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CHARITABLE GIVING
WITH UNCLE SAM AS YOUR PARTNER

PART ONE

by Christopher G. Stoneman

In this and the next article we will be taking a look at the estate planning ramifications of gifts to charity - hopefully in sufficient depth to give at least a nodding acquaintance with the income-, gift- and estate-tax rules as viewed primarily from the standpoint of the donor. There is also a substantial body of law, beyond the scope of our present discussion, which governs the conduct of charities and the organization and operation criteria with which they must comply if they are to be tax-favored recipients of donations - tax-favored both in terms of their supporters' tax deductions and of their own exemptions from income taxation.

So-called "charitable deductions" are available for gratuitous transfers by individuals, trusts, estates and corporations in the computation of their "taxable income"; in figuring an individual's "taxable gifts"; and in arriving at an estate's "taxable estate". Unfortunately, there are definitional differences between the charitable deductions for the three taxes, as the following discussion is intended to demonstrate.

Individuals' income tax. For income-tax purposes the primary statutory rules are found in Section 170 of the Internal Revenue Code, one of its longer provisions, which describes a discouragingly complex set of hoops through which many would-be philanthropists must pass before claiming their deductions. Space does not permit a comprehensive description of the obstacle course; but its main provisions may be summarized as follows.

There must be

(i) a transfer of property or money
(ii) to or "for the use of" a qualifying donee
(iii) with no material consideration for the gift

The donor who meets these three criteria may claim a deduction in arriving at his taxable income for the year of the gift up to but not in excess of a certain percentage of his "contribution base" (gross income less certain deductions) and may carry forward for the next five years any excess contribution and take a corresponding deduction in each year that any part of the gift remains undeducted.

Example—In 1998 Mortimer gives $10,000 to his favorite public charity but because of the income limitation noted is only able to deduct $2,500. If Mortimer's income picture remains the same and he makes no further charitable gifts until 2002, he may deduct $2,500 in 1999, $2,500 in the year 2000, and a final $2,500 in 2001.

The deduction percentages of the contribution base are 50% and 30%, depending upon the classification of the donee. More specifically, it must be determined whether the organization is a "private foundation", on the one hand, or a "publicly supported charity" or an "operating foundation" on the other.

In the case of a publicly supported organization (a college, hospital or church would be a typical example), or an "operating" private foundation, the general rule is that the donor may deduct the gift up to 50% of his contribution base for the year in which it was made and may carry the excess forward as Mortimer was required to do. In the case of a "private foundation" (negatively defined by law in terms of what it is not rather than what it is - but basically an organization whose support is derived from a single donor or a small group of donors), the applicable limitation is 30%. There is also an excess carryover provision in the law for gifts to 30% organizations. A charitable income tax deduction which has not been totally used up during a donor's lifetime, whether to a "30%" or a "50%" donee, evaporates at his death.

For a gift to qualify for an income tax deduction, the recipient must be "a corporation, trust, or community chest fund, or foundation" which was created or organized in this country. This is sometimes referred to as the "domestic organization" rule of the statute.
We should also take a look at the charitable deduction treatment of "split-interest" gifts, i.e., gifts that are both charitable and noncharitable in nature - especially what are known as "charitable remainder trusts" and "gift annuities."

1. Charitable remainder trusts. Under the old dispensation, a person could generally transfer money or property to a trustee to administer under a trust agreement which reserved all of the income from the trust to the donor or some other individual for life or a fixed term of years and then gave whatever remained at the death of the noncharitable beneficiary to the charity or charities which the donor had designated. This relatively straightforward arrangement gave the donor an income tax deduction based upon the actuarially determined present value (i.e., value when the trust was set up) of the charity's postponed right to receive the trust principal at the death of the income beneficiary.

In 1969 Congress changed the rules and provided that if a transfer to a "split-interest" trust was to give an income tax deduction for the value of the charitable remainder interest - i.e., the right to take the trust property on the income beneficiary's death or at the end of the term of years - it must comply with the very specific requirements of another Code provision, Section 664.

This new provision created two tax-exempt entities: the charitable remainder annuity trust, or "CRAT"; and the charitable remainder unitrust, or "CRUT". Be it a CRAT or be it a CRUT, there are several common characteristics; there are also two major differences.

