Using Single Member LLCs In Net Income Charitable Remainder Unitrusts

Using Single Member LLCs In Net Income Charitable Remainder Unitrusts

Article posted in Charitable Remainder Trust on 10 March 1999| comments
audience: National Publication | last updated: 15 September 2012
Print
||
Rate:

Summary

Income deferral unitrusts are one of the hot topics in current charitable remainder trust planning. In this edition of Gift Planner's Digest, Los Angeles attorney Reynolds Cafferata explores how a single member limited liability company may offer a superior solution to controlling the timing and amount of unitrust income distributions.

by Reynolds T. Cafferata

Charitable remainder unitrusts are a popular tool for combining charitable giving with other financial planning needs such as retirement planning or deferral of income from the sale of highly appreciated assets. Some donors of charitable remainder unitrusts seek to defer the distributions from the trust until a future time when the donor will have the need for the additional income. The deferral is possible with a charitable remainder unitrust that limits its distributions to its net income. Such a trust is required to distribute only its trust accounting income, which generally exists only when the trust has cash receipts. A variety of techniques are available to control when the trust will have cash receipts. These techniques include: investing in zero coupon bonds, holding a growth portfolio that generates little dividend income, purchasing a variable annuity or holding trust assets in a partnership. While each of these techniques can be effective to defer gain, each has certain drawbacks. An alternative tool for deferring gain may be to use a single member limited liability company ("LLC"). The single member LLC is a flexible tool for deferring income and appears to lack the disadvantages of the other methods of deferral.

Charitable Remainder Trusts

A charitable remainder trust makes payments to an individual (or individuals) beneficiary for a term of years or for the lifetime of the beneficiary.1 At the end of the trust term, the assets of the trust are distributed to a charitable organization. The payments to the beneficiary can be either in the form of an annuity or a unitrust amount.2 A charitable remainder annuity trust pays a fixed dollar amount each year to the beneficiary.3 A charitable remainder unitrust ("CRUT") pays out a fixed percentage of the value of the trust's assets determined annually to the beneficiary.4 Thus an 8% CRUT with assets worth $100,000 would pay to the beneficiary $8,000. If the value of the trust assets increased to $110,000 in the following year, the beneficiary would receive $8,800.

The CRUT can have two additional provisions. First, it can pay out the lesser of the (1) trust income or (2) the required unitrust amount ("income exception").5 Second, if this income exception is used, the trust can provide that if the trust income exceeds the unitrust amount in a year, the excess can be used to make up for prior years when trust income was less than the unitrust amount ("makeup provision").6 A trust that has an income exception and a makeup provision is often called a net income with make up charitable remainder unitrust ("NIMCRUT").

Deferral of Income

The income exception and make up provision of a NIMCRUT can be used to control the timing of distributions from the NIMCRUT to the beneficiary. Because of the income exception, the NIMCRUT is never required to pay to the beneficiary more than its income. The timing of distributions is controlled by controlling when the NIMCRUT has income that it will be required to distribute. Trust income is defined under state law principal and income acts.7 Because many trust instruments require distribution of trust income to the beneficiary, trust income is a cash concept. That is, the trust will not have trust accounting income if it does not have a cash receipt. Not all cash receipts are income, however. When the trust receives cash, the trustee must determine whether it is allocable to income or principal. State law and the trust instrument will determine which receipts are allocated to income and which receipts are allocated to principal.8 In general, under most state law acts, dividends, rents, royalties and interests are allocable to income.9 Receipts from the sale of capital assets are typically allocable to principal.10 Many state laws, however, allow the trust instrument to make other provisions.11 The Treasury Regulations, however, provide that the gain in the value of an asset that occurs before the asset is contributed to a NIMCRUT cannot be allocated to income.12

There are several popular techniques to control the timing of trust receipts, and thus control when a NIMCRUT will have trust accounting income. Each technique, however, has disadvantages.

