Case Study: The Unplanned CRT: Promises Made

Case Study: The Unplanned CRT: Promises Made

Case study posted in Charitable Remainder Trust on 23 February 2005| 3 comments
audience: National Publication | last updated: 18 May 2011


Although well intentioned, not every planned gift turns out as planned. In this case study, Vaughn W. Henry illustrates what can go wrong when an inexperienced planner uses the wrong planning vehicle in a declining investment market.

by Vaughn W. Henry

"Do the Right Thing.  It will gratify some people and astound the rest."

- Mark Twain

The Facts:

Too many advisors attending a single marketing program on charitable remainder trust (CRT) planning fail their clients when they try to navigate the tricky, reef-laden waters of split-interest trust planning. A classic example of advisor overconfidence is the case of Rosa Rodriguez (64) and her daughter, Amalia (38).

Rosa, widowed a few years ago, continued to manage the family restaurant located in an urban business district undergoing a recent renaissance. When a major bank wanted to expand, she agreed to sell her property at a significant price for what turned out to be a teardown project.  Rosa's life insurance agent, newly impressed with the product sales opportunities in a NIMCRUT, pitched the idea of a "spigot trust" funded with a deferred variable annuity after the charitable trust sold her $40,000 basis real estate for more than $2.5 million without recognizing an immediate tax.

Rosa is very family oriented, and while she didn't like the idea of paying over 25% of her proceeds in taxes, she was persuaded that a CRT was the perfect win-win-win strategy. Her insurance agent touted the $343,025 in charitable income tax deductions, a steady "guaranteed" income stream starting at $125,000 annually, projected to increase to nearly $500,000, and eventually providing an ongoing income for her unmarried daughter, Amalia.

The Problems:

Several problems have come to the surface after four years of trust operation, and now everyone is pointing fingers at the various advisors involved in this project. The errors are numerous:

1. Why not a flip? This is a NIMCRUT, the most complicated and difficult trust to manage. It would have been more prudent to use a FLIP-CRUT, which starts as a NIMCRUT; then, upon the happening of a predefined triggering event (such as the sale of the real estate),the trust converts to a more simply operated standard CRUT that has no need for complex definitions of "trust accounting income."

In addition, instead of contributing 100% of the real estate to a CRT, Rosa might have been better advised to split the parcel's ownership, and contribute only 2/3 of the property to the CRT and sell the remaining 1/3 interest in the property outright through a combined sale. Although there would have been some taxable gains in this part gift - part sale technique, she could have used the income tax deductions from the better planned CRT to offset her taxable gains. This would have given Rosa a cushion to absorb some of the variation in income produced by an annuity if it unexpectedly went underwater.

2. No liquidity. While Rosa has some charitable interests, she repeatedly stated her desire to pass something on to her family. By naming her daughter as a successor income beneficiary, she will pass some income to Amalia, but not until Rosa passes away. And by then it's possible her daughter will be well into her 70's. Obviously, this plan is not suitable if Rosa expects Amalia to receive any current income should a need develop in the near term.

3. What about the estate tax? Because the daughter has an income interest, even though the drafting attorney put language into the CRT document that stated her income interest was revocable by Rosa's will, thereby making the transfer incomplete for gift tax purposes, it is still an asset in Rosa's estate and subject to estate tax (if one exists at that time). In this case, that income interest will be valued and taxed based upon the trust's payout rate, the trust's value when Rosa passes away, and her daughter's age when she steps into the successor income recipient's role.  If there had been no revocation language in the trust document, a taxable gift to Amalia would have occurred when the trust was created (equal to present value of the Amalia's successor income interest).  Since the trust was created four years ago, the gift tax value on this $2.5 million CRUT would have been the present value of the income interest, or $2.157 million.  However, with a revocable interest for Amalia, there's no completed gift, and no gift tax due. The estate tax is another matter. If Rosa lives for 26 years and the trust is prudently invested in a way that produces a steady eight percent annual investment return, the CRT will be worth an estimated $5.19 million when Amalia inherits that income interest.  This scenario means the estate will then be taxed on a value of the $3 million income stream to benefit Amalia. Clearly, this is not a "zero tax plan."

