Terminating a Pooled Income Fund

Terminating a Pooled Income Fund

Article posted in Pooled Income Fund on 8 January 2000| comments
audience: National Publication | last updated: 18 May 2011


Of the three retained income gift vehicles, the pooled income fund ranks a distant third in terms of popularity. Why? Compare pooled income funds to charitable remainder trusts and charitable gift annuities in terms of payout amounts, the tax character of those amounts, and other factors, and the answer is clear -- so clear according to Los Angeles attorney David Wheeler Newman that many organizations that manage PIFs are now weighing their alternatives.

by David Wheeler Newman

There are many reasons for terminating a pooled income fund (PIF). Some of these include:

Poor investment return

  • Smaller PIFs typically lack critical mass to cost-effectively retain investment management.
  • Smaller PIFs may make portfolio diversification unrealistic.
  • Investment allocation. Beneficiary dissatisfaction
  • PIF rules limit annual distributions to income.
  • Principal and Income Act of state with governing law.
  • Capital gains typically not included.
  • Comparison with mutual fund yields that are total return including capital appreciation.
  • Comparison with commercial and gift annuities that distribute principal in addition to income.

Marketing distraction

  • Development officers have learned that it is difficult to offer everything on the gift planning menu, and would prefer to focus on selected gift opportunities.
  • You may need to explain why a donor can expect better performance from a CRT than the PIF record.

Alternatives For Termination

While there may be other possibilities, consider these alternatives for termination of a pool income fund.

Assets divided actuarially. If the pooled income fund is terminated while there are still both charitable and noncharitable beneficiaries, the assets of the PIF trust must be divided actuarially based on the relative interests of the income and remainder beneficiaries. Following the division of these assets, the portion allocable to the income beneficiaries would be distributed to them, while assets allocable to the public charity sponsoring the pooled income fund would be distributed to it.

If all PIF assets are sold and the cash proceeds distributed, any gain from the sale of assets are typically allocated to the charity under the terms of the PIF governing instrument and will flow with the distribution to the charity, which is generally exempt from tax on the distribution, while income items such as interest and dividends will flow to the income beneficiary (at least to the extent of his or her proportionate interest in the PIF), subject to tax under the general rules of Subchapter J of the Code pertaining to the income taxation of estates and trusts. Generally, ordinary income items will be taxable to the income beneficiaries of the trust. The result will typically be the same if, rather than sell PIF assets and distribute cash, the trustee instead makes distributions in kind.

Outright gift of the income interest. Some or all of the PIF income beneficiaries might be encouraged to make an outright gift to the sponsoring public charity of their income interest. The donor's income interest in the PIF is a capital asset with a tax basis of zero. The donor will be allowed a charitable contribution income tax deduction for the full value of the income interest (after subtracting from the donor's PIF account value the value of the charitable remainder interest, calculated using the normal method). The deduction will be subject to the 30% limitation for contributions of appreciated capital assets.

Charitable Remainder Trust Funded With PIF Income Interest

Before proposing this option to PIF participants, the gift planner must consider the policy of the sponsoring charity regarding the minimum size for a charitable remainder trust it will develop, or for which it will serve as trustee. This is important since the average PIF account value is much lower than the average CRT value. The minimum can, of course, be waived in the unique circumstance of PIF termination. However, before recommending waiver of this policy, the gift planner should consider the reason for the policy in the context of the problem the organization is trying to eliminate by terminating the PIF: The small size of the PIF provides an inadequate asset base over which the fixed costs of operating the PIF may be spread. To provide the participants with a more dependable income stream, a charitable remainder unitrust with a net-income limitation should probably be avoided. A standard unitrust, without a net-income limitation, creates the possibility of annual distributions declining over time if the unitrust percentage exceeds the total return earned by the trust. If a benefit of terminating the PIF that the gift planner is communicating to donors is bringing greater certainty to an uncertain situation, the annuity trust may be the most attractive CRT alternative.

In designing CRTs, planners must keep in mind the maximum annuity or unitrust percentage of 50% and the minimum value of the charitable remainder of 10%. Keep in mind that both figures relate to the donor's income interest in the PIF, not his or her entire PIF account that includes the PIF remainder interest that already belongs to the charity.

The donor will be allowed a charitable contribution income tax deduction for the value of his or her interest in the PIF, less the value of the income interest that the donor receives in the CRT. Distributions from the CRT to the income beneficiary will be characterized for tax purposes under the normal four-tier system of IRC §664(b). In a unitrust or annuity trust investing for total return, in which a portion of the distribution comes from capital gains realized by the trust, this could result in a portion of the beneficiary's distribution being long-term capital gains, a benefit the typical PIF income beneficiary never gets.