Existing Deferral Structures and Their Problems

Zero coupon bonds do not pay interest during the term of the bond, but only at maturity. Thus, a NIMCRUT that holds a zero coupon bond receives no trust accounting income during the term of the bond and would not be required to make distributions to the beneficiary. Using zero coupon bonds to defer income, however, limits the NIMCRUT to a single class of assets that do not provide the best investment performance over a long period of time. In addition, once the bond has been purchased, the maturity date and time for NIMCRUT receipt of income is established. Thus, zero coupon bonds do not provide a flexible method of deferral.

If the NIMCRUT assets are invested in growth stocks that pay little or no dividends, the NIMCRUT will have little or no trust income. Even if a stock is disposed of, so long as capital gains are not allocated to trust income by the trust instrument, the receipt from that sale would not be allocated to trust income. Accordingly, a growth stock portfolio can be used to defer distributions from a NIMCRUT. Using growth stocks to defer income also significantly limits the trustee's ability to balance the portfolio. Furthermore, the growth stock strategy creates a dilemma for determining how to treat trust capital gains. Under most state laws, a trust instrument could allocate capital gains to either income or to principal. As noted above, the Treasury Regulations allow only post contribution gain be allocated to income. Allocating post-contribution capital gain to income will make more of the trust return available for distribution to the beneficiary. This allocation, however, conflicts with the goal of deferral. If NIMCRUT capital gains are allocated to income, the trustee would create income required to be distributed to the beneficiary each time the trustee disposed of an appreciated position to make changes to the NIMCRUT's portfolio.

Variable annuities and partnerships have been used as containers to hold NIMCRUT investments and NIMCRUT cash so that regardless of the investments, the NIMCRUT will not have income until the variable annuity or partnership makes a distribution to the trust. The variable annuity or partnership can receive interest and dividends, and the proceeds of the sale of assets, holding and reinvesting those funds until the beneficiary desires a distribution from the NIMCRUT. When the beneficiary wants a distribution from the NIMCRUT, a distribution is made from the variable annuity or partnership to the NIMCRUT. That distribution is characterized as income and distributed to the beneficiary.

If the NIMCRUT purchases a variable annuity, it will be able to defer income without restricting its investments. The variable annuity can generally be invested in a variety of funds and assets. However, these investments will be limited to publicly traded securities, and may be limited to the products of the issuer of the annuity. The most significant disadvantage of a variable annuity is that under the annuity taxation rules, all income flowing from the annuity is taxable as ordinary income.13 Thus, although under the four tier rule,14 a beneficiary of the NIMCRUT might be able to take advantage of capital gains rates for such gains realized by the NIMCRUT, if the variable annuity is used, all distributions will be taxed as ordinary income. Each year, all the gains of the annuity are taxable to the NIMCRUT, regardless of distributions from the annuity.15 This taxation is not a problem because the NIMCRUT is tax exempt.16

To avoid the ordinary income tax rate and investment limitations of a variable annuity, some NIMCRUTs hold their assets in partnerships. Partnerships are not generally subject to tax because the income of the partnership flows through to and is reported by the partners of the partnership.17 Since the taxable income of the partnership flows through to the NIMCRUT, the investing of the partnership is included in the NIMCRUT's tax-exempt environment. Cash is contained in the partnership until distributed, providing the deferral income and payments from the NIMCRUT. The difficulty of using a partnership to defer income in a NIMCRUT is the requirement that the partnership have two partners.18 Accordingly, some taxpayer other than the NIMCRUT must participate in the partnership for this plan to work. Having the donor as a partner may raise self-dealing and fiduciary duty issues. In general, a tax-exempt partner and a non-exempt partner will have different requirements complicating the operations of the partnership. For example, the taxable partner will desire a distribution from the partnership to at least pay income taxes on the partner's share of partnership income. The NIMCRUT will not need or desire such distributions. Partnerships must file an information tax return and issue a K-1 to each partner, further complicating the administration of the NIMCRUT.

The Single Member LLC as the Deferral Vehicle

Several states now permit the formation of a single member LLC, including Delaware.19 An LLC is a highly flexible business entity that allows management of the entity by the owner while shielding the owner from liability for the LLC's debts under most circumstances. The recent check-the-box Treasury regulations allow the taxation of a single member LLC to flow through to its owner, similar to a partnership. Also like the partnership, distributions from the LLC can be controlled to determine the timing of trust accounting income. Accordingly, the single member LLC has all of the advantages of a partnership for deferral with the elimination of the disadvantage of needing an additional participant in the entity as required with a partnership.

Under the check-the-box regulations, for income tax purposes, the single member LLC is a disregarded entity.20 The owner of a single member LLC is treated as a sole proprietor with respect to the activity of the LLC. Thus, the single member LLC is a tax nothing, and does not even obtain its own taxpayer identification number.21 The treatment of the LLC income as trust income means that the activity of the LLC takes place in the tax exempt NIMCRUT. The tax reporting for a single member LLC is simpler than partnership tax reporting because there is no entity level tax return and no K-1's. All activity of the LLC is simply reported on the tax return of the NIMCRUT.

Although the single member LLC does not exist for income tax purposes, it would exist for purposes of trust accounting income. Accordingly, until a distribution is made from the LLC, the NIMCRUT would not have any trust accounting income and would not have an obligation to make a distribution to the beneficiary. Thus, the single member LLC allows for deferral distributions from the NIMCRUT.

There may be an issue of whether since the single member LLC is a disregarded entity for income tax purposes, it would be disregarded for purposes of the trust accounting income rules. Trust accounting income, however, is a function of state law.22 Under these rules, there is often a variance between the taxable income of the trust and its trust accounting income. Accordingly, it seems unlikely that the tax treatment of a single member LLC as a tax nothing will impact its treatment under the trust accounting rules for determination of trust income.

For donors seeking a flexible method of deferring distributions from a NIMCRUT, the single member LLC is a simple, effective structure.

Other Situations Where the Single Member LLC Will Be Useful

Prior to the issuance of the final charitable remainder trust regulations that allow existing NIMCRUTs to convert to standard unitrusts,23 another use for the single member LLC was to allow some existing NIMCRUTs that did not explicitly provide for an allocation of capital gain to income to effectively achieve that result. Many existing NIMCRUTs simply provide that trust income is determined according to the principal and income act of the state in which the trust is being administered. State law typically allocates gain from the sale of an asset to principal, not income.24 NIMCRUTs that do not allocate capital gain to income often give discretion to the trustee to allocate trust receipts between principal and income if the state principal and income act does not explicitly address the particular receipt of the trust.25 Many state principal and income acts do not address distributions from single member LLCs.26 Accordingly, if a NIMCRUT received a distribution from a single member LLC, it would be in the trustee's discretion to determine how that distribution should be allocated. Under the Restatement of the Law of Trusts, there is an example of a corporation that invests in real estate and earns its income from the appreciation on that real estate.27 Although the underlying activity is capital gain from the sale of assets, under the Restatement example, the distributions from that corporation would be treated as income.28 By analogy, the distributions from a single member LLC with a preferred return that invested in growth stocks could be characterized as income because the LLC generates its income from capital gains. Thus, the NIMCRUT invested in a single member LLC could effectively allocate capital gains to income and be free from the need to invest in assets that generate trust accounting income.

It is currently possible to convert an existing NIMCRUT to a standard unitrust so long as the court proceeding to make the conversion is commenced on or before June 8, 1999.29 The trust is actually changed to a combination of methods or "flip trust." A flip trust is a trust that starts out as a charitable remainder unitrust with a net income limit.30 After a triggering event, the trust changes to a standard unitrust on the following January 1.31 When reforming an existing NIMCRUT, the triggering event for the change in methods of the trust cannot be earlier than the year in which the court issues its order reforming the trust.32 As already noted, the change to a standard unitrust must occur on the January 1 after the triggering event. Accordingly, any NIMCRUT that is reformed this year in this manner will not actually change to be a standard unitrust until January 1, 2000. It may be advantageous to implement the strategy discussed above using the single member LLC to allocate capital gains to income prior to January 1 in order to maximize the growth and distributions from the trust. In addition, if a NIMCRUT is converted, any make up due to a beneficiary is lost when the change of methods of payment occurs.33 A single member LLC may assist in recovering the makeup amount.