From an estate planning perspective, using a CRT with a non-spousal income recipient has significant risks. Planners are generally better off having a one life CRT to benefit one beneficiary and using a life insurance trust to replace the wealth for the younger non-spousal beneficiary.  This would produce a larger income tax deduction of $1.015 million, make the gift and estate tax obligations more controllable, and the part sale - part gift strategy more likely to succeed.

4. No income in down markets. Unfortunately, the trust has not operated as predicted because the stock market has not had consistent positive returns. Too many planners have been wildly optimistic in their projections of market performance and volatility, and few make any projections for prolonged bear markets. In fact, this trust's value has declined from $2.5 million down to $1.9 million today. This trust defined trust accounting income to include "distributions for a life insurance or annuity contract." However, because tax deferred annuity contracts are taxed on a last in, first out (LIFO) accounting basis, an annuity contract that falls in value below its cost basis will not have any "income" to distribute. It can distribute principal at best and principal is never distributable from a net income unitrust.

As a result, Rosa has been unable to receive any distributions for three years. Since her insurance agent convinced Rosa that the "spigot trust" could distribute income "anytime she needed it," and he had used "guaranteed income" in his sales presentation, Rosa is quite upset with her advisors not being able to deliver on their projections. Her biggest complaint is that everyone glossed over the risks and no one bothered to tell her about the uncertainties inherent in this plan.

5. Inadequate diversification. The use of a single annuity from a single carrier within a NIMCRUT as the only investment, even if the separate accounts are diversified, may be risky.  Should the annuity contract fall below basis (purchase price), then future distributions are restricted until the contract value recovers.  For an annuity driven NIMCRUT to work as planned, the trust document has to be drafted properly and make reference to a state's principal and income act in a way that permits the annuity to perform as the controlling spigot. Otherwise, it will not function to control the recognition and timing of trust income. Planners may have several opinions about the advisability of defining income to include post contribution realized capital gains from an equity portfolio, zero coupon bonds, or single member LLC as a means of controlling income if they choose not to use a deferred annuity. In today's uncertain equity market and with a low interest fixed income portfolio choices, developing the right investment strategy is difficult if there is a need for immediate income production from a net income type CRT.

The Solution:

The obvious solution would have been not to use an income deferral strategy in the first place; however, as they say, "the cow is out of the barn." What can be done at this point?

First, if the value of the annuity is still significantly below its basis, surrendering the annuity at a loss (not exchanging) and reinvesting the proceeds in other "income" producing assets will turn cash flow on immediately. Planners must, however, consider any surrender penalties that may apply to the annuity contract involved. The surrender of the contract and any applicable penalties will establish a loss to the trust that can be used to offset any current year and future income. Therefore, the income recipient may receive some mitigation in the form of a tax-free distribution (Note: Some commentators differ regarding whether the loss would be an ordinary or long-term capital loss; either way, it would have to work its way through the four-tier system).

If the trust has been drafted to include capital gains in its definition of income, then a balanced fixed income and equity portfolio can be used. If capital gains are absent from the definition then investments will be selected that maximize the remaining available types of trust income (i.e., interest, dividends, rents, and royalties).

Income deferral planning has its place and can be very beneficial for both the donor and charity. However, the recommendation must fit the facts and goals. Be careful out there.

Disclaimer: This case study is intended to provide information of a general nature only and is not intended to provide legal, accounting, investment or other professional advice. Persons mentioned within this case study are fictional with any resemblance to real persons, living or dead, coincidental. Tax law rates and federal discount rates used in examples are based on those rates in effect at the time of publishing. Those viewing this case study should always check for latest tax and other relevant state and federal laws and regulations prior to completing charitable gifts.

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Re: Case Study: The Unplanned CRT: Promises Made

Variable annuities again under perform and do not provide diversification!A poor product in the charitable planning arena!

The Unplanned CRT

Thanks, Vaughn, for the warnings for some and reminders for the rest of us.

Unplanned CRT

Yet another reason to be cautious when creating CRTs that benefit someone other than the donor and their US citizen spouse. Chapter 14 of the Internal Revenue Code does not allow a taxable gift to be reduced by a retained NIMCRUT interest (other than in NIMCRUTs for donor and spouse). So in the situation above, if the gift to the daughter had not been left incomplete, the mother would have made a taxable gift of the entire value of the trust other than the charitable remainder! (And the value of the trust would have still been included in mom's taxable estate). The cite is Treas. Reg. Sec. 25.2702-1(c)(3), for those who are interested.

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