The CRAT is a trust from which a fixed payment is to be made at least annually to one or more noncharitable beneficiaries for a term of not more than 20 years or, in the case of individuals, for the life or lives of the individuals who in either case (term of years or life estate) must be alive when the trust is established. The payment must be made annually and must either be stated as a dollar amount or as a percentage of the initial value of the property placed in trust. In either case it must be at least 5% and not more than 50% of that value. No additions may be made to the trust. The remainder interest, determined at the outset must be worth at least 10% of the initial (and only) contribution.

Example—Hugh transfers stocks worth $500,000 to a CRUT which is to pay him and his wife, Charlotte, $30,000 a year for their joint lives and the life of the survivor of them. At the survivor's death the trust ends and whatever remains goes one half to Hugh's alma mater and one half to Charlotte's. This is a valid CRAT and Hugh will be entitled to treat the present value of the remainder interest as a charitable contribution in the year the trust is created. The amount of the contribution will depend upon the actual factor for the actuarially determined length of time that two individuals of Hugh's and Charlotte's ages will survive; and its current or postponed deductibility will depend upon the contribution base. How long Hugh and Charlotte actually live is irrelevant.

Example—Matilda creates a CRAT for her elderly housekeeper, Sarah, who is to receive 8% of the amount with which Matilda funds the trust. At Sarah's death the trust is to go to whatever charity Matilda has designated in her will or, if she fails to make an effective designation, to the Salvation Army. Again, a valid CRAT. Given Sarah's advanced years, the income tax deduction will be high in actuarial reflection of her modest life expectancy.

The CRUT is a little more complex than the CRAT and comes in two slightly differing forms. In the plain vanilla version a fixed percentage (not less than 5% and not more than 50%, as in the case of the CRAT) of the annually determined value of the trust property is required to be paid out each year. The payee criteria are the same as for the CRAT; there is a similar 10% value-of-remainder rule. Additions to a CRUT are permissible.

Example—On January 1, 1998, Seymour transfers stock with a value of $300,000 to a CRUT for his own benefit, with the provision that he is to receive a 6% payment for life. At his death the trust is to go to the public library in the town where he lives. The amount Seymour is entitled to receive in 1998 is $18,000. Assume that after Seymour's 1998 payment has been made the CRUT's value on January 1, 1999 is $320,000. He will be entitled to receive $19,200 in 1999. The market takes a tumble in 1999 and Seymour's 2000 payment will be proportionally reduced.

A more involved version of the CRUT is the income-with-make-up provision. Instead of the straight percentage payout, the trust provides that if the trust's income in any given year is less than the percentage amount, the trust pays only that year's income unless there have been one or more prior years in which the income exceeded the percentage amount. In that event, the annual income for all of the prior years is aggregated, as is the percentage amount for all such years. The latter is deducted from the former, and from the excess there is distributed to the noncharitable payee the amount by which the percentage amount for the current year exceeds that year's income.

Example—On February 1, 1995 David set up a 7% unitrust of this kind for the benefit of his grandmother, Laura, with remainder at her death to the American Red Cross. The annual February 1 values of the trust from 1995 through 1999 and the corresponding percentage amounts were as follows:

1995 1996 1997 1998 1999
$500,000 $490,000 $530,000 $410,000 $420,000
$ 35,000 $ 34,300 $ 37,100 $ 28,700 $ 29,400

The trust's income for each of the five years was as follows:

1995 1996 1997 1998 1999
$ 31,000 $ 32,000 $ 30,000 $ 32,000 $ 31,000

1995 - In 1995 Laura receives $31,000 (the lesser of the CRUT's 1995 income and the 1995 percentage amount).

1996 - In 1996 Laura is entitled to $32,000 (the lesser of the CRUT's 1996 income and the 1996 percentage amount).

1997 - In 1997 the income is again less than the percentage amount ($30,000 versus $37,100).

1998 - In 1998, however, the situation is reversed and income exceeds the percentage amount by $3,300. The aggregate of the percentage amounts for the preceding three years is $106,400 - $13,400 more than the income; the amount to which Laura is entitled remains at $32,000 since there was no prior year in which income exceeded the percentage amount.