Charitable gift annuity funded with PIF income interest. Donors might be encouraged to transfer their PIF income interest to the sponsoring public charity in exchange for a charitable gift annuity (CGA). The charity may observe a policy of issuing annuities based on the rates recommended by the American Council on Gift Annuities (AGCA). If a donor exchanges an income interest in the PIF for an annuity using these or similar rates, the income received by the donor will drop significantly. The charity may, instead, seek to replace the donor's current income from the PIF with comparable income from a CGA. This will require issuing CGAs providing substantially higher distributions than those that would result under the ACGA tables. (The case study below illustrates CGAs using rates that in some cases exceed 25%, and in all cases are much higher than those suggested by ACGA.) This discrepancy requires the charity to deviate from its regular CGA policy to offer this alternative to donors. The advisability and viability of doing so must be considered as part of a plan to terminate the PIF. Some states that regulate the issuance of CGAs to their residents, including California, require the charity to retain on file with the Insurance Commissioner rate tables used by the charity in its CGA program, and to issue all CGAs using rates consistent with those on file.

Regulatory compliance must also be considered before designing this alternative into a PIF termination plan. To avoid potentially serious issues with acquisition indebtedness, and to prevent gift annuities from being characterized as commercial-type insurance under IRC §501(m), the value of the annuity must be less than 90% of the value of assets transferred to charity.

Tax consequences. The donor will be entitled to a charitable deduction equal to the value of the PIF income interest, less the value of the CGA. As noted above, the income interest in the PIF is a capital asset with a zero basis. This feature of the funding asset will preclude the annuitant of a CGA funded with this type of asset from receiving payments that are tax-free return of basis under IRC §72. On the other hand, the rules of Section 72 will ensure that a considerable portion of each payment--everything within the exclusion ratio--will be long-term capital gaisn. This is a major benefit to offer the PIF participant whom you would like to exchange his or her interest for a CGA--a typical PIF beneficiary never receives a distribution characterized as long-term capital gains, and the portion of each payment taxed as long-term capital gains is more predictable and typically much larger for a CGA than for a CRT. As will be seen below, a charity wishing to terminate its pooled income fund is not restricted to only one option--they may be combined in the termination of the single pooled income fund.

Mechanics Of Terminating A PIF

Importance of state law. Possible alternatives for termination of a PIF depend on state law governing termination of trusts, under the relevant law applied to the PIF. One way to terminate the trust is by petition to the court. In some states, an acceptable reason for a court to grant a request by the trustee to terminate a trust is that the corpus of the trust is too small to be managed economically. This is often the reason the charity is considering the PIF termination in the first place:

The PIF has not grown to the critical mass necessary to effectively diversify investments, afford professional investment management, and spread administrative expenses, including trustee fees charged by banks, over a large enough asset base.

A separate basis for terminating a trust is that circumstances have changed since the trustor first established a trust. To plead this as a basis for terminating the PIF, the charity might show, for example, the growth in popularity of CGAs versus PIFs for smaller split interest gifts, and that if CGAs had earlier enjoyed the same level of popularity, the charity would never have established the PIF (and donors might never have contributed to it.)

The law of some states allows a trust to provide a non-judicial alternative method for termination of trusts. For example, California Probate Code §15404 allows termination of a trust by the agreement of the settlor (the donor) and all beneficiaries.

If all income interests in the PIF are transferred to the sponsoring charity, uneconomically low principal, or changed circumstances, the PIF trust will automatically terminate through the legal doctrine of merger, since the charity now holds all beneficial interests in the trust (i.e., the entire remainder interest and all income interests)

If distributing to each beneficiary the actuarial value of its interest in the PIF trust terminates the PIF, the distributions will be taxable, under the normal rules of Subchapter J of the Code. However, regardless of the method of termination, the trustee will be required a final return for the PIF. The trustee, for the final year, will issue final forms K-1 to the income beneficiaries. Regardless of the method of termination, the K-1 will reflect distributions made during the year, if any, prior to termination. In addition, if distributing the actuarial value of the income interest to one or more participants terminates the PIF, the K-1s issued to those participants will reflect additional amounts reportable under IRC §662.

Self-Dealing Rules

IRC §4947(a)(2) extends the prohibition on self-dealing transactions applicable to private foundations to pooled income funds. This should not be a problem for terminations described above in which the donor transfers his/her interest in the PIF to the public charity sponsoring the PIF since the charity is not a disqualified person for purposes of the self-dealing rules. But a termination of the PIF trust, with an actuarial division of its assets between the income beneficiaries and the charity, could give rise to self-dealing, since under IRC §4941(d)(1)(E), self-dealing includes a transfer of assets from a PIF to the donor that funded the PIF, or individuals such as a spouse or child related to the donor. However, IRC §4947(a)(2)(A) provides an exception for amounts payable under the terms of the trust to income beneficiaries. While this exception is clearly addressed to the annual distributions of income to the beneficiary over the term of the trust, it should be construed in a sufficiently broad manner to apply to terminating distributions resulting from the actuarial division of the PIF trust between the income beneficiaries and the charity.

Case Study

The College gift planner, John, has undertaken an analysis of the PIF sponsored by College, since at every meeting of his development committee, the same item always appears on the agenda: What do we do with the pooled income fund? There are a number of reasons for the committee's dissatisfaction with the College PIF. First and most disappointing is the lack of donor response--the College has not had a new PIF donor in over 10 years, even though the giving vehicle is regularly promoted in brochures, newsletter pieces, and other promotional materials.

As older participants have died, there are only three participants in the PIF, and total PIF assets have dwindled to $300,000. In the meantime, assets developed in the College planned giving program have grown like crazy since John has successfully developed an impressive portfolio of CRTs and several large charitable lead trusts, and the donor response to the gift annuity program increases every year.

John learns that the income payable from the PIF to participants has fallen with interest rates generally. Moreover, administrative expenses have skyrocketed--the large bank that has served as trustee of the PIF for many years charged its fee as a percentage of assets under management, with no minimum fee. But starting this year, the bank is imposing a minimum fee that has the effect of increasing fees for PIFs with total assets of less than $500,000. Taking these factors into account, the net return of the PIF declined from 5% two years ago to 4% last year, and taking into account the fixed cost of the trustee expense, will decline to 3% this year. John values the income interest of each of the three participants in the PIF, using the 5% return, which is the highest over the three years:

Name Age PIF Account Value of Income Intrest
Alfred 90 $100,000 $18,247
Betty 80 $100,000 $29,942
Chuck 70 $100,000 $44,126
Total $300,000 $92,315

John determines that the best thing to do for the College planned giving program is to terminate the PIF--a vehicle that just isn't working for the College--in order to focus on vehicles that are working. Reviewing the alternatives he could present to these donors, John initially observes that he would like to keep each of them as donors, and would therefore like to avoid actuarial division of the distribution of assets except as a last resort, and focuses initially on offering to establish a charitable remainder annuity trust for each of these donors, funded with his or her income interest in the PIF. However, his development committee has set a $50,000 minimum for CRTs, and the income interests of all three accounts are below this figure. Since John doesn't wish to solve one problem by causing another, he shelves the CRT alternative.

The plan. John's proposal is to inform the PIF donors by letter of the College's intention to terminate the PIF, and explain to them the reasons why. The letter will explain that each donor will receive cash equal to the actuarial value of his or her income interest in their PIF account, unless the donor chooses one of two gift alternatives. First, the donor may wish to make an outright gift of the entire income interest, entitling the donor to an income tax deduction for the entire value thereof. Second, the donor may wish to fund a gift annuity that will replace the PIF income the donor would otherwise receive and entitle the donor to a smaller tax deduction.

To make the gift annuity alternative as attractive as possible, John would like to illustrate gift annuities that will go beyond replacing this year's anticipated income from the PIF of $3,000 per donor, and instead replace the annual income of two years ago of $5,000 per donor. But when John sits down at his computer and does the calculations to support such a proposal, he learns that he has a problem using this concept for both Alfred and Betty: Funding an annuity of $5,000 per year with an asset valued at $18,247 for someone 90-years-old will not pass the 10% requirement of IRC §514(c)(5). John notes that an annuity of $4,700 is about the maximum he could offer Alfred. In Betty's case, funding an annuity of $5,000 with assets valued at $29,942 also won't qualify. On the other hand, a $5,000 annuity for Chuck will pass the 10% test.

At the next meeting of the development committee, when "What do we do with the pooled income fund?" comes up on the agenda, John presents his proposal for termination of the PIF and the proposal is approved by the committee.

Outcome. John sends letters to Alfred, Betty, and Chuck, informing them of the plan by the College to terminate the PIF. He precedes each letter with a telephone call alerting each donor that the letter is coming and follows up with a meeting with each donor.

Alfred reminds John that he was chair of the development committee when the PIF was first started (and when John was in elementary school), and the main reason he funded a pooled income fund gift rather than an outright gift was to kick off the PIF with a lead gift. He didn't need the income then, and he doesn't need it now. Since his accountant complains about receiving so many K-1s from Alfred's various income sources, he welcomes the chance to simplify his accountant's life while making a nice gift to the College toward the scholarship fund he has established and getting a nice tax deduction. Alfred agrees to assign his income interest in the PIF to the College.

