adoption by a state of an express unitrust amount as the definition of income, not on states that were adopting the power to adjust. And as noted above, the representatives informally concurred that the limitation of the use of the power with respect to amounts permanently set aside for charity and the ability to release the power to adjust should be adequate to allow a pooled income fund to maintain its deduction for capital gains permanently set aside for charity without a judicial proceeding. If, however, a charity wants to be completely free from doubt as to the ability of its pooled income fund to use the capital gains set aside deduction under California law, the charity will need to initiate a proceeding to reform the pooled income fund on or before October 2, 2004. Likely, however, such a proceeding is unnecessary in light of the two safeguards within California Probate Code Section 16336. With respect to states that have adopted an express "unitrust amount" as the definition of trust income, if the use of the unitrust amount is conditioned on the consent of the beneficiaries, the Trustee does not have the power to pay on that basis (unless beneficiary consent was obtained). Accordingly, even in a state with an express unitrust alternative, reformation may not be necessary.

As noted above, California Probate Code Section 16336 is based on the Revised Uniform Principal and Income Act. The annotations contained in the Uniform Law Act Treatises indicate that the states that have adopted the Revised Uniform Principal and Income Act, if adopting the power to adjust, have included both the limitation on the power to adjustment with respect to amounts permanently set aside for charity and the power to release the power to adjust in substantially the same form as the Uniform Act in California. Accordingly, the analysis with respect to California should be applicable to other states that have adopted the Revised Uniform Principal and Income Act.

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Pooled Income Funds

How does a trustee "release" the power to adjust, as mentioned in the Sept. 15th article on reformation of PIFs? Is there some formal step that needs to be taken?

release of power of adjustment in pooled income funds

Thomas-I do not know what state you are in. In California, see Probate Code section 16336(d)(2) which allows a trustee to release a power to adjust where it deprives the trust of a tax benefit (i.e. capital gain set aside). In the Uniform Principal and Income Act, revised in 1997 and last amended in 2000, see section 104(e) for this same power. To find the Uniform act, go to www.law.upenn.edu/library/ulc/ulc.htm and for your state specific P and I Act, go to www.law.cornell.edu, then to constitution and codes, then to other uniform laws, then to business and finance and then to uniform principal and income act. You will get a chart of links to your state's P and I act. You will then look for "Power to adjust between Principal and Income" or "Adjustment between Principal and income". Then look for "The trustee may release the entire power... (in part) or the power to adjust from principal to income..." See further that this power may be released permanently or for a specific period. The release for PIF, if that is what you intend and there may be cases where you do not intend to do so, should be permanent. It is done by an instrument created by the Trustee, stating that the Trustee releases the power pursuant to your state's statute section that you cite in this document that permits the release, and signed by the trustee and kept with the original trust instrument. The trustee may wish to have it notarized as I cannot tell you the procedure in all states, but notarization certainly does not hurt in any case. You should also check your pooled income fund trust instrument to see if it already provides for a release of any power held by the trustee. If so, cite that section as well. New pooled income funds can draft in that the trustee does not have the power to adjust. I hope this answers your question. Lynda Moerschbaecher www.lyndam.com

"Income" Definition for Type III Supporting Orgs

My question is a tangential to this issue. Type III SOs must distribute "substantially all income." If a Trust qualifies as a III SO, is its "income" defined under 643(b) [which would encompass the UPIA power to adjust] or under 4942?? Has anyone seen any opinions, PLRs, or research on this?? THANKS

TYPE III Income

That's a tangent. Anyway, its 4942 income. Look at Rev. Rul. 76-208 and regs under 4942. 53.4942(a)-2(d)(2)(ii) states that income includes short-term cap gains.

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