The flip trust in the regulations will allow deferral of payments to the beneficiary until a date certain in the future. This may be useful in planning for retirement using a charitable remainder trust. Prior to the flip, however, the trust will need to be managed to control the occurrence of trust income to avoid distributions. The single member LLC could be used to control trust accounting income in these circumstances. In addition, under the regulations, any makeup due to a beneficiary in a flip trust is eliminated when the trust changes to a standard unitrust. If the flip trust were drafted to provide that distributions from the LLC generated by post-contribution capital gain will be allocated to income, the LLC could help the beneficiary receive a makeup distribution prior to the flip, which would terminate the trust's ability to pay that makeup amount. If a donor wishes to start and stop distributions using a single member LLC, a NIMCRUT, and not a flip trust, likely should be used.

Conclusion

Each of the existing methods for deferring income in a NIMCRUT - zero coupon bonds, growth stocks, variable annuities and partnerships - have certain disadvantages. For many donors, the single member LLC may offer all of the advantages of deferral without any of the disadvantages of the prior structures for deferral. In addition, the single member LLC can work hand in hand with flip trusts to allow donors the maximum flexibility in achieving their philanthropic and financial goals.


  1. I.R.C. §664(d) (although not typical, a term of years trust may make payments to an entity such as a corporation or trust).back

  2. Id.back

  3. Id. §664(d)(1).back

  4. Id. §664(d)(2).back

  5. Id. §664(d)(3)(A).back

  6. Id. §664(d)(3)(B).back

  7. Treas. Reg. §1.664-3(1)(i)(b)(3); I.R.C. §643(b).back

  8. I.R.C. §643(b).back

  9. See, e.g., Cal. Prob. Code §16303(a)(2).back

  10. See, e.g., Cal. Prob. Code §16303(b)(1).back

  11. See, e.g., Cal. Prob. Code §16302(a)(1).back

  12. Treas. Reg. §1.664-3(a)(7)(i)(b)(4).back

  13. I.R.C. §72.back

  14. See, Id. §664(b). Under this rule, current ordinary income and the ordinary income from prior years is distributed from the NIMCRUT prior to distribution of net capital gains.back

  15. Id. §72(u).back

  16. Id. §664(c).back

  17. Id. §702(a).back

  18. Treas. Reg. §301.7701-2(c)(1).back

  19. Del. Code tit. 6, §18-101(6).back

  20. Treas. Reg. §301.7701-2(c)(2).back

  21. Prop. Treas. Reg. §301.6109-1(h)(2).back

  22. I.R.C. §643(b).back

  23. Treas. Reg. §1.664-3(a)(2)(i)(f)(3).back

  24. See, e.g., Cal. Prob. Code §16303(b)(1).back

  25. See, e.g. Cal. Prob. Code §16302(a)(3).back

  26. See, e.g. Cal. Prob. Code §§16300-16315.back

  27. Rest. (Second) Trusts §236, comment N.back

  28. Id.back

  29. Treas. Reg. §1.664-3(a)(1)(i)(f)(3).back

  30. Id. §1.664-3(a)(1)(i)(C).back

  31. Id. §1.664-3(a)(1)(i)(C)(2).back

  32. Id. §1.664-3(a)(1)(i)(f)(3).back

  33. Id. §1.664-3(a)(4)(i)(C)(3).back

Add comment

Login or register to post comments

Comments

Group details

Follow

RSS

This group offers an RSS feed.
 
7520 Rates: October 2.2% September 2.4% August 2.4%

Already a member?

Learn, Share, Gain Insight, Connect, Advance

Join Today For Free!

Join the PGDC community and…

  • Learn through thousands of pages of content, newsletters and forums
  • Share by commenting on and rating content, answering questions in the forums, and writing
  • Gain insight into other disciplines in the field
  • Connect – Interact – Grow
  • Opt-in to Include your profile in our searchable national directory. By default, your identity is protected

…Market yourself to a growing industry