When John meets with Betty, he is sorry to discover that her health has declined seriously since their last visit. Her condition makes it unlikely she will survive to her life expectancy of over nine years, making the proposed gift annuity less attractive for her. At the same time, her condition has created expenses that she could really use some additional resources to pay. Betty determines that the best alternative for her would be to receive cash of $29,942--the value of her income interest in the PIF.

Chuck has recently retired, and has been planning on his PIF income stream as part of his retirement income. He has watched with distress as the income has declined. He is very receptive to the idea of replacing his PIF interest with a gift annuity of $5,000 per year. This will not only put his retirement income on a more secure footing, he will also receive a charitable income tax deduction of $5,141 and convert half of his income from ordinary income to long-term capital gains.

John reports back to his committee that he has developed additional gifts of $23,388--the total of Alfred's outright gift of his PIF interest and Chuck's CGA gift of his PIF interest, and that Betty is agreeable to cooperating with the College attorney to terminate that PIF by written consent, allowable under state law without a court proceeding. Following his report, the PIF item disappears from the committee agenda forever.

An Alternative To Termination

What if the sponsoring charity has no complaints concerning its PIF other than the inadequate returns that it finds result from investing in bonds and other fixed income vehicles, and the frustration of being unable to replicate the types of returns distributed to beneficiaries of CRTs? Would it be possible to create a new PIF, or to reform the trust agreement of an old one, with a unitrust formula for calculating distributions to income beneficiaries?

The pooled unitrust fund. Charitable remainder unitrusts have become widely accepted by donors, in large part thanks to the success of gift planners illustrating how income recipients benefit from the unitrust formula. Yet, many organizations find that it is not cost effective to offer CRTs that are funded below a certain level. Rather than have charitable gift annuities, which are great but which provide a fixed payment to the annuitant without the possibility of sharing in total investment returns, as the only small-gift alternative to CRTs, would it be possible to create a PIF where distributions to the beneficiaries are made using a unitrust formula--a fixed percentage of the fair market value of trust assets, valued annually?

PIF requirements. One requirement for a trust to qualify as a PIF is that each income beneficiary must receive "income" proportionate to his/her interest in the trust based on units of participation in the PIF. "Income" for this purpose is fiduciary accounting income as defined under IRC §643(b). This is generally traditional income items--interest, dividends, rents, and royalties--under the principal and income law of the relevant state, which often allows the trustor to deviate from these "default" rules by otherwise providing in the trust instrument.

The NIMCRUT analogy. Planners have, for years, been fiddling with the definition of fiduciary accounting income by drafting provisions into trust agreements to ensure certain trust receipts are included in income for the purposes of the net income limitation and calculating make-up distributions. An example is allocation of post-contribution capital gains, which would ordinarily be principal under the default rules, to trust income to allow distribution of these realized capital gains.

The IRS in private letter rulings has approved many of these provisions. Would the IRS approve similar deviations in the context of a PIF? More specifically, if the trust agreement provides that "income" shall be the unitrust amount, could the IRS consider this to not "depart fundamentally from concepts of local law"--the standard applied by Treas. Reg. §1.643(b)-1? Maybe.

One of the benefits of a PIF, which unlike a CRT is not tax exempt, is that it is allowed a special deduction for recognized long-term capital gains that, pursuant to the governing instrument, is permanently set aside for charitable purposes--in other words, not payable to PIF income beneficiaries. Would this benefit be lost if the PIF used a unitrust formula to calculate distributions? Possibly not, since the deduction offsets gain "which pursuant to the terms of the governing instrument? is permanently set aside." If the governing instrument provides that all recognized capital gains in excess of the amount necessary to make the unitrust distribution shall be permanently set aside, perhaps this could still qualify for the deduction. Maybe not. Treas. Reg. § 1.642(c)-6 provides the method for calculating the deduction for a charitable gift made via a PIF, which is determined actuarially based on the highest rate of return earned by the PIF for the three years preceding the gift.

Of course, a very different method is used to calculate deductions for contributions to a CRT. Moreover, the IRS has already expressed its displeasure with multiple-donor CRTs (finding, in Ltr. Rul. 9547004 that a CRT with multiple donors isn't a trust at all and is taxable as an association). The bottom-line? On the one hand, there is little doubt that the pooled unitrust fund could be a terrific weapon to add to our gift planning arsenal. On the other hand, even gift planners who are accustomed to working without a net wouldn't want to attempt this one without a ruling!

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