1999 - Income again exceeds the percentage amount, this time by $1,600. The 1995-1998 aggregates are $125,000 (income) and $135,100 (percentage amounts) respectively. Laura is therefore entitled to receive an additional $1,600 (since the prior years' excess of percentage amounts over incomes is greater than the current year's deficit).

As noted, the CRAT or CRUT, as the case may be, enjoys an exemption from federal income tax. This means for example, that it may sell low-basis assets which it is given without being taxed on the gain it realizes upon the sale of those assets. Therein, of course, lies one of the CRT's major attractions. Taxpayers holding valuable non-income producing assets with very low cost bases may have them made productive of a cash flow where none was formerly available.

Recognizing that it may take time for a trustee to convert donated non-income producing property into income-producing property, the IRS has indicated that if the trust instrument so provides and if certain conditions are met, it plans to allow the trustee of a CRUT (but not of a CRAT) a distribution-free period in which it may make the conversion. This will occur when final regulations are issued. During this period no distributions need be made to the noncharitable beneficiary; after the period has ended, the regular distribution requirements kick in. This type of arrangement is known familiarly as a "flip" provision.

No discussion of the charitable remainder trust would be complete without a word or two about the taxation of the trust's noncharitable beneficiary or beneficiaries to whom the CRT makes its annual or more frequent distributions. As one might expect, those distributions are at least partially taxable. Here's how it works.

The distribution is treated, first, as "ordinary income" to the beneficiary - and therefore fully taxable - to the extent that at the time of the distribution the CRT had ordinary income for the current year or accumulated and not yet distributed ordinary income from a prior year or years.

If the distribution exceeds current and ordinary income, it is deemed to be made up of current and then accumulated capital gain income. Only after these two categories (ordinary income and capital gain income) have been exhausted is the distribution deemed to consist of tax-free income, current or accumulated; and in the unlikely event that all three categories of income have been "cleaned out", the distribution is regarded as a nonreportable return of principal.

Example—Andrew sets up an 8% CRUT on January 1, 1998. He transfers cash of $200,000 and a growth stock with a basis of $5,000 and a value of $40,000. On July 1, 1998 the trustee sells the stock for $42,000. During the year 1998 the trust receives $13,000 of fully taxable interest and dividend income and distributes $19,200 to Andrew (8% of $240,000). Andrew will be required to include $13,000 as ordinary income and $6,200 as capital gain ($19,200 minus $13,000). If the distribution to Andrew in 1999 exceeds that year's ordinary income, the difference between the distribution and the trust's ordinary income will be treated as capital gain (assuming that the capital gain realized in 1998, now "accumulated" capital gain, is enough to make up that difference).

2. Gift annuities. Another popular form of charitable gift is the gift annuity. The donor-annuitant and the charity enter into an agreement under which the donor transfers cash or property to the charity in exchange for the charity's promise to pay him a specified annuity (or to pay the annuity to another person) for the donor's or the other person's life or for a term of years. At the end of the annuity period the charity receives whatever remains. The annuity rate is less than the annuity rate which would be obtainable in the marketplace, hence the gift element.

Example—Lester Smith is approached by the Salvation Army whose work he has long admired. He pays $100,000 in exchange for an annuity of $5,000 to be payable at monthly intervals beginning when he turns 72 and then at his death to continue for the benefit of his wife for life if she survives him. He will be entitled to an income-tax deduction for the actuarially determined value of the charity's interest, which will reflect Mr. and Mrs. Smith's life expectancies and the periodicity of the annuity payments. Mr. and Mrs. Smith will be entitled to exclude a portion of each annuity payment from their gross income, representing the return of Mr. Smith's investment in the annuity contract, and will pay income tax on the excess. If and when the entire $100,000 investment has been recovered, the whole of each annuity payment becomes taxable.

A gift annuity may also be funded with the transfer of property rather than cash, in which case there will probably be an element of capital gain in the transaction on which the annuitant will be required to pay tax ratably over his or his and his wife's life expectancies.

The gift annuity is notably different from its CRT counterpart in that it constitutes a contract on the part of the charity which is therefore required to make the contracted annuity payments regardless of the value or even the continued existence of the money or property placed in the annuity.

GO TO PART TWO OF THIS ARTICLE

Christopher Stoneman

The complete list of Christopher Stoneman articles is: